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Corporate Finance
Lecture 3
Corporate Finance
Lecture 3 :
Project Appraisal
Impact Consultancy & Training Pte Ltd
Fundamentals of Project Appraisal

! Investing todays dollar for future benefits
! Characteristics of projects undertaken by corporate
! Normally involves large cash outlay at start of project
! Tends to be long term
! Project assets are not easily liquidated
! Mutually exclusive vs Independent projects
! Steps in Project Appraisal
! Derive relevant projects cash flows
! Assess the derived projects cash flows
Corporate Finance
Lecture 3
Examples of Project Cash Flows

Project A : Initial Outlay = $70,000
Year
1
2
3
4
5
6
7
Profit After Tax ($) Cash Flow ($)

5,000
15,000
5,000
15,000
5,000
15,000
5,000
15,000
5,000
15,000
5,000
15,000
5,000
15,000
Assume straight-line depreciation


! Profit = Revenues ($105,000) Expenses ($100,000) = $5,000
= (assumed)
NOT =
! NCF = Cash Inflows ($105,000) Cash Outflows ($90,000)
= $15,000
Note : Difference between Expenses of $100,000 & Cash
Outflows is the depreciation of $10,000 per annum
Corporate Finance
Lecture 3

Project B : Initial Outlay = $84,000
Year Profit After Tax ($)
1
20,000
2
8,000
3
6,000
4
2,000
5
2,000
6
2,000
7
2,000
Cash Flow ($)

32,000
20,000
18,000
14,000
14,000
14,000
14,000
Assume straight-line depreciation

Required rate of return for both projects : 10% p.a.
Methods of Assessment on Economic

Feasibility of Projects
! Two Broad Categories
! Non Discounted Cash Flow Methods
Payback
Accounting Rate of Return or Return on Investment
! Discounted Cash Flow Methods
Net Present Value
Internal Rate of Return
Profitability Index
Discounted Payback
Corporate Finance
Lecture 3
Non Discounted Cash Flow Methods :

Payback
Payback
! Calculate the time taken to recoup initial outlay
! Decision criteria :
! Compare with maximum period specified
! Advantages
! Easy to understand & apply
! Place importance on early cashflows
! Considers liquidity & risk exposure periods Risk Fencing
! Makes intuitive allowance for risk

Payback
! Disadvantages
! Ignores time value of money
! Ignores cash flows after payback
=> Bias against long-term projects
! Not a profit measure : Cant measure projects
attractiveness
! Measures risk in relation to speed of payback which may
not be realistic
! Payback is often used as a constraint along with another
method that will assess the projects attractiveness
Corporate Finance
Lecture 3

Payback
! Payback (Project A) = $70,000/$15,000 = 4.67 years
! Payback for Project B will be 4 years using the concept of cumulative cash
flows
Project B : Initial Outlay = $84,000
Year Cash Flow ($) Cumulative CF
0
(84,000)
(84,000)
1
32,000
(52,000)
2
20,000
(32,000)
3
18,000
(14,000)
4
14,000
0

ARR
Accounting Rate of Return (ARR)
! Also known as Average Accounting Rate of Return &
Return on Investment (ROI)
! Measures the average accounting rate of return over the life of
the project
Average Net Profit After Tax
ARR =
Average Investment
! Uses accounting profit

! Decision criteria
! Compare with minimum rate of return specified
10
Corporate Finance
Lecture 3

ARR
! Advantages
! Simple to calculate & easy to understand
! Common terminologies such as accounting profit &
investment (capital)
! Disadvantages
! Ignores time value of money
! Uses accounting profits rather than cash flows
=> Ignores timing of cash flows
11

ARR
! The average investment represent theoretically the average
amount of cash that remain invested in the project throughout
the project life ie. the average NBV of the project assets
assuming that this amount can be recovered if the project
sponsors were to quit the project
! Determine Average Investment for both projects
NBV
Yr 0
Yr 1
Yr 2
Yr 3
Yr 4
Yr 5
Yr 6
Yr 7
Average
Project A
70k
60k
50k
40k
30k
20k
10k
0k
35k
Project B
84k
72k
60k
48k
36k
24k
12k
0k
42k
NBV
12
Corporate Finance
Lecture 3

