feasibility of the project

How to know the feasibility of the project?

27/1/2017

A businessman invests in a project in the present and receives cash flows in future. Can we say that if the sum of his future cash inflows exceeds the total investment he made in present, the project will become feasible and he will start making the profit?

Well, let us understand with the help of an example:
Mr. A Invests Rs.1000 in the project initially. The life of the project is 1 year. He is expecting future cash flows of Rs.1070 year from this investment.
Therefore he is making profit of Rs.70/-(Rs.1070-Rs.1000) from this investment (return of 7% a year)
Is he actually making a profit or are we missing something?
Let us go one step ahead:

The purchasing power of the amount Rs.1070 received after one year will not be the same as that of the same amount if received in present. It is because of the rate of inflation, which is assumed to increase every year.
To further evaluate the project, we need to add the inflation factor in this project. Assuming the inflation rate be 7%, discount the future value Rs.1070 by 7%, we get, 1070/ (1+7%) = 1070/(1.07) = Rs.1, 000/-

Therefore, the future cash flow that businessman will receive has a present value of Rs.1, 000/-, which is the same amount which he invested initially in the project. His net profit is zero.

Therefore, the project is not feasible

The NPV, Net Present Value, is the difference between the present values of the projected cash inflows and the present values of the projected cash outflows. The positive outcome makes the project feasible while the negative value indicates that the project is not desirable.

The formula is:
\(NPV = [\frac{CF_1}{(1+i)^1} + \frac{CF_2}{(1+i)^2} + ........ + \frac{CF_n}{(1+i)^n}] - Initial\ Investment\)

Where,

CF1,CF2.....and CFn are the cash flows
i = Discount rate or the inflation rate
n = number of the years

Let us understand with multiple and unequal cash inflows:
The assumed discount rate is 10%
The above table can also be represented as:

\(NPV = \frac{10,000}{(1+0.1)^1} + \frac{20,000}{(1+0.1)^2} + \frac{35,000}{(1+0.1)3} + \frac{45,000}{(1+0.1)^4} + \frac{30,000}{(1+0.1)^5} + \frac{25,000}{(1+0.1)6} + \frac{5,000}{(1+0.1)^7}\)
- 1,00,000

\(NPV = \frac{10,000}{1.1} + \frac{20,000}{1.21} + \frac{35,000}{1.331} + \frac{45,000}{1.464} + \frac{30,000}{1.611} + \frac{25,000}{1.772} + \frac{5,000}{1.949}\)
- 1,00,000

Net Present Value = (9,091 + 16,259 + 26,296 + 30,736 + 18,628 + 14,112 + 2,566) - 1,00,000
= Rs. 17,957

The positive value of NPV implies that the project is feasible and worth for the investment.

Conclusion

The main disadvantage of the NPV method is that it requires you to make future projections of the cash-flows. This makes this method, not 100% accurate as it is based on estimates. The project may undergo unforeseen escalated costs.
NPV gives you the present value of the project in rupees. It does not provide the return in percentage. The venture may have positive net present value but the return percentage may be less than desired.

Therefore, if NPV is used while taking into consideration above disadvantages carefully, it can provide effective decision-making results.

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