Course No.

ET ZC414

Project Appraisal
BITS Pilani
Hyderabad Campus

Module : selection 1 Session 10

S. Hanumantharao Date : 2/15/2015

Total ppt :45

BITS Pilani
Hyderabad Campus

Investment Criteria
Chapter 8

Objectives
1.
2.
3.
4.
5.
6.

List and classify various investment criteria.

Discuss the properties of the NPV rule.
Explain the rationale for the NPV rule.
Benefit cost ratio : Profitability index
Internal rate of return
Discuss the problems associated with internal rate of
return:
1.
2.
3.
4.
5.

Non-Conventional Cash Flows

Mutually exclusive Projects
Different patterns of cash flow over time
Lending vs. Borrowing
Short-term and Long-term Interest Rates

7. Interpretations of IRR, XIRR and MIRR

BITS Pilani, Hyderabad Campus

Project appraisal: selection of

investment opportunities

Analysis of potential projects

Long-term decisions
Large expenditures
Difficult/impossible to reverse
Determines firms strategic direction
Hence we need good decision criteria

BITS Pilani, Hyderabad Campus

Good Decision Criteria

We will judge based on whether they
meet the following:
All cash flows considered?
TVM considered?
Risk-adjusted?
Ability to rank projects?
Indicates added value to the firm?

BITS Pilani, Hyderabad Campus

Evaluating a Project:
financial
The key steps involved in determining whether
a project is worthwhile or not are:
1.
2.
3.
4.

Estimate the costs and benefits of the project

Assess the riskiness of the project
Calculate the cost of capital
Compute the criteria of merit and judge whether the
project is good or bad.

We will look at the cost of capital in session 12

BITS Pilani, Hyderabad Campus

There are many criteria that have been suggested by

economists, accountants, and others to judge the
worthwhileness of capital projects. Indeed, scores of
criteria have been proposed, in the extensive literature
on this subject. Some are general and applicable to a
wide range of investments; others are specialized and
suitable for certain types of investments andBITS Pilani, Hyderabad Campus

Net Present Value

How much value is created from
undertaking an investment?
Step 1: Estimate the expected future cash flows.
Step 2: Estimate the required return for projects of this
risk level. (discount factor)
Step 3: Find the present value of the cash flows and
subtract the initial investment to arrive at the Net
Present Value.

BITS Pilani, Hyderabad Campus

Net Present Value

Sum of the PVs of all cash flows
n

CFt
NPV =
(1 +
t=
t
R)
0

NOTE:
t=0

Initial cost often is CF0 and is an outflow

n

NPV =

t=
1

CFt
- CF0
t
(1 + R)
BITS Pilani, Hyderabad Campus

Example Project cash flows are

Cost of capital =
Period 10%values
PV
0 -1000000 -1,000,000.00
1 200000 181818.1818
2 200000 165289.2562
3 300000 225394.4403
4 300000 204904.0366
5 350000 217322.4631
-5,271.62
NPV - 5,271.62
NPV(10%,B3:B7)+B2

BITS Pilani, Hyderabad Campus

NPV Decision Rule

If NPV is positive, accept the project
NPV > 0 means:
Project is expected to add value to the firm
Will increase the wealth of the owners

NPV is a direct measure of how well this project will meet

the goal of increasing shareholder wealth.

BITS Pilani, Hyderabad Campus

Net Present Values are Additive

The net present value of a package of projects is simply the
sum of the net present values of individual projects
included in the package.
When a firm terminates an existing project which has a
negative NPV based on its expected future cash flows,
the value of the firm increases by that amount.
Likewise, when a firm undertakes a new project that has a
negative NPV, the value of the firm decreases by that
amount.

BITS Pilani, Hyderabad Campus

Intermediate Cash Flows are

Invested at Cost of Capital
The NPV rule assumes that the intermediate cash flows of
a project - that is cash flows that occur between the
initiation and the termination of the project - are
reinvested at rate of return equal to that of cost of capital
NPV Calculation Permits Time, Varying Discount Rates. So
far we assumed that the discount rate remains constant
over time. This need not be always the case.
The NPV can be calculated using time-varying discount
rates. The general formula of NPV is as follows:

BITS Pilani, Hyderabad Campus

Rationale for the NPV Rule

Lending Borrowing
Cash inflow year 0 = OA, Year 1 = OB.
Mark AC = OB/(1+r), BD = OA*(1+r)
Join CD with a straight line. Slope of CD = 1+r
If you borrow against your future income, you can spend OC in year 0.
If you invest in Year 0, you can spend OD in Year 1.

lending
Borrowing
F

consumption frontier
AC= OB/
(1+r)

E
BITS Pilani, Hyderabad Campus

Investment opportunity
curve
Your investment opportunity, however, is not limited to just lending or
borrowing in the capital market. You may also consider investment in
land, building, plant, machinery, and other real assets.
Its slope is high to begin with but declines progressively because
the marginal return from additional investment in real assets tends

to decline.

