Chapter 3: The Economic

Evaluation of Investment
Proposals
1. Time Value of money
2. Net present value (NPV)
3. Graphical representation of NPV
4. Internal rate of return (IRR)
5. An economic rationale for IRR rule
6-1

Time Value of Money

Definition: A rationale human being would not value

the opportunity to receive a specific amount of money
today equally with the opportunity to have the same
amount at some future date. Most human beings
value the opportunity to receive money now higher
than receive one or two years from now the same
amount. The additional amount that is required for
receiving after a certain time period in future than the
amount received today is known as time value of
money. That is this additional amount is given as
value of time waiting. Actually the percentage change
in value of a certain amount of money for a certain
time period gap is known as time value of money
6-2

Rationale for Time Value of

Money

Time value of money is existed for the

following reasons:

Future uncertainty
Sacrifice present consumption or preference
for higher consumption in future period
Alternative investment opportunities i.e.
opportunity cost.
Sacrifice of cash holding preference
Inflation
6-3

Terminologies
Present value: The value of today that is
obtained by discounting a future cash flow
or a series of cash flows by the opportunity
cost of fund as discount rate.
Future value: The amount or value will be
obtained at a certain time point in future of
a cash flow or a series of cash flows by
compounding at a given interest rate or
opportunity cost over a certain time period.
6-4

Terminologies
Discounting: The process of finding the
present value of a cash flow or a series
of cash flows by using a given discount
rate.
Compounding: The arithmetic process of
determining the final value of a cash
flow or a series of cash flows by using a
certain interest rate
6-5

Terminologies

Simple interest rate: The interest rate

that charged only on the principal
amount for a specific period is called
simple interest rate.
Compound interest rate: The interest
rate that is charged both on principal
and interest amount period to period is
called compound interest rate.
6-6

Terminologies

Installment: Periodic payments or receipts related

to any transaction or contract are known as
installment.
Annuity: The equal amount of cash flow incurred at
equal time interval is called annuity.
Annuity due: The annuity under which the cash
flow is incurred at the beginning of each period is
called annuity due.
Annuity immediate: The annuity under which the
cash flow is incurred at the end of each period is
called annuity immediate.
6-7

Terminologies

Perpetuity: The annuity under which the cash flow

is incurred for a infinite period of time is called
Perpetuity..
Nominal interest rate: Rate of interest stated in an
agreement for transferring fund from one party to
another party is known as nominal interest rate.
Effective interest rate: Rate of interest ultimately
paid by the user of fund to the supplier of fund by
taking into consideration of timing frequencies and
other charges is known as effective interest rate.
6-8

Definition of capital
investment techniques
1. NPV: NPV is defined as the summation of the
present values of cash flows after tax in each
year over the project or investment period
minus the summation of present values of net
cash outflows in each year during that period.
2.

graphical presentation of
relationship between a projects and the firms
cost of capital or discount rate is called NPV
profile. A graph that plots a projects NPV
against the discount rates is defined as the
projects NPV profile.
NPV

Profile:

The

6-9

Definition
3. IRR: The discount rate that makes equal the present
value of a projects future cash inflows to the present
value of its total costs. Equivalently the rate that
forces the net present value to equal zero is internal
rate of return.
4. Modified IRR: The discount rate at which the present
value of a projects cost is equal to the present value
of its terminal value, where the terminal value is
found as the sum of the future values of cash inflows,
compound at the firms cost of capital.
6-10

Definition
5. Net Terminal Value: When terminal amount of any

project obtained from reinvestment is discounted into

present value at a certain required rate of return and
the present value of cash outlays is deducted from the
first, then the net result is known as net terminal value.
6. Profitability Index: It measures the present value of
returns per unit of investment is called
profitability index. It is defined as the ratio that is
obtained dividing the present value of future cash
inflows by the present values of cash outflows.
6-11

Example
An asset can be purchased for Tk.7,50,000 that will
provide net benefits Tk.1,00,000; Tk.3,00,000;
Tk.2,10000 & Tk.280000 in years 1, 2, 3 & 4
respectively. Reinvestment rate is 8% and cost of
capital is 10.5%.Would it be wise to purchase the
asset under the following techniques?
(i) NPV
(ii) IRR (iii) PI
(iv) MIRR
(v) NTV
6-12

An Economic Rationale for NPV

Rule
1. It recognizes time value of money.
2. It considers all cash flows occurring over
the entire life of the project to calculate its
rate of return.
3. It is consistent with the shareholders
wealth maximization goal.
6-13

An Economic Rationale for NPV Rule

4. It does not use the concept of required rate

of return.
5. It is easily understandable to the business
executives and non-technical people.

