NPV – Net Present Value, IRR – Internal Rate of Return, Payback Period.


Hi there, this is Imran here in this
video you would learn about return on investment techniques such as net
present value internal rate of return profitability index and payback period
these are also called as Capital budgeting techniques the knowledge that
you would acquire by learning capital budgeting techniques would be helpful
for you in project management program management financial management and for
students who are attending and via tasks if you’re preparing for PMP or prince2
it is very important for you to learn the Capital budgeting techniques because
you may get a couple of questions in exams that you may need to answer with
respect to decisions you make to choose between different projects and if you
are a project manager and if you are not aware of capital budgeting techniques
then I would say you must learn the capital budgeting techniques and the
recently it could help you to make informed decisions when you’re faced
with challenges with respect to the financial viability and business
justification of projects capital budgeting techniques fall under the
branch of financial management let me give you a brief overview of where does
the capital budgeting technique fit into under financial management the financial
management is primarily divided into 201 corporate finance to account in your
control these are further divided into sub functions each function is a big
subject in itself and would take hours if not days to learn about each function
and our focus would be on capital budgeting, the reason why
I am showing you the financial management overview is that it would
help you to understand where exactly the capital budgeting technique fit into
under financial management and if an organization decides to undertake a
project it could usually do two studies one is technical feasibility and other
is finish survival if the project is not technically
feasible then there is no point in going ahead with the project and if the
project is technically feasible and then the organization’s would conduct
financial viability for the projects with the help of Capital budgeting okay
so the point is what exactly is capital budgeting technique
capital budgeting technique is a planning process it determines whether
it is worth to take our invest organisations capsule into projects and
it always works for the benefit of the firm by increasing its financial value
and before we get started to learn about capital budgeting techniques it is very
important for you to learn among the terms discounted cash flow and non
discounted cash flow so the question is what is discounted cash flow and to
explain this you must first understand the time has a money value discounted
cash flow takes the time value of money into consideration for example the money
in hand today it invested in the bank will earn let’s say 6% per annum
so this six percent can be considered as a discounted cash flow and you need to
remember one thing it’s not only about the interest rate it could also be the
rate of return that an organization gets back if it invests the money in a
business which could earn more than the interest rate and let’s say 8% rate of
return is what we are getting by investing the capital in a business then
this 8% rate of return should be considered as a discounted cash flow and
this discounted cash flow is also called as opportunity cost of capital or
sometimes it is referred as cost of capture and now let’s move on to non
discounted cash flow now this is simple it does not take time value of money
into consideration so therefore the interest or the rate of
Britain is not taken into consideration now let’s see what is opportunity cost
of cats what is opportunity cost of capital
opportunity cost of capital is something that you would give up in order to get
something else let me ask you this question
what do you think is the opportunity cost for me for making this video if I’m
not making this video for you then I would be spending this I’m going out
with my friends or I would be spending time with my one-and-a-half here please
so the opportunity cost of making this video is the time lost spending with my
kid or with my friends and it applies to everyone even you watching this video if
you’re not watching this video then you would be doing something else and the
opportunity costs for you would be that something else and then the big question
comes why do people let go the opportunity cost the reason is because
people think rational meaning you weigh the pros and cons of all mutually
exclusive alternatives available you would choose the best alternative
available at that point in time because people expect to achieve greater
benefits choosing one alternative over the other mutually exclusive opportunity
discounted cash flow is nothing but the opportunity cost of capital so when I
say this houndred cash flow it also means that I’m
referring to the opportunity cost of capital or just say cost attached now
let’s look at these capital budgeting methods a net present value internal
rate of return profitability index these capsule budgeting techniques would
always consider the discounted cash flow without taking into consideration the
opportunity cost of capsule or the discounted cash flow we cannot calculate
the net present value or internal rate of return or profitable limits however
payback period the opportunity cost of capsule is an optional mostly when
calculating payback period the discounted cash flow is not considered
now let’s look at the future value present value let’s understand the
relationship between future value of money in present value for example let’s
say you have 100 dollars in hand today then what would be the future value of
that hundred dollars after one year similarly if you’re going to get $100
after one year for sure then what is the present value of that hundred dollars
now you should be able to calculate the future value or the present value if one
of the two information is available to us we can calculate using the formula FV
is equal to P V multiplied by 1 plus K whole power M K in this formula is the
discount rate in other words it is also the opportunity cost and n is the number
of years now let’s look at calculating the future value and present value with
some examples let’s first look at calculating the future value if you have
$100 and if you invest that money in a bank today and Bank promised you who
give you 8 percent per annum interest what would be the future value of that
hundred dollars after first year fifth year and 15 Q now here $100 is the
present value of the capsule and 8% is the opportunity cost of capsule now
