Present Value method

The method is also known as 'Time adjusted rate of return' or 'internal rate of Return' Method or Discounted cash-flow method In recent years, the method has been recognised as the most meaningful technique for financial decisions regarding future commitments and projects.

The method is based on the assumption that future rupee value cannot be taken as equivalent to the rupee value in the present. When we compare the returns or cash inflows with the amount of investment or cash outflows, both must be stated on a present value basis if the time value of money is to be given due importance. The problem of difference in time (when cash outflows and inflows take place) can be resolved by converting the future amounts to their present values to make them comparable.

The discounted cash flow rate of return or internal rt of return of n investment is the rate of interest (discount at which the present value of cash inflows and the present value of cash outflows become equal). The present value of future cash inflows can be calculated with help of following formula:
 

             S
P = ________
        (1 + i )ⁿ

Here P = Present value of future cash inflows

          S = Future value of a sum of money

          i = Rate of Return or required earning rate

          n = Number of year

This method can be examined under two heads.

 

(a) Net Present value method, and

(b) Internal rate of return method.


 

(a) Net Present Value Method.

The net present value method also known as discounted benefit cost ratio. Excess present value method or Net gain method takes account of all income whenever received. Under this method, a required rate of return is assumed, and a comparison is made between the present value of cash inflows at different times and the original investment in order to determine the prospective profitability. This method is based on the basic principle if the present value of cash inflows discounted at a specified rate of return equals of exceeds the amount of investment proposal should be accepted. This discounted rate is also known a the 'required earning ratio'. Present value tables are generally used in order to make the calculations prompt and to know the present value of the cash inflows at required earning ration corresponding to different periods. We can, however, use the following formula to know the present value of Re. 1 to be received after a specified period at a given rate of discount.

 

                             S
              PV=  ________
                         (1 + i )ⁿ

Where         PV = Present Value

                    r = rate of discount


 

Example.

Let us suppose an investment proposal requires an initial outlay of Rs. 40000 with an expected cash-inflow of Rs. 1,000 per year for five years. Should the proposal be accepted if the rate of discount is (a) 15 % or (b) 6% ?

We can find the present value of cash inflows with the help of present value tables as follows @ 15 % and 6 % :-

The method is regarded as superior to other methods of investment appraisal in several ways:-
 

(1) The method takes into account the entire economic life of the project investment and income.

 

(2) It gives due weight age to time factor of financing. Hence valuable in long term capital decisions. In the words of Charles Horngren, 'Because the discounted cash flow method explicitly and routinely weighs the time value of money, it is the best method, to use for long-range decisions.'

(3) it produces a measure which is precisely comparably among projects, regardless of the character and time shape of their receipts an outlays.


 

(4) This approach provides for uncertainty and risk by recognizing the time factor. It measures the profitability of capital expenditure by reducing the earnings to the present value.

 

(5) It is the best method of evaluating project where the cash flows are uneven. Cash inflows and outflows are directly considered under this method while they re averaged under other methods.

As the total present value of Rs. 3353 at a discount rat of 15 % is less than Rs. 4000 (the initial investment) the proposal cannot be accepted, if we ignore the other non-quantitative considerations. But the present value of Rs. 4212 at a discount rate of 6 % exceeds the initial investment of Rs. 4,000, the proposal can be acceptable.
 

The above example shows an even cash inflows every year. But if cash inflows is uneven, the procedure to calculate the present values is somewhat difficult. For example, if we expect cash flows at - Re. 1 one year after, Rs. 3 two years after. Rs. 4 three years after the present value at 15 % discount tat would be:-
 

   PV of Re. 1 to be received at the end of one year – 1 (.870) = .870

   PV of Re. 3 to be received at the end of one year – 2 (.756) = 1.512

   PV of Re. 4 to be received at the end of one year – 3 (.658) = 1.974

                                                                                               ________

Present value of series                                                                 4.356
                                                                                             _________

(b) Internal Rate of Return Method.

This method is popularly known as 'time adjusted rate of return method', 'discounted cash flow rate of return method', 'yield rate method', 'investor's method', or 'Marginal efficiency of capital' method.

In present value method the required earning rate is selected in advance. But under internal rate of return method, rate of interest or discount is calculated. Internal rate of return is the rate of interest or discount at which the present value of expected cash flows is equal to t total investment outlay. According to the National Association of Accountants, America “Time adjusted rate of Return is the maximum rte of interest that could be paid for the capital employed over the life of an investment without loss on the project. “ This rate is usually found by trial and error method. First we select an arbitrary rate of interest and find the present value of cash flows during the life of investment at tat selected rate. Then we compare present value with the cost of investment. If the present value if higher or lower than the cost of investment, w try another rate and repeat the process. If present value is higher than the cost, we shall try a higher rat of interest or vice-versa. This procedure continues till the present values and the cost of investment (total outlay in project) are equal or nearly equal. The rate at which present value and cot of investment are equal. The at is called internal rate of return.

Merits Of Discounted Cash Flow Method

The method is regarded as superior to other methods of investment appraisal in several ways

(1) The method takes into account the entire economic life of the project investment and income.

 

(2) It gives due weight age to time factor of financing. Hence valuable in long term capital decisions. In the words of Charles Horngren, 'Because the discounted cash flow method explicitly and routinely weighs the time value of money, it is the best method, to use for long-range decisions.'

(3) it produces a measure which is precisely comparably among projects, regardless of the character and time shape of their receipts an outlays.

 

(4) This approach provides for uncertainty and risk by recognizing the time factor. It measures the profitability of capital expenditure by reducing the earnings to the present value.

 

(5) It is the best method of evaluating project where the cash flows are uneven. Cash inflows and outflows are directly considered under this method while they re averaged under other methods.

Demerits or Limitations of Discounted cash Flow Method

The method suffers from the following disadvantages

(1) It involves a good amount of calculations hence it is difficult and complicated. But the supporters of this method rebute the argument and assert that difficulty of the method is unfamiliarity rather than its complexity.

 

(2) It does not correspond to accounting concepts for recording costs and revenues with the consequence that special analysis is necessary for the study of capital investment.

 

(3) The selection of cash inflows is based on sales forecasts which is in itself an indeterminable element.

 

(4) The economic life of an investment is very difficult to forecast exactly.

 

(5) The method considers discount on expected rate of return but the determine action of rate of return is in itself a problem.
 

Despite the above defects, the method provides an opportunity for making valid comparisons

between long-term competitive capital projects.

Originally posted by : Tarun
	Thanks for sharing.

welcome......:)

Originally posted by : future ca
	really good work done

Thank u......:)

VOWWW! THX A LOT...REALLLY VERY HELPFUL

Originally posted by : Disha Bhawnani
	VOWWW! THX A LOT...REALLLY VERY HELPFUL

u mst welcome dear........:)