A Note On The Financial Evaluation Of Projects

NET PRESENT VALUE Contd..

•It recognizes the importance of the time value of money.
•It takes into consideration the benefits accruing over the entire life of the project.
•It follows the principle of shareholder's wealth maximization.

The main drawbacks of this method are:

•In some cases it may be difficult to determine the appropriate discount rate. The choice of an appropriate discount rate is important because the relative desirability of the project will change with the change in discount rate.
• This method favors the project with the higher NPV. In some cases, the project with a higher NPV may involve a higher initial outlay which may exceed the budgeted investment outlay for the project.
•This method may not give satisfactory results when the two projects in question have different economic lives.

One of the basic assumptions of NPV is that all the intermediate cash flows are re-invested at a rate equal to the cost of capital. However, if this assumption is invalid, the net present value has to be modified taking into account the re-investment rate. The steps involved in the calculation of the Modified Net Present Value are given below. a)The terminal value of intermediate cash flows calculated at the new re-investment rate: Where,

TV = Terminal Value
CFt = Cash inflow at year end
r'= re-investment rate

b)The Modified Net Present Value is calculated in the following manner:

Where,

NPVn = Modified net present value
TV = Terminal Value
k = Cost of capital
I = Investment outlay

Example:

Consider the same example illustrated above. The net present value of a construction project at the cost of capital of 14% is Rs. 8694. However, the underlying assumption of the present value of annuity is that all the intermediate cash flows are re-invested at the same rate of discount i.e. 14%. If the re-investment rate is different from the discount rate, then the modified net present value will be different from the net present value of Rs. 8694. Considering re-investment rates of 18% and 12%, the modified net present value would be:

More...

APPRAISAL TECHNIQUES IN PRACTICE FOR VARIOUS TYPES OF PROJECTS

CONCLUSION

EXHIBIT I ASPECTS OF PROJECT APPRAISAL

EXHIBIT II PROJECT EVALUATION TECHNIQUES

2010, ICMR (IBS Center for Management Research).All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means - electronic or mechanical, without permission.

To order copies, call +91- 8417- 236667 or write to ICMR,
Survey No. 156/157, Dontanapalli Village, Shankerpalli Mandal,
Ranga Reddy District,
Hyderabad-501504. Andhra Pradesh, INDIA. Mob: +91- 9640901313, Ph: +91- 8417- 236667,
Fax: +91- 8417- 236668
E-mail: info@icmrindia.org
Website: www.icmrindia.org