Present-Worth Analysis: Chapter Learning Objectives

CHAPTER 5
Present-Worth Analysis
CHAPTER LEARNING OBJECTIVES:
 After completing this chapter, you should understand
the following concepts:

 How firms screen potential investment opportunities.
 How firms evaluate the profitability of an investment
project by considering the time value of money.

 How firms compare mutually exclusive investment
opportunities.
Independent versus Mutually Exclusive
Investment Projects
Mutually-exclusive projects refer to a set of projects out
of which only one project can be selected for investment.
A decision to undertake one project from mutually
exclusive projects excludes all other projects from
consideration.
Independent versus Mutually Exclusive
Investment Projects
 Unlike independent projects, in which a decision to
invest in one project has no bearing on the decision to
make investment in another, investment decision in
case of mutually exclusive projects is dependent on the
relative merit of the projects.
Initial Project Screening Method
 Evaluation of the project involves a comprehensive
assessment of the given project, policy, program or
investments, taking into account all its stages:
planning, implementation, and monitoring of results. It
provides information used in the decision-making
process.
Payback period
 Payback period refers to the period of time required
to recoup the funds expended in an investment.
 Payback period as a tool of analysis is often used
because it is easy to apply and easy to understand for

most individuals, regardless of academic training or
field of endeavor. When used carefully or to compare
similar investments, it can be quite useful.
 The payback period is considered a method of analysis
with serious limitations and qualifications for its use.
Advantages of the Payback Method
 The most significant advantage of the payback method
is its simplicity.
Disadvantages of the Payback Method
 Ignores the time value of money
 Neglects cash flows received after payback period
 Ignores a project's profitability.
 Does not consider a project's return on investment
ABC International has received a proposal from a
manager, asking to spend $1,500,000 on equipment that
will result in cash inflows in accordance with the
following table:
Year Cash Flow
1 +$500,000
2 +500,000
3 +500,000
4 +500,000
5 +500,000
 The total cash flows over the five-year period are
projected to be $2,500,000, which is an average of
$500,000 per year. When divided into the $1,500,000
original investment, this results in a payback period of
3years.
 if a project requires an initial investment of $4,000 and
provides uneven net cash inflows in years 1-5 as
shown, the investment would be fully recovered in year
4.
$1,000 $0 $2,000 $1,000 $500
1 2 3 4 5
 Discounted payback period: The length of time
required to recover the cost of an investment based on
discounted cash flows. Discounted cash flow analysis
(DCF): A method of evaluating an investment by
estimating future cash flows and taking into
consideration the time value of money.
 Example: Project X Requires An initial investment of
$2,324,000 is expected to generate $600,000 per year
for 6 years. Calculate the discounted payback period of
the investment if the discount rate is 11%.
Solution
 Prepare a table to calculate discounted cash flow of
each period by multiplying the actual cash flows by

present value factor. Create a cumulative discounted
cash flow column.
Present Value Discounted Cumulative
Year Cash Flow
Factor Cash Flow Discounted
n CF
PV$1=1/(1+i)n CF×PV$1 Cash Flow
0 -2,324,000 1.0000 -2,324,000 -2,324,000
1 600,000 0.9009 540,541 -1,783,459
2 600,000 0.8116 486,973 -1,296,486
3 600,000 0.7312 438,715 -857,771
4 600,000 0.6587 395,239 -462,533
5 600,000 0.5935 356,071 -106,462
6 600,000 0.5346 320,785 214,323
 Discounted Payback Period
= 5 + |-106,462| ÷ 320,785
= 5 + 106,462 ÷ 320,785
≈ 5 + 0.33
≈ 5.33 years
 Advantage: Discounted payback period is more
reliable than payback period since it accounts for time
value of money. It is interesting to note that if a project
has negative net present value it won't pay back the
initial investment.
 Disadvantage: It ignores the cash inflows from project
after the payback period. An attractive project having
lower initial inflows but higher terminal cash flows
might be rejected.
Accounting Rate of Return
Accounting Rate of Return (ARR) is the average net
income an asset is expected to generate divided by its
average capital cost, expressed as an annual percentage.
The ARR is a formula used to make capital budgeting
decisions.
These typically include situations where companies are
deciding on whether or not to proceed with a specific
investment (a project, an acquisition, etc.) based on the
future net earnings expected compared to the capital cost.
ARR = average annual profit / average investment
ARR – Example
 XYZ Company is considering investing in a project

that requires an initial investment of $100,000 for some
machinery. There will be net inflows of $20,000 for the
first two years, $10,000 in years three and four, and
$30,000 in year five. Finally, the machine has a salvage
value or scrap value of $25,000
Step One: Calculate average annual
profit
$

