Peirson Business Finance10e PowerPoint 05

Chapter 5
Project Evaluation:
Principles and Methods
Copyright 2009 McGraw-Hill Australia Pty Ltd 5-1

PPTs t/a Business Finance 10e by Peirson
Learning Objectives
Understand different steps of the capital-expenditure
process.
Different methods of project evaluation and decision
rules.
Outline the advantages and disadvantages of the main
project evaluation methods.
Explain why the NPV method is preferred to all other
methods.
Understand the link between economic value added (EVA)
and net present value (NPV).
Know the relationship between options, managerial
flexibility and firm value analysis during project evaluation.

Capital Expenditure Process
The capital expenditure process involves:
Generation of investment proposals.
Evaluation and selection of those proposals.
Approval and control of capital expenditures.
Post-completion audit of investment projects.

Generation of Investment
Proposals
Investment ideas can range from simple upgrades
of equipment, replacing existing inefficient
equipment, through to plant expansions, new
product development or corporate takeovers.
Generation of good ideas for capital expenditure
is better facilitated if a systematic means of
searching for and developing them exists.
This may be assisted by financial incentives
and bonuses for those who propose successful
projects.

Evaluation and Selection of
Investment Proposals
In order to evaluate a proposal, the following data
should be considered:
Brief description of the proposal.
Statement as to why it is desirable or necessary.
Estimate of the amount and timing of the cash outlays.
Estimate of the amount and timing of the cash inflows.
Estimate of when the proposal will come into operation.
Estimate of the proposals economic life.

Approval and Control of Capital
Expenditures
Capital-expenditure budget (CEB) maps out the
estimated future capital expenditure on new and
continuing projects.
CEB has the important role of setting administrative
procedures to implement the project (project
timetable, procedures for controlling costs).
Timing is important because project delays and
cost over-runs will lower the NPV of a project,
costing shareholder wealth.

Post-completion Audit of
Investment Projects
Highlights any cash flows that have deviated
significantly from the budget and provides
explanations where possible.
Benefits of conducting an audit:
May improve quality of investment decisions.
Provides information that will enable
implementation of improvements in the projects
operating performance.
May result in the re-evaluation and possible
abandonment of an unsuccessful project.

Methods of Project Evaluation
Different methods of project evaluation include:
Net present value (NPV).
Internal rate of return (IRR).
Benefit-cost ratio (profitability index).
Payback period (PP).
Accounting rate of return (ARR).

Project Evaluation Methods Used by
the Entities Surveyed
Table 5.1: Selected project evaluation methods used by the CFOs surveyed (a)
Method Percentage
Accounting Rate of Return 20.29
Profitability Index 11.87
Internal Rate of Return 75.61
Net Present Value 74.93
Payback Period 56.74
(a) The aggregate percentage exceeds 100% because most

respondents used more than one method of project evaluation.
Source: Graham, J.R. & C.R. Harvey (2001)

Discounted Cash Flow Methods
Discounted cash flow (DCF) methods involve
the process of discounting a series of future net
cash flows to their present values.
DCF methods include:
The net present value method (NPV).
The internal rate of return method (IRR).

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 = (1 + k )
t =1
t
C0 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

Net Cash Flow
Cash inflows:
Receipts from sale of goods and services.
Receipts from sale of physical assets.
Cash outflows:
Expenditure on materials, labour and
indirect expenses for manufacturing.
Selling and administrative.
Inventory and taxes.

Evaluation of NPV
NPV method is consistent with the companys
objective of maximising shareholders wealth.
A project with a positive NPV will leave the company
better off than before the project and, other things
being equal, the market value of the companys shares
should increase.
Decision rule for NPV method:

Accept a project if its NPV is positive when the
projects NCFs are discounted at the required rate of
return.

NPV Example
Example 5.1:
Investment of $9000.
Net cash flows of $5090, $4500 and $4000 at
the end of years 1, 2 and 3 respectively.
Assume required rate of return is 10% p.a.
What is the NPV of the project?

