Net Present Value Analysis

Use the following 5-step process in net present value analysis:
Step 1. Select the discount rate.
Step 2. Identify the costs/benefits to be considered in analysis.
Step 3. Establish the timing of the costs/benefits.
Step 4. Calculate net present value of each alternative.
Step 5. Select the offer with the best net present value.
This section will demonstrate the use of that 5-step process in two lease-purchase decision examples using nominal discount rates. You should follow the same steps for any net present value analysis whether you are using nominal discount rates or real discount rates.
Lease-Purchase Decision Example 1. Assume that you want to determine which of the following proposals will result in the lowest total cost of acquisition?
Offeror A: Proposes to lease the asset for 3 years. The annual lease payments are Rs10,000 per year. The first payment will be due at the beginning of the lease, the remaining two payments are due at the beginning of Years 2 and 3.
Offeror B: Proposes to sell the asset for Rs29,000. It has a 3-year useful life. Salvage value at the end of the 3-year period, will be Rs2,000.
Step 1. Select the discount rate. The term of the lease analysis is three years, so we will use the nominal discount rate for three years, 5.4 percent.
Steps 2 and 3. Identify and establish the timing of the costs/benefits to be considered in analysis. The expenditures and receipts associated with the two offers and their timing are delineated in the table below: (Parentheses indicate a cash outflow.)

JOIN KHALID AZIZ
CA MODULE B,C,D FINANCIAL ACCOUNTING 1 & 2, ECONOMICS & COST ACCOUNTING


Offer-Related Expenditures/Receipts
t Offer A Offer B
0 (Rs10,000) (Rs29,000)
1 (Rs10,000) -0-
2 (Rs10,000) -0-
3 -0- Rs2,000
Step 4. Calculate net present value. The tables below summarize the net present value calculations applied to each alternative.
Net present value of Offer A
t Cash Flow DF PV
0 (Rs10,000) 1.0000 (Rs10,000)
1 (Rs10,000) 0.9470 (Rs9,470)
2 (Rs10,000) 0.8968 (Rs8,968)
Net Present Value (Rs28,438)
Note the following points in the net present value calculations above:
o There are no cash inflows associated with Offer A, only outflows.
o Payments due now are not discounted.
o Offeror A payments due at the beginning of Years 2 and 3 are treated as if they are due at the end of Years 1 and 2.
o You could have calculated the net present value of Offer A using the Sum of Discount Factors (Appendix A-1) for the payments due at the beginning of Years 2 and 3. Remember that payments due now are not discounted and payments due at the beginning of Years 2 and 3 are treated as if they are due at the end of Years 1 and 2. The calculations would be:

Net present value of Offer B
t Cash Flow DF PV
0 (Rs29,000) 1.0000 (Rs29,000)
3 Rs2,000 0.8492 Rs 1,698
Net Present Value (Rs27,302)
Note the following points in the net present value calculations above:
o Offer B salvage value is treated as a cash inflow at the end of Year 3.
o Payments due now are not discounted.
Step 5. Select the offer with the best net present value. In this example, we would select Offer B, the offer with the smallest negative net present value.
Lease-Purchase Decision Example 2. Assume that we want to determine which of the following proposals will result in the lowest acquisition cost?
Offeror A—Proposes to lease the asset for 3 years. The monthly lease payments are Rs1,500; that is, the total amount for each year is Rs18,000. These payments are spaced evenly over the year, so the use of a MYDF would be appropriate.
Offeror B—Proposes to sell the asset for Rs56,000. It has a 3-year useful life. At the end of the 3-year period it will have a Rs3,000 salvage value.
Step 1. Select the discount rate. The term of the analysis is three years, so we will use the nominal discount rate for three years, 5.6 percent.
Steps 2 and 3. Identify and establish the timing of the costs/benefits to be considered in analysis. The expenditures and receipts associated with the two offers and their timing are delineated in the table below:
Offer Expenditures/Receipts
t Offer A Offer B
0 -0- (Rs56,000)
1 (Rs18,000) -0-
2 (Rs18,000) -0-
3 (Rs18,000) Rs3,000
Step 4. Calculate net present value. The tables below summarize the net present value calculations applied to each alternative.


Net present value of Offer A
t Cash Flow DF PV
1 (Rs18,000) 0.9731 (Rs17,516)
2 (Rs18,000) 0.9215 (Rs16,587)
3 (Rs18,000) 0.8727 (Rs15,709)
Net Present Value (Rs49,812)
NOTE the following points in the net present value calculations above:
o There are no cash inflows associated with Offer A, only outflows.
o Offeror A payments are due monthly, so we used the nominal rate, mid-year factors from Table.
o You could also calculate the net present value of Offer A using the Sum of Discount Factors in Table. That calculation would produce a slightly different answer due to rounding differences.

Net present value of Offer B
t Cash Flow DF PV
0 (Rs56,000) 1.0000 (Rs56,000)
3 Rs3,000 0.8492 Rs2,548
Net Present Value (Rs53,452)
Note the following points in the net present value calculations above:
o Offer B salvage value is treated as a cash inflow at the end of Year 3.
o Payments due now are not discounted.
Step 5. Select the offer with the best net present value. In this example, we would select Offer A, the offer with the smallest negative net present value.
9.6 - Identifying Issues And Concerns
Questions to Consider in Analysis. As you perform price/cost analysis, consider the issues and concerns identified in this section, whenever you use net present value analysis.
• Is net present value analysis used when appropriate?
Net present value analysis should be used in any analysis supporting Government decisions to initiate, renew, or expand programs or projects which would result in a series of measurable benefits or costs extending for three or more years into the future.
• Are the dollar estimates for expenditures and receipts reasonable?
The base for all present value calculations is estimated future cash flows. The rationale for those estimates must be documented and supported just like any cost estimate. This includes estimates of costs that will be included in the contract or lease agreement and estimates of other cash flows that are not included. All may be used in present value calculations.
• Are the times projected for expenditures and receipts reasonable?
Discount factors depend on the discount rate and the timing of the cash flow. The timing of any cash flow not documented in the contract or lease agreement must be clearly supported. The offeror is responsible for estimating and defending cash flow estimates included in the proposal. Government technical personnel have that responsibility for estimated costs related to item ownership.
• Are the proper discount rates used in the net present value calculations?
Unless precluded by agency policy, discount rates should be taken. If they are not, the rationale must be documented.
• The rate selected should be based on the number of time periods included in the analysis. If the period of the analysis does not match any of the discount rate periods, linear interpolation should be used to estimate a rate for that period of time.
o Nominal discount rates should be used for any analysis not based on constant year dollars. Real discount rates should be used for any analysis that is based on constant year dollars.
• Are the proper discount factors used in analysis?
The discount factor should be calculated considering the timing of the cash flow.
o End-of-year discount factors should be used for cash flows at the beginning or end of the year.
o Mid-year discount factors should be used for cash flows in the middle of the year or regularly throughout the year (e.g., monthly or quarterly).
• Are discount factors properly calculated from the discount rate?
End-of-year or mid-year discount rates should be calculated following the procedures.
• Have all cash flows been considered?
Net present value analysis must consider all relevant cash flows throughout the decision life cycle.
JOIN KHALID AZIZ
CA MODULE B,C,D FINANCIAL ACCOUNTING 1 & 2, ECONOMICS & COST ACCOUNTING