Inflows, Years 1 & 2(20,000*2) 40,000
Inflow, Year 3 & 4(10,000*2) 20,000
Inflow, Year 5 30,000
Less: Deprecation(100,000 – 25,000) (75,000)
Total Profit of Project 15,000
Average Annual Profit(15,000/5) 3,000

 Step Two: Calculate average investment
 Average investment = ($100,000 + $25,000) / 2 =
$62,500
 Step 3: Divide profit into cost
 ARR = 3,000/62,500 = 4.8%
 XYZ Company is looking to invest in some new
machinery to replace its current malfunctioning one.
The new machine, which costs $420,000, would
increase annual revenue by $200,000 and annual
expenses by $50,000. The machine is estimated to have
a useful life of 12 years and zero salvage value.
 Calculate the depreciation expense per year: $420,000 /
12 = $35,000
 Calculate the average annual profit: $200,000 –
($50,000 + $35,000) = $115,000

 Use the formula: ARR = $115,000 / $210,000 = 54.8%
 Therefore, this means that for every dollar invested, the
investment will return a profit of about 54.8 cents.

Profitability Index
Profitability Index is the ratio of the present value of
future cash flows of the project to the initial investments
in the project. This index helps in cost benefit analysis of
investment projects and helps them rank in order of the
best return on initial investments.
Profitability Index Formula = 1 + (Net Present Value /
Initial Investment Required)
Interpretation of Profitability Index
If the index is more than 1, then the investment is
worthy because then you may earn back more than you
invest in. So if you find any investment whose PI is more
than 1, go ahead and invest in it.
If the index is less than 1, then it’s better to step back
and look for other opportunities. Because when PI is less
than 1 that means you would not get back the money you
would invest.
 If the index is equal to 1, then it’s an indifferent or
neutral project. You shouldn’t invest in the project until
and unless you consider it better than other projects
available during the period. If you find that the PI of all
other projects to be negative, then consider investing in
this project.
Profitability Index Example
Nelson Enterprise has decided to invest in a project for
which the initial investment would be $100 million. As
they are considering whether it’s a good deal to invest
into, they have found out that the present value of future
cash flow of this project is 130 million. Is it a good
project to invest into in the first place? Calculate
Profitability Index to prove that.
 Profitability Index Formula = Present Value of Future
Cash Flow / Initial Investment Required
 PI = US $130 million / US $100 million
 PI = 1.3
 Profitability Index Formula = 1 + (Net Present Value /
Initial Investment Required)
 PI = 1 + [(Present Value of Future Cash Flow – Present
Value of Cash Outflow)/ Initial Investment Required]

 PI = 1 + [(US $130 million – US $100 million)/ US
$100 million
 PI = 1 + [US $30 million / US $100 million]
 PI = 1 + 0.3
 PI = 1.3

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CHAPTER 5

the following concepts:

project by considering the time value of money.

because it is easy to apply and easy to understand for

$1,000 $0 $2,000 $1,000 $500

each period by multiplying the actual cash flows by

 XYZ Company is considering investing in a project

Inflows, Years 1 & 2(20,000*2) 40,000

Inflow, Year 3 & 4(10,000*2) 20,000

Inflow, Year 5 30,000

Less: Deprecation(100,000 – 25,000) (75,000)

Total Profit of Project 15,000

Average Annual Profit(15,000/5) 3,000

($50,000 + $35,000) = $115,000

investment will return a profit of about 54.8 cents.

Value of Cash Outflow)/ Initial Investment Required]

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