Time Adjusted Capital Budgeting

Methods
02/04/2020
 Learning outcomes
• Explain the time adjusted methods of
evaluating investment projects
• Learn the advantages and disadvantages of
time adjusted methods
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 Net Present Value
• This method takes into account time value of
money concept
• The net present value of cash inflows and cash
outflows will be calculated separately for each
year by discounting these flow by firm’s cost
of capital or pre-determined rate.
 Steps to calculate NPV
• Determine cut off rate or pre-determined rate
• Calculate present value of cash outlay
• Cash present value of cash inflows
• Calculate net present value of each project by
subtracting PV of cash inflows from PV of cash
outflow.
• Projects having maximum NPV will be
selected.
Example
Solution
 Advantages of NPV
• Consider time value of money concept
• Takes into account earning over the entire life
of project and the true profitability of
investment proposal can be estimated
• Takes into accounts objective of maximizing
profitability
 Disadvantage of NPV
• Difficult to understand and operate
• May not give good results while comparing
projects with unequal investment
• Not easy to determine an appropriate
discount rate
 Internal rate of return method
• The cash flows of projects are discounted at a
suitable rate by hit and trial method which
equates net present value to the amount of
investment
Example
 Advantages of internal rate of return

• Time value of money

• Consider profitability of project throughout its
life
• Useful where cost of capital cannot be
calculated easily
 Disadvantage of IRR
• Difficult to understand and very difficult to
operate
• NPV seems to be better as it assumed that
earnings are reinvested at the rate of firm’s
cost of capital.
 Difference between NPV and IRR
• Under NPV, cash flows are discounted At
predetermined rate while in IRR, discounted rate
is calculated by using hit and trial method
• NPV recognizes the importance of market return
or cost of capital while IRR does not consider
market rate
• NPV assumed that cash inflows are reinvested
at cut-off rate while IRR assumed that cash
inflows are reinvested at internal rate of return.
 Profitability index method
• Called benefit cost ratio
• Profitability index=PV of cash inflows/PV of
cash outflows
• Projects are accepted if profitability index is
greater than one