project management: unit iv - project appraisal criteria

Project Appraisal Criteria

Prepared By Ghaith Al Darmaki

[email protected] for Engineering Business Managers

Manchester Business School

Project Management - Unit IV Prepared By: Ghaith Al Darmaki 2

Content

Introduction Pay Back Period-PBP.NPV –Net Present value IRR -Internal Rate of Return.


Investment Criteria

It is very important to judge if a project is a worthwhile or not.

Two main categories of Criteria: Investment

Criteria

Discounting Criteria

Non-Discounting

Criteria

NPV BCR IRR Payback Period

ARR Urgency

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The payback period: is the period of time that is required to recover the initial investment.

The payback period is stated in terms of number of years.

Computation of Payback period: The pay back period can be calculated in two different

situations: When annual cash inflows are equal: In this case,

the cash inflows being generated by a proposal are equal for all time periods. The payback period can be computed by dividing the initial cash outflows by the amount of cash inflows per time period.

PB = Initial cash outflow/investment Constant Annual Cash inflow

Payback Period


When the annual cash inflows are unequal: When the cash inflows are unequal, calculate the cumulative cash flows.

=> Calculate the cumulative inflows.

Payback Period


Examples of equals inflows: Problem (1):A project requires an initial cash outflow of Ro.5, 00,000 and is

expected to generate cash inflows of Ro.1, 00,000 p.a.for 8 years.

Solution: PB = Initial cash outflow/investment Constant Annual Cash inflow PB = 5, 00,000 = 5 years 1, 00,000 b) 5th year are considered as profit. The period over and

above the pay back period (the 6th, 7th, 8th), year is ignored.

The pay back period need not be the whole number.

Payback Period


Examples of equals inflows: Problem (2)A project requires an initial cash outflow of Ro.5,

00,000 and is expected to generate Cash Inflows of Ro.80, 000 p.a.for 8 years.

Solution: PB = Investment = 5, 00,000 Constant cash flows 80,000

= 6.25 years or 6 years and 3

months.

Payback Period


Examples of unequal inflows: Problem (1) An investment proposal requires a cash outflow of Ro.2,

00,000 and expected to generate cash flows of Ro.80, 000, Ro.60, 000, Ro.40, 000, Ro.20, 000 and Ro.15000 over next 5 years respectively. Calculate the pay back period.

Solution:

Thus, the pay back period is 4th year.

Payback Period


Examples of unequal inflows:

Example (2)

Payback Period

-1000000

-800000

-600000

-400000

-200000

0

200000

400000

600000

0 1 2 3

Series1

Series2

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The Decision Rule: the actual payback is compared with a predetermined pay back, that is, the pay back set by the management in terms of the maximum period during which the investment must recovered.

If the pay back period is less than the predetermined payback, then the project would be Accepted; if not, it would be rejected.

Payback Period


Advantages:1. It is very simple. It is easy to understand and apply.2. It is cost effective.3. The payback period measures the direct relationship between

annual cash inflows from Proposal and the net investment required.

4. It gives an indication of liquidity.5. The pay back period also deals with risk. The project with a

shorter payback period will be less risky. Disadvantages:1. The pay back period entirely ignores the cash inflows that

occur after the pay back period.2. It ignores the concept of required rate of return.3. The pay back period also ignores salvage value and total

economic life of the project.4. It ignores the time value of money.

Payback Period


The Net present value of a proposal is the sum of present values of all cash inflows related to a proposal, less the sum of present values of all cash outflows associated with a proposal.

Thus, NPV is the sum of the discounted values of all cash flows pertaining to a proposal.

The present value factors are multiplied to their respective net cash flows to arrive at the present value of each net cash flow. When all such present values are added the resultant figure is the Net Present Value.

Net Present Value (NPV)



NPV of a project is the sum of the present value of all cash flows that are expected to occur over the life of the project.

It converts future values to present values Future values are usually net benefits from investment It compares sum of present values against investment

Ct = cash flow at the end of year t n = life of the project r = discount rate

If NPV > 0 Accept the project. If NPV < 0 Reject the project.

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t InvestmenIntialr

CNPV

tt

n

t

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Present Value of A Single AmountDiscounting applies an interest rate to a future

value to get a present value PV0 = FVn / (1+r)n

(1+r)n : The discount factor.Example: You are supposed to get 1000OMR after

two years, what is the present value of this amount if the interest rate is 10%?

