PROJECT APPRAISAL METHODS

(Entrepreneurship Mgt Prof Bushra Ansari)

Payback Method | Payback Period Formula
The payback period is the time period required for the amount invested in an asset to be
repaid by the net cash outflow generated by the asset. The payback period is expressed
in years and fractions of years. For example, if a company invests Rs. 3, 00,000 in a
new production line, and the production line then produces cash flow of Rs. 1, 00, 000
per year, then the payback period is 3.0 years (Rs. 3, 00,000 initial investment / Rs.
1,00,000 annual payback). An investment with a shorter payback period is considered to
be better, since the investor's initial outlay is at risk for a shorter period of time. The
calculation used to derive the payback period is called the payback method.
The formula for the payback method is simplistic:
Divide the cash outlay (which is assumed to occur entirely at the beginning of the
project) by the amount of net cash flow generated by the project per year (which is
assumed to be the same in every year).
Payback Period Example
Vardaan Manufacturer is considering the purchase of a machine that costs Rs. 50,000
and which will generate Rs. 10,000 per year of net cash flow. The payback period for
this capital investment is 5.0 years. Vardaan Manufacturer is also considering the
purchase of a conveyor system for Rs. 36,000, which will reduce the transport costs by
Rs. 12,000 per year. The payback period for this capital investment is 3.0 years. If
Vardaan Manufacturer only has sufficient funds to invest in one of these projects, and if
it were only using the payback method as the basis for its investment decision, it would
buy the conveyor system, since it has a shorter payback period.
Summary
The payback method should not be used as the sole criterion for approval of a capital
investment. Instead, consider using the net present value or internal rate of return
methods to incorporate the time value of money and more complex cash flows, and use
through out analysis to see if the investment will actually boost overall corporate
profitability. There are also other considerations in a capital investment decision, such
as whether the same asset model should be purchased in volume to reduce
maintenance costs, and whether lower-cost and lower-capacity units would make more
sense than an expensive "monument" asset.

Accounting Rate of Return (ARR) Examples

Accounting rate of return (ARR, also known as average rate of return) is used to
estimate the rate of return for an investment project. The higher the ARR, the more
attractive the project is. If the ARR is higher than the minimum standard average rate of
return, then we will accept the project. However, this technique does not take into
account of the time value of money.
Calculation and Formula:
ARR = Average profit / Average investment
Example 1:
An investment of Rs. 600,000 is expected to give returns as follows:
Year 1 (Rs. 50,000), Year 2 (Rs. 150,000), Year 3 (Rs. 80,000), Year 4 (Rs. 20,000)
Calculate the average rate of return.
Solution:
Total returns over the four years = 50,000 + 150,000 + 80,000 + 20,000 = 300,000
Average returns per annum = 300,000 / 4 = Rs. 75,000
ARR = 75,000 / 600,000 = 12.5%

Net present value method

Net present value method (also known as discounted cash flow method) is a popular
capital budgeting technique that takes into account the time value of money. It uses net
present value of the investment project as the base to accept or reject a proposed
investment in projects like purchase of new equipment, purchase of inventory,
expansion or addition of existing plant assets and the installation of new plants etc.

Net present value is the difference between the present value of cash inflows and the
present value of cash outflows that occur as a result of undertaking an investment

project. It may be positive, zero or negative. These three possibilities of net present
value are briefly explained below:
Positive NPV:

If present value of cash inflows is greater than the present value of the cash outflows,
the net present value is said to be positive and the investment proposal is considered to
be acceptable.
Zero NPV:

If present value of cash inflow is equal to present value of cash outflow, the net present
value is said to be zero and the investment proposal is considered to be acceptable.
Negative NPV:

If present value of cash inflow is less than present value of cash outflow, the net present
value is said to be negative and the investment proposal is rejected.

Calculation Methods and Formulas

The first step involved in the calculation of NPV is the determination of the present value
of net cash inflows from a project or asset. The net cash flows may be even (i.e. equal
cash inflows in different periods) or uneven (i.e. different cash flows in different periods).

When they are even, present value can be easily calculated by using the present value
formula of annuity. However, if they are uneven, we need to calculate the present value
of each individual net cash inflow separately.
In the second step we subtract the initial investment on the project from the total present
value of inflows to arrive at net present value.
Thus we have the following two formulas for the calculation of NPV:
When cash inflows are even:

1 (1 + i)-n
NPV = R

Initial Investment
i

In the above formula,

R is the net cash inflow expected to be received each period;
i is the required rate of return per period;
n are the number of periods during which the project is expected to operate and
generate cash inflows.