L
Real
Estates

Lendin
g

D
BITS Pilani, Hyderabad Campus

Now let us look at what happens

when you invest different amounts in
Investment Opportunity Curve
real assets. Present value of benefits
- Present value of costs=NF-OF=ON
Net present value of investment DC =
Present value of benefits - Present
value of costs=QG-OG=OQ
Net present value of investment DH =
Present value of benefits - Present
value of costs= SH -OH= DS
Investment of DF in real assets
Investment of DG (an amount greater
than DF) in real assets
Investment of DH (an amount less
than DF) in real assets

Thus, when the net present value is maximized, you

reach the highest consumption frontier. is, then,
constitutes the rationale for the net present value
criterion.

Modified NPV

BITS Pilani, Hyderabad Campus

Consider two Reinvestment rates 14% and

20%

BITS Pilani, Hyderabad Campus

Cost of capital = 10%

BITS Pilani, Hyderabad Campus

Net Present Value Profile

BITS Pilani, Hyderabad Campus

Benefit cost ratio

Benefit cost ratio = BCR = PVB/I
Net Benefit cost ratio = NBCR = (PVB-I)/I.
where PVB is the present value of benefits, and I is the
initial investment.
BCR = 1+ NBCR
Accept if BCR > 1 or NBCR > 0
As values on the BCR (profitability index) increase, so does
the financial attractiveness of the proposed project.

BITS Pilani, Hyderabad Campus

Internal Rate of Return

Definition:
IRR = discount rate that makes the NPV = 0
Decision Rule:
Accept the project if the IRR is greater than
the required return
n
CF

t
(
1

IRR
)
t0

Most important alternative to NPV

Widely used in practice
Intuitively appealing
Based entirely on the estimated cash
flows
Independent of interest rates
BITS Pilani, Hyderabad Campus

Net Present Value Profile

BITS Pilani, Hyderabad Campus

Assumptions of IRR
1. The investment is held till maturity.
2. All intermediate cash flows are re-invested at IRR
3. The cash flows should be periodic i.e. the time interval
between two cash flows are equal.
. IRR is sometimes called the discounted cash flow rate of
return, rate of return, and effective interest rate.
. The internal term signifies the rate is independent of
outside interest rates.

BITS Pilani, Hyderabad Campus

NPV vs. IRR

NPV: Enter r, solve for
n
NPV
CFt

(1 R )
t 0

NPV

IRR: Enter NPV = 0, solve for IRR.

CFt
0

t
t 0 (1 IRR )
n

BITS Pilani, Hyderabad Campus

Trial and error

Cash flow (100,000) 30,000 30,000, 40000 and 45000. The IRR is
the value of r which satisfies the following equation:
100,000 = 30,000/(1+r)+ 30,000/(1+r)^2+ 40,000/(1+r)^3+ 45,000/
(1+r)^4
Try r=15, we get npv= 100,802-100,000 = 801
Try r= 16, we get npv = 98,641-100000 =1364
So r will be close to 15+ 801/(801+1364) = 15.37
0
1
2
3
4
IRR

-100000
30000
30000
40000
45000
15.37%

Try 15%
-100000
26087
22684.3
26300.7
25728.9
800.812

Try 16%
-100000
25862.1
22294.9
25626.3
24853.1
-1363.64
BITS Pilani, Hyderabad Campus

IRR - Advantages
Preferred by executives
Intuitively appealing
Easy to communicate the value of a project

If the IRR is high enough, may not need to estimate a

required return
Considers all cash flows
Considers time value of money
Provides indication of risk

BITS Pilani, Hyderabad Campus

IRR - Disadvantages
Can produce multiple answers
Cannot rank mutually exclusive
projects
Reinvestment assumption flawed

BITS Pilani, Hyderabad Campus

Non-Conventional Cash
Flows
Suppose an investment will
cost $90,000 initially and
will generate the following
cash flows:
Year 1: 132,000
Year 2: 100,000
Year 3: -150,000

The required return is 15%.

Should we accept or reject the
project?

BITS Pilani, Hyderabad Campus

NPV Profile
IRR = 10.11% and 42.66%

When you cross the x-axis more than once,

there will be more than one return that
solves the equation

BITS Pilani, Hyderabad Campus

Cash flows for which

IRR does not exist

0
1
2
NPV
IRR

15000
-45000
37500
$4,224.95
#NUM!

BITS Pilani, Hyderabad Campus

Mutually exclusive Projects

Proj P
Proj Q
12%
-10000
-50000
20000
75000
IRR
100%
50%

NPV
7,015.31 15,146.68

Both the projects are good,

but Q, with its higher NPV,
contributes more to the
value of the firm. Yet from
an IRR point of view P looks
better than Q.

The IRR rule, of course, can be salvaged in such cases by

considering the IRR on the incremental cash flow, if the projects
were not mutually exclusive.

