PROJECT APPRAISAL CRITERIA

CAPITAL EXPENDITURES AND THEIR IMPORTANCE The basic characteristics of a capital expenditure (also referred to as a capital investment or just project) is that it involves a current outlay (or current and future outlays) of funds in the receiving a stream of benefits in future Importance stems from Long-term consequences Substantial outlays Difficulty in reversing

PROCESS Identification of Potential Investment Opportunities Assembling of Investment Proposals Decision Making Preparation of Capital Budget and Appropriations Implementation Performance Review

PROJECT CLASSIFICATION Mandatory Investments Replacement Projects Expansion Projects Diversification Projects Research and Development Projects Miscellaneous Projects

INVESTMENT CRITERIA

INVESTMENT CRITERIA

DISCOUNTING CRITERIA

NON-DISCOUNTING CRITERIA

NET PRESENT VALUE

BENEFIT COST RATIO

INTERNAL RATE OF RETURN

PAYBACK PERIOD

ACCOUNTING RATE OF RETURN

PAYBACK PERIOD
Payback period is the length of time required to recover the initial outlay on the project Capital Project Year Cash flow Cumulative cash flow 0 -100 -100 1 34 - 66 2 32.5 -33.5 3 31.37 - 2.13 4 30.53 28.40 Pros Simple Rough and ready method for dealing with risk Emphasises earlier cash inflows Cons Fails to consider the time value of money Ignores cash flows beyond the payback period

Payback
The payback period of a project is the number of years it takes before the cumulative forecasted cash flow equals the initial outlay. The payback rule says only accept projects that payback in the desired time frame. This method is flawed, primarily because it ignores later year cash flows and the the present value of future cash flows.

Payback
Example Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less.
Project A B C Payback C0 C1 C2 C3 Period - 2000 500 500 5000 3 - 2000 500 1800 0 2 - 2000 1800 500 0 2 NPV@ 10% + 2,624 - 58 + 50

Book Rate of Return

Book Rate of Return - Average income divided by average book value over project life. Also called accounting rate of return.

book income Book rate of return = book assets

Managers rarely use this measurement to make decisions. The components reflect tax and accounting figures, not market values or cash flows.

NET PRESENT VALUE

n NPV = t=1

Ct Initial investment (1 + rt )t

NET PRESENT VALUE

The net present value of a project is the sum of the present value of all the cash flows associated with it. The cash flows are discounted at an appropriate discount rate (cost of capital) Year 0 1 2 3 4 5 Pros
Reflects the time value of money Considers the cash flow in its entirely Squares with the objective of wealth maximisation

Cash flow -100.00 34.00 32.50 31.37 30.53 79.90

Capital Project Discount factor (15%) Present value 1.000 -100.00 0.870 29.58 0.756 24.57 0.658 20.64 0.572 17.46 0.497 39.71 Sum = 31.96 Cons
Is an absolute measure and not a relative measure

NPV

PROPERTIES OF THE NPV RULE NPVs ARE ADDITIVE INTERMEDIATE CASH FLOWS ARE INVESTED AT COST OF CAPITAL NPV CALCULATION PERMITS TIME-VARYING DISCOUNT RATES NPV OF A SIMPLE PROJECT AS THE DISCOUNT RATE

BENEFIT COST RATIO

PVB Benefit-cost Ratio : BCR = I PVB = present value of benefits I = initial investment To illustrate the calculation of these measures, let us consider a project which is being evaluated by a firm that has a cost of capital of 12 percent. Initial investment : Benefits: Year 1 Year 2 Year 3 Year 4 Rs 100,000 25,000 40,000 40,000 50,000

The benefit cost ratio measures for this project are: 25,000 (1.12) BCR = 100,000 Pros Measures benefit per buck Cons Provides no means for aggregation

40,000 (1.12)2

40,000 (1.12)3

50,000 (1.12)4 = 1.145

INTERNAL RATE OF RETURN

Net Present Value

Discount rate

The internal rate of return (IRR) of a project is the discount rate that makes its NPV equal to zero. It is represented by the point of intersection in the above diagram
Net Present Value
Assumes that the discount rate (cost of capital) is known. Calculates the net present value, given the discount rate.

