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. |
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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. |
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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? |
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Vinu |
We have already calculated that. We arrived at Weighted Average cost of capital as 20%.
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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! |
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Vinu |
That confuses me! |
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Manu |
Vinu! We know, when we pay interest, we will save tax on interest. |
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Vinu |
Yes! |
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Manu |
In our example, Debt is Rs.50cr, Interest is 15% on debt. |
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Vinu |
Correct! |
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Manu |
We also agreed tax benefit on Interest will reduce interest cost. |
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Vinu |
Yes! |
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Manu |
So please work correct cost of interest. |
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Vinu |
It should be 15% x 70% = 10.50% |
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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! |
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Vinu |
Let me do that!
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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%. |
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Vinu |
Correct! This makes more sense! WACC has come down due to tax effect. |
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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. |
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Vinu |
Yes!!! Now I understand the link between the two! |
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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? |
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Vinu |
Yes! I’ll do that!
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Manu |
Good! Above table shows, if you invest Rs.100crs @ 17.75%, it should become Rs.369.56 Crs in 8 years. |
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Vinu |
Yes! Rs.369.56 Crs received after 8 years is equivalent to Rs.100 Cr now, if my return expectation is 17.75% |
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Manu |
Yes! Now total every year cash flows which you have estimated for the project. |
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Vinu |
It is Rs.409.40 Crs which is greater than Future Value of Rs.369.56cr. |
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Manu |
Yes! So this answers you that this project will earn more than your expected return of 17.75%. |
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Vinu |
Yes Manu! |
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Manu |
Now we have made this analysis and derived result by thumb rule only. Let us put it in a more professional way. |
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Vinu |
How? |
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Manu |
You please tabulate all the cash flows for 8 years |
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Vinu |
Ok
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Manu |
Now you have to find PV of all these year cash flows. |
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Vinu |
How do we calculate that? |
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Manu |
How did you calculated FV of an investment? |
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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. |
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Manu |
Can you make it as formula? |
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Vinu |
I’ll try. Future Value = Principal + Interest |
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Manu |
Break down further. |
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Vinu |
FV = Principal + [Principal x Interest Rate] = Principal [1 + Interest] |
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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? |
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Vinu |
I’ll calculate that many times. |
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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. |
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Vinu |
So, I should have no. of period in power? |
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Manu |
Yes! Have your formula like this. FV = PV [1 + i] n |
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Vinu |
Here ‘PV’ Stands for Present Value, ‘i’ Stands for Interest & ‘n’ Stands for no. of period. Is that correct? |
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Manu |
Yes! Through ‘PV’ you can find ‘FV’ and vice versa. |
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Vinu |
Ok! But why did you started saying all these? |
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Manu |
I wanted to give you the formula for finding ‘PV’. |
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Vinu |
Ok! |
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Manu |
Now you know, FV = PV [1 + i] n |
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Vinu |
PV = FV /[(1+i) n] |
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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. |
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Vinu |
I got it! |
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Manu |
Now can you find Present Value of our cash flows for 8 years, at expected rate of return of 17.75% ? |
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Vinu |
Ok!
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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. |
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Vinu |
Yeah…../p> |
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Manu |
NNow, multiply this PV Factors with Cash Flows to get Present Value of Cash Flows. |
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Vinu |
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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 |
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Vinu |
True! PV is less than 50% when compared with actual cash flows because of higher expected returns, I believe! |
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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. |
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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 |
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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 |
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Vinu |
Yes! This creates greater interest in the Project. |
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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. |
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Vinu |
It’s really great! Does this methodology or analysis has any technical name? |
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Manu |
Yes! It has. It is called “Net Present Value” method to evaluate an investment decision |
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Vinu |
Great! |
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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. |
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Vinu |
Viable? |
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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. |
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Vinu |
Yes Manu! I understand. Let me tabulate our example.
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Manu |
Good! NPV of your project is positive and so it is a viable project. |
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Vinu |
In case of multiple projects, out of which one has to be selected, how we should approach? |
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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. |
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Vinu |
Correct! Any Investment Decision should have the objective of creating wealth for the promoters. Thanks for this clarity in NPV concept. |
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Manu |
So, in this example itself you have understood the concept of
Good! |
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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