Introduction
Definition and Importance of Present Worth Analysis
Present Worth Analysis (PWA) is a financial evaluation method used to
determine the current value of future cash flows by discounting them to the
present. This technique helps in assessing the feasibility and profitability of
projects and investments by comparing the present value of expected
benefits to the initial costs.
Objectives of the Report
The report aims to:
1. Explore the end-of-year convention in PWA.
2. Analyse different viewpoints in economic analysis studies.
3. Examine the impact of borrowed money on PWA.
4. Assess the effects of inflation and deflation.
5. Discuss tax implications on present worth.
6. Define key economic criteria used in decision making.
7. Provide practical guidance on applying PWA techniques.
8. Compare multiple alternatives using PWA.
End-of-Year Convention
Definition and Application
The end-of-year convention assumes that all cash flows occur at the end of
each year. This simplifies the calculation of present value by standardizing
the timing of cash flows.
Comparison with Other Conventions
Beginning-of-Year Convention: - Assumes cash flows occur at the
start of the year. This convention often results in slightly higher
present values due to the earlier timing of cash flows.
Continuous Compounding: - Uses continuous compounding rates
for more precise calculations but is more complex to apply.
Advantages and Limitations
Advantages:
Simplifies calculations by standardizing cash flow timings.
Commonly used in financial modelling and valuation.
Limitations:
May not reflect the exact timing of cash flows in some projects.
Less accurate for projects with irregular cash flow patterns.
Viewpoint of Economic Analysis Studies
Traditional Economic Viewpoint
Traditionally, economic analysis focuses on metrics such as Net Present
Value (NPV), Internal Rate of Return (IRR), and Payback Period. These
metrics help in evaluating the profitability and risk of investments.
Modern Economic Perspectives
Modern perspectives incorporate broader criteria including:
Risk Management: - Assessing project risk and uncertainty.
Sustainability: - Considering environmental and social impacts.
Real Options Analysis: - Evaluating flexibility and future decision-
making opportunities.
Role in Project Evaluation
Economic analysis studies play a critical role in project evaluation by
providing a structured approach to assessing financial viability, comparing
alternatives, and making informed investment decisions.
Borrowed Money Viewpoint
Impact of Financing on Present Worth Analysis
Borrowed money affects the present worth analysis by altering the cash
flow structure and cost of capital. Interest payments and principal
repayments influence the overall financial evaluation.
Considerations for Debt Financing
Cost of Debt: - Interest rates and repayment terms impact the
present value calculations.
Debt Service Coverage: - The ability to service debt affects financial
stability and project viability.
Comparison with Equity Financing
Equity Financing: - Involves issuing shares and does not require
repayment but dilutes ownership.
Debt Financing: - Requires regular payments and has tax benefits
due to interest deductibility.
Effect of Inflation and Deflation
Impact on Present Value Calculations
Inflation and deflation affect the purchasing power of money and thus the
value of future cash flows. Inflation erodes the value of future cash flows,
while deflation increases their value.
Adjusting Cash Flows for Inflation and Deflation
Inflation Adjustment: - Cash flows should be adjusted upward to
reflect increased costs and decreased purchasing power.
Deflation Adjustment: - Cash flows should be adjusted downward to
reflect increased purchasing power.
Practical Implications
Inflation: - Requires incorporating expected inflation rates into
discount rates and cash flow projections.
Deflation: - Less common but may require similar adjustments to
account for increased value.
Taxes and Present Worth Analysis
Tax Effects on Cash Flows and Present Value
Taxes impact cash flows through deductions, credits, and payments.
Adjustments must be made to reflect the after-tax cash flows in present
worth calculations.
Tax Considerations in Financial Modelling
Depreciation: - Tax benefits from depreciation can affect cash flow
projections.
Tax Credits and Deductions: - Impact the overall financial
evaluation by reducing taxable income.
Case Study Examples
1. Real Estate Investment: - Analysing the effect of property taxes and
depreciation on the present value of rental income.
2. Corporate Projects: - Evaluating the impact of tax incentives and
credits on investment decisions.
Economic Criteria for Decision Making
Key Economic Criteria
Net Present Value (NPV): - Measures the difference between the
present value of cash inflows and outflows. A positive NPV indicates a
profitable project.
Internal Rate of Return (IRR): - The discount rate at which NPV
equals zero. Higher IRR indicates better profitability.
Payback Period: - The time required to recover the initial
investment. Shorter payback periods are generally preferred.
Application of Economic Criteria
Economic criteria are used to compare and select projects based on
profitability, risk, and time value of money. Sensitivity and scenario
analysis further refine decision-making by assessing the impact of varying
assumptions.
Sensitivity and Scenario Analysis
Sensitivity Analysis: - Evaluates how changes in key variables affect
project outcomes.
Scenario Analysis: - Examines different scenarios to understand
potential risks and opportunities.
Applying Present Worth Techniques
Step-by-Step Methodology
1. Identify Cash Flows: - Determine all relevant cash inflows and
outflows.
2. Select Discount Rate: - Choose an appropriate discount rate based
on risk and cost of capital.
3. Calculate Present Value: - Discount future cash flows to their
present value.
4. Analyse Results: - Compare the present value to the initial
investment to determine profitability.
Tools and Software for PWA
Excel: - Commonly used for financial modelling and present worth
calculations.
Financial Software: - Specialized software for more complex
analyses and scenario planning.
Common Mistakes and Best Practices
Accurate Data: - Ensure data accuracy and consistency in cash flow
projections.
Correct Discount Rate: - Use an appropriate discount rate that
reflects the risk and cost of capital.
Regular Review: - Continuously review and update financial models
to reflect changing conditions.
Evaluating Multiple Alternatives
Techniques for Comparing Alternatives
Present Worth Analysis: - Compare the present worth of different
alternatives to determine the best option.
Cost-Benefit Analysis: - Assess the costs and benefits of each
alternative to identify the most cost-effective solution.
Multi-Criteria Decision Analysis (MCDA)
MCDA integrates multiple criteria, including financial, environmental, and
social factors, to evaluate alternatives comprehensively. Techniques
include:
Weighted Scoring Models: - Assign weights to various criteria and
score alternatives based on their performance.
Analytic Hierarchy Process (AHP): - A structured method for
comparing alternatives and making decisions based on multiple
criteria.
