Chapter 6

The Application of
Project Evaluation
Methods

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PPTs t/a Business Finance 10e by Peirson

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Learning Objectives
Explain the principles used in estimating project
cash flows.
Compare mutually exclusive projects with different
lives.
Determine when to retire (abandon) or replace
assets.
Use sensitivity analysis and break-even analysis to
analyse project risk.
Use decision trees to analyse sequential decisions.
Explain the role of qualitative factors in project
selection.
Explain the effects of resource constraints on
project selection.

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Introduction
Practical project evaluation has to
accommodate:
Uncertainty with respect to cash flows.
Uncertainty with respect to the estimation of
the projects required rate of return.
The existence and implications of taxes.

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Application of the NPV Method

Estimation of cash flows in project evaluation:
Exclude financing charges
The required rate of return used to discount CFs
incorporates both the cost of equity and debt. Avoid
double counting financing charges in the CFs.

Focus on incremental cash flows

Is it a cash item?
Will the amount change if the project is undertaken?

Exclude sunk costs

Sunk cost irrelevant to future decision making.
Whether to continue a project should be based only on
expected future costs and benefits.

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Application of the NPV Method

(cont.)
Beware of allocated costs
Any costs that will not change as a result of the project
should be excluded from the analysis.

Include residual values

This will provide a CF at end of project.

Recognise the timing of the cash flows

Just as in the valuation of debt securities such as bonds,
the exact timing of CFs can affect the valuation of an
investment project.
A simplifying assumption is that net CFs are received at
the end of a period.

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Application of the NPV Method

(cont.)
Consistency in the treatment of inflation
Estimate cash flows based on anticipated prices, and
discount the cash flows using a nominal rate; or
Estimate cash flows without adjusting them for
anticipated price changes, and discount the cash flows
using a real rate.
The key is consistency. If the cash flows are nominal
(real), the discount rate must also be nominal (real).

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Inflation and the Need for

Consistency
Example 6.1:
Assume that an investment of $1000 is expected to
generate cash flows of $500, at constant prices, at
the end of each of 3 years. Assume that the expected
rate of inflation is 10% p.a., and that the nominal
required rate of return is 15% p.a.

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Inflation and the Need for

Consistency (cont.)
$1

(1 + p)
Inflation 10 %

Nominal Rate of
Return 15%

$1.10

(1 + i*)
Real Rate of
Return 4.55%
$1.15

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Inflation and the Need for

Consistency (cont.)
Solution:

(1 + p) (1 + i*) = (1 + i)
i* = (1 + i)/(1 + p) 1
i* = (1 + 0.15)/(1 + 0.10) 1 = 0.0455

NPV $1000
$500(1.10)/(1.15)
$500(1.10) 2 /(1.15) 2
$500(1.10) 3 /(1.15) 3 $373, NPV is 0
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Inflation and the Need for

Consistency (cont.)
NPV = $1000 + $500/(1.0455)
+ $500/(1.0455)2
+ $500/(1.0455)3
= $373
NPV is > 0

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6-10

Mutually Exclusive Projects with

Different Lives
One project may end before the other.
How to compare?
Assume that company will reinvest in a project identical
to that currently being analysed: Constant Chain of
Replacement.
Make assumptions about the reinvestment
opportunities that will become available in the future.

The second approach is more realistic and could be

implemented if the future investment opportunities are
known.
However, in practice, this approach would be
impossible to implement unless managers have
extraordinary foresight.
So, the constant chain of replacement approach is
often used.

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Constant Chain of Replacement

Assumption
Each project is assumed to be replaced at the
end of its economic life by an identical project.
Valid comparison only when chains are of
equal length.
This can be achieved by:
Lowest common multiple method.
Constant chain of replacement in perpetuity.
Equivalent annual value method.

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Constant Chain of Replacement in

Perpetuity
The idea is to make both projects comparable.
This is done by the following calculations, which

lead both chains to continue indefinitely:

NPV =

1 + k n
NPV0
1 + k n 1

Where:
NPV0 net present value of each replacement

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Equivalent Annual Value Method

(EAV)
Another way of making the projects comparable:
Involves calculating the annual cash flow of an

annuity that has the same life as the project and whose
present value equals the net present value of the project.

EAV =

NPV0
A n, k

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Chain of Replacement and

Inflation
Chain of replacement methods assume that, at
the end of the projects life, it will be replaced by an
identical project.
In an inflationary environment, the nominal
cash flows will obviously not be the same.
All cash flows and the required rate of return
should be expressed in real terms (to maintain
consistency).

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Is the Chain of Replacement

Method Realistic?
The assumption that the machines replaced and
the services they provide are identical in every
respect is unrealistic.
The impact of such assumptions is reduced by the
fact that the associated cash flows are further into
the future and are discounted to a present value.
However, it may be more unrealistic for
management to make predictions on replacement
projects further into the future.
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Deciding When to Retire

(Abandon) or Replace a Project
Retirement decisions:
Situations where assets are used for some time,
and then it is decided not to continue the operation
in which the assets are used.
Therefore, the assets are sold and not replaced.

Replacement decisions:
Situations where a particular type of operation is
intended to continue indefinitely.
The company must decide when its existing assets
should be replaced.

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Retirement Decisions
Want to determine, during the life of a project,
whether the project is still worthwhile.
NPV rule is the appropriate tool for retirement
decisions.
A project should be retired if the NPV of all its
expected future net cash flows is less than zero.
Example: Mortlake Ltd owns a 6-year-old machine.
End of year
6
7
8

Net cash flow

8 000
5 000

Residual value
12 000
6 000
0

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Example: Retirement Decisions

The required rate of return is 10%: When should the

machine be retired?
PV of retiring now is $12 000.
Maintaining machine will provide cash flows:
need to calculate NPV if we run machine to end of

years 7 and 8.

