© 2018 IJRAR October 2018, Volume 5, Issue 4 www.ijrar.

org (E-ISSN 2348-1269, P- ISSN 2349-5138)

Comparison of NDCF and DCF Techniques of

Project Appraisal
Vikas Shrotriya
Professor and Head
Department of Management Studies, SKIT,
Ramnagariya, Jagatpura, Jaipur – 302 017
Abstract

If the organizations had more than sufficient funds for all projects or all investment opportunities

that come to their way, there would have been no need to appraise any project but in real life, financial

resources are limited and it becomes imperative to appraise all projects from the view point of their financial

viability. It is the paucity of financial resources that the organizations cannot pursue all projects and thus the

organizations need to select the most viable project out of the many available ones. All projects, in the race

of getting selected, do not have same requirements of investment amounts and same cash inflows. Even the

life span of various projects is also different. In case of investment opportunities, the maturity date is

different. Thus, to appraise and compare different projects, the organizations use a number of methods and

techniques, as per their yardsticks. Some of these techniques are really simple to understand and apply while

others are technical, requiring certain knowledge of apprising. Also known as capital budgeting techniques,

the set of Non Discounted Cash Flow and Discounted Cash Flow techniques differ only in the aspect of

discounting of future cash flows. It is understood that with the passage of time, the purchasing power of

money is eroded and hence the amount supposed to be received in future need to be adjusted for such

reduction. The discounting rate is usually the required rate of return the organization wants to earn on its

projects. It is very much clear here that the non discounted cash flow techniques of project appraisal do not

consider time value of money. These techniques presume that the value of money today will also remain

same in future, as well. In practice, it is not so, as there is impact of inflation and other economic factors and

the value of money is less on a future date, in comparison to what it is today. In the coming paragraphs, a

comparison has been made between non discounted and discounted cash flow techniques.

Key words: Project appraisal, NDCF techniques, DCF techniques.

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Introduction
Everyone in this world yearns for more and more and unlimited money because money is the only

thing that has got the power to purchase any or all other things. If ample funds are with everyone, there is no

need to make any selection as one would be able to purchase all things or will be able to invest in all

available opportunities etc. But it is not so in real life. The scarcest resource is probably the financial

resource with any person as everyone has to earn it and everyone has got limited earning capacity. This

makes the life difficult as one has to decide upon the priorities and make selections every now and then.

Same is the case with organizations. Organizations too have scarce financial resources. Whenever there are

investment opportunities or number of projects available for persuasion, there is need to appraise them and

select according to a pre decided selection criteria. It is not possible for any firm to invest in all the projects

and it is even more important to know that whether the project is going to be profitable or not. Suppose

there are n number of projects available for investment then first of all the organization will short list those

projects which are profitable, using a pre defined criteria for the purpose, like projects having specific return

on investment etc. This will reduce the number of projects to be analyzed further. The projects need to be

analyzed from three dimensions. Firstly, the amount required for investment. Secondly, the tenure of project

and thirdly, return from the project. Various projects have different durations and the amount required as

initial investment also varies. Off course, returns from projects are also not same. Finding a tradeoff

between these three is the real challenge for any organization, in order to select the best project. Keeping in

view all these three dimensions, a number of techniques are used by the organizations. Non discounted and

discounted cash flow techniques are also the techniques applied by the organizations to appraise and rank

the projects. Organizations also use these techniques as yardsticks to check whether specific projects qualify

for investment or not. For example, an organization may decide that it will not at all consider those projects

which have payback period of more than five years or which do not have positive net present value etc.

organizations devote a lot of time and efforts in the exercise of selection of feasible projects as their future

depends on success of these projects. The projects demand commitment of large amount of funds and their

benefits are reaped by the organizations over a number of future years. Usually, these types of decisions are

irretrievable and these also affect the risk profile of the organization. It also depends on the type of the

project that how it is going to contribute into the success of the organization. Whether the project is related

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or not, with the current business of the organization, it is technology based or some new product or service

is being launched or it is expansion of present capacities, these are some critical issues which will affect the

fate of the organization. To deal with the selection process, the organizations resort to various methods and

techniques and non discounted and discounted cash flow techniques are also very popular project appraisal

techniques followed by the organizations to narrow down on feasible and profitable projects.

