Discounted Pay back period

• The discounted pay back period is the number of periods taken in recovering the
investment outlay on the present value basis.
• DPB as an example

Proj Cash flows PB DP NPV at 10%

ect B
C0 C1 C2 C3 C4

P -4000 3,000 1,000 1,000 1,000 2yrs

PV -4000 2727 826 751 683 2.6 987
yrs
Q -4000 0 4,000 1,000 2,000 2yrs
PV -4,000 0 3,304 751 1,366 2.9 1,421
yrs
 ARR Concept
• Consider two projects in hand ,one involving an investment
of Rs.1 lakh, which earns Rs.1,10,000 at the end of the year
and the other involving the same investment yielding
Rs.1,20,000 at the end of the year. In the former case, the
return is 10% on funds employed whereas in the latter, it is
20%.Hence,the choice of investment should be the second
option where the ROI is more.
• In cases where the projects have a longer life, say five years,
we have to take the average after tax profits and average
book value of fixed investments to calculate the same ROI as
above.
• Hence ARR is the investment’s average net income divided
by its average book value.
• It uses accounting information ie instead of cash flows and
market value it uses net income and book value.
 Concept ARR continued……..
• Book value of fixed assets-accounting profit method, ignores
expenditure of buying asset at the time of purchase. It records the
expenditure of an asset over the entire economic life of the project in
the form of depreciation, which is a non-cash item.
• Depreciation is the wear and tear of the fixed assets in the business. We
calculate depreciation on the basis of straight line method . The
straight line depreciation method divides the cost by the life.
SL = Cost / Life.
 Average income is calculated by taking the average of the net income
and dividing it by the number of years.
 Average book value of the investment is calculated by taking the
average of book value of investment in the beginning and book value
of the investment at the end and dividing it by the number of years.
 ARR
• Acceptance rule- Accept those projects whose ARR is higher
than the minimum rate established by the management and
reject those projects which have ARR less than the minimum
rate.
• Disadvantage
• Time value of money is ignored.
• Uses an arbitrary benchmark cutoffrate.
• Based on accounting values not cash flows and market
values.
 Question

• A project will cost Rs.40,000.Its stream of

earnings before depreciation ,interest and
Taxes(EBDIT)during first year through five
years is expected to be
10,000,Rs.12,000,Rs.14,000,Rs.16,000 and
Rs.20,000.Assume a 50% tax rate and
depreciation on straight line basis.Calculate
ARR.
Project with different lives
• Firms have to choose among projects with different lives
• Firms cannot solely rely on NPV since it is a rs figure and likely to be higher
for longer term projects.
• For eg a project of 5 yr has NPV of Rs.442 and a project of 10 yr has NPV of
Rs.478.
• On the basis of NPV alone the second project is better but this analysis fails
to factor in the additional net present value that the firm could make from
years 6 to 10 .
• In comparing a project with a shorter life to one with a longer life ,the firm
must consider the fact that it will get a chance to invest again sooner with
the shorter term project.
Equivalent Annual Annuity
• The NPv of projects with different lives can be made comparable in
another way. They can be converted into an equivalent annuity which
can be considered the annuallised net present value. The NPV is
annualized it can be compared legitimately across projects with
different lives.
• The NPV of a project can be converted into an annuity using the
following calculation
• EAA= NPV/ Present value Annuity factor
Equivalent Annual Annuities(EAA)
• EAA= finding the constant payment streams that the
projects NPV s would provide over their respective lives.
• Equivalent Annual Annuity essentially smoothes out all
cash flows and generates a single average cash flow for
all periods that (when discounted) equal the project’s
NPV.
• We take the NPV of each project and spread it over its
life time.
• EAA= finding the constant payment streams that the
projects NPV s would provide over their respective lives.
 EAA
• Masons Bakery Shop is considering purchasing one of two machines.
Machine A and Machine B are dough mixing machine that has a useful
life of 6 years and 4 years. During this time, the machine A represents an
NPV of 4 million.
• Machine B will represents an NPV of $3 million. Mason’s Bakery Shop
has a cost of capital of 10%. Which machine should the company invest
in?
• EAA of A= 4000000/4.3553= 918421.2
• EAA of B= 3000000/3.16999= 946375.2252

• Whichever machine has higher EAA will be selected. Machine B has a

higher EAA. Hence will be selected.
For calculation of NPV the cash flows
can be segregated into
•Initial Inflows
•Yearly/Annual Cash Flows
•Terminal Flows(End of the
life)
Initial Flows/Investment
• Start-ups require market survey on likely demand,
type of technology etc
• Cost of machinery –including installation and other
capital expenditure in addition to the working capital
will be included in project cost as an outflow at the
beginning of the year.
 Determining / determining cash flows for Investment Analysis
Taking on a project changes the firm’s overall cash flows today and in the future.
To evaluate a proposed investment, these changes must be considered in the cash
flows and then decide whether or not they add value to the firm.
A decision has to be taken regarding which cash flows are relevant and which are
not.
Relevant cash flows- a relevant cash flow for a project is a change in the firm’s
overall future cash flows that comes about as a direct consequence of the decision
to take that project. As relevant cash flows are defined in terms of changes in ,or
increments to, the firm’s existing cash flows, they are called the incremental cash
flows associated with the project.
 Incremental cash flows for project evaluation consist of any and all changes in
the firm’s future cash flows that are a direct consequence of taking the project.
Concept explained………..
• Any cash flow that exists regardless of whether or not a
project is undertaken is not relevent.
• The Stand-Alone Principle- once we identify the effect of
undertaking the proposed project on the firm’s cash flows,
we need to focus on the project’s resulting incremental cash
flows.
• The stand alone principle says is, that once we have
determined the incremental cash flows from undertaking a
project ,we can view this project as a kind of “minifirm”
with its own future revenues and costs, its own assets, and of
course, its own cash flows. Then the cash flows from this
minifirm will be compared to the cost of acquiring it.
• So a project gets evaluated purely on its own merit ,in
isolation from any other projects or activities.
 Identifying incremental cash flows
• Some common pitfalls while considering whether a cash
flow is relevant or not.ie sunk costs, opportunity
costs,erosion, net working capital, financing costs
• Sunk Costs-A cost that has already been incurred and cannot
be removed or recovered. Such a cost cannot be changed by
the decision today to accept or reject a project.ie the firm
will have to pay this cost no matter what.eg hiring a
financial consultant to help evaluate whether a line of milk
nutrient is to be introduced or not.
• Consulting fees is a sunk cost, because the consulting fees
must be paid whether or not the milk nutrient is actually
launched or not . This cost should not be considered in an
investment decision.
Sunk Cost
• A company spends $5 million on building an airplane. Prior to
completion, the managers realize that there is no demand for the
airplane. The aviation industry has evolved and airlines demand a
different type of plane. The company has a choice: finish the plane for
another $1 million or build the new in-demand airplane for $4 million.
In this scenario, the $5 million already spent on the old plane is a sunk
cost. It should not affect the decision and the only relevant cost is the
$4 million.