Discounted Cashflow (DCF)/Time-Adjusted (TA) Techniques:

 The characteristics of the DCF capital budgeting techniques is that they take into
consideration the time value of money while evaluating the costs and benefits of a project.
 It recognizes that cash flow streams at different time periods differ in value and can be
compared only when they are expressed in terms of a common denominator, that is,
present values.
 In one form or another, all these methods require cash flows to be discounted at a certain
rate, that is, the cost of capital. The cost of capital (K) is the minimum discount rate earned
on a project that leaves the market value unchanged.
 The second commendable feature of these techniques is that they take into account all
benefits and costs occurring during the entire life of the project.

Net Present Value (NPV) Method:

The first DCF/PV technique is the NPV. NPV may be described as the summation of the present
values of cash proceeds (CFAT) in each year minus the summation of present values of the net cash
outflows in each year. It correctly postulates that cash flows arising at different time periods
differ in value and are comparable only when their equivalents-present values-are found out.
The following steps are involved in the calculation of NPV:
 Cash flows of the investment project should be forecasted based on realistic
assumptions.
 Appropriate discount rate should be identified to discount the forecasted cash
flows. The appropriate discount rate is the project's opportunity cost of capital,
which is equal to the required rate of return expected by investors on investments
of equivalent risk.
 Present value of cash flows should be calculated using the opportunity cost of capital as
the discount rate.
 Net present value should be found out by subtracting present value of cash outflows
from present value of cash inflows. The project should be accepted if NPV is positive
(i.e., NPV > 0).
 The formula for the net present value can be written as follows:

where C1, C2... represent net cash inflows in year 1, 2..., k is the opportunity cost of capital, C0
is the initial cost of the investment and n is the expected life of the investment. It should be
noted that the cost of capital, k, is assumed to be known and is constant.

Acceptance Rule

It should be clear that the acceptance rule using the NPV method is to accept the
investment project if its net present value is positive (NPV > 0) and to reject it if the net
present value is negative (NPV < 0). Positive NPV contributes to the net wealth of the
shareholders, which should result in the increased price of a firm's share. The positive net
present value will result only if the project generates cash inflows at a rate higher than the
opportunity cost of capital. A project with zero NPV (NPV = 0) may be accepted. A zero
NPV implies that project generates cash flows at a rate just equal to the opportunity cost
of capital. The NPV acceptance rules are:
  Accept the project when NPV is positive NPV > 0
 Reject the project when NPV is negative NPV < 0
 May accept the project when NPV is zero NPV = 0
The NPV method can be used to select between mutually exclusive projects; the one
with the higher NPV should be selected. Using the NPV method, projects would be ranked
in order of net present values; that is, first rank will be given to the project with highest
positive net present value and so on.

Evaluation of the NPV Method

NPV is the true measure of an investment's profitability. It provides the most acceptable
investment rule for the following reasons:

Merits:

 Time value: It recognizes the time value of money-a rupee received today
is worth more than a rupee received tomorrow.
 Measure of true profitability: It uses all cash flows occurring over the entire life
of the project in calculating its worth. Hence, it is a measure of the project's
true profitability. The NPV method relies on estimated cash flows and the
discount rate rather than any arbitrary assumptions, or subjective
considerations.
 Value-additivity: The discounting process facilitates measuring cash flows in
terms of present values; that is, in terms of equivalent, current rupees.
Therefore, the NPVs of projects can be added. For example, NPV (A + B) = NPV(A)
+ NPV (B). This is called the value-additivity principle. It implies that if we know
the NPVs of individual projects, the value of the firm will increase by the sum of
their NPVs. We can also say that if we know values of individual assets, the firm's
value can simply be found by adding their values. The value-additivity is an
important property of an investment criterion because it means that each
project can be evaluated, independent of others, on its own merit
 Shareholder value: The NPV method is always consistent with the objective of the
shareholder value maximization. This is the greatest virtue of the method

Demerits:

 Cash flow estimation: The NPV method is easy to use if forecasted cash flows are
known. In practice, it is quite difficult to obtain the estimates of cash flows due to
uncertainty.
 Discount rate: It is also difficult in practice to precisely measure the discount rate.
 Mutually exclusive projects: Further, caution needs to be applied in using the
NPV method when alternative (mutually exclusive) projects with unequal lives,
or under funds constraint are evaluated. The NPV rule may not give
unambiguous results in these situations. These problems are discussed in detail in
a later chapter.
 Ranking of projects: It should be noted that the ranking of investment projects as
per the NPV rule is not independent of the discount rates. Let us consider an
example.
Suppose there are two projects-A and B-both costing ₹ 50 each. Project A
returns ₹100 after one year and ₹ 25 after two years. On the other hand,
 Project B returns ₹ 30 after one year and ₹100 after two years. At discount
rates of 5 per cent and 10 percent, the NPV of projects and their ranking are
as follows:

It can be seen that the project ranking is reversed when the discount rate is
changed from 5 per cent to 10 per cent. The reason lies in the cash flow
patterns. The impact of the discounting becomes more severe for the cash flow
occurring later in the life of the project; the higher is the discount rate, the
higher would be the discounting impact. In the case of ProjectB, the larger cash
flows come later in the life. Their present value will decline as the discount rate
increases.