8% means 8 500 that is equal to 0.08 and 1 plus K here is 1 plus 0.08 that is 1
point zero eight now you can see this on the screen here 1 plus K value K value
and present run now let’s use the formula and calculate the future value
moons now that we know the present value 1 plus K value and the N value it’s easy
to calculate the future value future value after 1 year is $100 multiplied by
1 point 0 H to the power of 1 and that gives you 108 dollars in future value
after five years is $100 multiplied by 1 point zero eight to the power of five
and if you do the calculations it will give you one hundred and forty six
dollars and similarly we can calculate the future value 100 dollars for any
period of time using the formula it could be for 15 years or any number of
years and for 15 years we are getting the value is three hundred and seventeen
dollars now I would request you after you watch this video come back to the
video again pause the video on the screen take a pen and paper in hand and
do the calculations this would help you to get prepared for the examinations
and do this for all the examples in this video that I show for calculations now
let’s look at how to calculate the present value
let’s say you have three scenarios where you are going to get hundred dollars
after one year five years in fifteen years then what would be the value of
one hundred dollars today now we have the formula through which we can
calculate the future value we would use the same formula to calculate the
present value the formula is present value is equal to future value divided
by one plus K to the power of n here the future value is $100 and the opportunity
cost of capsule is given as eight dollars eight percent sorry now using
the formula we can calculate the present value the present value of $100 to be
received after one year would be 100 divided by one point zero eight and that
would give you 93 dollars and similarly we can calculate the
present value of $100 to be received after five years or 15 years and for
that matter any period of time as long as we know the future value in the
discount rates now on the screen I’ve just done the calculations for the
present value for present value for one year present value for five years
present value for 15 years now you can just pause the screen and you can do the
calculations or you can come back and do the calculations now that we have
learned how to calculate the present value and future value it is just a
cakewalk for you to calculate the net present value and before we learn how to
calculate the net present value let’s look at the few important points that we
need to keep in mind and remember in order to calculate the net present value
net present value is determined by subtracting present value of all cash
outflows from the present value of all cash inflows meaning you would need to
take into consideration all the cash inflows for a project and calculate
their present value and we need to sum up all the present values and from the
sum of all present values you will need to subtract the cash outflows and that
would give you the net present value I know you’re confused a little bit here
but do not worry this would become clear when you look at an example in the next
coming slide and this is very important to remember once we calculate the net
present value it should always be positive for the project
being accepted if the net present value is negative that means the project is
not enhancing a viable now let’s get into the nitty-gritty of calculating the
net present value here is an example a sum of $400,000 is invested in an IT
project and below we have the cash inflows to the project up to a period of
five years and the opportunity cost of capsule is given as eight-person all we
need to do is calculate the net present value and bases the net present value
decide if the project is worth undertaking or do we need to reject the
project see in this example the $400,000 is spent out right initially fit is
called a cash outflow and coming to the revenue from the project at the end of
first year the project generates $70,000 and at the end of second year the
project generous $120,000 and at the end of third year it generates one $40,000
and for fourth year it generates one $40,000 and at the end of fifth year it
generates $40,000 now that we know how to calculate the present value we need
to calculate the present value for year one that is for $70,000 in for year two
that is 120 thousand dollars in for a 3-1 $40,000 and year for again one
$40,000 in for efi same $40,000 now once we get the present value for the EO one
two three four five we need to sum them up and subscribe to $400,000 and that
gives us the net present value information and if the net present value
is positive you should accept the project and if it is negative you should
check the hose I have done the calculations here I got all the present
value details for all the ears and when I sum them up I got the total value of
all caps in close as four hundred eight thousand nine hundred and fifty nine
dollars and for us to calculate the net present value we have to subtract the
cash outflows from the cash inflation remember the cash outflows for this
example was four hundred thousand dollars that was spent initially so that
becomes cash outflow now that we have the cash inflow for all the cash inflow
of all present values which is four hundred eight thousand nine fifty nine
dollars we need to subtract four hundred thousand dollars from this announce and
that would give us eight thousand nine hundred and fifty nine dollars and since
this net present value is positive this project in the accepted now let’s look
at another example the same example I would say what we have done is we have
just changed the opportunity cost of the capsule from eight percent to fifteen
percent now this was eight percent in the previous example and this is fifteen
version in this example and let’s see if the project is still financially viable
and won’t remain the same the time period remains the same it’s only just
the opportunity cost that has changed from 8 percent per annum to 15 percent
per annum now let’s look if this project is still financially viable or not I’ve
done the calculations on the screen we know the formula for present value now
using the present value formula we would calculate the present value for year 1
year 2 year 3 year 4 and year 5 that uses these values here on the screen now
if I sum them up I get three hundred and forty three thousand five hundred and
ninety one dollars and the cash outflow which we’ve done initially is four
hundred thousand dollars now if I subtract four hundred thousand dollars
from three hundred and forty three five ninety one dollars I get the net present
