PROJECT EVALUATION

TECHNIQUES: DISCOUNTED
CASH FLOW AND NONDISCOUNTED CASH FLOW
METHODS
TAIABUR RAHMAN

INTRODUCTION

There are two groups of project evaluation techniques:

discounted cash flow (DCF) analysis and non-discounted cash
flow (NDCF) analysis.
The first group includes the net present value (NPV) and the
internal rate of return (IRR).
The second group includes the payback period (PP) and the
accounting rate of return (ARR).
We will start with the second group and then take on the first
group which is more sophisticated and reliable.

CERTAINTY ASSUMPTION
Decision-making

occurs within a complex environment.

Financial analyst extract from the real world only those items
which are immediately relevant to the decision at hand, and
attempt to ignore those variables which may be too difficult to
handle.
The simplest financial models operate within a very restricted
worldview. These models make three highly simplifying
assumptions:
financial decision-makers are rational, i.e. they are risk-averse
wealth maximizers
the financial market is perfectly competitive and efficient, i.e.
there are no taxes, transaction costs or information costs
the future is certain, i.e. future events and the outcomes of all

PAYBACK PERIOD
The

length of time required to recover the cost of an investment.

The number of years it takes including a fraction of the year to
recover initial investment is called payback period.
Calculated as: For example, if a project cost $100,000 and was
expected to return $20,000 annually, the payback period would
be $100,000 / $20,000, or 5 years.

Cost of Project
Payback Period
Annual Cash Inflows

Payback period for uneven cash flows-To compute payback period,

keep adding the cash flows till the sum equals initial investment.
How long will it take for the project to generate enough cash to
pay for itself?

(500)

150 150 150 150 150 150 150

150

Balance:

(500)
(500) (350)
(350) (200)
(200) (50)
(50) 100
100 250
250 400
400 550
550

700
700

Breakeven year = 3; Balance = (50) at beginning of

that year; Cash flow in next year = 150.

So, Payback period = 3 + 50/150 = 3.33 years.

CFt
Cumulative

PaybackL

-100

10

60

-100

-90

-30

2.4

80
0

50

2 + $30/$80 = 2.375 years

PAYBACK FOR FRANCHISE L

EXERCISE-CAPITAL EXPENDITURE DATA FOR

BENNETT COMPANY(PB FOR PROJECT A-3 YEARS,
B-3.5)

When the payback period is used to make acceptreject decisions, the

decision criteria are as follows:
If the payback period is less than the maximum acceptable payback
period, accept the project.
If the payback period is greater than the maximum acceptable payback
period, reject the project.
The length of the maximum acceptable payback period is determined by
management.
This value is set subjectively on the basis of a number of factors,
including the type of project (expansion, replacement, renewal), the
perceived risk of the project, and the perceived relationship between the
payback period and the share value.
It is simply a value that management feels, on average, will result in
value creating investment decisions.

PAYBACK-THE DECISION CRITERIA

8

Is a 3.33 year payback period good?

Is it acceptable?
Firms that use this method will compare the payback
calculation to some standard set by the firm.
If our senior management had set a cut-off of 5 years for
projects like ours, what would be our decision?
Accept the project.

PAYBACK-DECISION CRITERIA

The payback period is widely used by large firms to evaluate small

projects and by small firms to evaluate most projects. Its popularity
results from its computational simplicity.
It is also appealing in that it considers cash flows rather than
accounting profits. By measuring how quickly the firm recovers its
initial investment, the payback period also gives implicit consideration
to the timing of cash flows.
Because it can be viewed as a measure of risk exposure, many firms
use the payback period as a decision criterion or as a supplement to
other decision techniques.
The longer the firm must wait to recover its invested funds, the
greater the possibility of a calamity. Therefore, the shorter the
payback period, the lower the firms exposure to such risk.

PB-STRENGTHS
10

PB LIMITATIONS

Firm cutoffs are subjective (explained earlier).

Does not consider time value of money.
Does not consider any required rate of return.
Does not recognize cash flows that occur after the
payback period

DOES NOT TAKE FULLY INTO ACCOUNT THE TMV

DOES NOT TAKE FULLY INTO ACCOUNT THE TMV

DeYarman Enterprises, a small medical appliance manufacturer, is

considering two mutually exclusive projects, which it has named projects
Gold and Silver.
The firm uses only the payback period to choose projects. The relevant
cash flows and payback period for each project are given in the following
table.
Both projects have 3- year payback periods, which would suggest that they
are equally desirable. But comparison of the pattern of cash inflows over
the first 3 years shows that more of the $50,000 initial investment in
project Silver is recovered sooner than is recovered for project Gold.
For example, in year 1, $40,000 of the $50,000 invested in project Silver is
recovered, whereas only $5,000 of the $50,000 investment in project Gold
is recovered. Given the time value of money, project Silver would clearly
be preferred over project Gold, in spite of the fact that they both have
identical 3-year payback periods.
The payback approach does not fully account for the time value of money,
which, if recognized, would cause project Silver to be preferred over
project Gold.

