FINANCIAL INDICATORS

Net present value (NPV) and Internal rate of return (IRR) are the two most commonly used methods to ascertain whether the worth of the project is more than the cost.

NPV is the fundamental financial measure of the present value of future net benefits to be derived from a project. It is calculated as the sum of time-adjusted values of cash outflows and inflows for each time period to the planning horizon. The cash outflows are the costs and inflows are the benefits. If CF_i is the after-tax incremental cash flow which occurs at the time period i , then the NPV can be calculated as follows:

Where, r = Rate of return for the project (or WACC)

n = Project planning horizon (or project duration/investment duration)

The decision rule is that the project is worthwhile for the investors if the NPV is positive.

IRR is the project's expected rate of return. IRR can be explained as the discount rate at which the present value of cost is equal to the present value of future benefits which are generated from the project. In order words, it is the discount rate at which the NPV = 0. By equating the NPV of a project equal to zero, the IRR for the project can be determined by solving for discount rate in the following manner:

Where, CF_t = After-tax cash flow in the time period t

The decision rule is that the project should be undertaken if the project's IRR is greater than the project's cost of capital.