value as – fifty-six thousand four hundred and
eight dollars and the net present value has become negative here so we should
not accept this project because this project is not financially viable now
look at the note on this page below though we have the same inflow and
outflow of cash when compared to the previous example the net present value
has changed from positive to negative when the opportunity costs of captain
has increased from eight percent fifteen version now what does they say they say
that net present value is very much dependent on the discount rate or the
opportunity cost of capsule now with this example we complete the net present
value and now let’s move on to the eternal rate of return calculations now
generally speaking the higher the project’s internal rate of return the
better and it’s more desirable to undertake the project’s internal rate of
return is the calculations by which we would be able to tell how much rate of
return are we getting from the project so higher the internal rate of return
the better for the project IRR which is also called as internal rate of return
can also be used through ranked projects now IRR is nothing but the discount rate
at which the net present value becomes sheer I’ll make it clear in a moment
let’s say you have to choose between two projects where the net present value of
the project is say and you are asked to choose one of the projects then you
would need to choose the project which has the higher internal rate of return
now you may get a couple of questions in exams asking you to choose between two
different projects they may give you the net present value details internal rate
of return it is and they would ask you to choose what project among the three
projects then you would need to choose the project which has highest internal
rate of return and remember this point the project’s internal rate of return
should be greater than because the project’s internal rate of
return is greater than opportunity cost you should always accept the cross and
if the project’s internal rate of return is less than the opportunity cost
you should reject the project because if the internal rate of return is less than
opportunity cost the project is not financially viable and it is better to
invest the money in a different project where we have a better instrument now
let’s look at the relationship between internal rate of return opportunity cost
and the net present value if IRR is greater than the opportunity cost then
the net present value will always be positive and if IRR is less than
opportunity cost then the net present value will always be negative as said
earlier as long as the net present value is positive the project is financially
viable in the moment the net present value goes to negative the project is
not energy divided right now let’s see an example and calculate the internal
rate of return for a project the project let’s say the project cost is thousand
dollars in the panel span is five years and it generates $200 at the end of year
one $300 at the end of year two $300 at the end of year three $400 in the year
four and $500 in the vo hi the opportunity cost is given here as twelve
receipts and now we are asked to calculate if the project is financially
viable or not faces the internal riddle now let’s look at the solution first we
need to calculate the net present value of the project then adjust the
opportunity cost until we get the net present value regime the opportunity
cost at which the net present value becomes 0 would be the internal rate of
return so we will tackle this solution with the following in mind if the NPV
positive that means at 12% opportunity cost the net present value is positive
so we need to increase the opportunity cost above to a person and see where
does the net present value become 0 once we find out the rate at which the
net present value becomes 0 we need to consider that rate has insulin later now
I will show you how the calculations are done let’s see the excel sheet which is
attached in this bitch and you get a period as to how the internal rate of
return is calculated so we know the formula to calculate the present value
and using the formula I have just automated this in the Excel report and
let me show you how it is done now we have all the future values here for year
1 year 3 a 3 year 4 5 we know what the discounted rate is its whole person
that’s given in the example here I have calculated the present value for year 1
year 2 year 3 year 4 and year 5 now I got cash inflow for all present values
as 1169 dollars I know the cash outflow is $1,000 so I calculated the net
present value which is 1 system in dollars now for us to calculate the
internal rate of return what we are doing is we need to adjust the discount
rate as I said the internal rate of return is nothing but the discount rate
at which the net present value becomes 0 now at 12% then at present values 1
system in dollars so let’s increase the 12% to 13% and let’s see what would be
the net present value so it dropped to 136 let’s look at code in version 321 or
$5 let’s see 15 versus $75 so net present
value is dropping as we increase the discount rate now let’s look at 17%
laters sorry 17% is harmful it’s $18 let’s see 18%
so it went to negative fruit should be in between 70 and 80 so let’s look at
some in point five right it’s five point five so let’s see seventeen point six
it’s two point eight 17.7 now it is close to zero zero point two four if I
make it seven point eight invention it so at 17 point seven percent discount
rate then it present value becomes zero now this would be the internal rate of
return because at seventeen percent discount rate the net present value have
become zero so this would be considered as the internal rate of now let’s go on
and let’s look at the profitability index before we move on to profitability
next let’s just look at this twelve percent discount rate the net present
value is one season in dollars in at 17.7% let us become zero point two four
close to zero so the IRR is seventeen / 17 point seven percent for this project
which is a pretty good internal rate of return let’s get on to profitability
next what is profitability index it is also again our decision-making criteria
to choose projects now it is a ratio by which we can tell how many dollars can
be earned in return for each dollar spends for you to be able to calculate
the profitability index you should know the present value of all cash inflows
and cash outflows and then divide the cash inflows with cash outflows and you
should be able to get the profitable day image I will show you how to calculate
