Unit 4

Working Capital
&
Time Value of Money
 Working Capital
M EANING AND CONCEPT OF WORKING CAPITAL

In accounting term working capital is the difference between current assets and current liabilities. If we
break down the components of working capital we will found working capital as follows:

Working Capital = Current Assets – Current Liabilities

Current Assets: An asset is classified as current when:

(i) It is expected to be realised or intends to be sold or consumed in normal operating cycle of the
entity;

The asset is held primarilyfor the purpose of trading;

It is expected to be realised within twelve months after the reporting period; It is non- restricted
cash or cash equivalent.
Generally current assets of an entity, for the purpose of working
capital management can be grouped into the following main heads:

(a)Inventory (raw material, work in process and finished goods)

(b)Receivables (trade receivables and bills receivables)

(c)Cash or cash equivalents (short-term marketable securities)

(d)Prepaid expenses
Current Liabilities: A liability is classified as current when:
It is expected to be settled in normal operating cycle of the entity.
The liability is held primarily for the purpose of trading

It is expected to be settled within twelve months after the reporting

period
Generally current liabilities of an entity, for the purpose of working
capital management can be grouped into the following main heads:

(a) Payable (trade payables and bills receivables)

(b) Outstanding payments (wages & salary etc.)

 Working Capital

On the basis of Value On the basis of Time

Net Permanent Fluctuating

Gross
(a)Value : From the value point of view, Working Capital can be defined as Gross
Working Capital or Net Working Capital.
Gross working capital refers to the firm’s investment in current assets.
Net working capital refers to the difference between current assets and current liabilities.
A positive working capital indicates the company’s ability to pay its short-term liabilities.
On the other hand a negative working capital shows inability of an entity to meet its short-
term liabilities.

(b)Time: From the point of view of time, working capital can be divided into two
categories viz., Permanent and Fluctuating (temporary).
• Permanent working capital refers to the base working capital, which is the
minimum level of investment in the current assets that is carried by the entity at all
times to carry its day to day activities.

• Temporary working capital refers to that part of total working capital, which is
required by an entity in addition to the permanent working capital. It is also called
variable working capital which is used to finance the short term working capital
requirements which arises due to fluctuation in sales volume.

The following diagrams shows Permanent and Temporary or Fluctuating or variable

working capital:
Both kinds of working capital i.e. permanent and fluctuating (temporary) are
necessary to facilitate production and sales through the operating cycle.
 Management of Working Capital
Working capital is required for smooth functioning of the business of an entity as
lack of this may interrupt the ordinary activities. Hence, the working capital needs
adequate attention and efficient management. When we talk about the management
it involves 3 Es i.e. Economy, Efficiency and Effectiveness and all these three are
requiredfor the working capital management.
The scope of working capital management can be grouped into two broad areas (i)
Profitabilityand Liquidityand (ii) Investment and Financing Decision.
Scope of Working
Capital Management

Liquidity and Investment and

Profitability Financing
 Profit and Loss Account
• The Profit and loss account is one of the thee most important
financial statements
• It records an organisations’ income and expenses (or revenues and
costs)
• For companies, it is required by the Companies Act 1985
• The P&L Account seeks to determine an organisation’s profit
(income less expenses) over a period of time
• The account is concerned with measuring an organisation’s
performance
• Profits are central to evaluating the organisation’s performance –
particularly where profit is an important objective of shareholders
• The P&L account is a key financial statement which
represents an organisation’s income less its expenses
over a period of time and thus determines its profit

• Income - revenue earned by a business

• Expenses - costs incurred in running a business

• A Profit and Loss Account (P&L) shows how much profit or loss
(negative profit ) the business has made over the reporting period

• It measures a company’s sales revenue and expenses over a period,

providing a calculation of profits or losses during that time

• It provides the easiest way to tell if a business has made a profit or loss
during the last time period

• The key figure is net profit after interest and tax-what is left after
revenues are used to pay expenses and taxes
The P&L consists of…
• Trading account
• this is concerned with gross profit or the profit made on trading activities.