ARR
! Alternatively, Average Investment =
(Initial Outlay + Salvage Value)
2
! ARR or ROI (Project A) = ($5,000/$35,000) X 100% = 14.3%
p.a.
! ARR or ROI (Project B) = {($42,000/7)/$42,000} X 100% =
14.3% p.a.
13
Methods of Assessment :
Discounted Cash Flow Methods
2 Basic Steps
! Derive the projects relevant cash flows
!
Identify the relevant cash flow items
Project the magnitude & timing of the future cash flows
! Discount the future cash flows with an appropriate

discount rate ie. Required rate of return or cost of capital
which depends on the proportion of equity & debt funding
employed in the project
14
Corporate Finance
Lecture 3
Discounted Cash Flow Methods : NPV

Net Present Value (NPV)
! Compares discounted future cash flows from the project
represented by its benefits & costs
NPV = PV(Benefits) - PV(Costs)
! Decision criteria
! NPV > or = 0 : Accept project
! Measures the immediate increase in wealth which results from
the adoption of a project when discounted at the firms cost of
capital or required rate of return
15
Discounted Cash Flow Methods : NPV

! Advantages
! Considers time value of money
! Absolute measure of project benefits in todays value
! Assume cash flows are reinvested at required rate of return
! NPVs are additive
! Disadvantages
! May not be able to handle capital rationing
! More difficult to comprehend for non-financial managers
16
Corporate Finance
Lecture 3
Discounted Cash Flow Methods :NPV

! NPV (Project A) = ($15,000 x PVIFA10%,7) - $70,000 =
$73,026 - $70,000 = $3,026
! NPV (Project B) = {($32,000 x PVIF10%,1) + ($20,000 x
PVIF10%,2) + ($18,000 x PVIF10%,3) + ($14,000 x PVIFA10%,4 x
PVIF10%,3)} - $84,000 = $8,485
17
Discounted Cash Flow Methods : IRR

Internal Rate of Return (IRR)
! Represents the discount rate that enable NPV = 0
!
NPV = PV(Benefits) - PV(Costs) = 0
PV(Benefits) = PV(Costs)
! IRR = Expected rate of return of the project

! Decision criteria
!
IRR > Required rate of return or cost of capital : Accept

project
! Solving for IRR : Will need to use the process of trial & error
which will be elaborated later
18
Corporate Finance
Lecture 3

Relationship Between Discount Rates & Net Present Value
Net Present
Value ($)
Y
0
10
15
20
25
30 Discount Rate
(%)
19

! When discount rate = 0, then NPV = Total Cash Inflows Total Cash Outflows
! Discount rate -> NPV
! At intercept, NPV = 0 & discount rate = 15%
=> IRR = 15%
! If (required rate of return or cost of capital) < IRR -> NPV > 0
-> Accept project
! Alternatively, when NPV > 0, say at point Y, the cost of
capital < IRR
20
10
Corporate Finance
Lecture 3

! IRR (Project A)
! As calculated earlier, the NPV at 10% is $3,026
! Try 12% : NPV = ($15,000 x PVIFA12%,7) - $70,000 =
$68,456 - $70,000 = ($1,544)
! Interpolate between 10% & 12% : IRR = 10% + [3,026/
(3,026 + 1,544)] x 2% = 11.32%
21

! IRR (Project B)
! As calculated earlier, the NPV at 10% is $8,485
! Try 14% : NPV = {($32,000 x PVIF14%,1) + ($20,000 x
PVIF14%,2) + ($18,000 x PVIF14%,3) + ($14,000 x
PVIFA14%,4 PVIF14%,3)} - $84,000 = ($858)
! Interpolate between 10% & 14% : IRR = 10% + [8,485/
(8,485 + 858)] x 4% = 13.63%
22
11
Corporate Finance
Lecture 3