the profitability index in an example now you need to remember this you should
accept the project if the profitability index is greater than one and you should
reject if it is less than one again the higher the profitability
for a project it is more desirable to undertake the project and let’s look at
the relationship between net present value and profitable index if net
present value is greater than 0 then the profitability index is greater than 1 if
the net present value is less than 0 then the profitability index is less
than 1 and remember this point this is very important
profitability index can never be negative it would always be greater than
0 the reason being is not subtracting the
cash outflows from hash enclosure we’re just dividing the cash inflows in the
cash outflows so therefore the profitability index can never be
negative it would always be greater than zero and the ideal profitability net
should always be greater than one and anything less than one for profitability
index the project is not financially viable now let’s look at the example for
profitability index in this example an investment of $25,000 is invested in a
project which is giving you a series of cash inflows that’s here it’s giving you
$5,000 at the end of year $100,000 enough a to $10,000 at end of year 3
again $10,000 at end of year four and $3,000 in the VF 5 and if the required
rate of return is 12 percent what is the profitability index the profitability
index is calculated by dividing the present value of all cash inflows by
present value of all cash outflows so first we need to calculate the present
value of all years all the years here and sum them up and divide it with the
cash outflow let’s see the excel sheet in which I have automated using the
formula to calculate a profitable English all right we know the formula
for present value now we know all the future values you
know the years of one two three four five I know the discount rate is 12%
I have automated the formula here so we calculate the present value for you one
calculate the present value for here to present value for year three per year
for input year five I got the individual present values for year one two three
four five now if I sum them up I get twenty six
thousand eight hundred fourteen dollars now in this example the cash inflow for
all the present values is twenty-six thousand eight hundred and fourteen
dollars but we have been given twenty five thousand dollars as cash outflows
all we need to do is divide twenty six thousand eight hundred fourteen dollars
with twenty five thousand dollars and that would give you the profitable
business here is the profitability on points is M so the profitability index
for this project is one point zero seven as I said earlier if the profitability
index is greater than one we can accept the project now if we change the
profitability index the discount rate the profit it would affect the
profitable index if I increase this it becomes third one four zero four see as
I increase the opportunity cost the profitability index went down so we have
a direct relationship between the discount rate and the property the
difference that’s about the profitability index now let’s move on to
the payback period now what is payback period it is the length of time required
for an investment to recover its initial cash or growth for example if you invest
thousand dollars in a project and it generates five hundred dollars every
year for a period of five years then what is the payback period I would say
the payback period would be three years because
it takes two years to recover the thousand dollars we invested in the
project initiative so the payback period is two years and generally speaking
organizations do not consider time value of money in a back idiot and again it
depends on the organization’s you’re working for however if you want to take
the time value of money into consideration for calculating payback
period you may do so and here is the important point good projects will not
only have a good internal rate of return or the net present length but they also
have early payback periods so if you’ve given a couple of projects with good
internal rate of return and in a present value choose the project which has early
payback period if the internal rate of return hundred present values are the
same for the projects you should go with the project that has the early day back
period now let’s look at the example that’s on the screen and I think with
that this video would come to an end in this example an investment of $25,000 in
IT projects you a series of cash inflows has described below it in the first year
$5,000 in the second year $9,000 in the third and fourth years $10,000 and in
the fifth year it gives you $3,000 so what would be the payback period for
this project the solution is simple we need to calculate the time it takes to
earn $25,000 since we are not given the discount rate we need to just calculate
this payback period without considering the opportunity cost so in the end of
first year we got $5,000 and at the end of second year we got $9,000 so the
total amount we got at the end of second year is $14,000 it’s just the cumulative
of all the revenue that we get at the end of the ears okay so at the end of
third year it becomes one four thousand dollars since we need to
get back with twenty five thousand dollars let’s see if I calculate this
the cumulative of four years it would become thirty four thousand dollars
since we are concentrating only on 25 thousand dollars let’s break the fourth
year the venue in two month wise revenue and that would be ten thousand divided
by Club and that is eight hundred and thirty three dollars per month so for
three years one month we would earn about 24,000 plus eight hundred and
thirty three dollars and that would be twenty-four thousand eight hundred and
thirty dollars close to 25 thousand dollars and in three years two months
fine we would earn about twenty five thousand 666 dollars so we can say that
the payback period is in between three years one month and three years two
months for this project okay so that’s about the payback period payback period
is easy to calculate all we just need to do is just calculate the amount at what
period of time we would be able to recover the initial investments right so
let’s have a quick recap in this video we learned about the capital budgeting
techniques learn what is discounted cash flow and non discounted cash flow we
learned how to calculate the future value present value we learn how to
calculate the net present value internal rate of return payback period and
profitable index and with this we end this video tutorial if you find this
tutorial informative please subscribe and thumbs

