DEPARTMENT OF INTERNATIONAL ECONOMIC RELATIONS

THE UNIVERSITY OF ECONOMICS AND LAW

Part 2 – PROJECT APPRAISAL

Lecture 4
INVESTMENT CRITERIA FOR PROJECT APPRAISAL
Thanh-Tra Ngo, 2017
1
 Content

Time value of money

Net present value (NPV)

Internal rate of return (IRR)

Benefit/Cost ratio (B/C)

Payback Period

2
 Time value of money
Denote r: interest rate/rate of return/ Present 1$
opportunity cost of capital (the loss of After 1 year 1$.(1 + r)
potential gain when financing for project
After t year 1$.(1 + r)t
instead of other investment chances.

Time value of money:

Future value: Pt = P0 (1 + r)t
Present value: P0 = Pt / (1 + r)t

•  (1+r)t : future value at year t of current 1$

à (1+r)t : compounding factor
•  1/(1+r)t : present value of 1$ at year t.
à 1/(1+r)t : discount factor

3
Investment criteria for project appraisal

Net
present
value
(NPV)

Benefit/
Cost ratio
(B/C)
Internal
Payback
rate of
Period
return
(Tpp)
(IRR)

4
 1. Net Present Value (NPV)

NPV = Net Present Value = Present value of Net benefits

= Present value of Benefits – Present value of Costs

Denote:

•  B : Benefit (Cash inflow)

•  C : Cost (Cash outflow)

•  NCF : Net Cash Flow

•  PV(B) : Present value of Benefits

•  PV(C) : Present value of Costs

5
 1. Net Present Value (NPV)
n
B0 B1 Bn Bt
PV ( B) = + + ... + =∑
(1 + r ) (1 + r )
0 1
(1 + r ) t =0 (1 + r )
n t

n
C0 C1 Cn Ct
PV (C ) = + + ... + =∑
(1 + r ) (1 + r )
0 1
(1 + r ) t =0 (1 + r )t
n

t t
Bt Ct
NPV = PV(B) - PV(C) = ∑ t
−∑ t
t=0 (1+ r) t=0 (1+ r)
Or
(B0 − C0 ) (B1 − C1 ) (Bn − Cn )
NPV = 0
+ 1
+ ...+
(1+ r) (1+ r) (1+ r)n
n
(Bt − Ct ) n NCFt
=∑ t
=∑ t
t=0 (1+ r) t=0 (1+ r)
6
The cash flows are given as below with discount rate of 15% per year

36 36 836
PV (B) = + +
(1+ 0.15)1 (1+ 0.15)2 (1+ 0.15)3
= 31.3+ 27.2 + 549.7 = 608.2
PV (C) = 650
NPV = PV(B) - PV(C) = 608.2 - 650 = −41.8 $800

$36 $36
$36

0 1 2 3

- $650

7
 Using with Excel
Use function Fx/ Financial/NPV:

= NPV (rate;value1;value2;…) + value year 0

= NPV (discount rate; net cash flows from year 1 to year n) +

net cash flow at year 0

•  Noting that the accumulated value of PV(NCF) at year n is

NPV

8
Using with Excel

9
 Decision Rule 1 of NPV
•  Do not accept any project unless it generates a positive
NPV when discounted by the opportunity cost of funds.
o  NPV = 0: investors can expect to recover their incremental
investment and also earn a rate of return on their capital that
would have been earned elsewhere and is equal to the private
discount rate used to compute the present values à investors
would be neither worse off nor better off than they would have
been if they had left the funds in the capital market.
o  NPV > 0: investors can expect not only to recover their capital
investment, but also to receive a rate of return on capital
higher than the discount rate.
o  NPV < 0: investors cannot expect to earn a rate of return equal
to the discount rate, nor can they recover their invested capital.
10
 Decision Rule 1 of NPV
An investor has 4 independent investment opportunities without
budget constraint. All projects are discounted by equity's cost of
capital. Which one is chosen?

Project PV(Investment cost) NPV

$ million $
A 1 70,000
B 5 -50,000
C 2 0
D 3 -25,000

11
 Decision Rule 2 of NPV
Within the limit of a fixed budget, choose the subset of the
available projects that maximizes the NPV.
•  Suppose the following set of projects describes the investment
opportunities faced by an investor with a fixed budget for capital
expenditures of $4.0 million. All projects are discounted by equity's
cost of capital. Which one is chosen?