PV0 = FVn / (1+r)n

PV0 = 1000/(1.1)2 = 826.45 OMR Out of S

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ExampleFour year project (project discount rate = 10%)

t0 t1 t2 t3 t4

Project Outlay - 10000Project net cash flows 4000 4000 3000

1000Discounted cash flows: /(1.1)1 /(1.1)2 /(1.1)3

/(1.1)4

year 1 3636year 2 3306

year 3 2254year 4 683

Net Present Value (NPV) = - 121Out o

f Sco

pe



The Decision Rule:The NPV is positive accept the project Reject the project if the NPV is negative.

The positive NPV of a proposal signifies the present worth of its inflows is more than the present worth of its out flows. Thus; the NPV represents the excess of benefits over the costs in real term.



Advantages:1. It recognizes the time value of money.2. It is capable of evaluating proposals that is profit seeking.3. The discount rate is most appropriate to ensure the minimum

expectations of share4. Holders are adequately met.5. The NPV allows for both the recovery of the initial investment

and the earnings at a Pre-stipulated rate.6. It is based on accounting information which is readily available

and familiar to businessman

Disadvantages:1. It involves lengthy and difficult calculation.2. Determination of the required rate of return is a difficult job.3. It is difficult to estimate economic life of a project with full

accuracy


Internal Rare of Return (IRR)

The IRR of a proposal is defined as the discount rate at which the NPV of the proposal works out to zero.

IRR is the discount rate that equates present value of cash inflows with present value of cash outflows.

First find out the PV of cash outflows at chosen original discount rate. Depending upon whether the NPV so arrived at positive or negative, another PV of cash inflows is calculated by taking a discount rate that is higher or lower than the original rate. Now two rate and two corresponding PVs.


It is the discount rate which gives a net present value of zero.

It is the discount rate which equates the present

value of cash flow with the initial investment.

r = IRR If IRR > Cost of Capital Accept the project. If IRR < Cost of Capital Reject the project

Investment CriteriaInternal Rate of Return (IRR)

tt

n

t r

Ct InvestmenIntial

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1

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-15000

-10000

-5000

0

5000

10000

15000

20000

25000

0 2 4 6 8 10 12 14 16 18 20 22 24

discount rate

Internal Rate of Return

One way of discovering the IRR is to calculate the NPV of the project for different interest rates and graph the result. The cutover point on the interest axis of the graph is the internal rate of return

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Example 8.3-8.4:


Excel Formula:IRR(values)

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The IRR is calculated by interpolating the two rates with the help of the following formula:

IRR=r1% +PV of cash inflows at r1 - PV of cash outflows * (r2-r1)

PV of cash inflows at r1- PV of cash inflows at r2

r1=rate of interest that is lower of the two rates at which PV of cash inflows is calculated

r2=rate of interest that is higher of the two rates at which PV of cash inflows is calculated



The original discount rate can be chosen in a manner that can help us in reducing the number of iterations. This can be done by following the steps.1. Calculate the pay back period. Incase the project

generate the uneven streams of cash flows, then the weighted average of cash inflows should be calculated. The original investment must be divided by the weighted average cash flow to arrive at the artificial payback period.

2. Then, search for the PVAF factor as near as possible to the figure obtained as payback period in the row that stands for the life of the project. The interest rates that correspond to the PVAF value should be taken as the range with in which the IRR lies.



The Decision Rule: The IRR is compared with the required rate of return.

This rate is also known as the cut off rate or the hurdle rate. A proposal may be accepted if its IRR is more than the required rate.

If the IRR is less than Required rate, the proposal is rejected. If the required rate of return is equal, the firm is indifferent as to whether accept or reject the proposal.



Advantages:1. It takes into account the time value of money.2. It is profit oriented concept.3. The IRR of the proposal is expressed as a percentage and is compared

with the cut of rate, This is also expressed as a percentage.4. It is based on the cash flows rather than the accounting profit. Disadvantages:1. It involves a complicated calculation hence it is difficult to use.2. It is difficult to use in decision making 3. The estimate of cash inflows are based on the estimates of sales and

cost which are uncertain.4. A critical shortcoming of the IRR method is that it is commonly

misunderstood to convey the actual annual profitability of an investment.



Problem:A chemical company is considering investing in a project costs

Ro.4, 00,000.The estimated salvage value is zero. Tax rate is 50%.The company uses straight line depreciation and the proposed project has cash Flow before tax (CFBT) as follows.

Year CFBT (Ro.)

