Corporate Financial Management

By Md. Monowar Hossain, FCA, CPA,

FCMA,CISA,CPFA(UK),FCGA,FCS
md.monowar@gmail.com

CFM
Corporate Financial Management (CFM)
06. Capital investment appraisal (con...)
Module -06 (31) Accounting Rate of Return
(32) Payback Period
(33) Discounted Payback Period
402.06
(34) Net Present Value
Capital
(35) Internal Rate of Return and their comparison
investment
(36) Implications of taxation and inflation
appraisal
(37) Capital rationing
(con...)
(38) Capital budgeting under uncertainty
(39) Lease or buy decisions
Learning outcomes:
(b) Net Present Value
(c) Advantages and limitations of NPV
(d) Formulas of NPV
(e) Use of NPV
(f) Calculation of NPV
Net Present Value (NPV)
Net Present Value (NPV)
The net present value takes into account the Net present value (NPV) is the difference
profitability by analyzing cash flows over the life of between the present value of cash
the project. It uses the cost of capital to discount inflows and the present value of cash
the cash flows. Net present value (NPV) is the outflows over a period of time. NPV is used
difference between the present value of cash in capital budgeting and investment
inflows and the present value of cash outflows over planning to analyze the profitability of a
a period of time. projected investment or project

The net present value (NPV) method is a process of calculating the present value of cash
flows (inflows and outflows) of an investment proposal, using the cost of capital as the
appropriate discounting rate, and finding out the net profit value, by subtracting the
present value of cash outflows from the present value of cash inflows.
The equation for the net present value, assuming that all cash outflows are made in the initial year,
will be:

Where A1, A2…. Represent cash inflows, K is the firm’s cost of capital, C is the cost of the
investment proposal and n is the expected life of the proposal. It should be noted that the cost of
capital, K, is assumed to be known, otherwise the net present, value cannot be known.

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12th Edition (September-2021)
 Corporate Financial Management
By Md. Monowar Hossain, FCA, CPA,
FCMA,CISA,CPFA(UK),FCGA,FCS
md.monowar@gmail.com

NPV is calculated by discounting the future net cash flows after tax using the firm’s risk-adjusted
cost of capital. Then all the present values of the future cash flows are added up. Then the initial
outlay is subtracted from the sum of the present values. The decision rule is to accept all projects
if the NPV is equal to zero or greater than zero, provided there is no capital rationing.

Where ‘k’ is the opportunity cost of capital and ‘N’ is the time period of the project (years).

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KEY POINTS:
• Net present value, or NPV, is used to calculate today’s value of a future stream of
payments.
• If the NPV of a project or investment is positive, it means that the discounted present value
of all future cash flows related to that project or investment will be positive, and therefore
attractive.
• To calculate NPV you need to estimate future cash flows for each period and determine the
correct discount rate.

The Formula for NPV

If analyzing a longer-term project with multiple cash flows, the formula for the net present
value of a project is:

If you are unfamiliar with summation notation, here is an easier way to remember the concept
of NPV:
NPV=Today’s value of the expected cash flows−Today’s value of invested cash

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https://www.investopedia.com/ask/answers/032615/what-formula-calculating-net-present-value-npv.asp
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12th Edition (September-2021)
 Corporate Financial Management
By Md. Monowar Hossain, FCA, CPA,
FCMA,CISA,CPFA(UK),FCGA,FCS
md.monowar@gmail.com
Examle:

Examle:

Advantages and limitations of NPV

Advantages:
1. It recognizes the time value of
money
2. It considers all cash flows over the
entire life of the project in its
calculations.
3. It is consistent with the objective
of maximizing the welfare of the
owners.
Limitations:
1. It is difficult to use
2. It presupposes that the discount rate which is
usually the firm’s cost of capital is known. But in
practice, to understand cost of capital is quite a
difficult concept.
3. It may not give satisfactory answer when the
projects being compared involve different amounts
of investment

Problem no. 49: (NPV)

FYR Car Repair, Inc. would like to purchase a new machine for $400,000. The machine will have
a life of 4 years with no salvage value, and is expected to generate annual cash revenue of
$180,000. Annual cash expenses, excluding depreciation, will total $20,000. The company uses
the straight-line depreciation method, has a tax rate of 30%, and requires a 10% rate of return.
Required: a) Find the NPV of this investment b) Should the co.purchase the machine? Explain.
Solution of problem no. 49: (NPV)
The NPV is $50,112 as shown in the following figure.

a Initial investment purchase price does not directly affect net income and therefore is not

adjusted for income taxes.

