Project

Evaluation
Techniques

By
Mohammed Khan
Khaja Rameez
 Learning Objectives
Understand the purpose of the project
evaluation techniques..

Different methods of project evaluation

and decision rules.

Outline the advantages and

disadvantages of the project evaluation
methods.

Explain why the NPV method is

preferred to all other methods.
 Project
Evaluation
Project evaluation is the process of evaluating a
companys potential investments and deciding which
ones to accept.
This also explains how to estimate a projects cash
flows and analyse its risk.
It always work for the benefit of firm by increasing its
financial value.
Use each method to reach a decision on a particular
practical capital investment opportunity.
 Methods of Project Evaluation

Net present value (NPV).

Internal rate of return (IRR).

Accounting rate of return (ARR).

Payback period (PP).

 Project Evaluation Methods Used
by the Entities Surveyed
Table 1: Selected project evaluation methods used by the Chief
financial officers CFOs

Method Percentage
Net Present Value 81.93

Internal Rate of Return 67.61

Payback Period 56.74
Accounting Rate of Return 20.29
Profitability Index 11.87

The aggregate percentage exceeds 100% because most

respondents used more than one method of project evaluation.
 Cash Flows
Discounted Cash Flow (DCF)
The investment decisions made by taking into account the interest.
Time value of money is considered.
Net present value (NPV)
Internal rate of return (IRR)

Non-Discounted Cash Flow (NDCF)

In NDCF, the interest is not taken in to consideration.
Time value of money is not considered.
Accounting rate of return(ARR)
Payback period( PP)
 Future Value and Present Value
NPV considers Time Value of money
Money grows over time when it earns interest.
A dollar in hand today is worth more than a dollar in future

FV = Future value
PV = Present Value
K = Discounted Rate
n = Number of years
 Example
If $100 is invested in a bank today may earn 8% per year, what is
the FV of $100 for 1st, 5th and 15th year ?

After one year the future value of $100 is $108.

After five years the future value of $100 is $146.93.
After Fifteen years FV of $100 is $317.22.

If $100 is to be received after 1,5 & 15 years, what is the PV of

$100 today ?

The PV of $100 to be received after 1year is $93 today.

The PV of $100 to be received after 5years is $63 today.
The PV of $100 to be received after 15years is $32 today.
 Net Present Value(NPV)
Difference between the PV of the net cash flows (NCF) from
an investment, discounted at the required rate of return, and the
initial investment outlay.

Measuring a projects net cash flows:

Forecast expected net profit from project.

Estimate net cash flows directly.

The standard NPV formula is given by:

n
Ct where:
NPV C0
t 1 1 k
t C0 = initial cash outlay on project
Ct = net cash flow generated by project at time t
n = life of the project
k = required rate of return
 Evaluation of NPV
NPV method is consistent with the companys
objective of maximizing shareholders wealth.
NPV realistically predicts the future cash flow.
NPV is the sum of all discounted cash flows.
If NPV > 0 (Positive), the project can be accepted.
The greater the NPV, the better the project
financial benefits.
Net present value = Present Value of Cash
Inflows Present Value of Cash Outflows .
 Example of NPV
Example 1:
Investment of $400,000.

Series of cash inflows of $70,000, $120,000, $140,000,

$140,000 and $40,000 at the end of years 1, 2, 3, 4 and 5
respectively.

If opportunity cost of capital is 8% p.a. should we accept

or reject the project.
 Example 1
Solution :
Step 1 : Calculate the PV of year 1, 2, 3, 4 and 5.

Rate of Return @
Year Future Value Present Value
8%
1 $ 70,000.00 1.08 $ 64,814.81
2 $ 120,000.00 1.1664 $ 102,880.66
3 $ 140,000.00 1.259712 $ 111,136.51
4 $ 140,000.00 1.36048896 $ 102,904.18
5 $ 40,000.00 1.469328077 $ 27,223.33
$ 408,959.49
Step 2 : Total PV of all years is $ 408,959.50

Step 3 : PV of Cash inflows-PV of cash outflows ($408,959-

$400,000)=$ 8959.

Since NPV is positive, this project can be accepted.

 Example 2
For same example calculate NPV with opportunity cost of
capital 15%.
Step 1: Rate of
Year Future Value Return @ Present Value
15%
1 $ 70,000.00 1.15 $ 60,869.57
2 $ 120,000.00 1.3225 $ 90,737.24
3 $ 140,000.00 1.520875 $ 92,052.27
4 $ 140,000.00 1.74900625 $ 80,045.45
5 $ 40,000.00 2.011357188 $ 19,887.07
$ 343,591.60

Step 2 : Total PV of all years is $ 343,591

Step 3 : PV of Cash inflows-PV of cash outflows ($343,591-
$400,000)=$ -56409
Since NPV is negative, this project should be rejected.

Note : NPV value changed with change in rate of return. Therefore NPV is
dependent on discount rate of interest value or in other words opportunity cost of
capital.
 Advantages Disadvantages
Recognises the time value of Sometimes it is difficult to
choose the correct discount
money.
rate.
Looks at the opportunity cost of
investment.

Quick and easy.

Involves both cash inflow and
outflow for the life time of the
investment.
 IRR-Internal Rate of Return
IRR is a discount rate at which NPV becomes Zero.
IRR, tells how much rate return of return from the project.

Why IRR, what is the use of calculating IRR ?