1 1, 00,00

2 1, 50,000

3 2, 00,000

4 2, 50,000

5 3, 00,000 Determine the following :( i) Internal Rate of Return (IRR) (ii)

Net Present Value (NPV) at 15%



Solution:

CFBT (Cash Flow Before Tax) =profit before Tax + Depreciation

PBT (Profit Before Tax) = CFBT - Depreciation PAT (Profit After Tax) =PBT - Tax CFAT (Cash Flow After Tax) = PAT +

Depreciation



CFBT Depreciation

PBTCFBT-

Depreciation

Tax50%

PATPBT-Tax

CFATPAT+

Depreciation

Pvf@15%

PVof CFA

T

100000 80000 20000 10000 10000 90000 0.8696 78261

150000 80000 70000 35000 35000 115000 0.7561 86957

200000 80000 120000 60000 60000 140000 0.6575 92052

250000 80000 170000 85000 85000 165000 0.5718 94339

300000 80000 220000 110000 110000 190000 0.4972 94464

446073



PV of cash outflows = Ro.4, 00,000 NPV = Ro.4, 46,073- Ro.4, 00,000 = Ro.46,

073. The NPV is positive, hence the project is

accepted.

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IRR:1. Calculate the pay back period. Incase the project

generate the uneven streams of cash flows, then the weighted average of cash inflows should be calculated. The original investment must be divided by the weighted average cash flow to arrive at the artificial payback period.

2. Then, search for the PVAF factor as near as possible to the figure obtained as payback period in the row that stands for the life of the project. The interest rates that correspond to the PVAF value should be taken as the range with in which the IRR lies.



IRR:1. Calculate the weighted average of cash

inflows

Weighted average=[(90000*5)+(115000*4)+(140000*3)+(165000*2)+(19000*1)] /15 = 1, 23,333.33

2. Measure the artificial pay back periodthe artificial pay back period=4, 00,000/1, 23,333=3.2432



IRR:3. search for the PVAF factor as near as possible to

the figure obtained as payback period in the row that stands for the life of the project. The interest rates that correspond to the PVAF value should be taken as the range with in which the IRR lies.



IRR:4. The interest rates corresponding to the figures closet to

3.2432 are 16% and 18%

CFAT Pvf@16% PV of CFAT Pvf@18% PV of CFAT

90000 0.8621 77586 0.8475 76271

115000 0.7432 85464 0.7182 82591

140000 0.6407 89692 0.6086 85208

165000 0.5523 91128 0.5158 85105

190000 0.4761 90461 0.4371 83051

434332 412227



IRR:4.

IRR=r1% +PV of cash inflows at r1 - PV of cash outflows * (r2-r1)

PV of cash inflows at r1- PV of cash inflows at r2

r1=16%; r2 =18%

PV of cash inflows at r1=4, 34,332:PV of cash inflows at r2=4, 12,227

Thus, IRR = 16+ 434332 - 400000 *(18-16) 434332 - 412227 = 16+ (34332*2)/22105=16+3.11 =

19.11%


Exercises

Problem II: Saud Bhawan Limited company is considering investment in a

project requirement a capital outlay of Ro.2,00,000.Forecast for annual income after depreciation but before tax is as follows:

Year Ro. 1 1, 00,000 2 1, 00,000 3 80,000 4 80,000 5 40,000Depreciation taken as 20% on original cost and taxation at 50%of net

income. You are required to evaluate the project according to NPV method taking cost of capital as 10%.


Exercises

Inputs CFBT (Cash Flow Before Tax) =profit before Tax +

Depreciation PBT (Profit Before Tax) = CFBT - Depreciation PAT (Profit After Tax) =PBT - Tax CFAT (Cash Flow After Tax) = PAT + Depreciation

Initial Investment= Ro.2,00,000 PBT is given, PBT (Profit Before Tax) = CFBT – Depreciation Depreciation is 20% of original cost = 0.2 * 200 000 = 40

000 Tax is 50% of the net income

Requirement NPV at 10% discount rate.


Exercises

Depreciation

PBT Tax PAT

CFAT Pvf @ 10%

PVof CFAT

CFBT-Depreciatio

n

50% PBT-Tax

PAT+ Depreciation

40,000 100,000 50,000 50,000 90,000 0.9091 81819

40,000 100,000 50,000 50,000 90,000 0.8264 74376

40,000 80,000 40,000 40,000 80,000 0.7513 60104

40,000 80,000 40,000 40,000 80,000 0.6830 54640

40,000 40,000 20,000 20,000 60,000 0.6209 37254

308193


Exercises

PV of cash outflows = Ro.200,000 NPV = 308,193 - 200,000 = Ro . 108,193 The NPV is positive, hence the project is

accepted.

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Assignment

Question 8 from the question bank. Submission: 6th May 2013.


THANK YOU

project management: unit iv - project appraisal criteria

Education

cash inflows of

cash flows of

annual cash inflows

computation of payback

period of time

initial cash outflow

constant cash flows

cumulative cash flows