Internal Rate of Return

Assumes that the net present value is zero Figures out the discount rate that makes net present value zero

IRR

NPV & IRR

PROBLEMS WITH IRR NON-CONVENTIONAL CASH FLOWS MUTUALLY EXCLUSIVE PROJECTS LENDING VS. BORROWING DIFFERENCES BETWEEN SHORT-TERM AND LONG-TERM INTEREST RATES

Internal Rate of Return

Pitfall 1 - Lending or Borrowing?
With some cash flows the NPV of the project increases s the discount rate increases. This is contrary to the normal relationship between NPV and discount rates.

Project A B

C0 1,000 + 1,000

C1 + 1,500 1,500

IRR + 50 % + 50 %

NPV @ 10 % + 364 364

Pitfall 2 - Multiple Rates of Return

Internal Rate of Return

(-44%)

Certain cash flows can generate NPV=0 at two different discount rates. The following cash flow generates NPV= 0 at both IRR% of and +11.6%. NPV 600 300 0 -30 -600 IRR=-44% IRR=11.6% Discount Rate

IRR

Internal Rate of Return

Pitfall 2 - Multiple Rates of Return
It is possible to have a zero IRR and a positive NPV

Project C

C0 + 1, 000

C1 + 3, 000

C2 + 2 ,500

IRR None

NPV @ 10 % + 339

Internal Rate of Return

Pitfall 3 - Mutually Exclusive Projects IRR sometimes ignores the magnitude of the project. The following two projects illustrate that problem.

Project C0 C1 IRR NPV @10% D 10,000 + 20,000 100% + 8,182 E 20,000 + 35,000 + 75% + 11,818

Internal Rate of Return

Pitfall 3 - Mutually Exclusive Projects

Profitability Index
When resources are limited, the profitability index (PI) provides a tool for selecting among various project combinations and alternatives A set of limited resources and projects can yield various combinations. The highest weighted average PI can indicate which projects to select.

Profitability Index
NPV Profitability Index = Investment

Profitability Index

Project A B C

C0 10 5 5

C1 + 30 +5 +5

C2 +5 + 20 + 15

NPV @ 10 % 21 16 12

Profitability Index
Cash Flows ($ millions)

Project A B C

Investment ($) 10 5 5

NPV ($) 21 16 12

Profitabil ity Index 2.1 3.2 2.4

Profitability Index
Proj A B C D NPV 230,000 141,250 177,600 162,000 Investment 200,000 125,000 160,000 150,000 PI 1.15 1.13 1.11 1.08

Select projects with highest Weighted Avg PI

WAPI (BD) = 1.13(125) + (300) = 1.01 1.08(150) (300) + 0.0 (25) (300)

Profitability Index
Proj A B C D NPV 230,000 141,250 177,600 162,000 Investment 200,000 125,000 160,000 150,000 PI 1.15 1.13 1.11 1.08

Select projects with highest Weighted Avg PI

WAPI (BD) = 1.01 WAPI (A) = 0.77 WAPI (BC) = 1.06

Multi Period
Project A B C
Project D PI

C0 10 5 5
C
0

C1 + 30 +5 +5
C1 40 0 .4

C2 +5 + 20 + 15
C
2

NPV @ 10 % 21 16 12
NPV @ 10 % 13

+ 60

Linear Programming
Maximize Cash flows or NPV Minimize costs
Example

Max NPV = 21Xn + 16 Xb + 12 Xc + 13 Xd subject to 10Xa + 5Xb + 5Xc + 0Xd <= 10 -30Xa - 5Xb - 5Xc + 40Xd <= 12

INVESTMENT APPRAISAL IN PRACTICE Over time, discounted cash flow methods have gained in
importance and internal rate of return is the most popular evaluation method. Firms typically use multiple evaluation methods.

Accounting rate of return and payback period are widely employed as supplementary evaluation methods.

