Conventional vs project financing; ARR, NPV, PI, payback

Conventional finance vs project finance

Numerical

The project life and discount rate are not given. Assumptions: life = 5 years, discount rate = 10%, straight-line depreciation, and tax is ignored.

• Net annual cash flow = 10,00,000 - 2,00,000 = Rs 8,00,000
• Depreciation = (25,00,000 - 5,00,000)/5 = Rs 4,00,000 per year
• Average annual profit = 8,00,000 - 4,00,000 = Rs 4,00,000

ARR

$$\begin{aligned} \text{Average investment} &= \frac{25{,}00{,}000 + 5{,}00{,}000}{2} = 15{,}00{,}000\\ ARR &= \frac{4{,}00{,}000}{15{,}00{,}000} \times 100 = 26.67\% \end{aligned}$$

NPV (annuity factor at 10%, 5 years = 3.7908; PV factor at year 5 = 0.6209)

$$\begin{aligned} PV_{inflow} &= 8{,}00{,}000 \times 3.7908 + 5{,}00{,}000 \times 0.6209 = 33{,}43{,}090\\ NPV &= 33{,}43{,}090 - 25{,}00{,}000 = 8{,}43{,}090 \end{aligned}$$

Profitability index

$$PI = \frac{33{,}43{,}090}{25{,}00{,}000} = 1.337$$

Simple payback period

$$\text{Payback} = \frac{25{,}00{,}000}{8{,}00{,}000} = 3.125\ \text{years} = 3\ \text{years}\ 1.5\ \text{months}$$

Answer: ARR = 26.67%; NPV = Rs 8,43,090; PI = 1.337; payback = 3.125 years. NPV is positive and PI is more than 1, so the project is acceptable.