Question – a) What is net present value method of discounted cash flow and what are its merits.
b) A company is evaluating two alternatives for distribution within the plant. Two alternatives are: -
1) ‘A’ System with a high initial cast but low annual cost but low annual operating costs.
2) ‘B’ system which costs less but have considerably higher operating casts. The decisions to construct the plant have already been made and choice here will have no effect on the overall revenues of the project. The cast of capital of the plant is 12% and the project expected net costs are listed below: -
Expected net Cash Costs (in Rs)
Year A System B System
0 (3, 00, 00) (1, 20,000)
1 (66000) (96000)
2 (66000) (96000)
3 (66000) (96000)
4 (66000) (96000)
5 (66000) (96000)
What is the present value of cost of each alternative?
Answer – NPV method recognizes the time value of money. It correctly admits that cash flows occurring at different time periods differ in value. Therefore, there is the need to find out the present values of all cash flows.
NPV method is the most widely used technique among the DCF methods.
Steps involved in NPV method: -
1) Forecast the cash flows, both inflows and outflows of the projects to be taken up for execution
2) Decisions on discount factor or interest factor. The appropriate discount rate is the firm’s cost of capital or required rate of return expected by the investors.
3) Compute the present value of cash inflows and outflows using the discount factor selected.
4) NPV is calculated by subtracting the PV outflows from the present value of cash inflows.
Computation of present value
Year A System B System Incremental
1 (66000) (96000) 30000
2 (66000) (96000) 30000
3 (66000) (96000) 30000
4 (66000) (96000) 30000
5 (66000) (96000) 30000
Present value of incremental saving =
300000 x PVIFA (12%, 5)
= 300000 x 3.605 = 108150
Incremental cash out lay = 180000/71850
Since the present value of incremental net cash inflows of a system over B system is negative. A system is not recommended.
There, B system is recommended.
b) A company is evaluating two alternatives for distribution within the plant. Two alternatives are: -
1) ‘A’ System with a high initial cast but low annual cost but low annual operating costs.
2) ‘B’ system which costs less but have considerably higher operating casts. The decisions to construct the plant have already been made and choice here will have no effect on the overall revenues of the project. The cast of capital of the plant is 12% and the project expected net costs are listed below: -
Expected net Cash Costs (in Rs)
Year A System B System
0 (3, 00, 00) (1, 20,000)
1 (66000) (96000)
2 (66000) (96000)
3 (66000) (96000)
4 (66000) (96000)
5 (66000) (96000)
What is the present value of cost of each alternative?
Answer – NPV method recognizes the time value of money. It correctly admits that cash flows occurring at different time periods differ in value. Therefore, there is the need to find out the present values of all cash flows.
NPV method is the most widely used technique among the DCF methods.
Steps involved in NPV method: -
1) Forecast the cash flows, both inflows and outflows of the projects to be taken up for execution
2) Decisions on discount factor or interest factor. The appropriate discount rate is the firm’s cost of capital or required rate of return expected by the investors.
3) Compute the present value of cash inflows and outflows using the discount factor selected.
4) NPV is calculated by subtracting the PV outflows from the present value of cash inflows.
Computation of present value
Year A System B System Incremental
1 (66000) (96000) 30000
2 (66000) (96000) 30000
3 (66000) (96000) 30000
4 (66000) (96000) 30000
5 (66000) (96000) 30000
Present value of incremental saving =
300000 x PVIFA (12%, 5)
= 300000 x 3.605 = 108150
Incremental cash out lay = 180000/71850
Since the present value of incremental net cash inflows of a system over B system is negative. A system is not recommended.
There, B system is recommended.