– It considers time value of money.

– The major concept of this is that money available at the present time is worth more than the same amount in the future due to its potential earning capacity.

– This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received.

            It includes:

A) B/C ratio:

– It is defined as the ratio of the discounted benefit stream to the discounted cost stream.

– OR it is the ratio of the present worth of incremental benefit stream (cash inflows) to the present worth of incremental cost stream (cash outflows) due to enterprise.

– When it is expressed in percentage it is called profitability coefficient.

Note: The absolute value of  BCR  will vary depending on the interest rate chosen.  The higher the interest rate,  the smaller the resultant benefit-cost ratio.

Decision Criteria:

I) If the B/C ratio is greater than 1 project is accepted.

ii) If the B/C ratio is less than 1 the project is rejected.

iii) If the B/C ratio is one then the decision is indifference.

Benefits

– NPV and B/C ratio are similar because if NPV is +ve then B/C ratio is greater than 1.

– This method is simple and easy to calculate.

– Used in ranking the mutually exclusive project but cannot be used in ranking non-mutually exclusive projects.

Demerit

– This method discriminate with the projects with low B/C ratio but have large wealth generating capacity than the alternatives with higher B/C ratio but low income generating capacity.

B) Net present worth:

– The present worth of the benefits less the present worth of the costs of a project called NPV/NPW.

– It is present value of incremental net benefit.

–  It is the discounted profit in absolute form.

Decision criteria:

a) NPV +ve = Accepted

b) NPV -Ve = Rejected

c) NPV 0 = Indifferent

Merit

– It is good for those seeking the higher profitability

– Good for selecting the mutually exclusive project e.g. bigger dam vs smaller dam. Furrows sprinkler irrigation.

Relationship between Discount rate and NPV

– Inverse relationship

Limitation

– NPV is not useful for comparison if initial investment amount are different.

– Let two initial investment 70 lakh and 20 lakh have both NPV 1 crores

In this case the higher investment is selected because it creates multiplier effects in economy by creating wings of employment and social welfare .e.g. in investing poultry enterprises, driver, labor, vet doctors, accountant  etc. will get employment opportunities.

c) Discount rate

– It is rate at which an agent determines present worth of future cash flow.

– Generally interest rate is used as discount rate

d) Required rate of return

– It is rate of return below which investor does not wants to invest.

– It is also called as opportunity cost of capital.

– By using required rate of return investor discount his cash flow and find the worthiness of business.

Mathematically,

Required rate of return = I + risk premium + service charge + etc.

e) Internal rate of return (IRR)

– The internal rate of return of a project is the discount rate, which makes its net present value equal to zero i.e. present value of benefits equals’ present value of cost.

– It is the maximum interest rate that the project can pay.

– It is the maximum earning capacity of project.

IRR= L_i + [(H_i-L_i) NPV at L_i]/[NPV at L_i-NPV at H_i]

where, H_i = Higher discount rate

            L_i = Lower discount rate

Decision criteria:

1. For mutually exclusive project: IRR>Opportunity cost :- Project accepted.
2. For non-mutually exclusive project : High IRR value :- Project accepted.

Merit

– It used to rank the project in descending order.

– It shows the maximum earning capacity of the project.

Limitation

– It cannot be used in mutually exclusive business.

– If DR exceed IRR than the NPV becomes –ve.

2. Undiscounted measure

– It ignores time factor

a) Payback period

– The payback period is the length of time required to recover the initial investments.

It is useful in investment at risky sector investments.

Mathematically ,

Pay back period = no of years preceding the final recovery + [Balance still to be recovered/      cash flow during the final year of recovery]

or, Pay back period = Initial investment/ Annual net cash return.

Decision criteria

– Accept any project that has minimum pay back period.

Merit:

-It is simple to calculate and easy to understand.

Demerit:

-Payback period has very limited economic meaning because it ignores the time value of money and the cash flows after the payback period.

b) Simple rate of return (SRR)

SRR= (Average annual net cash flow after financing / Investment amount) * 100

Decision criteria

i. SRR > RRR; accepted

SRR= RRR; indifferent

iii. SRR< RRR; rejected.

c) Proceeds per unit of outlay

– It is calculated by dividing total net value of incremental production by the total amount of investment.

– So higher the proceeds per unit of outlay, the higher the economic feasibility of the investment or project.