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12th Edition (September-2021)
 Corporate Financial Management
By Md. Monowar Hossain, FCA, CPA,
FCMA,CISA,CPFA(UK),FCGA,FCS
md.monowar@gmail.com
b Amount equals cash revenue before taxes × (1 – tax rate); $126,000 = $180,000 × (1 – 0.30).
c Amount equals cash expense before taxes × (1 – tax rate); $14,000 = $20,000 × (1 – 0.30).
d Depreciation tax savings = Depreciation expense × Tax rate. Depreciation expense is $100,000

(= $400,000 cost ÷ 4-year useful life).

Thus, annual depreciation tax savings is $30,000 (= $100,000 depreciation expense × 0.30 tax rate).
Yes, the company should purchase the machine. The positive NPV of $50,112 shows the return
of this proposal is above the company’s required rate of return of 10%.

Problem no. 50: [Net present value]

Farhana Company needs a machine for its manufacturing process. The cost of the new machine is
$80,700. The expected useful life of the machine is 8 years. At the end of 8-year period, the machine
would have no salvage value. After installation, the machine would increase cash inflows by $30,000
per year. Farhana is interested to know the NPV of the machine to accept or reject this investment.
The minimum required rate of return of the company is 16% on all capital investments.
Required: Compute net present value of the machine. Is it acceptable to purchase the machine?

Solution of problem no. 50: [Net present value]

Net present value computation:

Amount of Present
16%
Years cash value
Factor
flows of cash flows
Annual cash inflow 1 – 8 $30,000 4.344* $130,320
Initial cost of the
Now $(80,700) 1.000 $(80,700)
machine
Net present value $49,620

* Value from present value of an annuity of $1 in arrears table.

(ii) Purchase decision:

The positive net present value (computed above) indicates that the investment is profitable,
therefore the machine should be purchased.

Problem no. 51(A): [NPV analysis of two alternatives]

The MONYEM company is considering two projects, project A and project B. Project A requires the
purchase of an equipment but no working capital investment whereas project B requires a working
capital investment but no equipment. The relevant information for net present value analysis is
given below:
Project A Project B
Cost of equipment $600,000 –
Working capital needed – $600,000
Annual cash inflows $160,000 $120,000
Salvage value (scrap value) of equipment $40,000 –
Project life 8 years 8 Years

The working capital required for project B will be released at the end of project life. MONYEM
company uses an 18% discount rate.

Required: Are the two projects comparable using net present value (NPV)? If yes, select the best
investment using net present value (NPV) method.

Page # 153
12th Edition (September-2021)
 Corporate Financial Management
By Md. Monowar Hossain, FCA, CPA,
FCMA,CISA,CPFA(UK),FCGA,FCS
md.monowar@gmail.com

Solution of problem no. 51(A): [NPV analysis of two alternatives]

Yes, the two projects are comparable because both the projects require equal amount of initial
investment.

NPV of project A:
Amount
Present value
of 18%
Years of
cash Factor
cash flows
flows
Cost of equipment Now $600,000 1.000 $(600,000)
Annual cash inflow 1 – 8 $160,000 4.078* $652,480
Salvage value of the
8 $40,000 0.266** $10,640
equipment
Net present value (NPV) $63,120

NPV of project B:
Amount of Present value
18%
Years cash of
Factor
flows cash flows
Working capital needed Now $600,000 1.000 $(600,000)
Annual cash inflow 1 – 8 $120,000 4.078* $489,360
Release of working capital 8 $600,000 0.266** $159,600
Net present value
$48,960
(NPV)

*Value from “present value of an annuity of $1 in arrears table”.

