Illustration.

1 :

A. Calculation of Pay-back period (PB Period):

Cash outlay of the project $40,000

Total Cash inflow for the first five years 35,000

(7,000 x 5 Yrs) ----------
Balance of cash outlay left to be paid back in the 6th year 5,000
-----------
Cash inflow for 6th Year 8,000

So, the payback period is between 5th and 6th years,

5000
i.e 5 Yrs + -------
8000
5
5 Yrs + -------
8
= 5 + 0.625

= 5.625 Yrs
B. Calculation of Net Present Value @10% Discount Rate:

Year Net Cash inflow $ Present Value at Discount Rate of 10% Present Value of
Cash Inflow$
(1) (2) (3) (2) x (3) = (4)
1 7,000 0.909 6363
2 7,000 0.826 5782
3 7,000 0.751 5257
4 7,000 0.683 4781
5 7,000 0.621 4347
6 8,000 0.564 4512
7 10,000 0.513 5130
8 15,000 0.467 7005
9 10,000 0.424 4240
10 4,000 0.386 1544
Total 48,961

Net Present Value = Present Value of Cash Inflow – Cost of the Investment

NPV = 48,961 – 40,000

= 8,961
C. Calculation of Profitability Index @10% Discount Rate:

Present Value of Cash Inflows

Profitability Index = --------------------------------------
Cost of the Investment
48,961
= ---------
40,000
= 1.22

D. Calculation of Internal Rate of Return :

Year Net Cash Inflow $ Present Value Present Value Present Value Present Value
at Discount at Discount of Cash of Cash
Rate of 10% Rate of 15% Inflow 10% Inflow 15%
(1) (2) (3) (4) (2) x (3) = (5) (2) x (4) = (6)
1 7,000 0.909 0.870 6363 6090
2 7,000 0.826 0.756 5782 5292
3 7,000 0.751 0.658 5257 4606
4 7,000 0.683 0.572 4781 4004
5 7,000 0.621 0.497 4347 3479
6 8,000 0.564 0.432 4512 3456
7 10,000 0.513 0.376 5130 3760
8 15,000 0.467 0.327 7005 4905
9 10,000 0.424 0.284 4240 2840
10 4,000 0.386 0.247 1544 988
Total 48,961 39,420

Net Present Value at 10% = Present Value of Inflow - Cost of the Investment
= 48,961 - 40,000
= 8,961
Net Present Value at 10% = Present Value of Inflow - Cost of the Investment
= 39,420 - 40,000
= - 580 (Negative)
As the Net Present Value @15% Discount Rate is Negative, Hence IRR fall in between 10% and
15%. The correct IRR can be calculated as follows.
Note: ≥ D Accept
≤ D Reject
= D No effect
D Opportunity Cost
 Positive NPV
IRR = Low Discount Rate + ------------------------------------------------------ x (PVH –PVL)
PV@Lower Discount Rate – PV@Higher Discount Rate

Where
Positive NPV = Positive Net Present Value (8961)
PV@ Lower Discount Rate = Present Value @Lower Interest Discount factor (48,961)
PV@ Higher Discount Rate = Present Value @ Higher interest Discount factor (39,420)
PVH = Present Value Higher Discount factor rate (15%)
PVL = Present Value Lower Discount factor rate (10%)

8,961
IRR = 10% + -----------------------x (15% – 10%)
48,961 - 39,420

10 8,961 5
IRR = ---- + -----------------------x ----
100 48,961 - 39,420 100

10 8,961 5
IRR = ---- + -----------------------x ----
100 9,541 100

IRR = 0.1 + 0.9392 X 0.05

= 0.1 + 0.0470

= 0.1470 X 100

= 14.70%
Illustration.2 :
The Profitability of the Machine can be compared on the basis of Net Present Value (NPV) of
Cash Inflows as follows:
Year Discount factor@10% Machine – A $ Machine – B $
Cash Inflow Present Value Cash Inflow Present Value
(1) (2) (3) (2) x (3) = (4) (5) (2) x (5) = (6)
1 0.91 40,000 36,400 120,000 109,200
2 0.83 120,000 99,600 160,000 132,800
3 0.75 160,000 120,000 200,000 150,000
4 0.68 240,000 163,200 120,000 81,600
5 0.62 160,000 99,200 80,000 49,600
Total 518,400 523,200