DOES NOT RECOGNIZE CASH FLOW THAT TAKE PLACE

AFTER THE PB

DOES NOT RECOGNIZE CASH FLOW THAT TAKE PLACE

AFTER THE PB

Rashid Company, a software developer, has two investment

opportunities, X and Y. Data for X and Y are given in Table. The
payback period for project X is 2 years; for project Y it is 3
years.
Strict adherence to the payback approach suggests that project
X is preferable to project Y. However, if we look beyond the
payback period, we see that project X returns only an additional
$1,200 ($1,000 in year 3$100 in year 4$100 in year 5), whereas
project Y returns an additional $7,000 ($4,000 in year 4$3,000
in year 5). On the basis of this information, project Y appears
preferable to X.
The payback approach ignored the cash inflows occurring after
the end of the payback period

THE ACCOUNTING RATE OF RETURN

The accounting rate of return (ARR) is the ratio of average

accounting income to investment value.
For example, suppose we have an initial outlay of $200, and
subsequent annual accounting income figures of $80, $110, $70
and $120. The average annual accounting income would be (80
+ 110 + 70 + 120)/4 = $95, and the ARR would equal 95/200,
or 47.5%.
Unfortunately, there are several variations on this simple
measure. The divisor can take on several meanings and values.
Examples of three of these are:

THE ACCOUNTING RATE OF RETURN

Average of opening and closing book-values. With an opening

book-value of $200, we might assume a closing written down
book-value of $40. The average value thus committed to the
investment is (200 + 40)/2 = $120. The ARR is thus 95/120, or
79.16%.
Average of net opening and closing book-values. Given the
values of $200 and $40, the net average value is (200 40)/2
= $80, and thus the ARR is $95/80, or 118.75%.
Average of progressive written down book-values. Written down
book-values at the end of each year are: $160, $120, $80 and
$40. The average is (160 + 120 + 80 + 40)/4 = $100, and thus
the ARR is 95/100, or 95%. Each of the four calculated ARR
values, 47.5%, 79.16%, 118.75% and 95% is correct.

THE ACCOUNTING RATE OF RETURN

The ARR is obviously not a reliable measure. It also suffers other

conceptual drawbacks: it does not account for the time value of
money; it uses accounting data which is not directly related to
the wealth of the firm; and it has no objective decision criterion.
The decision criterion usually employed is a comparison of the
ARR with the required rate of return.
As we have seen, the ARR is only an accounting ratio; it is not a
time value of money measure. It should not be compared to the
time value required rate of return.
ARR is a very unsophisticated, vague and misleading measure.
ARR is not recommended as a capital budgeting decisionmaking criterion. The ARR may play a role as an aid and comfort
measure for supporting a project which is acceptable under the
NPV criterion.

NET PRESENT VALUE (NPV)

An approach used in capital budgeting where the present value

of cash inflows is subtracted by the present value of cash
outflows.
NPV is used to analyze the profitability of an investment or
project.
NPV analysis is sensitive to the reliability of future cash inflows
that an investment or project will yield.
Formula

NPV
NPV compares the value of a dollar today versus the
value of that same dollar in the future, after taking
inflation and return into account.
If the NPV of a prospective project is positive, then it
should be accepted. However, if it is negative, then the
project probably should be rejected because cash flows
are negative.
Present Value of all costs and benefits of a project.
Concept is similar to Intrinsic Value of a security but
subtracts of cost of project.
NPV= PV of Inflows- Initial Outlay (IO)

NPV =

CF1
(1+ k )

CF2
+
(1+ k )2

CFn = Cash flow at time n

k = required rate of return

CFn
CF3
++

n IO
3
(1+
k
)
(1+ k )

NET PRESENT VALUE

P R O J E C T
Time
0
1
2
3
4

A
(10,000.)
3,500
3,500
3,500
3,500

B
(10,000.)
500
500
4,600
10,000

k=10%
0

(10,000)

500

455
413
3,456
6,830
$11,154

500

4,600

NPV =
PV Benefits - PV Costs
= $11,154
- $10,000
= $1,154

10,000

Accept Project
since NPV > 0

21

NET PRESENT VALUE

P R O J E C T
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000

Time
0
1
2
3
4

k=10%
0

(10,000)

NPV =

3,500

3,500
(1+ .1 )

3,500

3,500
(1+ .1)2

3,500

3,500

3,500
3,500
+

3
4
(1+ .1 ) (1+ .1 )

PV of 3,500 Annuity for 4 years at 10%

10,000

22

Time
0
1
2
3
4

NET PRESENT VALUE

P R O J E C T
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000

k=10%
0

(10,000)

NPV =
=

3,500

3,500
(1+ .1 )

1
3,500( .10

3,500

3,500
(1+ .1)2

3,500

3,500

3,500
3,500
+

3
4
(1+ .1 ) (1+ .1 )

1
4)
.10(1+.10)

10,000

- 10,000

= 11,095 10,000 = $1,095

23

If projects are independent

then accept all projects
with NPV 0.