Objectives of the study

Following are the objectives of the present study:

1. To understand non discounted cash flow (NDCF) techniques of project appraisal.

2. To understand discounted cash flow (DCF) techniques of project appraisal.

3. To compare NDCF and DCF techniques of project appraisal.

NDCF Techniques

Non discounted cash flow (NDCF) techniques of project appraisal are really simple to understand.

These techniques involve least calculations and are easy to apply in practice. By the term non discounted, it

is meant that the time value of money has not been considered i. e. the present value and the future value of

money is being treated as same. The cash inflows or even the future cash outflows are not being brought at

par with their present value.

Since time immemorial, the criterion to analyze the investment opportunity is to find out the time

period in which the invested amount is recovered. There used to be no consideration for time value of

money. NDCF techniques are also so simple and the very first technique is based on the same traditional

criterion. The first technique known as Pay Back Period (PBP) considers the time duration in which the

original payment is received back. For example if Rs 20,000 are invested and Rs 5,000 are earned per year,

the payback period is 4 years. In the same case, if the cash inflows are Rs 5,000, Rs 4,700, Rs 4,500, Rs

5,000 and Rs 4,500 for year 1 to 5 respectively, the payback period is 4.18 years. This is simply the duration

in which the invested amount is recovered. There is no other criterion like what is being earned from the

project or what amount is received the payback period etc. The Second technique is the Accounting Rate of

Return (ARR) also known as Return on Investment (ROI) that calculates return as the percentage of original
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investment. This technique too does not consider time value of money. Average return divided by average

investment and multiplied by 100 gives the ARR of the project. Using both the techniques, the organization

can fix a benchmark like the organization will not consider projects having payback period of more than

four years or say five years and similarly the organization may not consider the projects having ARR of less

than 13% or say 15%, whatever deems fit to the organization. NDCF techniques are, no doubt simple to

understand and apply, but they do not consider the impact of time on the value of money.

DCF Techniques

DCF techniques are an edge over NDCF techniques of project appraisal as these consider time value

of money. Before landing into DCF techniques, let us first understand the concept of discounting. If suppose

Rs 100 are invested today @ 10% for one year, the amount to be received after one year is Rs 110. If it is

known that Rs 110 will be received after one year and if the organization wants to know the amount that can

be invested today at 10% required rate of return, the answer is Rs 100. In other words, one can say that Rs

100 is the present value of Rs 110 expected to be received after one year @ 10% rate of return and Rs 110 is

the future value of Rs 100 being invested today, for one year @ 10% rate of return. To reach at the present

value from the future value, the future value is to be multiplied by a discounting factor. For investment for

one year duration @ 10%, this factor is 0.909. This is arrived at by dividing 1 by (1+0.1). Similarly,

discounting factors for other rate of interest for different years can be calculated.

Exhibit 1

Rs 100 invested for 1 year @ 10%

Multiply by 1.1
Present Value Future Value

Rs 100 Rs 110
Multiply by 0.909 (or Divide by 1.1)

Now, as the concept of discounting is clear, let us discuss DCF techniques of project appraisal.

Basically, there are four DCF techniques, namely adjusted payback period, net present value, profitability

index or benefit cost ratio and internal rate of return.

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In order to make the technique of payback period more effective, first the cash flows are discounted

and then payback period is calculated. This is called the technique of Adjusted Payback Period (APBP). It is

obvious that APBP is more in duration, in comparison to the PBP as the cash flows are discounted at the

required rate of return. In Net Present Value (NPV) technique, the present value of cash outflows is

deducted from the present value of cash outflows. Projects with negative NPV are rejected out rightly.