**Value from “present value of $1 table”.

According to NPV method, project A looks more desirable because its net present value is more
than project B.

Problem no. 51(B): [Comparison of projects using net NPV method ]

MUTTAKEEN company is trying to choose the best investment project from two alternative projects.
The company has $30,000 to invest. The information about two alternatives is given below:
Project Project
X Y
Investment required $30,000 $30,000
Annual cash inflows $8,000 0
Single cash inflow at the end of 8
– $120,000
years
Project life 8 years 8 years

The discount rate of MUTTAKEEN company is 15%.

Required: Give your recommendations to the company in selecting the best project to invest
$30,000.

Page # 154
12th Edition (September-2021)
 Corporate Financial Management
By Md. Monowar Hossain, FCA, CPA,
FCMA,CISA,CPFA(UK),FCGA,FCS
md.monowar@gmail.com

Solution of problem no. 51(B): [Comparison of projects using net NPV method ]

Net present value of project X:

Amount of Present value
Years 15% Factor
cash flows of cash flows
Cash inflow 1–8 $8,000 4.487* $35,896
Investment required Now $(30,000) 1.000 $(30,000)
Net present value $5,896
Net present value of project Y:
Amount of Present value
Years 15% Factor
cash flows of cash flows
Cash inflow 8 $120,000 0.327* $39,240
Investment required Now $(30,000) 1.000 $(30,000)
Net present value $9,240
Recommendations: Project Y’s net present value is $9,240 which is more than project X’s net
present value. Project Y is therefore, more desirable.

Problem no.52: (NPV and Payback Period Analysis)

Suppose that your CS batchmate has approached you with an opportunity to lend $25,000 to his
business. The business plans to offer home infusion therapy and monitored in-the-home healthcare
services to surgery patients in the different area. Funds would be used to lease a delivery vehicle,
purchase supplies, and provide working capital. Terms of the proposal are that you would receive
$5,000 at the end of each year in interest with the full $25,000 to be repaid at the end of a ten-year
period.
(1) Assuming a 10% required rate of return, calculate the present value of cash flows
and the net present value of the proposed investment.
(2) Based on this same interest rate assumption, calculate the cumulative cash flow of
the proposed investment for each period in both nominal and present-value terms.
(3) What is the payback period in both nominal and present-value terms?
(4) What is the difference between the nominal and present-value payback period?
(5) Can the present-value payback period ever be shorter than the nominal payback period?

Solution of problem no.52: (NPV and Payback Period Analysis)

(1) The present value of cash flows and the net present value of the proposed investment can be
calculated as follows:
Present Value Present Value
Year Cash Flow Interest Factor Cash Flow
0 ($25,000) 1.0000 ($25,000)
1 5,000 0.9091 4,545
2 5,000 0.8264 4,132
3 5,000 0.7513 3,757
4 5,000 0.6830 3,415
5 5,000 0.6209 3,105
6 5,000 0.5645 2,822
7 5,000 0.5132 2,566
8 5,000 0.4665 2,333
9 5,000 0.4241 2,120
10 5,000 0.3855 1,928
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12th Edition (September-2021)
 Corporate Financial Management
By Md. Monowar Hossain, FCA, CPA,
FCMA,CISA,CPFA(UK),FCGA,FCS
md.monowar@gmail.com
Cost of Capital 10.0%
Present Value of Benefits $30,723
Present Value of Cost $25,000
Net Present Value $5,723
(2 & 3) The cumulative cash flow of the proposed investment for each period in both nominal and
present-value terms is:
Cash Present Value Present Value Cumulative Cumulative
Year Flow Interest Factor Cash Flow Cash Flow PV Cash Flow
0 ($25,000) 1.0000 ($25,000) ($25,000) ($25,000)
1 5,000 0.9091 4,545 (20,000) (20,455)
2 5,000 0.8264 4,132 (15,000) (16,322)
3 5,000 0.7513 3,757 (10,000) (12,566)
4 5,000 0.6830 3,415 (5,000) (9,151)
5 5,000 0.6209 3,105 0 (6,046)
6 5,000 0.5645 2,822 5,000 (3,224)
7 5,000 0.5132 2,566 10,000 (658)
8 5,000 0.4665 2,333 15,000 1,675
9 5,000 0.4241 2,120 20,000 3,795
10 5,000 0.3855 1,928 25,000 5,723

Payback Period = 5 years

Present Value Payback = 7.28 years (= 7 +

Period $658/$2,333).

