- When cash inflows remain uniform:
In any project, whatever the business theme is- the cash flows are uniform. To calculate the IRR (Internal Rate of Return), it is essential to locate the factor in annuity table.
For calculating the factor, it can be formulated by,
F = I/ C
Where,
F = Factor to be located
C = Cash Inflow per Year
I = Initial Investment
After finding the result, this factor should be located in Table II. This will then represent thenumber of years with respect to the estimated useful life of company’s asset.
- When cash inflows are not uniform:
Here, the trial and error method is used to calculate the internal rate of return.
Steps to calculate:
- To get an approximate idea about the rate, first it is essential to determine the factor by using the above formula.
Hence, it can be written as,
F = I/ C
Where,
F, Factor will be the first trial rate
- In the above context, the next two, i.e., second trial rate and third trial rate can be determined.
- Now, after finding three trial rates, it is the time to find the IRR
By using the formula,
IRR = Lower trial rate + NPV at lower rate/ NPV at lower rate – NPV at higher rate x Difference between higher and lower trial rate
- Profitability Index Method:
This method is used to evaluate the profit rate of a project. It is also considered as time adjusted method. With the help of this method, the financial managers can rank any project as per its profitability statistics.
Profitability Index = Present Value of Cash Inflows/ Initial Cash Outlay
Or, it can also be written as,
Profitability Index =
Present value of future cash inflows/ Present value of future cash outflows x 100
Note:
If the present value index of the project will be equal to or greater than 1, then 100% will be selected.
- Discounted Pay Back Method:
To calculate the present values of cash inflows and cash outflows, an appropriate discount factor is considered while using this method. For its determination, the present values of inflows are cumulated in the order of time. This is how cumulative present value of inflows is equal to the present value of outflows. This procedure is known as discounted pay back period.
For Example:
Suppose the Project Cost is xxx,
Year Cash Inflow p/v Discounted Cash Flows (DCF)
1
2
3
4
5
After calculating DCF, if this value is equal to cash outflow, then it is termed as discounted pay back period. In this context, the value of DCF is acceptedonly when any project gives a shorter pay back period.
Links of Previous Main Topic:-
- Introduction to financial management
- Introduction and types of dividend
- Concept of cost of capital
- Capitalization meaning
- Concepts of working capital
- Concept of capital expenditure
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