Project PV(Investment cost) NPV

$ million $
E 1 60,000
F 3 400,000
G 2 150,000
H 2 225,000
12
 Decision Rule 3 of NPV
When there is no budget constraint but a project must be chosen
from mutually exclusive alternatives, investors should always
choose the alternative that generates the largest NPV.
•  Consider three projects, I, J and K, that are mutually exclusive for
technical reasons & they are best potential projects that would
yield a positive NPV. All are discounted by equity's cost of capital.
Which one is chosen?

Project PV(Investment cost) NPV

$ million $
I 1 300,000
J 4 700,000
K 1.5 600,000
13
 Special cases

•  Perpetuity

•  Annuity

14
 Perpetuity

•  A perpetuity (denotes as P) is a constant stream of

identical cash flows with no end.

•  Present value of perpetuities:

o  P: cash flow each period;

o  r: discount rate

P
PV ( P) =
r

15
 Annuity
•  An annuity (denotes as A) is a cash flow stream in which
the cash flows are equal and occur at a regular interval.
•  Types of annuity:
o  Ordinary annuity: the equal payments are made at the end
of each compounding period starting from the first
compounding period.
o  Annuity due: the equal payments are made at the
beginning of each compounding period starting from the
first period.
o  Deferred annuity: the first payment is deferred a certain
number of k compounding periods after the first.

16
 Present value of ordinary annuity
Denote art as equal-payment-series present-worth factor

A A A 1− (1+ r)−t
PV (A) = 1
+ 2
+ ...+ t
= A.[ ] = A.ar
t

(1+ r) (1+ r) (1+ r) r

PV (A).r(1+ r)t
A=
(1+ r)t −1
A A A A A
……………
Year
0 1 2 3 4 …………… t
t periods, t payments
17
 Present value of annuity due
A A A
PV (A) = A+ 1
+ 2
+ ...+
(1+ r) (1+ r) (1+ r)t−1
1− (1+ r)−(t−1) [(1+ r)t − 1]
= A + A.[ ] = A(1+ r)
r (1+ r)t r

A A A A A A
……………
Year
0 1 2 3 4 …………… t-1 t
t periods, (t – 1) payments
of ordinary annuity

18
 Present value of deferred annuity

1− (1+ r)−(t−k ) [(1+ r)(t−k )

−1]
PV (A) = A.[ ] / (1+ r) = A.
k

r r(1+ r)t

k deferment periods A A A A
……………
Năm
0 1 2 3 4 …………… t-1 t
t periods, (t –k) payments
of ordinary annuity

19
 Ordinary annuity applications
•  Calculate annually equal cash flows (e.g., loan repayment method
as even total repayment (interest and principal)).
à Use function Fx/ Financial/PMT: PMT(rate,nper,pv,fv,type)
o  Rate : interest rate
o  Nper : number of payments
o  Pv : present value (loan amount).
o  Fv : future value, or the amount left after final principal payment is
made. If not, it is assumed “Fv = 0” in Excel.
o  Type : number 0 or 1, refer to the point of payment time. In Excel, it is
assumed as ending of each period if typing 0 or untying; as beginning
of each period if typing 1.

•  Overcome disadvantage of NPV.

20
 Advantages and disadvantages of NPV
•  Advantages:
o  Maximize investors’ benefits
o  Take account the time value of money and risk into
decision-making.
o  Consider all cash flows of projects.
o  Be able to plus and minus NPV of projects with same
lifetimes.
•  Disadvantages:
o  Require the guesswork about the project's cost of capital.
o  Not useful for comparing projects with different lifetimes.

21
 2. Internal rate of return - IRR
•  The rate of return:
E.g. Buying a flat and selling it after 1 year. Investment cost C0 =
$350.000. Cash inflow in year 1: C1 = $400.000

Profit C − C0 $400.000 − $350.000

Rate of return = = 1 = = 0,1439 ≈ 14, 3%
Investment C0 $350.000
§  The internal rate of return
Discounting project’s cash flows with the discount rate of r.
When NPV = 0: C1 C1 − C0
NPV = C0 + =0⇒r= (*)
1+ r C0
From (*): Project’s rate of return is also the rate at which project's NPV
equals to 0 we call this rate as internal rate of return.

22
 Internal rate of return - IRR

•  Internal Rate of Return – IRR is the discount rate at which

the net present value of all the cash flows from a project
or investment equal zero.

( Bt − Ct )
n
IRR = r => NPV = ∑
*
=0
t = 0 (1 + r )
* t

•  Note: The cost (C) in above formula dose not include

depreciation and interest expenses.

