This part covers Net Present Value Technique (NPV))
Note: This is a third part of earlier articles “Analysis on Capital Budgeting Techniques”. Start reading this Part III article only after reading the Part I &II. Articles available in the following links:
Part I:
Analysis on capital budgeting techniques
Part II:
Analysis on capital budgeting techniques  Part II
(Watch out for Part IV – VI in the coming weeks)
Manu takes Vinu through Future Value, Present Value and Net Present Value (NPV) Concepts and teaches him how to take Investment Decision using NPV Technique:
Manu 
Good! We have already understood the “Payback period” concept. At that time, I told you, Don’t look merely at cash flows but you should also consider Time Value of Money. 

Vinu 
Yes Manu! Our example Project of Rs.100 Crs has cash flows for 8 years and it’s total is Rs.409.40 Crs. 

Manu 
Yes! Here total cash flows doesn’t make much sense. You have to find the present value of the cash flows. If you want to find the present value of the cash flows, you should know what is the expected return? If you recollect our Rs.1000 Example in Time Value of Money, we were able to find the present value, because of 10% expected rate of return. So, to proceed further, we should know what is the expected return for our project? 

Vinu 
We have already calculated that. We arrived at Weighted Average cost of capital as 20%.


Manu 
Yes Vinu! Already we have calculated WACC as 20%. But we have not considered effect of tax on Interest while calculating cost of capital! 

Vinu 
That confuses me! 

Manu 
Vinu! We know, when we pay interest, we will save tax on interest. 

Vinu 
Yes! 

Manu 
In our example, Debt is Rs.50cr, Interest is 15% on debt. 

Vinu 
Correct! 

Manu 
We also agreed tax benefit on Interest will reduce interest cost. 

Vinu 
Yes! 

Manu 
So please work correct cost of interest. 

Vinu 
It should be 15% x 70% = 10.50% 

Manu 
Yes! You have to adjust 30% tax rate and only 70% of interest rate is your cost now. Good! Please tabulate your cost of capital table! 

Vinu 
Let me do that!


Manu 
Good! Your table now shows your funds are in equal proportion. Weightage will change according to the mix. And your WACC is only 17.75% and not 20%. 

Vinu 
Correct! This makes more sense! WACC has come down due to tax effect. 

Manu 
Yes! You have to do this tax adjustment in cost of capital computation, because your cash flows were arrived after considering tax effect on interest. 

Vinu 
Yes!!! Now I understand the link between the two! 

Manu 
Good! So now your project should generate a return of 17.75% every year for 8 years. Can you please prepare a table to show what would be the cash that have to be generated for this 8 years? 

Vinu 
Yes! I’ll do that!


Manu 
Good! Above table shows, if you invest Rs.100crs @ 17.75%, it should become Rs.369.56 Crs in 8 years. 

Vinu 
Yes! Rs.369.56 Crs received after 8 years is equivalent to Rs.100 Cr now, if my return expectation is 17.75% 

Manu 
Yes! Now total every year cash flows which you have estimated for the project. 

Vinu 
It is Rs.409.40 Crs which is greater than Future Value of Rs.369.56cr. 

Manu 
Yes! So this answers you that this project will earn more than your expected return of 17.75%. 

Vinu 
Yes Manu! 

Manu 
Now we have made this analysis and derived result by thumb rule only. Let us put it in a more professional way. 

Vinu 
How? 

Manu 
You please tabulate all the cash flows for 8 years 

Vinu 
Ok


Manu 
Now you have to find PV of all these year cash flows. 

Vinu 
How do we calculate that? 

Manu 
How did you calculated FV of an investment? 

Vinu 
Future Value is simple. I have to calculate Interest on principal. Then I have to add it with principal. This will give me FV. 

Manu 
Can you make it as formula? 

Vinu 
I’ll try. Future Value = Principal + Interest 

Manu 
Break down further. 

Vinu 
FV = Principal + [Principal x Interest Rate] = Principal [1 + Interest] 

Manu 
Fine! But this formula will take you for one year only. What will you do if you have to calculate more number of years.Say 2nd year, 3rd year and so on? 

Vinu 
I’ll calculate that many times. 

Manu 
Rather raise the number of times to the power in the formula. It means, if you have to calculate many times or for many period, you take it to the power. 

