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Lesson 26. NPV METHOD OF CAPITAL BUDGETING
Module 5. Investment decision
Lesson 26
NPV METHOD OF CAPITAL BUDGETING
26.1 Introduction
Cash flows are yearly net benefits accrued from the project. It they are weighted by discount rate, they become discounted cash flows. These discounted cash flows are the best estimates to decide on the worth of the project. This approach will give the Net Present Worth of the project. The present worth of the costs is subtracted from the present worth of the benefits in order to arrive at the Net Present Worth of the project every year.
From the annual stream of gross benefits of the project, the capital invested and the other input costs like labour, machinery, fertilizers, pesticides, management, etc., are deducted. From the residual, the return of capital and return on capital or return to capital, i.e., recovering investment made in the project (depreciation) and compensation for the use of money (interest) are computed. This residual is called cash flow of the project. In financial analysis the cash flow is the net incremental benefit of the project. But, in accounting, the term implies the sum of cash flows of projects plus depreciation allowance. The concept of cash flow in the financial analysis includes, both return of capital and return to capital. We generally do not resort to deduction of depreciation, i.e., allowance of return of capital or interest in the economic analysis, because our analytical technique automatically takes care of return of capital in determining the worth of the project. In economic analysis, income taxes, sales taxes, custom duties are only transfer payments, but not payments used in the production process. Hence, from the gross returns these are not deducted. But, in financial analysis, taxes are a cost, which the individual must pay before arriving at the recovered capital, and compensating it for the use of capital.
By far, financial analysis aims at estimation of returns to all resources employed in the project. Hence, borrowed capital is considered as a benefit received, while, its interest is considered as a cost and it is deducted from the gross returns. In economic analysis, this consideration is ruled out because of the assumption, that all the resources employed in the project belong to someone or the other, within the society. In the economic analysis, it is important that the prices of some of the inputs must be shadow prices. In financial analysis all prices are market prices and they must include taxes and subsidies. For vivid distinction between cash flows in the economic analysis visàvis financial analysis (Gittinger, 1976) may be referred.
This is simply the present worth of the cash flow stream. Sometimes, it is referred to as Net Present Value (NPV). The choice of discount rate to be used in the measurement of Net Present Value (NPV) poses many problems as discussed earlier. It is helpful in working out benefitcost ratio of the project. The selection criterion of the projects depends upon the positive value of the net present worth, when discounted at the opportunity cost of the capital. This could be satisfactorily done, provided there is a correct estimate of opportunity cost of capital. NPV is an absolute measure, but not relative.
NPV of the project is estimated using the following equation:
Where,
P_{1} = Net cash flow in first year,
i = Discount rate,
t = Time period, and
C = Initial cost of the investment.
Projects with positive NPV are given weightage in the selection compared to those with negative present values, while zero NPV makes the investor indifferent.
26.2 Profitability Index
Here we relate the NPV of the cash flows of the project to the total capital required (cr) for a project through “profitability index”. It is defined as the ratio of net present values of the cash flows to the initial capital expenditure (co). Assuming that all the capital expenditure is incurred in year zero, the profitability index (PI) is as follows:
PI =
Table 26.1: Estimation of Profitability Index
Original amount invested in a Project = Rs. 60,000
Year 
Cash flow (in Rs.) 
Discounting Factor (15%) 
Net Present Worth (in Rs.) 
1 
14,500 
0.8929 
12,947 
2 
14,900 
0.7972 
11,878 
3 
16,600 
0.7118 
11,816 
4 
18,700 
0.6355 
11,884 
5 
19,000 
0.5674 
10,781 
6 
20,000 
0.5066 
10,132 

1,03,700 

69,438 
PI =