• P&L account
• this is concerned with net profit or the overall level of profit made by a
business

• Appropriation account
• this is concerned with what is done with the profit - how much is distributed to
shareholders and how much is retained
Components of the trading and profit and loss account

Sales Income earned from selling goods

Cost of sales The cost of directly providing the sales

Gross profit Sales less cost of sales. Profit after deducting

direct costs
Other income Non-trading income which the firm has
earned e.g. income from investment and from
sale of fixed assets
Expenses Indirect costs- overheads such as rent, light
and heat
Net profit Sales less cost of sales less expenses. Profit
after deducting all costs
 Cost of sales
• Expenditure incurred in producing or providing the goods

• This is the direct costs that can be attributed to sales revenue generated over
the trading period

• The cost of goods actually sold in any period

• This excludes the cost of goods left unsold and all overheads except
manufacturing

• Cost of sales equals opening stock plus purchases of stock during the
accounting period minus closing stock

• Opening stock is inherited from previous years

 Gross Profit
• Equals sales revenue minus cost of sales

• Sales revenue/sales /turnover is revenue received from selling goods or services

• Cost of sales are costs arising directly from producing or selling goods

• Gross profit
• tells us how well the firm is trading but is does not take into account all the
costs of the firm
• a measure of the gain of the organisation from buying and selling
• measures how much was actually made directly from whatever the business
is selling - before it starts to pay for overheads
 Expenses
• These are indirect of overhead costs

• They are directly linked to production

• Expenses are divided into:

• selling and distribution costs (including marketing costs, delivery and

distribution)
• administration costs (general running of the business including rent, rates,
telephone bill)
• Most expenses are a result of a cash payment or will lead to a cash payment
• But depreciation is a non-cash expense. It represents the expense of using a
 Net profit
• Net profit is equal to gross profit minus all indirect expenses

• But we are now presented with a variety of different definitions of net

profit:
• Operating profit
• Profit before interest and tax
• Profits before tax
• Profits after tax
 Operating profits

• This is profit from day to day operations

• All direct costs and indirect expenses have been deducted but
• it only concerns profit from normal trading activities
• income from other activities such as the sale of one off exceptional
items and income from investments are not included
• interest payments/receipts have not been taken into account
 Uses of Profit and Loss Accounts
• Business owners are keen to see how much profit they have made at the end of the trading
year. The size of the profit may be a guide to the performance of the business.

• A comparison is also possible because a profit and loss account will show the previous
year’s figures. It is possible to calculate the gross profit margin and the net profit margin
from the profit and loss account.

• The ratio of gross profit to sales turnover is known as the Gross Profit Margin:
Gross Profit x 100
Turnover
• A rise in the gross profit margin may be because turnover has increased relative to cost
of sales
• A fall may be because costs of sales have risen relative to turnover.
• Gross profit does not take into account the general overheads of the business. So a
business may be more interested in the ratio of the t profit to turnover or the Net Profit
Margin. This can be calculated by,
Net Profit x 100
Turnover
• To see how well a business has controlled its overheads. If the gross profit is far larger
than the net profit this would suggest that the company’s overheads are quite high.

• To help measure its growth. A guide to a businesses growth may be the value of its
turnover compared with the previous year’s.

• The earnings per share is also shown on the profit and loss account for limited companies.
This shows shareholders how much each share has earned over the year. However this is
not necessarily the amount of money which they receive from the company. This is the
dividends per share.
Limitations of Profit and Loss
Accounts
• Business accounts cannot be used to show what is going to happen in the
future. The Profit and Loss account uses historical information. The
account shows what has happened in the past. However it may be possible
to identify future trends by looking at the accounts for a longer period of
time say 4-5 years .