Internal Rate of Return (IRR) Method

 The second discounted cash flow (DCF) or time-adjusted method for appraising capital
investment decisions is the internal rate of return (IRR) method.
 This technique is also known as yield on investment, marginal efficiency of capital, marginal
productivity of capital, rate of return, time-adjusted rate of return and so on.
 Like the present value method, the IRR method also considers the time value of money by
discounting the cash streams. The basis of the discount factor, however, is different in both
cases.
 In the case of the net present value method, the discount rate is the required rate of return
and being a predetermined rate, usually the cost of capital, its determinants are external to
the proposal under consideration. The IRR, on the other hand, is based on facts which are
internal to the proposal.
 While arriving at the required rate of return for finding out present values the cash flows—
inflows as well as outflows— are not considered. But the IRR depends entirely on the initial
outlay and the cash proceeds of the project which is being evaluated for acceptance or
rejection. It is, therefore, appropriately referred to as internal rate of return.
 IRR can be determined by solving the following equation for r:

where r = The internal rate of return, C 1..Cn = Cash inflows at different time periods, and C 0 =
Cash outlay at different time period

It can be noticed that the IRR equation is the same as the one used for the
NPV method. In the NPV method, the required rate of return, k, is known and
the net present value is found, while in the IRR method the value of r has to be
determined at which the net present value becomes zero.

Uneven Cash Flows:

Calculating IRR by Trial and Error

The value of r in Equation can be found out by trial and error. The approach is to
select any discount rate to compute the present value of cash inflows. If the
calculated present value of the expected cash inflow is lower than the present value
of cash outflows, a lower rate should be tried. On the other hand, a higher value
should be tried if the present value of inflows is higher than the present value of
outflows. This process will be repeated unless the net present value becomes zero.

Acceptance Rule

 The accept-or-reject rule, using the IRR method, is to accept the project if its
internal rate of return is higher than the opportunity cost of capital (r > k). Note
that k is also known as the required rate of return, or the cut-off, or hurdle
rate.
 The project shall be rejected if its internal rate of return is lower than the
opportunity cost of capital (r < k).
 The decision maker may remain indifferent if the internal rate of return is equal to
the opportunity cost of capital. Thus the IRR acceptance rules are:

 Accept the project when r > k

 Reject the project when r < k
 May accept the project when r = k
The reasoning for the acceptance rule becomes clear if we compare NPVs and discount rates
for the project. If the discount rate is less than IRR, then the project has positive NPV; if it is
equal to IRR, the project has a zero NPV; and if it is greater than IRR, the project has negative
NPV. Thus, when we compare the IRR of the project with the opportunity cost of capital, we
are in fact trying to ascertain whether the project's NPV is positive or not. In case of
independent projects, IRR and NPV rules will give the same results if the firm has no shortage
of funds.
Evaluation of IRR Method

IRR method is like the NPV method. It is a popular investment criterion since it
measures profitability as a percentage and can be easily compared with the
opportunity cost of capital. IRR method has following merits and demerits.
Merits:
 Time value The IRR method recognizes the time value of money.
 Profitability measure It considers all cash flows occurring over the entire life of the
project to calculate its rate of return.
 Acceptance rule It generally gives the same acceptance rule as the NPV method.
 Shareholder value It is consistent with the Shareholder Wealth Maximization
objective. Whenever a project's IRR is greater than the opportunity cost of capital,
the shareholders' wealth will be enhanced.
Demerits:

 Multiple rates Aproject may have multiple rates, or it may not have a unique
rate of return. As we explain later on, these problems arise because of the
mathematics of IRR computation.
 Mutually exclusive projects It may also fail to indicate a correct choice between
mutually exclusive projects under certain situations.
 Value additivity Unlike in the case of the NPV method, the value additivity principle
does not hold when the IRR method is used - IRRs of projects do not add. Thus, for
 Projects A and B, IRR(A) + IRR(B) need not be equal to IRR (A + B).
 Example: The NPV and IRR of Projects A and B are given below:

It can be seen from the example that NPVs of projects add:

NPV(A) + NPV(B) = NPV(A + B) = 9.1+2.7=11.8,

while IRR(A)+IRR(B) ≠ IRR(A + B) = 20%+12% ≠ 15.2%

PROFITABILITY INDEX

Yet another time-adjusted method of evaluating the investment proposals is the

benefit - cost (B/C) ratio or profitability index (Pl). Profitability index is the ratio of the
present value of cash inflows, at the required rate of return, to the initial cash outflow
of the investment. The formula for calculating benefit-cost ratio or profitability index
is as follows:

Acceptance Rule

The following are the PI acceptance rules:

 Accept the project when PI is greater than one PI> 1

 Reject the project when PI is less than one PI< 1
 May accept the project when PI is equal to one PI= 1

The project with positive NPV will have PI greater than one. PI less than one means that the
project's NPV is negative.

Evaluation of Pl Method

Like the NPV and IRR rules, PI is a conceptually sound method of appraising
investment projects. It is a variation of the NPV method, and requires the same
computations as the NPV method.

Merits:

 Time value: It recognizes the time value of money.

 Value maximization It is consistent with the shareholder value maximisation
principle. A project with PI greater than one will have positive NPV and if
accepted, it will increase share-holders' wealth.
 Relative profitability In the PI method, since the present value of cash inflows is
divided by the initial cash outflow, it is a relative measure of a project's
profitability.

Demerits:
 Like NPV method, PI criterion also requires calculation of cash flows and estimate
of the discount rate. In practice, the estimation of cash flows and discount rate
poses problems.