**Evaluation **

‘I fie Plinths value method including the NPV variation possesses several merits, TIle first. and probably the most significant, advantage is that it explicitly recognizes the time value of money. In Example 10.6, for instance (Table 10.1.4). the total cash inflows (CFAT) pertaining to the two machines (A and B) arc equal. But the present value as well as the f”I’V is different, As can he seen from Table 10.11. this’ is primarily because of the differences in the pattern of the cash , streams. 111 e magnitude of CFAT in the case of barnacle A is lower in the earlier years as compared to the machine B while it is greater in the latter years. Because of larger inflows in the first two years, the NPV of machine 13 is larger than that of machine A. 111e need for n-cognising the time value of money is. thus, satisfied by this method. Secondly. it also fulfills the second attribute of a sound m,:thoJ of appraisal in Ih;1I it considers the total benefits arising out of the proposal ovvr its hfctim«. Thirdly, a changing discount rate can he built into the :’-il’\’ calculations by altering the denominator. This feature becomes important as this rate norm;tlly chang« becnuse the longer thl’ time span: the lower is the value of money and the highc’r i, till’ discount rate. Fourthly, this method is particularly useful for tlu- ,del’lion (If mutuallv l’xdusin’ projects. This aspect will be discussed in detail in the latter pan of the chapter, where it is shown that for mutually exclusive choice problems, the ~PV method is the best decision-criterion. Finally, this method of asset selection is instrumental in achieving the objective of financial management which is the maximization of the shareholders’ wealth. The rationale behind this contention is the effect on the market price of shares as a result of the acceptance Iff a proposal

having present value exceeding the initial outlay or, as a variation having !’I’V. greater than zero. The market price, of the shares will be affected hy the relative force of what the investors expect and what actual rerun is earned on the funds. 111e discount rate that is used 10 convert benefits into’ present values is the minimum rate or the rate of ‘interest is that when the present values of

cash inflows is equal to the initial outlay or when the NPV = O. the return on investment just equals the expected or required ‘rate by investors. There would, therefore, Is no change in the market price of shares. when the present value exceeds the outlay other the return would be higher than expected-by the investors. It would, therefore, lead to an increase in share prices. The present value method is, thus, logically consistent .with the goal of maximizing shareholders’ wealth in terms of maximizing the market price of the shares. In brief, the present value method is a theoretically correct technique for the selection of . investment projects, Nevertheless, it has certain limitations also. In the first place, it is difficult to calculate as ‘wt’ll as understand and use in comparison with the pay back method or even the ARR method. This, of course, is a minor flaw. The second, and a more serious problem associated with the present value method, involves the calculation of the required rate of return io discount the cash flows. 111 t’ discount rate is the most important element used in the calculation’ of the present values: because different discount rates will give different present values. The relative desirability of ‘a proposal will change with a change in the discount rate. For instance. for a proposal involving an initial outlay of Rs 9,000. having annuity of Rs 2,800 for ‘i years, the ner present values for different required r:1;es of return are given in-Table 10.12.

and use in comparison with the pay back method or even the ARR method. This, of course, is a minor flaw. The second, and a more serious problem associated with the present value method, involves the calculation of the required rate of return to discount the cash flows. 111 t’ discount rate is the most important element used in the calculation’ of the present values: because different discount rates will give different present values. The relative desirability of ‘a proposal will change with a change in the discount rate. For instance. for a proposal involving an initial outlay of Rs 9,000. having annuity of Rs 2,800 for ‘i years, the ner present values for different required r:1;es of return are given in-Table 10.12.

NPV). But it is likely that this project may also involve a larger initial outlay. Thus, in case of projects involving different outlays, the present value method may not give dependable results. Finally, the present value method may also not give satisfactory results in the case of two projects having different effective lives. In general, the project with a shorter economic life would be preferable, other things being equal. A project which has a higher present value may also have a larger economic life so that the funds will remain invested for a longer period, while the alternative proposal may have shorter life but smaller present value. In such situations, the present value method may not reflect the true worth of the alternative proposals.