Vinu 
So, I should have no. of period in power? 

Manu 
Yes! Have your formula like this. FV = PV [1 + i] n 

Vinu 
Here ‘PV’ Stands for Present Value, ‘i’ Stands for Interest & ‘n’ Stands for no. of period. Is that correct? 

Manu 
Yes! Through ‘PV’ you can find ‘FV’ and vice versa. 

Vinu 
Ok! But why did you started saying all these? 

Manu 
I wanted to give you the formula for finding ‘PV’. 

Vinu 
Ok! 

Manu 
Now you know, FV = PV [1 + i] n 

Vinu 
PV = FV /[(1+i) n] 

Manu 
Good! Now use this formula to find out ‘PV’ of all the cash flows for 8 years. In this formula, the portion “[ 1/(1+i) n]” is called as factor which you will multiply with Cash Flows to derive Present Value. 

Vinu 
I got it! 

Manu 
Now can you find Present Value of our cash flows for 8 years, at expected rate of return of 17.75% ? 

Vinu 
Ok!


Manu 
You have done it beautifully. Let me check your PV Factor calculation for year 1 __1__= ______1____ (1+i) n (1+17.75%)1 = _____1____ (1+0.1775) 1 = 0.849. You got that right! Let me also check on random, say, PV factor for year 5. __1__= ______1____ (1+i) n (1+17.75%) 5 = _____1____ (1+0.1775) 5 = __1__ 2.2636 = 0.442 SSo you are correct! It matches with your PV factors in your table. 

Vinu 
Yeah…../p> 

Manu 
NNow, multiply this PV Factors with Cash Flows to get Present Value of Cash Flows. 

Vinu 


Manu 
Now look at your table. You are earning Rs.409.40 Crs cash flows over a period of 8 years but its present value is only Rs.197.57crs 

Vinu 
True! PV is less than 50% when compared with actual cash flows because of higher expected returns, I believe! 

Manu 
Yes! You are correct. If you expect high returns, PV of future cash flows will be low. But what is important is you have to compare the PV of future cash inflows with PV of cash outflow. 

Vinu 
Ok! In our case, PV of cash out flow is Rs.100Crs. I think we need not make any special workings because it is being spent now. PV of cash inflows is Rs.197.57cr 

Manu 
Look at it! It sounds like great deal. It’s like you give Rs.100 Cr now and simultaneously taking back Rs.197.57cr You not only get back your Rs.100crs but also get additional Rs.97.57cr 

Vinu 
Yes! This creates greater interest in the Project. 

Manu 
Yes and it would! Because you have brought your 8 years future picture compressed into single value and you can compare that with your investment amount to take a decision. 

Vinu 
It’s really great! Does this methodology or analysis has any technical name? 

Manu 
Yes! It has. It is called “Net Present Value” method to evaluate an investment decision 

Vinu 
Great! 

Manu 
In this method, you will Find ‘PV’ of cash inflows and compare it with ‘PV’ of cash out flows. If ‘PV’ of Inflows is greater than or equal to ‘PV’ of cash out flow then those projects are viable projects. 

Vinu 
Viable? 

Manu 
Yes! Because those projects not only generates profits, but their profits also matches the expected level. If PV of cash inflow matches PV of out flow, it generates expected return and you know the rest, I believe. 

Vinu 
Yes Manu! I understand. Let me tabulate our example.


Manu 
Good! NPV of your project is positive and so it is a viable project. 

Vinu 
In case of multiple projects, out of which one has to be selected, how we should approach? 

Manu 
In case of multiple projects, select the project with highest NPV. Because highest NPV means, your project earns more than the expected returns. When the project earns more than the expected returns, it will result in creation of wealth for the owners of the company. 

Vinu 
Correct! Any Investment Decision should have the objective of creating wealth for the promoters. Thanks for this clarity in NPV concept. 

Manu 
So, in this example itself you have understood the concept of
Good! 

Vinu 
Thanks Manu! 
Part IV will be continued next week….
Author:
CA N Raja, B.Com.,PGDBA, ACA
Chartered Accountant
nrajca@gmail.com
www.concells.in/elearning
For more such articles from Manu and Vinu, access www.concells.in/elearning
Tags :Others