23
 Decision rule of IRR
Denote MARR as the cost of capital or minimum acceptable
rate of return.
•  Good project: NPV ≥ 0 ó IRR ≥ MARR
•  Bad project: NPV < 0 ó IRR < MARR
NPV
NPV

IRR
Discount rate %
Ÿ
24
 Calculating IRR = ?

•  Buying a flat for renting and selling it at the ending of year 3.

Year 0 1 2 3
Cash flow ($000) -350 +16 +16 +466

•  IRR is the discount rate at which the NPV of all the cash
flows equal zero. Hence:

16, 000 16, 000 466, 000

NPV = −350, 000 + + + =0
1 + IRR (1 + IRR) 2
(1 + IRR) 3

⇒ IRR = ?

25
 Calculating IRR = ?

•  Calculating by interpolation:
o  Choose r1 so that NPV1 > 0
o  Choose r2 so that NPV2 < 0 (r1 < r2)

(r2 − r1 )NPV1
IRR = r1 +
( NPV1 + NPV2 )

•  Calculating by Excel: Use function Fx/Financial/IRR:

= IRR(values; guess) = IRR(NCF0:NCFn; 10%)

= IRR(net cash flows from year 0 to year n; guessing value, e.g.10%)

26
 A – Advantages of IRR

•  Easy to visualize for managers

•  Required rate of return is not needed for finding IRR

•  IRR shows information related to “safe level” of project.

27
 “Safe level” of IRR

•  Consider a small project (S) with investment cost C of $10,000

and receive a cash inflow CF1 of $16,500
à NPV = $5,000 (r=10%) and IRR = 65%
•  Consider a large project (L) with investment C of $100,000 and
receive a cash inflow CF1 of $115,550
à NPV = $5,045 (r=10%) and IRR = 15.6%
• If CF1 decreases by 39% (from $16,500 à $10,000) à project
can recover initial investment cost.
• If CF1 decreases by less than 15.5% (from $115,550 à
$100,000) à project can not recover initial investment cost.
à IRR of project (S) implies that this project has a higher “safe
level”.
28
 B – Disadvantages of IRR

•  If projects have different costs of capital over period, it is

more difficult to comparing with IRR.
•  IRR may not be unique: A project can have many IRRs,
especially when the time profile of the net cash flow
crosses the axis more than once.

Year 0 1 2 3 4 5
NCF ($ million) -22 +15 +15 +15 +15 -40

à IRR = 6% or 28%

29
 B – Disadvantages of IRR

NPV

IRR = 6%

IRR = 28%

Ÿ Ÿ Discount rate %

NPV

30
 B – Disadvantages of IRR

•  IRR is not unified with NPV in decision-making.

IRR(A) > IRR(B) ≠> NPV(A) > NPV(B)
ü  Exclusive projects & different scales:

Project C0 C1 IRR NPV with i=10%

A - 10,000 + 20,000 100% + 8.182
B -20,000 +35,000 75% + 11.818

31
 B – Disadvantages of IRR

ü  Exclusive projects & different point of investment times:

0 1 2 3 4 5 IRR NPV@8%

A -1000 1200 20% 111.11

B -1000 1200 20% 81.67

ü  Exclusive projects & different lifetimes:

0 1 2 3 4 IRR NPV@7%
A -350 +400 14.29% +24
B -350 +16 +16 +16 +466 12.96% +59

32
 B – Disadvantages of IRR
NPV lines of 2 projects intersect at the interest rate of 12.26% (crossover rate).
•  If MARR > 12.26% à IRRA > IRRB and NPVA > NPVB à choose project A
•  If MARR < 12.26% à IRRA > IRRB but NPVA < NPVB à which project is chosen?

NPV

B
A

Ÿ
IRRA = 14.29%
0
12,26%
Ÿ Ÿ r%

33 IRRB = 12.96%
3. The ratio of Benefit and Cost (B/C)

•  B/C = Benefit/Cost Ratio

PV(Benefit)
B/C =
PV(Cost)

•  Normal B/C Adjusted B/C

B (B – C)

34
 Normal B/C
B

Normal B/C is the ratio of present

value of operating cash inflows
(benefits) and present value of
C
cash outflows (costs), including
operating cash outflows and
investment cash flows.

PV(Cash inflows)
B/C =
PV(Cash outflows)
PV(Operating cash inflows)
=
PV(Operating cash outflows + Investment cashflows)

35
Adjusted ratio of Benefit and Cost (Adjusted B/C)
(B – C)
Adjusted B/C is the ratio of
present value of net operating
cash flows (benefits) and
present value of investment
costs.