NPV Example (cont.)
Solution:
Apply the NPV formula given by Equation 5.5.
n
Ct
NPV = C0
t =1 (1 + k )
t
5090 4500 4000

= + + 9000
(1.10 ) (1.10 ) (1.10 )
2 3
= 4627 + 3719 + 3005 9000

= 2351
Thus, using a discount rate of 10%, the projects

NPV = +$2351 > 0, and is therefore acceptable.

Internal Rate of Return (IRR)
The internal rate of return (IRR) is the
discount rate that equates the PV of a projects
net cash flows with its initial cash outlay.
IRR is the discount rate (or rate of return) at which
the net present value is zero.
The IRR is compared to the required rate of

return (k).
If IRR > k, the project should be accepted.

Calculation of Internal Rate of
Return
By setting the NPV formula to zero and treating the
rate of return as the unknown, the IRR is given by:
n
Ct
(
t =1 1 + k
t

)
C 0 = 0
where:
C0 = initial cash outlay on project
n = life of the project
r = internal rate of return

Calculation of Internal Rate of
Return (cont.)
Using the cash flows of Example 5.1, the IRR is:
5090 4500 4000

+ + 9000 =
1 + IRR (1 + IRR ) (1 + IRR )
2 3
IRR = 25%

Multiple and Indeterminate
Internal Rates of Return
Conventional projects have a unique rate of
return.
Multiple or no internal rates of return can occur for
non-conventional projects with more than one
sign change in the projects series of cash flows.
Thus, care must be taken when using the IRR
evaluation technique.
Under IRR: Accept the project if it has a unique
IRR > the required rate of return.

Choosing Between the
Discounted Cash Flow Methods
Independent investments:
Projects that can be considered and evaluated in
isolation from other projects.
This means that the decision on one project will not
affect the outcomes of another project.
Mutually exclusive investments:

Alternative investment projects, only one of which can be
accepted.
For example, a piece of land is used to build a factory,
which rules out an alternative project of building a
warehouse on the same land.

Choosing Between the Discounted
Cash Flow Methods (cont.)
Independent investments:
For independent investments, both the IRR and
NPV methods lead to the same accept/reject
decision, except for those investments where the
cash flow patterns result in either multiple or no
internal rate(s) of return.
In such cases, it doesnt matter whether we use

NPV or IRR.

Choosing Between the Discounted
Cash Flow Methods (cont.)
Evaluating mutually exclusive projects:
NPV and IRR methods can provide a different
ranking order.
The NPV method is the superior method for mutually
exclusive projects.
Ranking should be based on the magnitude of NPV.

Benefit-Cost Ratio (Profitability
Index)
The profitability index is calculated by dividing
the present value of the future net cash flows by
the initial cash outlay:
PV of net cash flows

Benefit Cost Ratio =
Initial cash outlay
Decision rule:
Accept if benefitcost ratio > 1
Reject if benefitcost ratio < 1

Other Methods of Project
Evaluation
Two major non-discounted cash flow
methods that are used:
Accounting rate of return method (ARR)
Payback period method (PP)
These methods are usually employed in

conjunction with the discounted cash flow
methods of project evaluation.

Accounting Rate of Return
Earnings (after depreciation and tax) from a
project expressed as a percentage of the
investment outlay.
The calculation involves:
Estimating the average annual earnings to be
generated by the project.
Investment outlay (initial or average).

Accounting Rate of Return
(cont.)
Fundamental problems of ARR in project
valuation:
Arbitrary measure based on accounting profit as
opposed to cash flows, depends on some accounting
decisions such as treatment of inventory and
depreciation.
Ignores timing of the earnings stream no time
value of money concepts are applied, as equal
weight is given to accounting profits in each year of
the projects life.

Payback Period
The time it takes for the initial cash outlay on a project to be
recovered from the projects after-tax net cash flows.
Using Example 5.1, assume cash flow occurs throughout year
and 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
for the project to recover its initial cost.
Decision:
Compare payback to some maximum acceptable payback period.
What length of time represents the correct payback period as a
standard against which to measure the acceptability of a particular
project?