Profitability Index (PI) is calculated by dividing present value of cash inflows by present value of cash

outflows. The project needs to have a PI of at least more than 1 in order to be considered further. The rate

the project is earning by itself is called as Internal Rate of Return (IRR). At IRR, NPV is zero and PI is one.

Let us further understand these techniques by taking a hypothetical example.

Hypothetical Example 1:
Table 1: Calculation of PB, APB, NPV, PI (Example 1)

(All figures in Rs)

Particulars Project A Project B

Initial Outlay 50000 Year wise PV PV 60000 Year wise PV PV

Factor (10%) Factor (10%)
Year 1 cash inflow 10000 0.909 9090 20000 0.909 18180

Year 2 cash inflow 20000 0.826 16520 13000 0.826 10738

Year 3 cash inflow 15000 0.751 11265 15000 0.751 11265

Year 4 cash inflow 18000 0.683 12294 17000 0.683 11611

Year 5 cash inflow 12000 0.621 7452 18000 0.621 11178

Now, PB for Project A is 3.28 years and for Project B it is 3.71 years. ARR for Project A is

30% and the same for Project B is 27.67%. APB for Project A is 4.11 years and for Project B it is 4.73

years. NPV of Project A is Rs (9090+16520+11265+12294+7452)-50000=Rs 6621 and NPV for Project B

is Rs (18180+10738+11265+11611+11178)-60000=Rs 2972. PI for Project A is 1.13 and for Project B it is

1.05. IRR calculated for Project A is 15% and IRR for Project B is 12%. Thus, it is noticed that Project A

ranks over Project B using any of the appraisal technique. Now, let us go a step further in analysis through

another hypothetical example.

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Hypothetical Example 2:
Table 2: Calculation of PB, APB, NPV, PI (Example 2)

(All figures in Rs)

Particulars Project A Project B

Initial Outlay 50000 Year wise PV PV 50000 Year wise PV PV

Factor (10%) Factor (10%)
Year 1 cash inflow 20000 0.909 18180 12000 0.909 10908

Year 2 cash inflow 18000 0.826 14868 14000 0.826 11564

Year 3 cash inflow 16000 0.751 12016 16000 0.751 12016

Year 4 cash inflow 14000 0.683 9562 18000 0.683 12294

Year 5 cash inflow 12000 0.621 7452 20000 0.621 12420

In this hypothetical example, the investment amount is same; the length of both the projects is also

equal but the cash inflows are in reverse order. PB for Project A is 2.75 years and for Project B it is 3.44

years. ARR for both the projects is 32%. APB for Project A is 3.52 years and for Project B it is 4.26 years.

NPV of Project A is Rs 12078 and NPV for Project B is Rs 9202. PI for Project A is 1.24 and for Project B

it is 1.18. IRR calculated for Project A is 20% and IRR for Project B is 17%. In this example, it can be

observed that Project A scores over Project B despite of the fact that both the projects have equal amount of

investment and equal life time but the sequence of cash inflows is reverse. The time effect on money is

easily visible in case of Project B where larger amounts are received towards the end of the project life. In

fact, the amount received in the beginning of the project life has higher present value in comparison to the

same amount received during later years.

Comparison of both types of techniques

NDCF and DCF techniques of project appraisal are useful in analyzing the capital cash flow streams.

The basic difference between these two sets of technique is the discounting of cash inflows in case of DCF

techniques, which consider time value of money. DCF techniques prove to be better analytical tool as the

value of money on present day is always more then what it would be on a future date. While NDCF

techniques are really simple to understand and apply but after analyzing the same project using DCF

techniques the project may seem financially non viable. Consider the following hypothetical example:

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Hypothetical Example 3:
Table 2: Comparison of PB and NPV (Example 3)

(All figures in Rs)

Particulars Project A

Initial Outlay 10000 Year wise PV PV

Factor (10%)
Year 1 cash inflow 4000 0.909 3636

Year 2 cash inflow 3000 0.826 2478

Year 3 cash inflow 2500 0.751 1878

Year 4 cash inflow 1500 0.683 1025

Year 5 cash inflow 1000 0.621 621

The PB for the above project is 3.33 years but the NPV for it is negative at required rate of 10%.