100 Replies to “NPV – Net Present Value, IRR – Internal Rate of Return, Payback Period.”

  1. MY SINCERE THANKS to this wonderful video and big thanks to the LECTURER (Mr Imran) presenting the chapters covered. i now have a much better understanding to the topics which i have been trying to seek help for the longest time. i am very grateful to Mr Imran (If i address correctly from start of video)

  2. you made it sound so easy that now I have interest in learning more from you. thanks for such an informative video.

  3. This video is awesome, one of my seniors forwarded me this video as I was facing difficulty to understand these topics. I used to intermingle these concepts and Mr.Imran illustrated in very easy way (for all non-business backgrounds). If any high school student watches this video he will understand these topics easily.
    Once again thanks for your remarkable effort for learners.

  4. Thank you dear Imran Sir really me was seeking helps from someone to cover these topics , but today you teaches so well and you explain the topics in detail .
    Again thanks for this video

  5. THANK YOU…THIS VIDEO IS VERY VERY HELPFUL AND IT SIMPLIFY THE TECHNIQUES VERY WELL.THANKS.

  6. This video is very essential to me. The explanation is nice and easily understand. Thank you for your smart explanation. God bless you and your beloved family thank you again.

  7. wh?at happens to a 15yr investment with no inflows? i.e II =x amount and every year there is just x amount of additional outflow. you only get lump sum after 15yrs. e.g investing in a new premium whiskey that will take 15yrs to mature and during the period you need to pay for storage (while distilling)

  8. Bro i dont knw what to say but u really saved my ass out here ❤
    Got accounting test tommorow about this topic and didint knw anything an hour ago
    Im now 100% sure imma ace the test
    Once again thanks man ur tge best 👊

  9. Such a master skill you used to put things in order that makes very easy to understand.
    This is how big professors use to teach.

  10. In the given sum of IRR, you are using excel, is there no manual way? And is trial and error the only way to solve it (if there are multiple cash flows)?

  11. Excellent Lecture, thanks Mr. Imran. Your presentation and grasp on Topic is perfect. After watching this video, my all doubts got cleared. Thank You So much, will wait for more such videos.

  12. in NPV first year is usually not discounted. in 14.56 of video the amount of first year (70000) should not be discounted. because discount rate should be started from second year of operation. correct me please if I'm wrong.

  13. Great video. I wonder i you get back to about min. 3:10 – 3:20 where you said "time has a money value". I presume you meant "money has a time value".

  14. This is such a great lecture, the breakdown, really helps reading the book alone was not helping but I enjoy watching this video.

  15. Superb crisp and clear explanation.. I am not from accounts background but with your explanation I am able to understand.
    Thank you so much sir

  16. I find a video very special, i tried to cover the knowledge when i was in college but i ended up confused. Thank u very much.

  17. Hi …video is very helpful…but one technique is Missing of Non discounted method that is ARR…plz explain that also

  18. please add other topics of financial management sir.video was excellent .subscribed please do add more so that it would help many more

  19. Thanks for this video its help me alot from where i can get the relevant video continuously regarding leverage, and cash management?

  20. Absolutely wonderful lecture brother…. You just made me feel confident for my exams….. Bravo 👍👍👏🏾

  21. The explanation and examples were good to understand… !!! And gives better understanding… I will share this video to my friends… !😊 Thankyou sir!!!

  22. Thanks a lot sir it’s really helpful! Tomorrow having exam its makes easy to learn capital budgeting now!
    I want you one video on WACC please !
    Good luck !

  23. The best academic explanation I have ever seen on Youtube. If you can upload a video on Life Cycle Costing using NPV calculations, It would be a huge social service. Best of Luck

  24. What an awesome explanation……i understood very easily….. Keep posting this type of vedioes…..these are very useful……

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