Question

Assuming that you are working in a company in Hong Kong and have to explain how time value of money should be considered in making investment decisions in the company. Design and describe an investment or a project to be considered in your organization, which could be any kind of investment or project that you are interested in. Identify and explain the data you needed for calculating the net present value of the investment. Make assumptions to the data you needed and demonstrate TWO calculations, in which one results in accepting the investment and one results in rejecting the investment, with explanations. (20 marks) (The expected length of each question is around 350-450 words.)

Answer 1

Net Present Value method is the modern method of evaluating the proposals. It is the difference between the total present value of future cash inflows and the total present value of the future cash outflows. It has the following advantages:

1. It recognizes the time value of money.

2. It considers the total benefits arising out of the proposal.

3. It is the best method for the selection of mutually exclusive projects.

4. It helps to achieve the maximization of shareholders wealth.

Accept/Reject criteria

If the present value of cash inflows is more than the present value of cash outflows, the proposal is accepted and if the present value of cash inflows is less than the outflows the project is rejected.

For calculating the NPV we require the following information:

• Initial Investment
• Estimated Life
• Scrap Value
• Profits before Depreciation and Taxation / Cash Inflows
• Discount Rate

Let’s consider the following example

Project 1-

Initial Investment - Rs.20,000

Estimated Life -5 years

Scrap Value - Rs.1,000

Cash Inflows -

Year 1	5,000
Year 2	10,000
Year 3	10,000
Year 4	3,000
Year 5	2,000

Present Value factors @ 10%

Year 1	0.909
Year 2	0.826
Year 3	0.751
Year 4	0.683
Year 5	0.621
Year 6	0.564

Calculation of NPV for Project 1    

Year	Cash Inflows	Present Value of Rs.1 @ 10%	Present Value of Cash Inflow (Cash Inflow x Discounting Factor)
Year 1	5,000	0.909	4,545
Year 2	10,000	0.826	8,260
Year 3	10,000	0.751	7,510
Year 4	3,000	0.683	2,049
Year 5	2,000	0.621	1,242
Scrap Value	1,000	0.621	621
Total			24,227

NPV = Total discounted Inflows- Initial Investments

        = 24,227 – 20,000

          = 4,227

Project 2-

Initial Investment - Rs.30,000

Estimated Life -5 years

Scrap Value - Rs.2,000

Cash Inflows -

Year 1	20,000
Year 2	10,000
Year 3	5,000
Year 4	3,000
Year 5	2,000

Present Value factors @ 10%

Year 1	0.909
Year 2	0.826
Year 3	0.751
Year 4	0.683
Year 5	0.621
Year 6	0.564

Calculation of NPV for Project 2

Year	Cash Inflows	Present Value of Rs.1 @ 10%	Present Value of Cash Inflow (Cash Inflow x Discounting Factor)
Year 1	20,000	0.909	18,180
Year 2	10,000	0.826	8,260
Year 3	5,000	0.751	3,755
Year 4	3,000	0.683	2,049
Year 5	2,000	0.621	1,242
Scrap Value	2,000	0.621	1,245
Total			34,728

NPV = Total discounted Inflows- Initial Investments

        = 34,728 – 30,000

          = 4728

Thus, Project 2 will be selected because it has a higher value of NPV. This means that the present value of cash inflows is higher than the present value of cash outflows. However, for project 1 is also given positive results but project 2 will be more beneficial due to higher NPV.