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Concept of Cash Flow Analysis

The document discusses key concepts in cash flow analysis for investment projects: 1. Net present value (NPV) is the difference between the discounted value of cash inflows and outflows, with a positive NPV indicating a profitable project. 2. The discount rate incorporates interest and risk, and is used to calculate the present value of future cash flows. 3. Internal rate of return (IRR) is the discount rate that results in an NPV of zero, and projects with an IRR higher than the discount rate should be accepted. 4. Payback period is the time for cumulative cash flows to repay the initial investment, with shorter payback preferred.

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115 views4 pages

Concept of Cash Flow Analysis

The document discusses key concepts in cash flow analysis for investment projects: 1. Net present value (NPV) is the difference between the discounted value of cash inflows and outflows, with a positive NPV indicating a profitable project. 2. The discount rate incorporates interest and risk, and is used to calculate the present value of future cash flows. 3. Internal rate of return (IRR) is the discount rate that results in an NPV of zero, and projects with an IRR higher than the discount rate should be accepted. 4. Payback period is the time for cumulative cash flows to repay the initial investment, with shorter payback preferred.

Uploaded by

Jatin Rambo
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Concept of Cash Flow Analysis

Net Present Value(NPV): The net present value (NPV) is defined as the difference between the
sum of the discounted cash flows expected from the investment and the amount initially invested
.The higher the net present value of all cash flows during the life-cycle of a well, the more
profitable the well is:
𝐶𝐹
𝑁𝑃𝑉 =
(1 + 𝑖)

Where NPV is the net present value, i is the discount rate, n is the life span of the project, t is the
time of the cash flow.

NPV is the best suited decision criteria, and positive NPV means that the project is profitable

Discount Rate: The discount rate encompasses both interest and risk as compensation for the
time value of money.

Discount factor:
𝒅𝒏 = (𝟏 + 𝒊) 𝒏
Where, n is each year, with 0 representing the base year to which values are discounted;

𝒅𝒏 is the discount factor applicable for year n;

i is the discount rate.

 Accept all projects with NPV > 0


 Drop all projects with NPV < 0

For example, consider “Project A” of one year duration

Initial investment = - Rs. 100

Expected cash flow after one year = Rs. 50

Expected cash flow after two years = Rs. 60

Discount rate = 20%

NPV = -Rs.100 + Rs.41.66 + Rs. 41.66 = -Rs.16.68

Based on the project NPV, the project is rejected

Other example of Net Present Value


Expected Cash Flow
Year (t) Project A(Rs.) Project B(Rs.) Project C(Rs.)
0 -200 -390 -600
1 120 270 300
2 140 220 350

Discount Rate= 10%

NPV for Project A = Rs. 25

NPV for Project B = Rs. 37

NPV for Project C = Rs. -38

Accept Project A

Accept Project B

Drop Project C

Internal Rate of Return (IRR)

It is the single discount rate that produces a NPV of zero. It is also described as the discount rate
that equates the present worth of cash flows to be equal to the present worth of the investments.

𝐶𝐹
0=
(1 + 𝐼𝑅𝑅)

Example:

Year (t) Expected Cash Flow (Rs)

0 -200
1 120
2 140
 Accept all project with IRR > discount factor
 Drop all project with IRR < discount factor

Payback Period: Payback or payback period is defined as the length of time required for the
return on an investment to "repay" the sum of the original investment. All other things being
equal, the better oil development is the one with the shorter payback period. The payback can be
defined by using the following equation:

𝐶𝐹 ≥ 0
Where b represents the payback point at which the cumulative cash flow is positive for the first
time in the project life

Profit to Investment Ratio: This is a simple factor which nevertheless is an excellent measure
of investment potential of a particular project. It is given by:

𝑪𝒖𝒎𝒖𝒍𝒂𝒕𝒊𝒗𝒆 𝒏𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆 − 𝒐𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕


𝑷𝑰𝑹 =
𝑶𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

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