A Note On The Financial Evaluation Of Projects

NET PRESENT VALUE Contd..

Unlike the payback method, this criterion takes into account the discounted cash flows of a project. In this method, cash flows are discounted at the cost of capital, which shows the time value of money as well as the riskiness of the cash flows.

The decision rule for this criterion is to accept the project with less payback period or when the accumulated discounted cash flows are equal to the initial investment. The discounted payback period is measured as follows:

*The cost of capital is assumed as 10%

*The present value of cash flow at the end of the 1st year = Cash flows at the end of the 1st year/(1 + 0.10)¹

The initial investment in Project X (Rs 155000) is paid back in 4.27 years and the initial investment in project Y (Rs 48000) is paid back in 3.82 years This method has the following merits: •It takes into account the time value of money.

•It considers the riskiness of cash flows. The demerit of this method is that it does not have any particular decision rules.

•The project is accepted when the actual discounted payback period is less than the required or predetermined payback period. •The project is rejected when the actual discounted payback period is greater than the required or predetermined payback period.

•Where there are mutually exclusive projects, the one with the least discounted payback period but less than the cut off payback period must be selected.

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