Solution: NPV

= 12 000 +

8000 + 6000

1.1
= 12 000 + 12 727 = $727

NPV8 = 12 000 +

8000 + 5000
1.1
1.12

= 12 000 + 7273 + 4132 = $595

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Example: Retirement Decisions

(cont.)
In this case, the NPV of running the machine

for one additional year (year 7) is +$727. As

this NPV is positive, the machine should be
retained for year 7.
In the case of year 8, the NPV of running the

machine for the second additional year is $595.

As this NPV is negative, the machine should be
retired at the end of year 8.

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Replacement Decisions
The constant chain of replacement method may
be used to evaluate replacement decisions.
Two cases of replacement:
Identical replacement.
Non-identical replacement.

Identical replacement:
Choose the replacement frequency that maximises the
projects net present value for a perpetual chain of
replacement, or maximises its equivalent annual value.

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Replacement Decisions (cont.)

Non-identical replacement: When should the old
machine be discarded in favour of the new one?
First, determine the optimum replacement frequency
for the new machine, based on identical replacement.
Second, the equivalent annual value (EAV) of the
new machine at its optimum replacement frequency
is compared with the NPV of continuing to operate
the old machine.
The changeover should be made when the NPV of
continuing to operate the old machine for one more
year is less than the EAV of the new machine.

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Analysing Project Risk

Effect of risk on the value of a project is included
in the required rate of return.
However, many assumptions are made in
forecasting cash flows.
How do we factor in variability of these
forecasts?
Through the use of:
Sensitivity analysis.
Break-even analysis.
Simulation techniques.

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Sensitivity Analysis
Analyse effect of changing one or more input
variables to observe the effects on the results
(similar to what if we changed ?).
Steps:
Pessimistic, optimistic and expected estimates made
for each variable.
NPV is calculated using expected estimates for each
variable except one. Procedure repeated using the
optimistic and pessimistic estimates of each variable.
Difference between pessimistic and optimistic NPV
is calculated for each variable.

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Break-Even Analysis
A form of sensitivity analysis.
Measuring sensitivity of profitability of project to
variation in one variable, sales for example.
Calculating the sales volume at which the
present values of the projects cash inflows and
outflows are equal, such that the net present
value is zero.
Predicting minimum sales required for the project
to be profitable the break-even point.

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Simulation
Changing all the variables whose values
are uncertain.
Steps:
Random selection of values by computer from
the distribution of each of the specified variables.
Computer calculates values for projects cash
flows for each year and stores results.
Procedure repeated at least 100 times.
Results of all individual runs are combined to produce
a probability distribution for the projects cash flows.

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Decision-Tree Analysis
Used to evaluate a sequence of decisions
relating to an investment in a risky project.
The decision-tree approach takes into account
the probability of various events occurring and
the effect of those events on the expected NPV
of a project.
Useful when a limited number of contingencies
are possible at different stages, otherwise it
becomes too complex.

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HECS-HELP: Decision-Tree
Analysis
HECS-HELP loan scheme allows students
to defer payment of university fees.
Several ways to pay involving contingencies
imply that decision-tree analysis can be applied.
Main features:
Pay up-front and receive a 20% discount.
Take the HECS-HELP loan and repay through
taxation, contingent on income.
Loan charge (interest rate) is the inflation rate.
Voluntary repayments attract a 10% discount.

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HECS-HELP: Decision-Tree
Analysis (cont.)
Decision-tree analysis allows us to consider the
best approach to dealing with a HECS-HELP debt.
Do we repay now with a 10% discount or pay off
gradually through tax without a discount?
We can decide by calculating NPV of various
decisions along the decision tree.
Need to take into account various factors such
as level of income, required return on funds and
possibility of leaving workforce/unemployment.
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Qualitative Factors and the

Selection of Projects
Qualitative factors may be important in terms of
project selection.
For example: corporate image, improved employee
satisfaction, union pressure, etc.

Difficult to value some of these factors, but they

are important.
Quantitative analysis should be supported by
qualitative analysis.

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Project Selection with Resource

Constraints
Sometimes a companys managers believe that they
are prevented from undertaking all acceptable
projects because of a shortage of funds.
Capital rationing:
A condition where a firm has limited resources available for
investment and must reduce the number and/or size of
projects chosen because of this limitation.

Internal capital rationing:

Management impose a limit on capital expenditure,
choosing not to take on all positive NPV projects available.

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Project Selection with Resource

Constraints (cont.)
Possible reasons:
Conservative management unwilling to borrow.
Unwilling to issue more shares because of possible
effects on the control of the company.
Project proposals based on optimistic forecasts can
be used by divisional managers to expand divisions,
empire building.

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Project Selection with Resource

Constraints (cont.)
External capital rationing:
Occurs when the capital market is unwilling to supply the
funds necessary to finance the projects that a companys
management wishes to undertake.

Reasons:
Financial intermediaries are subject to controls on the
amount of lending (unlikely in a deregulated system).

Empirical evidence suggests that capital rationing

is unlikely to arise from an unwillingness of the
capital market to supply funds.
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Summary
Practical aspects of project evaluation were
covered.
Estimating cash flows:
Exclude financing charges, allocated costs and sunk
costs.
Include all incremental cash flows.
Consistency in treatment of inflation on cash flows
and rates.

Constant chain of replacement is used to

evaluate and compare projects of differing lives
and in analysing asset replacement decisions.
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Summary (cont.)
Effects of risk on a project evaluated using
sensitivity, break-even, simulation and
decision-tree analysis.
Qualitative factors cannot be incorporated into
NPV calculations but are important and must
be considered.
Resource constraints lead to capital rationing
in project evaluation.

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