! Advantages
! Recognise time value of money
! As it is a relative measure, can compare projects of
different sizes
! Disadvantages
! May be inconsistent with NPV for mutually exclusive
projects
! May not have unique solution for unconventional cash
flows ie. Multiple IRRs
! May be no real numbers for IRR
! Assumes reinvestment rate to be equal to IRR which may
not be realistic
23

Assessing Mutually Exclusive Investments
! Given below is an example of two mutually exclusive
investments, A & B
! NPV will give the correct signal to management
! Assuming an annual cost of capital of 15% & estimated net
actual annual cash flows as stated, then the four methods will
give conflicting results
! Each method has its own set of decision rules
24
12
Corporate Finance
Lecture 3

Year
Project A
Project B
(25,000)
(10,000)
5,000
5,000
12,500
10,000
12,500
(1,000)
12,500
Total
$17,500
$4,000
NPV ($)
4,166 *
1,251
IRR (%)
22
24 *
Payback (years)
2.6
1.5 *
ARR (%)
35 *
26.7
25

Multiple Solutions For IRR
Example
Yr
0
1
2
CF
-1,600 10,000 -10,000
1, 600 +
10, 000 10, 000
=0
2
1.25
1.25
1, 600 +
10, 000 10, 000
=0
5
52
( )
26
13
Corporate Finance
Lecture 3

Therefore IRR = 25% or 400%
2 changes in signs of CFs, from negative to positive to negative
=> 2 IRRs
n changes => n IRRs
27

Dual Rates of Return
1,000
500
Net Present
Value ($)
100
200
300
400
Discount Rate (%)
500
-500
-1,000
-1,500
28
14
Corporate Finance
Lecture 3

May be no real numbers for IRR
Consider 3 CFs : a, b, c for Yr 0, 1, 2 respectively. IRR is found
by solving the following equation for r
a+
b
1+r
( ) (1 + r )
=0
Multiplying by (1+r)2
a 1+r
( ) + b (1 + r )+ c = 0
If b2 < 4ac, there are no real solutions
29

Example
a = -7,000, b = 12,000, c = -6,000
2 IRRs :
1+ 6
7
( 1
Since square root of a negative number is imaginary, IRRs are

not real
30
15
Corporate Finance
Lecture 3
Discounted Cash Flow Methods :

Profitability Index
Profitability Index (PI)
! Also known as Benefit-Cost Ratio
! Measures the productivity or profitability of each investment
dollar
! Extension of the NPV approach
PI =
(
)
PV(Costs)
PV Benefits
Net PI =
NPV
PV Costs
31

Profitability
! PI & Net PI (Project A)
! PV of Future Benefits as determined earlier = $73,026
! Then PI = $73,026/$70,000 = 1.043
! Net PI = $3,026/$70,000 = 0.043
! PI & Net PI (Project B)
! PV of Future Benefits as determined earlier = $92,485
! Then PI = $92,485/$84,000 = 1.101
! Net PI (Project B) = $8,485/$84,000 = 0.101
32
16
Corporate Finance
Lecture 3

Profitability Index
! Decision criteria
! PI > 1 : Accept project
! Net PI > 0 : Accept project
! Advantages
! Similar to IRR
! Disadvantages
! Similar to IRR except that unique solution exists
33

Discounted Payback
Discounted Payback
! Time taken to recover initial outlay based on PV of future
cashflows
! Basically, a truncated NPV method where the time taken for
the project to reach NPV = 0 ie. a breakeven concept
! Decision Criteria
! Compare with maximum discounted period specified
! Conceptually similar to payback
! May have to solve the breakeven period by trial & error
process or Cumulative PV of future cash flows
34
17
Corporate Finance
Lecture 3