According to NPV criterion, this project is not worth considering for investment while as per PB the project

is recovering its investment in 3.33 years. This is so because NDCF techniques are focusing on recovery of

original investment only and are not considering any earning on the invested amount while the DCF

techniques are considering the required rate of return to be earned by the project by which the cash inflows

are discounted. Another difference is that in case of PB, the cash inflow after the payback period are

immaterial and even the terminal value of the project is not considered. In DCF techniques, all inflows are

taken care of. That way also, DCF techniques are a step ahead of NDCF techniques. In case of projects

requiring unequal investment amounts, or of different life, it becomes imperative to apply DCF techniques

as these techniques are not limited to the initial years of the projects. One limitation of DCF techniques is

that these are technical in nature and involve calculations and thus some understanding of the subject is

required. APB tries to overcome the limitation of PB by considering e discounted cash inflows but it still

suffers from the limitation of not considering the cash inflows after the payback period and the terminal

value. ARR considers all cash inflows but suffers from the limitation of not considering the time value of

money. Thus, the biggest limitation of NDCF techniques is that these do not consider the effect of time on

purchasing power of money. DCF techniques, on the other hand prove to be superior over NDCF techniques

as these consider discounting of cash inflows and also that these cover all the cash flows throughout the life

of the project, including the terminal value. Many projects which look lucrative prime facie, using NDCF

techniques, turn non profitable when analyzed using DCF techniques due to the reason that DCF techniques

consider required rate of return from the projects. A comparison of NDCF and DCF techniques reveals that
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DCF techniques are better than NDCF techniques and in many cases DCF techniques provide better analysis

of projects.

Conclusion
The organizations need capital funds for n number of reasons like expansion of present capacities,

diversification from present business, replacement of heavy machines or equipments with an objective of

modernization and these may be sometimes emergency investments. New business ventures are also tried by

the organizations. For all such purposes, capital investments are needed. A peculiar feature of capital

projects is that these are irreversible and due to this vary reason it becomes crucial that these projects are

analyzed from the viewpoint of financial viability. Any organization considering capital investment projects

is actually committing its scarce financial resources and moreover, these financial resources are competing

for various mutually exclusive investment opportunities. It is considerable here that capital investment

projects convert current assets into fixed assets and the features of both these types of assets are different,

main difference being long term commitment of funds in fixed assets. These investments further affect the

profitability of the organization as may be possible that during the initial years some projects fail to generate

any revenue. All projects which seem financially viable initially may not be worth taking up for

consideration for investment. For the purpose of selecting projects for investment, organizations apply many

techniques, in order to let the projects jump the cut off criteria and attain some rank in the process of

selection. NDCF and DCF techniques are such techniques which help the organizations to firstly, identify

those projects which can be considered for investment by deciding upon benchmarks as cut off points.

Secondly, to enable the organizations to rank the projects to make the comparison of projects easier. And

thirdly, to let the organizations get an idea of what the project is going to earn. Due to these reasons

organizations use NDCF and DCF techniques of project appraisal. NDCF techniques do not discount the

cash flows as these do not consider time value of money. These are simple to understand and apply. The

results provided by these techniques can be misleading. DCF techniques are a step ahead of NDCF

techniques as these consider time value of money DCF techniques discount the future cash flows by the

required rate of return, to arrive at the present value of such future cash flows. This provides a refined

picture of the cash streams of the projects and also guides the organization about the worth of the project as

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on present date. DCF techniques make the comparison of cash outflows and inflows more effective as all the

cash flows are now considered on the same date. This makes DCF techniques superior to NDCF techniques.

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