WEBVTT
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Welcome to the course Depreciation Alternate
Investment and Profitability Analysis We are
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continuing with module 3 Profitability Analysis
In this lecture I will discuss a method for
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Profitability Analysis that is called Discounted
Cash Flow Part 1 Now this discounted plot
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to cash flows are the type of method which
use the time value of money Earlier methods
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which we have discussed Profitability Analysis
they do not use the time value of money
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But discounted cash flows use the time value
of money so that is why these are the different
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methods than the earlier ones In capital budgeting
discounted cash flow analysis is a method
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for valuing a project company or asset using
the concept of time value of money while estimating
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the cost and benefit of a given project Though
there are many variations in this methods
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but all methods require cash flow to be discounted
at a certain rate that is the cost of the
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capital which is the minimum discounted rate
earned on a project that leaves the market
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value unchanged
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These methods take into account all investment
costs and benefits that the project incurs
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during its entire life period The important
characteristics of DCF which is Discounted
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Cash Flow capital budgeting is that it takes
into consider consideration the time value
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of money while estimating the cost and benefit
of a given project Theoretically the DCF is
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arguably the most sound method of valuation
Discounted Cash Flow models are powerful but
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they do have short comings
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Commercial banks have widely used Discounted
Cash Flow as a method for valuing commercial
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real estate construction projects This practice
has 2 substantial short comings number 1 the
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discounted rate assumption relies on the market
for competing investment at the time of the
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analysis which would likely change perhaps
dramatically over time and number 2 that straight
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line assumptions about the straight line assumptions
about income to increase are generally based
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upon historic increases in market rate but
never factors in the cyclic nature of many
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real estate markets
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Most loans are made during boom real estate
markets and these markets usually last fewer
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than 10 yeaRupees Now thus the Discounted
Cash Flow valuation should only be used as
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a method of intrinsic valuation for companies
with stable predictable cash flows Discounted
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Cash Flow that is shortly in short it is called
DCF Analysis includes methods like Net Present
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Value method Internal Rate of Return method
Net Terminal Value Method and Profitability
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Index
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The Net Present Value method The Net Present
Value method is a Discounted Cash Flow method
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in which present value which is PV of the
DCF is used NPV is described as summation
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of the present value of the cash flow after
tax which is called CFAT in each year minus
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this summation of the present value of the
net cash out flow in each year Now the formula
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for this is NPV can be mathematically expressed
as NPV is equal to summation I equal to sorry
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J equal to 1 to N CFATj divided by 1plusi
to the power jplusSVplusWCA divided by 1plusi
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to the power N minus summation j is equal
to N COFj 1plusi to the power J
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Now where CFATj is the cash flow after tax
at jth year high rate of return generally
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based on cost of capital N equal to lifespan
of cash flow of project SV Salvage Value of
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the project at the end of the lifespan WCA
is the working capital COFj is the cash outflow
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at the j at here The accept-reject rule for
a project evaluated by NPV is to accept the
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project if NPV is positive and reject if its
negative now through examples let us explain
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this
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So for this purpose we take example number
1 the objective of this example with the value
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of cash in given the value of cash inflow
to project and cash outflow from project compute
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Net Present Value that is NPV
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Example is the cash inflow after tax of a
given project is shown below the project costs
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project cost 60000 at the start and then 20000
at the end of third year cost of capital is
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equal to 20 percent this is basically I find
the value of the Net Present Value So if I
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see time line at t equal to 0 60000 is invested
and t equal to 3 at the third year end of
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the first year end of second year end of the
third year another 20000 is invested in the
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project and whatever receipts receipts are
given here
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Year 1 2 3 4 5 6 cash flow after tax this
is 12000 this is 13500 this is 14800 this
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is 16543 this is 18760 this is 19567 and the
summation of this is 95170 Now obviously this
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is Net Present Value so at t equal to 0 60000
is invested and after 3 years end of 3 years
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20000 is invested so this has to be brought
to this timeline Similarly here all these
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values have to be brought to the timeline
t equal to 0 So if I see here this t equal
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to 0 this is 1 2 3 4 5 6 so this is receipt
is 19567 this is 18760 like this in the first
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year this is 12000 so all this has to be brought
to the 0 timeline
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And then we add these values up we add these
values up and then take a difference and see
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whether the NPV Net Present Value is positive
or negative
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So let us solve this problem
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Now solution example 1 initial cost of the
project is 60000 now the cash out flow of
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the 20000 takes place at the end of third
year this 20000 takes place at the end of
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third year So present value of the cash flow
value of Rupees 20000 cash flow at the end
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of third year is equal to 20000 divided by
1 plus 0.3 this comes out to be 15026.30
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So I add here 15026.30 this comes out to be