6-14

An Economic Rationale for IRR

Rule

If the internal rate of return exceeds the cost of

capital of the fund used to finance a
project, a surplus remains after paying for
the capital and this surplus accrues to the
firms stockholders. Therefore, taking on a
project whose IRR exceeds its cost of
capital increases the value of the firms
stock.
6-15

Traditional measures of investment

worth
Payback Period Method: Payback method means
how many years will it take for the cash benefits
to pay the original cost of an investment,
normally
disregarding
salvage
value.
It
measures the number of years required for the
cash flow after tax to payback the original
outlay required in an investment proposal. If the
project generates constant annual cash flows,
the payback period can be computed by
dividing cash outlay by annual cash inflow.
6-16

Traditional measures of investment

worth
Discounted Payback Period: The length
of time required for an investments
discounted cash flows to equal its initial
cost is known as discounted payback
period. Based on discounted payback
rule, an investment is acceptable if its
discounted payback is less than some
pre-specified number of years.
6-17

Traditional measures of investment worth

Example of payback and discounted payback:

Yea Cash flows

r
Undisc Disc
1
2
3
4

Cum cash flows Initial

cost is
Undisc Disc
Tk.300
000;
10000 8888 10000 88889 cost of
0
9
0
capital
10000 7901 20000 16790 is
0
2
0
1
12.5%
10000 7023 30000 23813
0
3
0
4
10000 6243 40000
0
0
0

30056
4

Payback
=3
years
Discoun
ted
payback
=4
years
(apprx)

6-18

Traditional measures of investment

worth
Average/Accounting Rate of Return: The
accounting rate of return also known as
the return on investment, uses accounting
information as revealed by financial
statement to measure the profitability of
an investment. It is found by dividing the
average after tax profit by the average
investment. The average investment
would be equal to half of the original
investment if it is depreciated constantly.
6-19

Traditional measures of investment

worth
Example of Average/Accounting Rate
of Return: Required investment is
Tk.500000 and project life expectancy
is 5 years. Expected net income aftertax
are
Tk.100000,
Tk.150000,
Tk.50000, Tk.0 & (Tk.50000) in next 5
years. Average net income is Tk.50000
and average investment/book value is
Tk.250000. So average rate of return is
20%.
6-20

Problems
1. What will be present value of Tk.500000 will be
received 8 years from now at 15% discount rate?
2. Find the present value of Tk.20000, Tk.25000,
Tk15000 and Tk.30000 will be received in years 0, 1,
2
&
3
respectively
by
considering
discount/compound rate is 10%.

3. Find the present value of Tk.50000, Tk.28000,

Tk.52000 and Tk.40000 will be received in years 1, 2,
3
&
4
respectively
by
considering
discount/compound rate is 10%.

4. You have a choice of receiving 10 payments of

Tk.85000 a year, with the first payment to be
6-21
21
received one year from now, or Tk.500000 in cash

Problems
5. You have a choice of receiving 15 payments of
Tk.50000 a year, with the first payment to be
received just now, or Tk.600000 at a time today. If
your opportunity cost is 15% which would you prefer?

6. RIC Inc. manufactures and sells tobacco products in

the market. The company receives about Tk.200000
cash flow each year from the product after all
expenses, including taxes. Samson Ltd has recently
offered to buy the product for Tk.1500000. RICs
opportunity cost is 11%. Should it sell the product if it
thinks its life expectancy is indefinitely long?

7. What will be future value of Tk.300000 deposited in

a bank after 5 years from now22at 9% interest rate?6-22

Problems

8. Find the future value of Tk.10000, Tk.30000,

Tk.45000 and Tk.60000 will be received in years 0, 1, 2
& 3 respectively by considering compound rate of 11%.

9. Find the future value of Tk.30000, Tk.20000,

Tk.25000 and Tk.30000 will be received in years 1, 2, 3
& 4 respectively by considering compound rate of
10.5%.

10. ou have a choice of receiving 5 payments of

Tk.150000 a year, with the first payment to be received
one year from now or Tk.500000 at a time at the end of
6-23
23
the total period. If your opportunity
cost is 12% which

Problems

11. You have a choice of receiving 10 payments of

Tk.50000 a year, with the first payment to be
received just now, or Tk.750000 at a time at the end
of the total period. If your opportunity cost is 13%,
which would you prefer?

12. Contractual interest rate in a loan agreement is

16% and loan processing fee is 2%. What is the
effective interest rate of the loan if interest is
compounded monthly?
24

6-24

Homework
Questions & problems:
3.5, 3.6, 3.12 & 3.14

6-25