CFO Decision Tools

Survey Data on CFO Use of Investment Evaluation Techniques

NPV, 75%

IRR, 76%

Payback, 57%

Book rate of return, 20% Profitability Index, 12% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

SOURCE: Graham and Harvey, The Theory and Practice of Finance: Evidence from the Field, Journal of Financial Economics

Inflation
INFLATION RULE Be consistent in how you handle inflation!! Use nominal interest rates to discount nominal cash flows. Use real interest rates to discount real cash flows. You will get the same results, whether you use nominal or real figures

Inflation
Example You own a lease that will cost you 8,000 next year, increasing at 3% a year (the forecasted inflation rate) for 3 additional years (4 years total). If discount rates are 10% what is the present value cost of the lease?
1+ nominal interest rate 1 + real interest rate = 1+inflation rate

Inflation
Example - nominal figures

Year 1 2 3 4

Cash Flow PV @ 10% 8000 8000 1.10 = 7272.73 8240 = 6809.92 8000x1.03 = 8240 1.102 2 8487 .20 8000x1.03 = 8240 = 6376.56 1.103 .82 8000x1.033 = 8487.20 8741 = 5970 . 78 4 1.10 $26,429.99

Inflation
Example - real figures

Year 1 2 3 4
8000 1.03 8240 1.032 8487.20 1.033 8741.82 1.034

Cash Flow = 7766.99 = 7766.99 = 7766.99 = 7766.99

7766.99 1.068 7766.99 1.0682 7766.99 1.0683 7766.99 1.0684

PV@6.7961% = 7272.73 = 6809.92 = 6376.56 = 5970.78 = $26,429.99

Equivalent Annual Cost

Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.

Equivalent Annual Cost

Equivalent Annual Cost - The cost per period with the same present value as the cost of buying and operating a machine.
present value of costs Equivalent annual cost = annuity factor

Equivalent Annual Cost

Example Given the following costs of operating two machines and a 6% cost of capital, select the lower cost machine using equivalent annual cost method.
Year 1 2 15 5 10 6

Machine A B

3 5 6

4 5

PV@6% 28.37 21.00

EAC 10.61 11.45

Timing
Even projects with positive NPV may be more valuable if deferred. The actual NPV is then the current value of some future value of the deferred project.
Net future value as of date t Current NPV = t (1 + r )

Timing
Example You may harvest a set of trees at anytime over the next 5 years. Given the FV of delaying the harvest, which harvest date maximizes current NPV?
Harvest Year 0 1 Net FV (1000s) 50 64.4 % change in value 28.8 2 77.5 20.3 3 4 5 89.4 100 109.4 15.4 11.9 9.4

Timing
Example - continued
You may harvest a set of trees at anytime over the next 5 years. Given the FV of delaying the harvest, which harvest date maximizes current NPV?

64.4 NPV if harvested in year 1 = = 58.5 1.10

Timing
Example - continued
You may harvest a set of trees at anytime over the next 5 years. Given the FV of delaying the harvest, which harvest date maximizes current NPV?

64.4 NPV if harvested in year 1 = = 58.5 1.10

Harvest Year 0 1 NPV (1000s) 50 58.5 2 64.0 3 4 5 67.2 68.3 67.9

Fluctuating Load Factors

Two Old Machines Annual output per machine 750 units Operating cost per machine 2 750 = $1,500 PV operating cost per pachine 1,500/.10 = $15,000 PV operating cost of two machines 2 15,000 = $30,000

Fluctuating Load Factors

Two New Machines Annual output per machine Capital cost per machine Operating cost per machine PV operating cost per pachine PV operating cost of two machines 750 units $6,000 1 750 = $750 6,000 + 750/.10 = $13,500 2 13,500 = $27,000

Fluctuating Load Factors

One Old Machine Annual output per machine Capital cost per machine Operating cost per machine PV operating cost per machine PV operating cost of two machines 500 units 0 2 500 = $1,000 One New Machine 1,000 units $6,000 1 1,000 = $1,000

1,000/.10 = $10,000 6,000 + 1,000 / .10 = $16,000 ................................$26,000

What To Discount
Cash Flows.not accounting income/expenses Estimate Cash Flows on an Incremental Basis Do not confuse average with incremental payoffs Beware of allocated overhead costs Include all incidental effects Do not forget working capital requirements Include opportunity costs Forget sunk costs Treat inflation consistently Post Tax