• Stakeholders who are interested in the accounts must be aware that it is

possible to disguise or manipulate financial information in the accounts.
 The Balance Sheet
• The balance sheet is a picture of the financial position of a
business at a particular point in time. The balance sheet
contains information about the assets, the liabilities and the
capital of the business
 Sections within the Balance Sheet
• ASSETS – are the resources that a business owns and uses. They are divided into
Fixed and Current. Fixed assets such as machinery are used again and again over a
period of time. Current assets are used up in production such as stock and raw
materials.

• LIABILITIES – are the debts of the business,, i.e. what it owes to other businesses,
individuals and institutions. Liabilities are a sources of funds for a business. They
might be short term, such as an overdraft, or long term such as a mortgage or bank
loan.

• CAPITAL – is the money introduced by the owners of the business, for example when
they buy shares.
• In all balance sheets the value of assets will equal the value of liabilities
and capital.

• Any increase in total assets must be funded by an equal increase in

capital or liabilities, i.e a business wanting to buy extra machinery
(assets) may need a bank loan (a liability). Alternatively a reduction in
credit from suppliers (a liability) may mean a reduction in stocks that can
be bought (an asset)

So, Assets = capital + liabilities

Presenting the Balance Sheet

Balance sheets are presented in a vertical format , one advantage of

presenting the sheet in this format is that it is easy to see the amount of
working capital (current assets – current liabilities) that a business has.
This will show if the business is able to pay its day to day bills. The net
assets (Total assets – current liabilities – long term liabilities) of the
business are also clearly shown.
 Uses of Balance Sheets
• Provides a summary of and valuation of all business assets, capital and liabilities – this is a
legal requirement laid down by law and by the accounting bodies.

• Be used to analyse the asset structure of a business. It can show the money raised by the
business has been spent on different types of asset.

• Be used to analyse the capital structure of a business. A business can raise funds from
many different sources such as shareholders’ capital, retained profit and long term and
short term sources (i.e. loans, investors).

• Looking at the value of the working capital (current assets (fixed +current) ) can indicate
whether a firm is able to pay its everyday expenses or is likely to have problems.

• Is a guide to a firm’s value.

Limitations of the Balance Sheet
• The value of many assets listed in the balance sheet may not reflect the amount of money
the business would receive if it were sold, i.e. fixed assets are listed at cost less
depreciation, however depreciation allowance is estimated by accountants.

• Many balance sheets do not include intangible assets such as goodwill, brand names, and
skills of workforce may be excluded because they are difficult to value or could change
suddenly. If such assets are excluded the value of the business may be understated.

• A balance sheet is a static statement. Many of the value for assets, capital, and liabilities
are listed in the statement are only valid for the day the balance sheet was published. After
another day’s trading many of the figures will have changed.

• Many argues that the balance sheet lacks detail as they only include totals and are not
broken down further.
Objectives of Ratio Analysis
• Standardize financial information for comparisons
• Evaluate current operations
• Compare performance with past performance
• Compare performance against other firms or
industry standards
• Study the efficiency of operations
• Study the risk of operations
Ratio Analysis
1. Liquidity – the ability of the firm to pay its way
2. Investment/shareholders – information to enable decisions to be
made on the extent of the risk and the earning potential of a business
investment
3. Gearing – information on the relationship between the exposure of
the business to loans as opposed to share capital
4. Profitability – how effective the firm is at generating profits given
sales and or its capital assets
5. Financial – the rate at which the company sells its stock and the
efficiency with which it uses its assets
Liquidity
Acid Test

• Also referred to as the ‘Quick ratio’