ACCEPT A & B

If projects are mutually

exclusive, accept project
with
higher NPV.
Mutually Exclusive:

ACCEPT B only

Mutually Exclusive:
Means
Meansunder
underconsideration.
consideration.(You
(Youmay
mayonly
onlychoose
chooseone.)
one.)
that
thatthe
theacceptance
acceptanceof
ofone
oneproject
projectprecludes
precludesthe
theacceptance
acceptanceof
ofthe
theother
other
projects
projects

NPV DECISION RULES

24

NPV-EXERCISE
Time Period

Return (8%)

IO

1,000,000

1st

450,000

2nd

400,000

3rd

350,000

4th

300,000

5th

250,000
25

INTERNAL RATE OF RETURN

Internal rate of return (IRR)is the interest rate at which the

netpresent valueof all thecashflows (both positive and
negative) from a project orinvestmentequal zero.
Internalrate of returnis used to evaluate the attractiveness of a
project orinvestment.
If the IRR of a new project exceeds a companys required rate of
return, that project is desirable.
If IRR falls below the required rate of return, the project should
be rejected.
Since the IRR cannot be expressed in terms of a solvable
mathematical formula for projects, the economic life of which
extends over a number of years, this rate is normally calculated
by a trial-and-error process using a computer package.

INTERNAL RATE OF RETURN

How it works/Example:
The formula forIRRis:
0 = P0+ P1/(1+IRR) + P2/(1+IRR)2+ P3/(1+IRR)3+ . . .
+Pn/(1+IRR)n
where P0, P1, . . . Pnequals thecashflows in periods 1,
2, . . . n, respectively; and
IRR equals the project's internalrate of return.

INTERNAL RATE OF RETURN

Assume Company XYZ must decide whether to purchase a piece

of factory equipment for $300,000.
The equipment would only last three years, but it is expected to
generate $150,000 of additional annualprofitduring those
years.
Company XYZ also thinks it can sell the equipment for scrap
afterward for about $10,000. Using IRR, Company XYZ can
determine whether the equipment purchase is a better use of
itscashthan its otherinvestmentoptions, which should return
about 10%.

INTERNAL RATE OF RETURN

Here is how the IRR equation looks in this scenario:
0 = -$300,000 + ($150,000)/(1+.2431) + ($150,000)/
(1+.2431)2+ ($150,000)/(1+.2431)3+ $10,000/(1+.2431)4
Theinvestment's IRR is 24.31%, which is the rate that makes
thepresent valueof the investment's cash flows equal to zero.
From a purely financial standpoint, Company XYZ should
purchase the equipment since this generates a 24.31% return
for the Company --much higher than the 10% return available
from otherinvestments.

CONCLUSION

The NPV is preferred to its discounted cash flow counterpart, the

internal rate of return, and both of these methods are far more
desirable than the non-discounted cash flow methods, the
accounting rate of return and the payback period. The primacy
of the NPV model derives from its direct relationship to the
firms goal of wealth maximization. This direct linkage between
model output, the decision criterion and the goal of the firm,
allows us to employ the NPV in unusual project evaluation tasks.
These tasks include the choice among mutually exclusive
projects, the setting up of asset replacement chains, the
calculation of an optimum replacement cycle and the decision
to retire existing assets.
Here the useful versatility of the NPV model is demonstrated,

PROJECT ANALYSIS UNDER RISK

We have discussed project analysis under certainty, i.e. in a norisk situation. In reality, however, the future cash flows of a
project are not certain.
Measuring the risk associated with the expected cash flows of
the project and incorporating this risk into the determination of
the net present value (NPV) is essential for any real world
project evaluation.
There are various ways in which risk can be incorporated into
the NPV computation and capital budgeting decision support.
These include the risk-adjusted discount rate, the certainty
equivalent, sensitivity and break-even analysis and simulation.
They are the risk-adjusted discount rate and certainty
equivalent methods.

PROJECT ANALYSIS UNDER RISK

Although the CE method is conceptually and theoretically

superior to the RADR method, the CE method is not widely used
in practice owing to the lack of a satisfactory objective
quantitative procedure for the estimation of certainty equivalent
coefficients.
On the other hand, well established quantitative approaches are
available for the estimation of a risk-adjusted discount rate. The
capital asset pricing model and the weighted average cost of
capital are two such methods discussed in this chapter. It may
be noted that even when using these quantitative methods, the
estimation of the final discount rate does (and always should)
involve some subjective judgements by the decision-makers
about the risk of the proposed project. Another two approaches
to incorporating risk into project analysis, sensitivity and break-