In recent times, time-discounted rale of return llas received more prominance as a meaningful nleasure oS financial decisions. The time adjusted rate of return based on either net present value or the discou~lted cash [low is. being used to screen and rank capilal exllenditure proposals. The details of two important time adjusted rate of return analyses have been presented in subsequent paragraphs.
Net Present Value (NPV) Method
The method is based on the principle that 'an investment is to be accepled if the present value of its fulure cash inflow discounted at a specific rate of return, equals or exceeds the present value of amount of investments requiredhnade. If an illvestor spends a rupee today he expects to get the return a liltle more than a rupce afterwards. This is because the time has to add to the value of inoney spenl now.
Thc cluantum that he will get will mutually be dependent upoil what he expects to get in return. The present value for payment of Re. 1 to be received after n years at any rate of return can be found from the following formula :
pv(n,k)=1/(1+k(n))
where P V and k are Ulc present value and the discounting rale respectively. The present value ol' Re. 1 at a rate of return of 10% after one year is as follows :
pv(1,10%)=1/(1+0.01)=0.909 and
after 2 years, it would be P V(2, 10%) = 1/(1 + 0 . 0 1 )2 = 0.826 and so on.
Thus,
where
n = Total number of years,, md
CIF, = Cash inflow at the end of year t.
To arrive at a decisive conclusion, one will have to consider the net present value which takes into account Ule present value of costs deducted from Ule present value of the money to be received in future. Thus,
NPV = PV of cash inflows (benefits) - PV of cash outllows (costs)
Discoullted Cashflow or Internal Rate of Return (IRR)
In the present value method, the required rate is selected in advance, internal rate of return nlell~od finds the earnings rate, k at which the present value equals the present value of amount of investment, i.e. NPV equals zero. This is known as discounted cashflow rate of return or internal rale of return.
The rate of return is interpolated from the present value table which makes the present value of net cash inflows equal to the cash outlay on the project. A proposal for expenditure on a project will be preferred and accepted showing highest (anlong others) rate of discount found by interpolation and trial and error.The present value metl~ods consider the time value of money by laking the present value of each yeu's net cash inflow.
Net Present Value (NPV) Method
The method is based on the principle that 'an investment is to be accepled if the present value of its fulure cash inflow discounted at a specific rate of return, equals or exceeds the present value of amount of investments requiredhnade. If an illvestor spends a rupee today he expects to get the return a liltle more than a rupce afterwards. This is because the time has to add to the value of inoney spenl now.
Thc cluantum that he will get will mutually be dependent upoil what he expects to get in return. The present value for payment of Re. 1 to be received after n years at any rate of return can be found from the following formula :
pv(n,k)=1/(1+k(n))
where P V and k are Ulc present value and the discounting rale respectively. The present value ol' Re. 1 at a rate of return of 10% after one year is as follows :
pv(1,10%)=1/(1+0.01)=0.909 and
after 2 years, it would be P V(2, 10%) = 1/(1 + 0 . 0 1 )2 = 0.826 and so on.
Thus,
where
n = Total number of years,, md
CIF, = Cash inflow at the end of year t.
To arrive at a decisive conclusion, one will have to consider the net present value which takes into account Ule present value of costs deducted from Ule present value of the money to be received in future. Thus,
NPV = PV of cash inflows (benefits) - PV of cash outllows (costs)
Discoullted Cashflow or Internal Rate of Return (IRR)
In the present value method, the required rate is selected in advance, internal rate of return nlell~od finds the earnings rate, k at which the present value equals the present value of amount of investment, i.e. NPV equals zero. This is known as discounted cashflow rate of return or internal rale of return.
The rate of return is interpolated from the present value table which makes the present value of net cash inflows equal to the cash outlay on the project. A proposal for expenditure on a project will be preferred and accepted showing highest (anlong others) rate of discount found by interpolation and trial and error.The present value metl~ods consider the time value of money by laking the present value of each yeu's net cash inflow.
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