In this investment driven era, allocating funds in the right assets with right returns will only make you profitable and get you an edge over the other investors. Investing in a project/ business/ asset is done with a vision of earning righteous returns. ‘Returns’ is considered to be the most cardinal concept in the investment decision. Before investing the outlay, the investor evaluates the investment whether it is generating good returns or not. On the basis of returns, the decision to invest is taken.
The widely used methods of evaluating the investments are Net Present Value and Internal Rate of Return method. These methods are used by the investors to calculate the expected returns on their investment. Usage of these methods depends on the type of investment, before understanding the usage, let us understand some basic terminologies:
- Initial outlay: The initial investment/ cost of project which the investor puts into the project, also known as cash outflows
- Cash inflows: The amount of cash which the investment generates or the returns generated.
- Tenure: The time period of the investment
- Discount factor: The percentage value which is decided as per the inflation and the prevailing market rate of alternate investments by which present value of the future cash flows is calculated.
UNDERSTANDING THE NET PRESENT VALUE METHOD:
Under this method of investment evaluation, the returns on an investment are calculated by keeping the ‘Time Value of Money’ factor into consideration. It recognises the fact the Rupee earned today is worth more than the Rupee earned tomorrow. Under this method the discount rate or the rate of return is decided which should be equal or more than the prevailing market rate. The present value of cash inflows in future are calculated by these discount rates and the total cash inflows are compared with the cash outflows (investment cost) and the difference is the Net Present Value (NPV). If the NPV is positive or equal to the cash outflow then the investment should be viable.
Let’s take an example for better understanding,
Mr. A is planning to buy a machinery whose cost is ₹ 200000 (cash outflows) with expected life of 5 years and the cash inflows for the investment for year 1, year 2, year 3, year 4 and year 5 are ₹ 50000, ₹ 60000, ₹ 80000, ₹ 70000 and ₹ 50000 respectively. The discount rate is @ 10%. The present values of future cash inflows will be calculated @ 10% at 5 years with present value factors at 0.909, 0.826, 0.751, 0.683 and 0.621 and the present values of cash flows would be ₹ 45,450, ₹ 49,560, ₹ 60080, ₹ 47810 and ₹31050, so the total inflows are ₹ 233950. So, the NPV for this investment would be ₹ 33950. The NPV is positive, so this investment is viable.
UNDERSTANDING THE INTERNAL RATE OF RETURN METHOD:
Under this method, cash flows of a project are discounted at a suitable rate by hit and trial method which equates the NPV with the total amount of investment where different inflows are equated with various discount rates and the two closest discount rates to the outlay are selected to reach the exact IRR.
*Initial outlay= ₹60000 (neg)
NPV at 14%= ₹60595
NPV at 15%= ₹59285
So, the IRR will be determined by using both the discount rates i.e., 14% and 15%.
IRR= 14%+(595/595+715) * (15%-14%)= 14.45%
The IRR is expressed in % terms. The concept of time value of money is also considered under this method. This method can be used for both whether the cash inflows are even for the life of asset or uneven over the life of asset. The correct IRR will be determined where the NPV of all the inflows will be equal to 0.
Another method for calculation of IRR,
Assume a company is reviewing two projects. Management must decide whether to move forward with one, both, or neither. Its cost of capital is 10%. The cash flow patterns for each are as follows:
PROJECT A: PROJECT B:
*Initial outlay= ₹5000 (neg) *Initial outlay= ₹ 5000 (neg)
Cash inflows are as follows, Cash inflows are as follows,
Year 1=₹1700 Year 1=₹400
Year 2=₹1900 Year 2=₹700
Year 3=₹1600 Year 3=₹500
Year 4=₹1500 Year 4=₹400
Year 5=₹700 Year 5=₹300
*INITIAL OUTLAY IS NEGATIVE AS IT IS CASH OUTFLOW
For project A,
₹0 = (−₹5,000) + ₹1,700 ÷ (1 + IRR)1 + ₹1,900 ÷ (1 + IRR)2 + ₹1,600 ÷ (1 + IRR)3 + ₹1,500 ÷ (1 + IRR)4 + ₹700 ÷ (1 + IRR)5
For project B,
₹0 = (−₹2,000) + ₹400 ÷ (1 + IRR)1 + ₹700 ÷ (1 + IRR)2 + ₹500 ÷ (1 + IRR)3 + ₹400 ÷ (1 + IRR)4 + ₹300 ÷ (1 + IRR)5
CONCLUSION- the project A will be selected as it has a greater IRR than the cost of capital (10%). Project B will be rejected as it’s IRR is less than the cost of capital.
The projects with higher IRR are selected.
NPV V/S IRR
- NPV is calculated in terms of currency and is an absolute measure and IRR is calculated in terms of percentage (%) and it is a relative measure.
- NPV is mostly used by general public as it is less complex than IRR which is mostly used by financial managers.
- NPV produces different results for the same project if the discount rates are changed but IRR produces same results even if the discount rates are changed for the same project.
NPV OR IRR- WHICH TO CHOOSE?
If you are choosing amongst two or more mutually exclusive projects, the opportunity cost (the value of the next-best alternative when a decision is made is) is taken into consideration so NPV method is the best here because it is more realistic because of it’s absolute returns. It is a safer way of investing in long term projects than IRR.
IRR is used when comparison of multiple projects is made it is difficult to determine discount rates. Using IRR is a complement to NPV as it will provide you with returns and better analysis of investments.
CONFLICTS BETWEEN NPV AND IRR RESULTS ARISES WHEN:
- There is significant difference in the size (amount) of cash outlays.
- Difference in cash flow patterns
- Unequal expected lives of the projects.
IN SUCH CASES, DEPENDING UPON THE NPV RESULTS IS ALWAYS RELIABLE BECAUSE OF THE ABSOLUTE RETURNS AND THE END MOTIVE IS TO MAXIMISE THE SHAREHOLDER’S WEALTH.