When cash inflows are uneven:

R1

R2

NPV =

R3

+
(1 + i)

+
(1 + i)

+ ... Initial Investment

(1 + i)

Where,
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period;
R3 is the net cash inflow during the third period, and so on

Decision Rule
Accept the project only if its NPV is positive or zero. Reject the project having negative
NPV. While comparing two or more exclusive projects having positive NPVs, accept the
one with highest NPV.
Calculate the net present value of a project which requires an initial investment of
243,000 and it is expected to generate a cash inflow of Rs.50,000 each month for 12
months. Assume that the salvage value of the project is zero. The target rate of return is
12% per annum.
Solution
We have
Initial Investment = Rs.2,43,000
Net Cash Inflow per Period = Rs.50,000
Number of Periods = 12
Discount Rate per Period = 12% 12 = 1%

Net Present Value

= Rs.50,000 (1 (1 + 1%)^-12) 1% Rs.2,43,000
= Rs.50,000 (1 1.01^-12) 0.01 Rs.2,43,000
Rs.50,000 (1 0.887449) 0.01 Rs.2,43,000
Rs.50,000 0.112551 0.01 Rs.2,43,000
Rs.50,000 11.2551 Rs.243,000
Rs.5,62,754 Rs.2,43,000
Rs.3,19,754

Internal Rate of Return (IRR)

Internal rate of return (IRR) is the discount rate at which the net present value of an
investment becomes zero. In other words, IRR is the discount rate which equates the
present value of the future cash flows of an investment with the initial investment. It is
one of the several measures used for investment appraisal.
Decision Rule
A project should only be accepted if its IRR is NOT less than the target internal rate of
return. When comparing two or more mutually exclusive projects, the project having
highest value of IRR should be accepted.

IRR Calculation
The calculation of IRR is a bit complex than other capital budgeting techniques. We
know that at IRR, Net Present Value (NPV) is zero, thus:
NPV = 0; or
PV of future cash flows Initial Investment = 0; or

CF1
( 1 + r )1

CF2
( 1 + r )2

CF3
( 1 + r )3

+ ...

Initial Investment = 0

Where,
r is the internal rate of return;
CF1 is the period one net cash inflow;
CF2 is the period two net cash inflow,
CF3 is the period three net cash inflow, and so on

But the problem is, we cannot isolate the variable r (=internal rate of return) on one side
of the above equation. However, there are alternative procedures which can be followed
to find IRR. The simplest of them is described below:

1.
2.
3.
4.
5.

Guess the value of r and calculate the NPV of the project at that value.
If NPV is close to zero then IRR is equal to r.
If NPV is greater than 0 then increase r and jump to step 5.
If NPV is smaller than 0 then decrease r and jump to step 5.
Recalculate NPV using the new value of r and go back to step 2.

Example
Find the IRR of an investment having initial cash outflow of Rs.213, 000. The cash
inflows during the first, second, third and fourth years are expected to be Rs.65,200,
Rs.96,000, Rs.73,100 and Rs.55,400 respectively.

Solution
Assume that r is 10%.
NPV at 10% discount rate = Rs.18,372
Since NPV is greater than zero we have to increase discount rate, thus
NPV at 13% discount rate = Rs.4,521
But it is still greater than zero we have to further increase the discount rate, thus
NPV at 14% discount rate = Rs.204
NPV at 15% discount rate = (Rs.3,975)
Since NPV is fairly close to zero at 14% value of r, therefore
IRR 14%

Break-even Point Equation Method

Break-even is the point of zero loss or profit. At break-even point, the
revenues of the business are equal its total costs and its contribution margin
equals its total fixed costs. Break-even point can be calculated by equation
method, contribution method or graphical method. The equation method is
based on the cost-volume-profit (CVP) formula:

px = vx + FC + Profit
Where,
p is the price per unit,
x is the number of units,
v is variable cost per unit and
FC is total fixed cost.
Calculation
BEP in Sales Units
At break-even point the profit is zero therefore the CVP formula is simplified
to:
px = vx + FC
Solving the above equation for x which equals break-even point in sales
units, we get:

FC

Break-even Sales Units = x =

pv

BEP in Sales Dollars

Break-even point in number of sales dollars is calculated using the following
formula:
Break-even Sales Rupees = Price per Unit Break-even Sales Units
Example
Calculate break-even point in sales units and sales rupees from following
information:
Price per Unit

Rs.15

Variable Cost per Unit

Rs.7

Total Fixed Cost

Rs.9,000

Solution

We have,
p = Rs.15
v = Rs.7, and
FC = Rs.9,000
Substituting the known values into the formula for breakeven point in sales
units, we get:
Breakeven Point in Sales Units (x)
= 9,000 (15 7)
= 9,000 8
= 1,125 units
Break-even Point in Sales Dollars = Rs.15 1,125 = Rs.16,875