Discounted Payback
! Discounted Payback (Project A)
! Effectively, need to solve for n where NPV = ($15,000 x
PVIFA10%,n) - $70,000 = 0
! As calculated earlier, the NPV at 10% for 7 years is $3,026
! Try 6 years : NPV = ($15,000 x PVIFA10%,6) - $70,000 =
$65,329 - $70,000 = ($4,671)
! Interpolate between 6 & 7 years : Discounted Payback = 6
+ [4,671/(3,026 + 4,671)] x 1 year = 6.61 years
35

Discounted Payback
! Discounted Payback (Project B)
Year Cash Flow
($)
0
(84,000)
1
32,000
2
20,000
3
18,000
4
14,000
5
14,000
6
14,000
7
14,000
PV of CF
(84,000)
29,091
16,529
13,524
9,562
8,693
7,903
7,184
Cumulative
PV of CF
(84,000)
(54,909)
(38,380)
(24,856)
(15,294)
( 6,601)
1,302
8,486 (NPV)
Discounted Payback = 5 + (6601/7,903) = 5.84 years
36
18
Corporate Finance
Lecture 3

Discounted Payback
! Advantages
! Eliminate the major disadvantage of ignoring TVM in
payback method but no longer easy to calculate
! Other advantages similar to payback method
! Disadvantages
! Similar to Payback except for recognising TVM
37
Assessing a Projects Cash Flows

! Identify relevant cash flows items : Cash flows that come
about due to undertaking of the project
! Direct incremental cash flows
Initial outlay
Recurrent cash flows over projects life
Terminal or salvage cash flows
Changes in net working capital requirement : Increase
(Application) & Decrease (Source)
Incremental fixed overheads
38
19
Corporate Finance
Lecture 3

!
Indirect Incremental cash flows

Cash savings
Opportunity cost of scarce resources
Side effects : Can be positive or negative
Tax effects
Additional tax payable on incremental profit
Tax savings on capital allowances : Effectively reduces
the taxable profit resulting in lesser tax being paid
It is the taxation version of depreciation in
accounting
39

Accelerated vs Normal capital allowance
Normal allowance is where the annual capital
allowance for a capital asset is equal to its annual
depreciation
Accelerated allowance is where the firm can claim
the cost of the capital assets over a shorter period
than its normal depreciation period resulting in
Tax deferment ie. Paying less tax in the earlier
years
Higher NPV
40
20
Corporate Finance
Lecture 3

Investment allowance : Firm is allowed to claim capital
allowance in excess of the cost of the capital asset
resulting in tax reduction & thus higher NPV
Balancing Charge vs Balancing Allowance
Balancing Charge relates to the profit on disposal of
capital asset which will be taxable
Balancing Allowance relates to the loss on disposal
of capital asset which will be tax deductible
41

! Common Irrelevant Cash Flows : Existing or past cash flows
that occurred regardless of investment decision
! Sunk costs : Costs that cannot be recovered even if project
is not undertaken as they are incurred at the point of
decision making
Example : Infrastructure cost, R&D etc
!
Allocated existing fixed overheads

Example : Rent
42
21
Corporate Finance
Lecture 3

! Estimate projects life
! Economic life of projects assets
! Demand for output
! Specific concessionary period
! Breakeven period
! Determine the timing of cash flows occurrence
! Highly dependent on the assumptions
! Determine the periodical net cash flows
! Select method(s) of cash flows assessment
43
Project Appraisal Involving Capital

Rationing
! Situation in which a budget ceiling or constraint is placed
upon the amount of funds to be invested
! Involves allocation of scarce capital resources among
competing economically viable projects
! Need to select combination of projects that provide Greatest
Aggregate NPV while complying with constraint
=> Constrained Maximisation
44
22
Corporate Finance
Lecture 3
Types of Capital Rationing

! Internal (soft) capital rationing
! Self imposed by the management of the firm
! Rationales : To keep growth within the current firm &
management capabilities
! May be due to limitations of other non-capital resources
! If limits lead to passing of truly good projects, management
should consider
Raising more money
Relaxing the limits it has imposed on capital spending
45
Types of Capital Rationing