• (Current assets – stock) : liabilities
• 1:1 seen as ideal
• The omission of stock gives an indication of the cash the firm has in
relation to its liabilities (what it owes)
• A ratio of 3:1 therefore would suggest the firm has 3 times as much cash as
it owes – very healthy!
• A ratio of 0.5:1 would suggest the firm has twice as many liabilities as it
has cash to pay for those liabilities. This might put the firm under pressure
but is not in itself the end of the world!
 Current Ratio
• Looks at the ratio between Current Assets and Current
Liabilities
• Current Ratio = Current Assets : Current Liabilities
• Ideal level? – 1.5 : 1
• A ratio of 5 : 1 would imply the firm has £5 of assets to
cover every £1 in liabilities
• A ratio of 0.75 : 1 would suggest the firm has only 75p in
assets available to cover every £1 it owes
• Too high – Might suggest that too much of its assets are tied
up in unproductive activities – too much stock, for
example?
• Too low - risk of not being able to pay your way
Investment/Shareholders
 Investment/Shareholders
• Earnings per share – profit after tax / number of shares

• Price earnings ratio – market price / earnings per share – the higher the better
generally for company. Comparison with other firms helps to identify value
placed on the market of the business.

• EV / EBITDA Ratio - Enterprise Value / EBITDA ratio - the higher the better
generally for company . It measures the operational performance of the firm.

• Dividend yield – ordinary share dividend / market price x 100 – higher the
better. Relates the return on the investment to the share price.
Gearing
Gearing
• Gearing Ratio = Long term loans / Capital
employed x 100

• The higher the ratio the more the business is

exposed to interest rate fluctuations and to having
to pay back interest and loans before being able to
re-invest earnings
Profitability
Profitability
• Profitability measures look at how much profit the firm generates
from sales or from its capital assets

• Different measures of profit – gross and net

• Gross profit – effectively total revenue (turnover) – variable costs (cost of
sales)

• Net Profit – effectively total revenue (turnover) – variable costs and fixed
costs (overheads)
Profitability
• Gross Profit Margin = Gross profit / turnover x 100

• The higher the better

• Enables the firm to assess the impact of its sales and how much it
cost to generate (produce) those sales

• A gross profit margin of 45% means that for every £1 of sales, the
firm makes 45p in gross profit
 Profitability
• Net Profit Margin = Net Profit / Turnover x 100

• Net profit takes into account the fixed costs involved in production – the
overheads

• Keeping control over fixed costs is important – could be easy to overlook for
example the amount of waste - paper, stationery, lighting, heating, water, etc.

• e.g. – leaving a photocopier on overnight uses enough electricity to make

5,300 A4 copies. (1,934,500 per year)

• 1 ream = 500 copies. 1 ream = £5.00 (on average)

• Total cost therefore = £19,345 per year – or 1 person’s salary

Profitability
• Return on Capital Employed (ROCE) = Profit /
capital employed x 100

• The higher the better

• Shows how effective the firm is in using its capital to generate
profit
• A ROCE of 25% means that it uses every £1 of capital to
generate 25p in profit
• Partly a measure of efficiency in organisation and use of capital
Financial
Asset Turnover

• Asset Turnover = Sales turnover / assets employed

• Using assets to generate profit

• Asset turnover x net profit margin = ROCE

Stock Turnover
• Stock turnover = Cost of goods sold / stock expressed as times per year

• The rate at which a company’s stock is turned over

• A high stock turnover might mean increased efficiency?

• But: dependent on the type of business – supermarkets might have high stock
turnover ratios whereas a shop selling high value musical instruments might
have low stock turnover ratio

• Low stock turnover could mean poor customer satisfaction if people are not
buying the goods (Marks and Spencer?)
Debtor Days

• Debtor Days = Debtors / sales turnover x 365

• Shorter the better

• Gives a measure of how long it takes the business to

recover debts

• Can be skewed by the degree of credit facility a firm offers

ng at the ratios there are a number of cautionary points concerning their use that need
fied :

and duration of the financial statements being compared should be the same. If not, the
seasonality may cause erroneous conclusions to be drawn.

unts to be compared should have been prepared on the same bases. Different treatment of
depreciations or asset valuations will distort the results.

