118 Financial Management
There is one more difference. Alternative 1, assumes that the interest and loan repayment
obligations are of the same order and focuses on the ability of the firm to meet these
obligations jointly. Alternative 2 assumes that the interest burden is of a higher priority,
and focuses on the ability of the firm to meet the principal repayment obligation, once
the interest obligation is fully met.
These traditional methods of investment appraisal are misleading to a dangerous extent.
A means of measuring cash that allows for the importance of time is needed. This is
provided by the discounting methods of appraisal, of which there are basically two
methods, both of which meet the objections to the payback period and the average rate
of return methods.
Discounting Methods of AppraisalNet Present Value
The net present value of a project is equal to the sum of the present value of all the cash
flows associated with the project. One of the most important concepts originating from
the time value of money, NPV is calculated by subtracting the present value of the cash
outflows (investment) from the present value of the cash inflows (income).
Suppose you are making an investment of Rs 1 lac today and are expecting that you
will get Rs 1.1 lacs one year from now. You will only invest if the present value of Rs
1.1 lac that you are getting one year hence is more than Rs 1 lac you have invested
today. Using the table for present value of Rs 1, the multiplying factor for one year at
10% is 0.909. If we multiply Rs 1.1 lac with .909 we get approx. Rs 1 lac. This means
that we are getting a return of 10% from the project.
If you again look at the same table, the value gets lowered as the interest rate increases,
which means that for an interest rate of more than 10% we will be getting a present
value which will be lower than the investment we are making. So if we are expecting a
return of 15% for one year, we will not invest as the present value of Rs 1.1 lac at 15%
discount rate is lower than the investment of Rs 1 lac we are making today.
The formula for calculating the NPV is:where NPV = net present value
CFt = cash flow occurring at the end of year
C0 = Initial cash out flow or investment
t = (t = 0 ......n), A cash inflow has a positive sign, whereas a cash
outflow has a negative sign