! External (hard) capital rationing
! Unable to raise additional funds from banks or capital
markets
=> Externally imposed
! May be forced to pass positive NPV projects
46
23
Corporate Finance
Lecture 3
Example of Decision Making with

Capital Rationing
Co ABC has the following possible projects available
Project
A
B
C
D
E
F
G
Initial Outlay
150,000
90,000
60,000
350,000
100,000
30,000
80,000
NPV
16,000
16,500
2,000
55,000
15,000
3,000
10,000
PI
1.107
1.183
1.033
1.157
1.150
1.100
1.125
Suppose ABC has only $500,000 to invest, which of the above projects will be
selected assuming they are independent & economically viable
47

Capital Rationing
! Projects selected through ranking by NPV
Project
Initial Outlay
NPV
! D
350,000
55,000
! B
90,000
16,500
! A (40%)
60,000
6,400
500,000
77,900
48
24
Corporate Finance
Lecture 3

Capital Rationing
! Projects selected through ranking by PI
Project
Initial Outlay
NPV
! B
90,000
16,500
! D
350,000
55,000
! E (60%)
60,000
9,000
500,000
80,500
Projects selected by PI provide a higher aggregate NPV
49
25

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Corporate Finance

Impact Consultancy & Training Pte Ltd

Fundamentals of Project Appraisal

Impact Consultancy & Training Pte Ltd

Examples of Project Cash Flows

Profit After Tax ($) Cash Flow ($)

Assume straight-line depreciation

Examples of Project Cash Flows

Impact Consultancy & Training Pte Ltd

Examples of Project Cash Flows

Cash Flow ($)

Assume straight-line depreciation

Methods of Assessment on Economic

Non Discounted Cash Flow Methods :

Non Discounted Cash Flow Methods :

Non Discounted Cash Flow Methods :

Impact Consultancy & Training Pte Ltd

Non Discounted Cash Flow Methods :

! Uses accounting profit

Non Discounted Cash Flow Methods :

Impact Consultancy & Training Pte Ltd

Non Discounted Cash Flow Methods :

Impact Consultancy & Training Pte Ltd

Non Discounted Cash Flow Methods :

Impact Consultancy & Training Pte Ltd

Identify the relevant cash flow items

Project the magnitude & timing of the future cash flows

! Discount the future cash flows with an appropriate

Impact Consultancy & Training Pte Ltd

Discounted Cash Flow Methods : NPV

Discounted Cash Flow Methods : NPV

Impact Consultancy & Training Pte Ltd

Discounted Cash Flow Methods :NPV

Impact Consultancy & Training Pte Ltd

Discounted Cash Flow Methods : IRR

NPV = PV(Benefits) - PV(Costs) = 0

! IRR = Expected rate of return of the project

IRR > Required rate of return or cost of capital : Accept

Discounted Cash Flow Methods : IRR

Impact Consultancy & Training Pte Ltd

Discounted Cash Flow Methods : IRR

Impact Consultancy & Training Pte Ltd

Discounted Cash Flow Methods : IRR

Impact Consultancy & Training Pte Ltd

Discounted Cash Flow Methods : IRR

Impact Consultancy & Training Pte Ltd

Discounted Cash Flow Methods : IRR

Discounted Cash Flow Methods : IRR

Impact Consultancy & Training Pte Ltd

Discounted Cash Flow Methods : IRR

Impact Consultancy & Training Pte Ltd

Discounted Cash Flow Methods : IRR

10, 000 10, 000

10, 000 10, 000

Impact Consultancy & Training Pte Ltd

Discounted Cash Flow Methods : IRR

Impact Consultancy & Training Pte Ltd

Discounted Cash Flow Methods : IRR

Impact Consultancy & Training Pte Ltd

Discounted Cash Flow Methods : IRR

If b2 < 4ac, there are no real solutions

Impact Consultancy & Training Pte Ltd

Discounted Cash Flow Methods : IRR