o judge the overall performance of the firm a group of ratios, as opposed to just one or
d be used. In order to identify trends at least three years of ratios are normally required.
SOME IMPORTANT NOTES
• Liabilities have Credit balance and Assets have Debit balance

• Current Liabilities are those which have either become due for payment or shall fall due
for payment within 12 months from the date of Balance Sheet

• Current Assets are those which undergo change in their shape/form within 12 months.
These are also called Working Capital or Gross Working Capital

• Net Worth & Long Term Liabilities are also called Long Term Sources of Funds

• Current Liabilities are known as Short Term Sources of Funds

• Long Term Liabilities & Short Term Liabilities are also called Outside Liabilities

• Current Assets are Short Term Use of Funds

SOME IMPORTANT NOTES
• Assets other than Current Assets are Long Term Use of Funds

• Installments of Term Loan Payable in 12 months are to be taken as Current Liability only
for Calculation of Current Ratio & Quick Ratio.

• If there is profit it shall become part of Net Worth under the head Reserves and if there
is loss it will become part of Intangible Assets

• Investments in Govt. Securities to be treated current only if these are marketable and
due. Investments in other securities are to be treated Current if they are quoted.
Investments in allied/associate/sister units or firms to be treated as Non-current.

• Bonus Shares as issued by capitalization of General reserves and as such do not affect the
Net Worth. With Rights Issue, change takes place in Net Worth and Current Ratio.
 Summary of Financial Ratios
• Ratios help to:
• Evaluate performance

• Structure analysis

• Show the connection between activities and

performance

• Benchmark with
• Past for the company
• Industry

• Ratios adjust for size differences

 Limitations of Ratio Analysis
• A firm’s industry category is often difficult to identify

• Published industry averages are only guidelines

• Accounting practices differ across firms

• Sometimes difficult to interpret deviations in ratios

• Industry ratios may not be desirable targets

• Seasonality affects ratios

 The Time Value of Money
Would you prefer to
have 1 million dollar
now or
1 million dollar 10 years
from now?

Of course, we would all

prefer the money now!
This illustrates that there is
an inherent monetary value
attached to time.
What Does Time Value of Money Mean?

• The concept that money available today is worth more than

the same amount of money in the future
• This preference rests on the Time value of money.
• Thus, a money received today is worth more than a money
received tomorrow, why?
This is because that
• a money received today can be invested to
earn interest
• Due to money's potential to grow in value over
time.
• Because of this potential, money that's
available in the present is considered more
valuable than the same amount in the future
• Time Value of Money is dependent not only on the
time interval being considered but also the rate of
discount used in calculating current or future values.

• Based on this, we can use the time value of money

concept to calculate how much you need to invest or
borrow now to meet a certain future goal
 Interest
• A rate which is charged or paid for the use of money.
An interest rate is often expressed as an annual percentage of the
principal.
• a nominal interest rate, is one where the effects of inflation have
not been accounted for.
• Real interest rates are interest rates where inflation has been
accounted for
• Changes in the nominal interest rate often move with changes in
the inflation rate, as lenders not only have to be compensated for
delaying their consumption, they also must be compensated for
the fact that a dollar will not buy as much a year from now as it
What are the components of interest rate?
• Real Risk-Free Rate - This assumes no risk or uncertainty, simply reflecting
differences in timing.
• Expected Inflation - The market expects aggregate prices to rise, and the
currency's purchasing power is reduced by a rate known as the inflation rate.
• Default-Risk Premium - What is the chance that the borrower won't make
payments on time, or will be unable to pay what is owed? This component
will be high or low depending on the creditworthiness of the person or entity
involved.
• Liquidity Premium- Some investments are highly liquid, meaning they are
easily exchanged for cash. Other securities are less liquid, and there may be a
certain loss expected if it's an issue that trades infrequently.
• Holding other factors equal, a less liquid security must compensate the
holder by offering a higher interest rate.
• Maturity Premium - Other things being equal, a bond obligation will be
more sensitive to interest rate fluctuations, if maturity period is longer.
Simple Interest and Compound Interest

When you deposit money into a bank, the bank pays you
interest.
When you borrow money from a bank, you pay interest to the
bank.
Simple interest is money paid
only on the principal. Rate of interest is the
percent charged or earned.