7526.30 So this is my investment in the present
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value term So this value here is Rupees 75026.30
Now all these values has to be converted into
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time t equal to 0 that means their present
value needs to be computed and then added
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up So if I do that so the PV factor for this
present value factor for this is 1 divided
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by 1 plus 0.1 to the power 1 this comes out
to be 0.909 this is 1 divided by 1 plus 1.1
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2 1 plus 0.1 3 similarly this 1.01 4 this
is 1.01 5 this is 1.01 to the power 6 So I
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calculate these factors these factors are
0.826 this is 0.751 this is 0.683 this is
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0.621 and this is 0.564
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And if I multiply this with this with this
so my present value of this value is 12000
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multiplied by 0.909 this comes out to be 10908
Similarly if I do this this comes 11156 this
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comes 11119 this comes 11298.87 this comes
11648.1 this comes 11045.1 and if I add them
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together the sum is 67175.1 Now so NPV is
equal to so summation of all these things
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becomes Rupees 67175.1 so NPV is equal to
67175.1 minus this value 75026.30 this comes
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negative 7851.2 so this is a negative quantity
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That means whatever I am investing I am not
getting due to the profit So my conclusion
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is as the value of the NPV is negative and
hence the project is not acceptable But the
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further analysis shows because if you see
the difference the difference is 75026.30
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and 67175.10 point 21 0 now let me quickly
do it without error this is 75026.30 minus
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67175.10 this is coming 7851.20 this is the
deficiency Now if we see the investment what
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we have done here the cost of the investment
comes out to be this investment costing me
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here is 15026.30 That is this is the value
here if I transfer this to the present value
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That means if I am not investing this money
into the project then my NPV will be positive
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because the difference is only 7851.20 and
if I drop this expenditure which is 15026.30
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my NPV will be positive So I should look that
whether doing away this expenditure can solve
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my problem or not
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Now let us take another example example number
2 Now the objective of the example number
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2 is compare the present value or discounted
cash flow of given cash flow when interest
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rate is given Also compare payback period
for undiscounted as well as discounted cash
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flow Now the example number 2 is find out
the discounted cash flow present value of
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2 different machines A & B from the data given
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Now cost of capital cost of capital is 10
percent that is I i is 10 percent or 0.1 in
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fraction initial cost of equipment A is equal
to 10000 initial cost of equipment B is 13000
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and cash flows after tax
machine A machine B
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this is 1 2 3 4 5 This is 2460 3256 3326 2156
5210 this is 1980 2678 8769 7650 4320 So obviously
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these cash flows are at different Timelines
and has to brought to the timeline 0
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Now for the machine A machine A if we take
this is timeline t equal to 0 I am sinking
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a money of 10000 this is A And I am receiving
money 1 2 3 4 5 now these values 2460 3256
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3256 3326 2152 2156 I think 2156 5210 5210
so all these money’s have to be PV has be
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calculated And then we have to add it up and
whatever value comes we will deduct 10000
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and see that NPV is positive or negative So
for this if I see the PV factor
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which is basically 1 by 1plusi to the power
j so the PV factors are 0.909 0.826 0.751
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0.683 0.621 now how this calculated let us
pick up this
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This is nothing but this investment 3256 so
here this is for 2 years it has to be brought
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back that means this factor is 1plus i is
point 1 to the power 2 and this comes out
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to be 1.1 to the power 2 and that inverse
of it comes to be 0.8264 Similarly let us
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calculate for this this is 1plus0.1 to the
power 5 comes out to be 1.1 to the power 5
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equal to this as a inverse of this is 0.621
So I have shown you how this PV factor has
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been calculated
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Now if you multiply this
then we get a present value this is machine
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A this is machine B so I get present value
2236.14 this is 2689.456 2497.826 1472.548
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and this is 3235.41 and if I do summation
this is 12131.38 Similarly if I calculate
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this is 1799.82 2212.08 this is 6585.519 this
is 5224.95 this is 2682.72 and if this one
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this is 1850 51037 Now this is more and this
is less so the cash outflow for both the machines
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are negative and hence we cannot select this
machine because the NPV is negative we cannot
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select these machines
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But if we find out the payback period for
this
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if we find out the payback period of this
PV of machine A is equal to 10000 divide by
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because if we add them up here this is 16408
and this is 25397 so this is 10000 divided
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by 16408 comes to be 0.61 years and PV of
B comes out to be 13000 divided by 25397 is
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equal to 0.51 years And if I use this discounted
values present values then
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using PV values then PV of A is equal to 10000
divided by this value which is 12131.38 this
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comes to be 0.824 and PV of B is 13000 divided
by this value 18505.837 comes out to be 0.703
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now we see that these values are considerably
increased when I am using the present value
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of the cash flow
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Now let us summarize in this lecture I have
started a new method which are called Net
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Present Value method which comes under Discounted
Cash Flow methods because Discounted Cash
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Flow methods are time adjusted methods and
we have solved a few problems We have also
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solved a problem using Net Present Value method
and Payback Method and we saw that if Net
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Present Value of the cash flows are used then
PV of the machines increase Thank You