Based on the information provided in part (2), it is clear that the cumulative cash
(4) flow in nominal dollars reached $0 at the end of Year 5. This means that the
nominal payback period is 5 years. The cumulative cash flow in present-value dollars
exceeds $0 when the Year 8 interest payment is received.
This means that the present-value payback period is roughly 7 years. If cash flows
were received on a continuous basis, the present-value payback period would be 7.28
years (=$658/$2,333).

(5)
Assuming a positive rate of interest, the present-value payback period is always longer than
the nominal payback period. This stems from the fact that present-value dollars are always
less than nominal dollars, and it therefore takes longer to receive a fixed dollar amount back
in terms of present-value dollars rather than in nominal terms.

Problem No. 53 (net present value of the new product)

The MONYEM Trading Company has obtained a license to introduce a new product for 6 years. The
product would be purchased from manufacturing company for $10 per unit and sold to customers
for $20 per unit. The estimated annual cash expenses to sell the new product would be $18,000.
Other information associated with the new product is given below:

Cost of equipment needed $30,000

Working capital needed $40,000
Repairs and maintenance of equipment in 5
$2,500
years
Residual value of equipment in 6 years $5,000
The working capital would be released at the end of 6-year period. The expected annual sales are
5,000 units per year. The discount rate of the company is 16%.
Required: Compute net present value of the new product. Would you recommend its addition?

Page # 156
12th Edition (September-2021)
 Corporate Financial Management
By Md. Monowar Hossain, FCA, CPA,
FCMA,CISA,CPFA(UK),FCGA,FCS
md.monowar@gmail.com

Solution of problem No. 53 (net present value of the new product)

Sales revenue (5,000 units × $20) $100,000

Cost of goods sold (5,000 units × $10) $(50,000)
Expenses $(18,000)
Net annual cash inflow $32,000

Amount Present
16%
Item Years of value
Factor
cash flow of cash flow
Cost of equipment 0 $(30,000) 1.000 $(30,000)
Working capital requirement 0 $(40,000) 1.000 $(40,000)
Repair of equipment 5 $(2,500) 0.476* $(1,190)
Annual cash inflow from sale of new
1–6 $32,000 3.685** $117,920
product
Residual value of the equipment 6 $5,000 0.410* $2,050
Release of working capital 6 $40,000 0.410* $16,400
Net present value $65,180
*Value from “present value of $1 table”.
**Value from “present value of an annuity of $1 in arrears table”.

Conclusion: The new product should be introduced because its net present value is positive.

Problem no. 54: [NPV]

A manufacturing unit of FYR Ltd. engaged in the production of automobile parts is considering a
proposal of purchasing one of the two plants: Plant-A of Plant-B.

(i) The annual costs of the two plants are as follows:

(ii) Details of the Plant-A of Plant-B are given below:

(iii) Interest on capital @10%.

(iv) 10% interest tables

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12th Edition (September-2021)
 Corporate Financial Management
By Md. Monowar Hossain, FCA, CPA,
FCMA,CISA,CPFA(UK),FCGA,FCS
md.monowar@gmail.com

Required: Will it be advantageous to buy Plant-A or Plant-B? Substantiate your answer with help
of comparative unit cost of plants. Make other relevant assumption.

Solution of problem no. 54: [NPV]

Decision: As the unit cost is less in proposed Plant-B, it may be recommended that it is
advantageous to acquire Plant-B.

Problem No. 55 (Capital Budgeting)

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12th Edition (September-2021)
 Corporate Financial Management
By Md. Monowar Hossain, FCA, CPA,
FCMA,CISA,CPFA(UK),FCGA,FCS
md.monowar@gmail.com

Solution of problem no. 55 (Capital Budgeting)

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12th Edition (September-2021)