I = P  rt
Time that the money is
Principal is the amount of money borrowed or invested (in
borrowed or invested. years).
Compound interest

Compound interest is interest paid not only on the

principal, but also on the interest that has already been
earned. The formula for compound interest is below.

A = p(1 + r )
t

“A” is the final dollar value, “P” is the principal, “r”

is the rate of interest, and “t” is the number of
compounding periods per year.
Uses of Time Value of Money
• Time Value of Money, or TVM, is a concept that is used in all aspects
of finance including:
• Bond valuation
• Stock valuation
• Accept/reject decisions for project management
• Financial analysis of firms
• And many others!
Types of TVM Calculations
There are many types of TVM calculations viz.
• Future value of a lump sum
• Present value of a lump sum
• Present and future value of cash flow stream
• Present and future value of annuities
Cash Flow Diagrams

Cash flow diagrams are graphical representation of cash flows (inflows and out flows)
along a time line.

Individual inflows or outflows are designated by vertical lines and relative magnitude
can be represented by the heights of lines.

Cash inflows are designated by vertical lines above the axis and cash outflows below the
time line axis.

Inflows take a positive sign whereas outflows take negative sign. Cash flow diagrams
involve magnitude and direction fulfilling the properties of flow.
1.Cash flow transactions
Cash flow transactions are of five types, Viz.
i)Single cash flow
ii)Uniform series
iii)Linear Gradient series
iv)Geometric gradient series
v)Irregular series
Let’s discuss each of the above cash flow transactions.
Single payment cash flow: It involves a single present or future cash flow. The diagram
of this is given below.

F (inflow)
0
time line n
P (outflow)

In this diagram there is single cash out flow (P) which occurs at ‘0’ time and Cash
inflow of (F), which occurs at nth time.
Uniform series: Here cash flows involve a series of equal amounts occurring at equal
interval of time. It is also known as annuity.
Uniform series: Here cash flows involve a series of equal amounts
occurring at equal interval of time. It is also known as annuity.
Linear Gradient series: It is a series of
cash flows displaying properties of
arithmetic progression series. So the cash
flow increases or decreases by a fixed
amount.
Geometric Gradient series: It is a series
of cash flows displaying properties of
geometric progression series. So the
cash flow increases or decreases by a
fixed ratio (or percentage).
Irregular payment series: When the cash flows do not
display any regular overall pattern over time, the series is
known as Irregular payment series.
Compound Interest Factors