PV(Operating cash inflows - Operating cash ouflows )

B/C =
PV(Investment cashflows)
PV(Net operating cashflows)
=
PV(Investment cashflows)

36
 Decision rule of B/C

•  Good project:

PV(B)
B/C = ≥1
PV(C)

•  Bad project:

PV(B)
B/C = <1
PV(C)

37
 A – Advantage of B/C

NPV is the difference between of present value of cash

inflows and present value of cash outflows while B/C is the
ratio between them.

=> In term of economics, NPV refers to absolute

measurement of the wealth but not compared with investment
scale, while B/C refers to relative measurement of investment
efficiency because it is compared with investment scale.

38
 B – Disadvantages of B/C

•  Projects with different scales

Project ($ million) PV(C) PV(B) B/C NPV

A 1 1.3 1.3 0.3

B 8 9.4 1.175 1.4
C 1.5 2.1 1.4 0.6

By B/C à choose project C.

By NPV à choose project B.
à Which project is chosen?

39
 B – Disadvantages of B/C

•  Projects with difference in definition of cost.

o  What is Cost (C)? Total cost (C0 +Ct) or Investment
cost (C0)?

Project A Project B
Present value of benefits (B) 2000 2000
Present value of operating costs (C) 500 1800

Present value of investment cost (C0) 1200 100

Normal B/C [B/(C+C0)] 1.18 1.05

Adjusted B/C [(B-C)/C0] 1.25 2.00

40
 4. Pay-back Period

Pay-back period is the length of time required for an

investment to recover its initial outlay in terms of net
benefits or net operating cash flows.

Pay-back period = A + (B/C)

•  A is the last period with a negative cumulative cash flow;

•  B is the absolute value of cumulative cash flow at the

end of the period A;

•  C is the total cash flow during the period after A

41
 Calculating Tpp
•  Base on net cash flow NCF without consideration to the
time value of money à payback period

•  Base on net cash flow NCF with consideration to the time

value of money à DCF (Discounted Cash Flow) à
discounted payback period: the length of time required for
an investment to recover its initial outlay in terms of net
discounted net benefits or discounted net operating cash
flows, with discount rate used as project’s cost of capital.

42
 Calculating Tpp

0 1 2 3 4

Net cash flow -1000 100 300 400 675

Cumulative
NCF -1000 - 900 - 600 - 200 475

Pay-back period = 3 + 200/675 = 3.3 (years)

43
 Calculating Tpp with discount rate r of 10%

0 1 2 3 4

Net cash flow -1000 100 300 400 675

Discounted
NCF -1000 91 248 301 461
Cumulative
discounted NCF -1000 - 909 - 661 - 361 100

Pay-back period = 3 + 361/461 = 3.78 (years)

44
Decision rule of Tpp

Tpp < T*

(T* is required pay-back period)

45
 A - Advantages of Tpp

•  Easy to calculate:
o  Just basing on net cash flow or discounted net cash flow can
know about the time to recover investment cost.
•  Be a good indicator in case of high-risk projects and investment
costs needed to be recover soon
o  A project with short payback period can improve the liquidity
position of the business quickly. The payback period is
important for the firms for which liquidity is very important.
o  An investment with short payback period makes the funds
available soon to invest in another project.
o  A short payback period reduces the risk of loss caused by
changing economic conditions and other unavoidable
reasons.
46
 B - Disadvantages of Tpp

•  It does not consider the useful life of the assets, cash

inflow or outflows after payback period.
•  It does not let us know about the owners’ wealth or the
ratio between net benefits and investment cost, or which
the appropriate pay-back period is.

47
 Comparison of using all criteria

% all Average mark in the scale 0-4

companies (0 = never use; 4 = always use)
Criterion always/
usually
use Small Large
All companies companies companies
IRR 76 3.1 2.9 3.4
NPV 75 3.1 2.8 3.4
Tpp 57 2.5 2.7 2.3

Source: Data is recorded at 1999 from Journal of Financial Economics, Vol.60,

Issue 2-3, J.R Graham and C.R.Harvey, “The theory and practice of Corporation
Finance: Evidence from the Field,” May 2001, pp.187-243

48
 References

•  “Cost-Benefit Analysis for Investment decisions”, Glenn

P. Jenkins & Arnold G. Harberger, NXB Havard
University (Chapter 4)

•  “Financial Management”, Eugene F. Brigham & Joel F.

Houston, (Chapter 3, 10, 11, 12, 13)

•  Lecture notes of Project Appraisal for Investment

development, Fulbright Economics Teaching Program,
2009.

49