Machine – A Machine – B

Net Present Value = Present Value of Inflow – Cost of the Investment

= 518,400 – 400,000 = 523,200 – 400,000

= 118,400 = 123,200

Present Value of Cash Inflows

Profitability Index = -----------------------------------------
Initial Investment

518,400 523,200
= ---------- = ------------
400,000 400,000

= 1.29 = 1.30

Net Present Value as Profitability Index are higher in case of Machine B and hence B will be
preferred.
Illustration.3 :

Profitability Statement
Description Machine – M Machine – N
$ $
Estimated Saving (Per annum) :
Scrap 5,000 8,000
Direct Wages 60,000 80,000
Total Estimated Savings (A) 65,000 88,000
Additional Cost (Per annum) :
Maintenance 8,000 10,000
Supervision 12,000 18,000
Total Additional Cost (B) 20,000 28,000
Net Savings or Annual Cash Inflows (A - B) 45,000 60,000

Initial outlay of the Project

Payback Period = -----------------------------------
Annual Cash Inflow

$90,000 $180,000
= ------------ = -----------
45,000 60,000

= 2 Years = 3 Years

As Pay-back period in case of Machine M is less than that in case of Machine N, Machine M is
recommended.

Note: Tax has been ignored as the rate of tax has not been given.
Illustration. 4 :

Description Project–A Project– B

$ $
Total Profit (After Depreciation , Interest and 6,000 10,000
Taxes)
Average Annual Profit 6,000/4 10,000/5
= Total Profit/Expected Life
Average Annual Profit 1,500 2,000
Net Investment in the Project 20,000 30,000

Average Annual Profit

Average Rate of Return (ARR) = ------------------------------------- x 100
Net Investment in the project

Project – A Project - B

1,500 2,000
= --------- x 100 = --------- x 100
20,000 30,000

= 7.5% = 6.66%

Note:
But if we calculate Average Rate of Return on Average investment which is initial
investment divided by 2 : then,

Stage . 1
Net Investment on the Project
Average investment = ---------------------------------------
2

20,000 30,000
= ------------- = ---------
2 2

= 10,000 = 15,000
Stage. 2
Average Annual Profit
Average Return on Average Investment =-------------------------------- x 100
Average Net Investment

Project – A Project - B

1,500 2,000
= --------- x 100 = -------x 100
10,000 15,000

= 15% = 13.33%

The average return on average investment is higher in case of Project A and is also higher than
the require rate of return of 12% and hence Project A is suggested to be undertaken.

Illustration. 5 :

Calculation of Net Present Value – Project. X

Year Cash flows Present Value of $1@10% discount Present Value of
factor using PV Tables Net Cash flows
1 5,000 0.909 4545
2 10,000 0.826 8260
3 10,000 0.751 7510
4 3,000 0.683 2049
5 2,000 0.621 1242
Scrap Value 1,000 0.621 621
Total 24,227

Net Present Value (NPV) = Present Value of Net Cash flows – Outlay of Investment

= 24,227 – 20,000 = 4,227

 Calculation of Net Present Value – Project. Y
Year Cash flows Present Value of $1@10% discount Present Value of
factor using PV Tables Net Cash flows
1 20,000 0.909 18,180
2 10,000 0.826 8,260
3 5,000 0.751 3,755
4 3,000 0.683 2,049
5 2,000 0.621 1,242
Scrap Value 2,000 0.621 1,242
Total 34,728

Net Present Value (NPV) = Present Value of Net Cash flows – Outlay of Investment

= 34,728 – 30,000 = 4,728

We find that Net Present Value of Project Y is higher than the NPV of Project X and hence it is
suggested that project Y should be selected.