IRR is used to rank different projects.
The higher the projects IRR, the more desirable to undertake project.
If other factors are same for different projects, then project with highest
IRR value is considered.
Note:
Accept the project when IRR > Discount rate (K).
Reject the project when IRR < Discount rate (K)
May accept the project when IRR = Discount rate
 Formula for IRR

Relationship between IRR, Discount rate and NPV

If IRR > Discount rate The NPV is always positive.
If IRR < Discount rate The NPV is always negative.
If IRR = Discount rate The NPV is Zero.
Note:
As long as the NPV is positive the project is financially viable.
The moment that NPV becomes negative, the project is not financially
viable.
 Example
The cost of project is $1000 it has a time horizon of 5 years
and expected year wise cash inflows are

Year 1 : $200

Year 2 : $300

Year 3 : $300

Year 4 : $400

Year 5 : $500.

Compute IRR of the project, if opportunity cost of capital is 12%.

Should we accept the project ?
 Example
At Dsicount rate of 12% NPV is 169 (Positive)

year (n) FV (1+K)^n K (Discount rate) K% PV

1 $ 200.00 1.12 12 0.12 $ 178.57

2 $ 300.00 1.2544 $ 239.16
3 $ 300.00 1.404928 $ 213.53
4 $ 400.00 1.57351936 $ 254.21
5 $ 500.00 1.762341683 $ 283.71
$ 1,169.18
Cash inflow Cash outflow NPV
$ 1,169.18 $ 1,000.00 169.184

At Dsicount rate of 17.7% NPV is Zero

year (n) FV (1+K)^n K (Discount rate) K% PV

1 $ 200.00 1.177 17.7 0.177 $ 169.92

2 $ 300.00 1.385329 $ 216.56
3 $ 300.00 1.630532233 $ 183.99
4 $ 400.00 1.919136438 $ 208.43
5 $ 500.00 2.258823588 $ 221.35
$ 1,000.25
Cash inflow Cash outflow NPV
$ 1,000.25 $ 1,000.00 0.24883

Therefore the IRR is 17.7% > Discount rate, The project can be accepted.
 Advantages Disadvantages
It shows the return of the original Tedious to calculate if a
money invested. financial calculator is not
No need to calculate the cost of available.
capital.
Easy to understand and
communicate Recognises the time
value of money.
 ARR-Accounting Rate of Return
Earnings (after depreciation and tax) from a project

expressed as a percentage of the investment outlay.

Decision rule
The calculation involves:
If ARR > 0 project must be
Estimating the average annual earnings accepted

to be generated by the project. If ARR < 0 project must be

rejected.
Investment outlay (initial or average).
 Example
Find ARR for Initial investment of $130,000 for 6 years useful
life with a scrap value of $ 10,500 and with increase in expected
annual tax is $ 32,000.
 Advantages
ARR is consistent with
measuring business performance.
Managers feel comfortable with
using measures expressed in
percentage terms as ARR does.
Disadvantages
Ignores Time Value of Money
Can Lead to an Illogical Decision
It is Based on the Accounting
Profit, Not the Future.
 PP-Payback Period
The length of time it takes for an initial investment to be repaid
out of the net cash inflows from a project
A manager using PP would need to have a maximum payback
period in mind.
Example :

Investment of $9000.Net cash flows of $5090, $4500 and $4000

at the end of years 1, 2 and 3 respectively. Find the payback
period of the project.
Project cost: 9000
Year 1: +5090
3910
Year 2: 3910/4500 = 0.87,
So it takes 1.87 years or 1 year 10 months 15 days for the project to
recover its initial cost.
 Decision Rule for PP

For any project to be acceptable, it must fall with

in the maximum payback period.

Where there are competent projects that meet the

maximum payback period requirement, the project

with the shortest payback period should be selected.

 Payback period (contd.)
Strengths:

It is a simple method to apply.

It identifies how long funds are committed to a project.

Can easily understood my managers.

Weaknesses:
Cash flows arising beyond the payback period are ignored.
PP only looks at the risk that the project will end earlier than
expected.
PP is not linked to promoting increases in the wealth of the
business
https://www.youtube.com/watch?v=KbtTk2azIjY
 Why is NPV superior to ARR & PP

NPV is a better method of appraising investment

opportunities than either ARR or PP because it fully takes

account of each of the following:

The timing of the cash flows.

The whole of the relevant cash flows.

The objectives of the business.

 Summary of Evaluation Methods
Discounted cash flow methods are superior investment
appraisal methods.

DCF methods will always give the same accept/reject decision

for a conventional project.

Investment decision techniques are based on number of

assumptions may not be true.

In practice, the above-mentioned alternative project evaluation

methods (most likely payback period) may be used in conjunction
with DCF methods.

Payback methods looks at how long it will take to pay back the
cost of the initial investment.
 Summary (Contd.)
Average rate return looks at the percentage rate of return on the
investment.

Discounted cash flow ( NPV ) looks at the present values of any

future revenues from the investment.

NPV method is recommended for project evaluation. The method

is consistent with shareholder wealth maximization.

NPV is also simple to use and gives rise to fewer problems than
the IRR method, such as non-uniqueness.

Independent projects accept if NPV > 0,

reject if NPV < 0.
 References
Brigham, E. F., & Daves, P. R. (1999). Student spreadsheet
applications disk: To accompany Intermediate financial
management, 10e : Version, Chapter 12.
Capital Budgeting Techniques. Retrieved from
http://www.cliffsnotes.com/more-
subjects/accounting/accounting-principles-ii/capital-
budgeting/capital-budgeting-techniques
Retrieved from
http://educ.jmu.edu/~drakepp/principles/module6/advdistable.
pdf
Business finance. (1900). Loveland, Colo.: Duke
Communications.