Payback Period (cont.)
Strengths:
It is a simple method to apply.
It identifies how long funds are committed to a project.
Weaknesses:
Inferior to discounted cash flow techniques because it
fails to account for the magnitude and timing of all the
projects cash flows.
Does not consider how profitable a project will be, just
how quickly outlay will be recovered.

Summary of Evaluation Methods
Discounted cash flow methods are superior
investment appraisal methods as they account for
timing of cash flows and the time value of money.
DCF methods will always give the same
accept/reject decision for a conventional project.
In practice, the above-mentioned alternative
project evaluation methods (most likely payback
period) may be used in conjunction with DCF
methods: see Table 5.1.

Economic Value Added (EVA)
Alternative to discounted cash flow methods,
accounting rate of return and payback period.
Key factor is the required rate of return.
EVA is the difference between the projects
accounting profit and the required return on
the capital invested in the project.
EVA can be improved by increasing accounting
profit or by reducing capital employed.

Economic Value Added (cont.)
EVA is given by:
EVAt = Ct + (I t I t 1 ) kI t 1
where:
I t = investment value, end of year t
I t 1 = investment value, end of year t -1
k = required rate of return
Discounted sum of EVAs equals NPV of project.

Real Option Analysis
In practice, company management will often have time
flexibility in their investment decision choices and ways to
manage project if firm decides to proceed.
Management choices are often known as real options.
Option gives a successful tender for a project the right but
not the obligation to initiate operation on a project.
Depending on changes in circumstances successful bidder
may or may not take up option immediately. Hence, option
gives bidder the right to exploit any advantageous changes
in circumstances.
It is significant to consider value associated with
managements flexibility. (pp.1278)

Summary
NPV method is recommended for project
evaluation. The method is consistent with
shareholder wealth maximisation.
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.

Summary (cont.)
Mutually exclusive projects accept project with the
highest NPV.
In practice, other valuation methods such as accounting
rate of return, payback period and economic value
added are used in conjunction with NPV, despite a
preference for DCF methods.
This may be to measure some other effect, such as the
effect of the project on liquidity payback period.
Real option analysis considers managerial flexibility is
valuable unlike project evaluation methods, where the
idea of management ability to intervene in an ongoing
project is ignored.


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Chapter 5

Copyright 2009 McGraw-Hill Australia Pty Ltd 5-1

Copyright 2009 McGraw-Hill Australia Pty Ltd 5-2

Evaluation and selection of those proposals.

Approval and control of capital expenditures.

Post-completion audit of investment projects.

Copyright 2009 McGraw-Hill Australia Pty Ltd 5-3

Copyright 2009 McGraw-Hill Australia Pty Ltd 5-4

Copyright 2009 McGraw-Hill Australia Pty Ltd 5-5

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Copyright 2009 McGraw-Hill Australia Pty Ltd 5-8

(a) The aggregate percentage exceeds 100% because most

Copyright 2009 McGraw-Hill Australia Pty Ltd 5-9

Copyright 2009 McGraw-Hill Australia Pty Ltd 5-10

Copyright 2009 McGraw-Hill Australia Pty Ltd 5-11

Receipts from sale of physical assets.

Selling and administrative.

Inventory and taxes.

Copyright 2009 McGraw-Hill Australia Pty Ltd 5-12

Decision rule for NPV method:

Copyright 2009 McGraw-Hill Australia Pty Ltd 5-13

Copyright 2009 McGraw-Hill Australia Pty Ltd 5-14

5090 4500 4000

= 4627 + 3719 + 3005 9000

Thus, using a discount rate of 10%, the projects

Copyright 2009 McGraw-Hill Australia Pty Ltd 5-15

The IRR is compared to the required rate of

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5090 4500 4000

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Mutually exclusive investments:

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In such cases, it doesnt matter whether we use

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PV of net cash flows

Copyright 2009 McGraw-Hill Australia Pty Ltd 5-23

These methods are usually employed in

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Discounted sum of EVAs equals NPV of project.

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