Illustration. 6 :
Calculation of Internal Rate of Return
Cash flow Table at various Assumed Discount Rates of 10%,12%,14%,15%
Year Annual Dis.Rate PV Dis.Rate PV Dis.Rate PV Dis.Rate PV
Cashflow PVF10% PVF12% PVF14% PVF15%
1 15,000 0.909 13635 0.893 13395 0.877 13155 0.870 13050
2 20,000 0.826 16520 0.797 15940 0.769 15380 0.756 15120
3 30,000 0.751 22530 0.712 21360 0.675 20250 0.658 19740
4 20,000 0.683 13660 0.636 12720 0.592 11840 0.572 11440
66345 63415 60625 59350

The present value of net cash flows at 14% rate of discount is $60,625 and at 15% rate of
discount it is $59,350. So, the initial cost of investment, which is $60,000 falls in between these
two discount rates. At 14% the NPV is +625 (60,625 – 60,000 = +625). But, at 15% the NPV is -
650 (59,350 – 60,000 = -650). We may say that

Positive NPV
Internal Rate of Return = LDR + -------------------- x (PVH – PVL)
PV@L – PV@H
Where
LDR = Lower Discount Rate (14%)
PNPV = Positive Net Present Value (+625)
PV@L = Present Value at Lower (60,625)
PV@H = Present Value at Higher (59,350)
PVH = Present Value at Higher Rate (15%)
PVL = Present Value at Lower Rate (14%)

625
Internal Rate of Return = 14% + -------------------- x (15% – 14%)
60,625 – 59,350

625
Internal Rate of Return = 14% + -------------------- x (1%)
1275

14 625 1
Internal Rate of Return = --- + -------------------- x ----
100 1275 100

IRR = 0.14 + 0.4902 x 0.01

= 0.14 + 0.0049

= 0.1449 x 100

= 14.49%

Illustration 7:
Calculation of Net Present Values and Profitability Index
Year Cash Inflows PVfactor@10% PV$
1 20,000 0.909 18,180
2 15,000 0.826 12.390
3 25,000 0.751 18,775
4 10,000 0.683 6,830
Total 56,175
Net Present Value = Total Present Value – Initial Outlay

= 56,175 – 50,000

= 6,175
 Present Value of Cash Inflows
Profitability Index (Gross) = ----------------------------------------
Initial outlay
56,175
= ----------
50,000
= 1.1235

As the Profitability Index is higher than 1, the proposal can be accepted.

NPV
Net Profitability Index = -----------------
Net Cashoutlay

6,175
= ---------
50,000
= 0.1235 (or)
Net Profitability Index = Profitability Index (Gross) – 1

= 1.1235 – 1

= 0.1235

As the Net Profitability Index is positive. The proposal can be accepted.

Illustration. 8:

(i) Calculation of Net Present Value (NPV)

Year PVfactor Project – A Project - B
CashFlow $ Present Value Cash Flow $ Present Value
0 1 -50,000 -50,000 -80,000 -80,000
1 0.909 62,500 56,812.5 96,170 87,418.53
Net Present Value 6,812.5 7418.53

(ii) Calculation of Internal Rate of Return (IRR)

Project – A Project – B

Initial outlay 50,000 80,000

PV factor =--- ------------------- --------- ---------
Annual Cash Flow 62,500 96,170

= 0.80 0.8319
 IRR (Using PV Tables) = 25% 20%

Suggestion:
According to the NPV Method, Investment in Project B is better because of its higher positive
NPV ; but according to the IRR Method Project A is a better investment because of the higher
IRR. Thus, there is a conflict in ranking of the two mutually exclusive proposals according to the
two methods. Under these circumstances, we would suggest to take up Project B which gives a
higher NPV because in doing so the firm will be able to maximize the wealth of the shareholders.

Illustration.9 :

Calculation of NPV and Profitability Index

Year PVfactor Project – X Project - Y
At 10%
Cash flow $ Present Value$ Cash flow $ Present Value $
0 1 -100,000 -100,000 -70,000 -70,000
1 .909 80,000 72,720 60,000 54,540
2 .826 80,000 66,080 60,000 49,560
Net Present Value 38,800 34,100

Present Value of Cash Inflows

Profitability Index (PI) = -----------------------------------------
Present Value of Cash Outflows

Project – A Project - B

138,800 104,100
Profitability Index (PI) = -------------- = ----------
100,000 70,000

Profitability Index (PI) = 1.388 = 1.4871

= 1.39 = 1.49

Note: 72,720 + 66,080 = 138,800 & 54,540 + 49,560 = 104,100

According to NPV Method Project X is acceptable because of its higher positive NPV, but
according to profitability index method Project Y is acceptable because of higher PI. Thus there
is a conflict in ranking of the two mutually exclusive proposals under the two methods. In these
circumstances we would suggest the firm to take up Project X which gives higher NPV in
absolute terms because in doing so the firm would be able to maximize the wealth of the
shareholders.