Compound interest factor is that factor when multiplied by a single amount or uniform
series gives an equivalent amount at compound interest. There are eight types of
compound interest factors. Let’s discuss one by one.
a)Single payment compound amount factor: Here given Future amount ‘F’; it is needed
to find out ‘P’ amount. It means F is converted to P amount by help of rate of
interest ‘i’ and time period ‘n’. The notation used for this conversion is (F/P,i,n)
F= P (F/P, i, n) = P (1+i) n
b)Single payment present worth factor: To find the present worth of a future amount,
this factor is used. The notation for this is (P/F, i, n)
P= F (P/F, i, n) = F (1+i)-n
C) Equal payment series compound amount factor: Given annuity amount, it is
needed to find out F amount.
F= A (F/A, i, n) = A [(1+i) n-1]/i
d) Equal payment series sinking fund factor: In this case given a fund F which needs to be filled up (sank) in
terms of annuity (A) amount.
A= F (A/F, i, n) = F [i/ (1+i) n-1]
e) Equal payment series present worth factor: Given A, i, n, we need to find P amount.
P= A (P/A, i, n) = A [(1+i)n-1]/[i(1+i)n]
f) Equal payment series capital recovery factor: Given P, i, n, we need to find equivalent annual amount A.
A= P (A/P, i, n) = P [i(1+i)n]/ [(1+i)n-1]
g) Linear gradient series annual equivalent amount factor: If the first amount is A1 at the end of the first year
and the gradient amount is G (equal increment), then annual equivalent amount will be found out.
A= A1 + G (A/G, i, n)
A1+ G [(1+i) n-in-1]/ [i (1+i) n-i]
h) Geometric gradient series Present amount factor: If the first amount is A1 at the end of the first year, and the
geometric gradient g, i, n are given, then we can find out the present worth of these cash flows.
P= {A1 (P/ A1, g, i, n)}
Present worth comparisons
Why present worth comparisons?
Comparisons of assets or investment projects are necessary in order to select the best among
the alternatives, i.e., to accept one and reject others. When these alternatives are mutually
exclusive in nature, comparisons need to be taken into account a particular point of time, i.e.,
at current or base period as the reference year. Moreover, as the value of any currency keeps
on changing over time, comparisons cannot be made across time unless the value of the
projects is transferred into a particular time. Let’s take an example: An invested amount of
INR 10, 00000 in the year 2014 cannot be compared with 10, 00000 in the year 2011 as both
the investment occurred in two different times. These two amounts need to be transferred to
the same time for comparison purpose.
In present worth method, cash flows of each of the projects occurring in different time are
converted to ‘zero time’ (base period), by the help of rate of interest and time factor, which is
known as ‘discount rate’. The best alternative project is selected by comparing the present
worth amounts of alternatives. Two deciding factors govern in choosing alternatives, viz.
minimization of cost (use of least present worth) and maximization of profit (maximum
present value).
For present worth comparison method, the following assumptions need to be taken. Viz.,
a) All cash flows (inflows as well as out flows should be known
b) Time and rate of interest is to be given
c) Constant time value of money
d) Before tax cash flows are to be taken for comparison
e) No intangible factors are to be taken
Basis of cash flows and calculation of Present worth method
• Present worth calculation depend on the nature of cash flows, i.e., whether the
cash flows are cost-dominated cash flow stream or revenue-dominated cash
flows stream.
• If majority of cash flows from a project are inflows, then the said cash flow
stream is known to be revenue dominated and if majority of cash flows are
costs, then cash flow stream is known to be cost dominated cash flow.
• In case of revenue –dominated cash flows, all the inflows take a positive sign
and all the out flows take a negative sign. But the reverse happens in case of
cost- dominated cash flow stream.
 Let’s take that the cash flows of X project are given, P is the initial investment, R1, R2,
R3, R4, R6 are the cash inflows for respective years and C5 is the additional investment
amount in year 5. Now let’s find the present worth amount of project X

The above cash flows are an example of revenue- dominated cash flow. Therefore,
Pw (X) i = -P+ R1/ (1+i) 1+ R2/ (1+i) 2+ R3/ (1+i) 3 + R4/ (1+i) 4 – C5/ (1+i) 5 + R6/ (1+i) 6
Present worth method can be applicable to the following four different cases. Viz.
Case: 1 Comparison of assets/projects that have equal lives (Co-terminated
assets)
If the projects are having equal lives, the best alternative can be chosen by the help of
Present worth method. Let’s take there are two alternative projects X and Y and both
can continue for 4 years having different cash flows. In this case equal payment series
present worth factor
(P/A, i, n) can be applied.
If Pw(X)> Pw (Y),
then X project should be preferred
Case: 2 Comparison of assets/projects that have unequal lives
In case of projects having unequal lives, two techniques can be applied, i.e., Common
multiple method and a definite Study- period method. In case of common-multiple method,
LCM of unequal lives of the projects are taken and it is tried to find how many times a
particular project can repeat (replace) itself. The number o f times a particular project can
replace itself is calculated by the ratio of LCM and the individual life of projects. That is
why this method is also known as Repeated project method. After finding out the repetition
times of projects, then only present worth method can be applied. Whereas in case of a Study
period method, a definite period of analysis is taken into account irrespective of the
individual longevity of the alternative projects. Therefore, in a study period method, projects
always have salvage value.
Case: 3 Comparison of assets/projects that have infinite lives
Generally we doubt on the infiniteness longevity of project, but this infinite lives is only
meant for long-lived assets like dams, fly-overs, tunnels, railway tracks etc. which can
continue to render service beyond generations (that means here lives of projects (n) tend to
infinite). For these examples Capitalised cost is calculated for comparisons of alternatives.
According to Riggs, Bedworth and Randhawa (2004:90), Capitalised cost is “the sum of the
first cost and the present worth of (mine: annual) disbursements assumed to last forever…”
In capitalised cost we try to reduce each of the cash flows, initial cost as well as other cash
flows to zero time.
Now capitalised cost can be derived from equal payment series present worth factor.
(P/A, i, n) = [(1+i) n -1]/ i(1+i)n
When ‘n’ ∞, then Lim (P/A, in, n)
Case: 4 Comparison of deferred investments
In case of deferred investment projects (to arrange for something to happen at a later
time than you had planned), present worth comparison method can also be applicable to
judge whether the deferred on e is better than the current one.
Future worth comparisons
When each of the cash flows of projects is expressed in terms of future time by the help of
discounting factor is known as the future worth method4. We are able to get the future value of
each of the projects and compare whose worth is the maximum and accordingly the project
with the highest future value is preferred.
Fw= Pw (F/P, i, n)
= Pw (1+i) n

Payback Period (Payout) Method

Payback period method finds out how quickly the investment amounts of a project get
recovered. Therefore this method tries to find the minimum time period required to get back the
invested amount of a project. This period is known as payback period of a concerned project.
This method emphasises on the riskiness of the project and is indifferent to profitability. So
this method ignores the cash flows happening beyond payback period. Although this method of
comparison is not equivalent to present worth (or future method) as the former does not
entertain the discounted cash flows, but this method is the simplest one. It is particularly
Rate of Return
Rate of return is a percentage that indicates the relative yield on different uses of
capital. In engineering economic evaluation studies, there are 3 types of rate of used,
viz., Minimum acceptable rate of return (MARR), Internal rate of return (IRR) and
External rate of return (ERR). Let’s describe each of the aforesaid rates of return.
MARR: It is the lowest level of return which makes allows investment and makes an
investment possible.
IRR: It is the discount rate at which net present worth is zero. i.e.,
If B and C are the benefits and costs respectively with respect to different years, then
IRR is calculated as B1-C1/ (1+i) 1= 0
ERR: It is the rate of return that is possible under current economic conditions.
However, our topic of discussion is IRR and its application.
Calculations of IRR
Let’s suppose that there are 2 mutually exclusive projects – A & B and B is
more costly. We can say that B= A+ (B-A)
(B-A) is known as incremental cash flow. Now the steps to find the IRR are as
follows
a)Calculate (B-A)
b)Compute IRR on this incremental cash flow
c)Decision rule is:
IF IRR (B-A) > MARR, then select B project If IRR (B-A) <
MARR, then select A project
IRR (B-A) = MARR, indifferent to take either A or B
IRR is calculated by the following three methods. Viz.,
i) Direct solution method
ii) Trial and error method
iii) Computer solution method
Let’s take an example.
The cash flows for two mutually exclusive
alternatives of projects A and B are given. If
MARR is 10% which alternative is to be chosen?
We know that there exists an inverse relationship between i and pw.
So in order make the PW zero, i* needs to be raised
If i*= 14%, PW= 165
If i*= 16%, PW= -160.23
The i* at which PW would be zero can be found out by the method of
interpolation
i*= 14%+ (165-0)/[165-(-10.23)]× (16%-14%)
= 15.01%
As this i* > MARR, B is to be preferred.