P
Q Incremental
12%
-10000
-50000
-40000
20000
75000
55000
IRR
100%
50%
37.5%
NPV
7,015.31 15,146.68 8,131.64

BITS Pilani, Hyderabad Campus

NPV Profiles
$30,000.00

IRR for P = 100%

$25,000.00

IRR for Q = 50%

$20,000.00

Crossover Point =
37.5%

$15,000.00
$10,000.00
$5,000.00
$0.00

0
($5,000.00)

0.2

0.4

0.6

If projects are mutually

exclusive
If k > crossover point,
the two methods lead
to the same decision
and there is no
conflict.
If k < crossover point,
the two methods lead
to different
accept/reject
0.8 decisions.
1
1.2

($10,000.00)
.375
BITS Pilani, Hyderabad Campus

Different patterns of cash flow

over time

Both the projects look good but X, with its higher NPV,
contributes more to the value of the firm.
Yet from an IRR point of view Y looks more attractive.
Hence the IRR rule can be misleading when a choice
has to be made between mutually exclusive projects
which have different patterns of cash flow over time.
BITS Pilani, Hyderabad Campus

Lending vs. Borrowing

The IRR rule cannot distinguish between lending and borrowing
and hence a high IRR need not necessarily be a desirable thing.
To illustrate this point, let us consider two projects A and B.
A involves investing 4000 at a rate of return of 50 percent,
whereas B involves borrowing 4000 at a rate of return of 75
percent. Yet if we go by the IRR figures alone, B appears more
attractive than A

BITS Pilani, Hyderabad Campus

Short-term and Long-term

Interest Rates
Thus, the cash flow for year 1, C1, is discounted at the
opportunity cost of capital for year 1, r1; the cash flow for year
2, C2, is discounted at the opportunity cost of capital for year 2,
r2; so on and so forth.
The IRR rule says that a project should be accepted if its IRR is
greater than the opportunity cost of capital.
But what should we do when there are several opportunity
costs?
Should we compare IRR with r1 or r2 or r3 ... or rn?
We have to, in effect, compute a complex weighted average of
various rates to get a number comparable to IRR.
BITS Pilani, Hyderabad Campus

Interpretation of IRR :1
Unrecovered Investment Balance is Zero

Unrecovered Investment Balance

and IRR
IRR works out to
30%

BITS Pilani, Hyderabad Campus

Interpretation of IRR :2
compounded rate of return earned on the initial investment

Now, let us consider the second interpretation, according to which the internal rate of
return is the compounded rate of return earned on the initial investment, for the entire
life of the project.
In our numerical example, where the initial investment is Rs.300,000,the internal rate of
return of the project is 30 percent, and the life of the project is three years, the value of
the benefits of the project, assessed at the end of three years, will be
Rs.300,000(1+0.30)^3 = Rs.659,100.
For our numerical example, it means that the intermediate cash inflow of Rs.417,000
occurring at the end of the second year (this is the only intermediate cash inflow for the
project) can be re-invested at a rate of return equal to 30 percent. Given this
assumption, we find that the value of all benefits, assessed at the end of three years,
works out to Rs.659,100 as follows:

= 300, 000*(1.3)^3
BITS Pilani, Hyderabad Campus

Conflicts Between NPV and

IRR
NPV directly measures the increase in value to the firm
You can't estimate the NPV unless you know the discount
rate, but you can still calculate the IRR.
IRR can be mentally compared to expected inflation, the
current borrowing rates, the cost of capital, an equity's
portfolio return, and so on
Whenever there is a conflict between NPV and another
decision rule, always use NPV
IRR is unreliable in the following situations:
Non-conventional cash flows
Mutually exclusive projects

BITS Pilani, Hyderabad Campus

XIRR and How to Calculate it?

When the payments are at Irregular interval, we use XIRR.
In an Excel sheet, Put Date and Value for each row

BITS Pilani, Hyderabad Campus

Modified Internal Rate of Return

(MIRR)
IRR assumes that positive cash flows are reinvested at
the same rate of return as that of the investment.
This is unlikely as funds are reinvested at a rate closer to
the organizations cost of capital or return on cash.
The IRR therefore often gives an overly optimistic rate of
the cash flows. For comparing projects more accurately,
the cost of capital should be used for reinvesting the
interim cash flows.

BITS Pilani, Hyderabad Campus

Modified Internal Rate of return using

the cost of capital for cashflows

BITS Pilani, Hyderabad Campus

Given the cash flows and wacc

=15%

BITS Pilani, Hyderabad Campus

Different reinvest rate

wherenis the number of equal periods at the end of which the

cash flows occur (not the number of cash flows),PVispresent
value(at the beginning of the first period),FVisfuture value(at
the end of the last period).
The formula adds up the negative cash flows after discounting
them to time zero using the external cost of capital,
adds up the positive cash flows including the proceeds of
reinvestment at the external reinvestment rate to the final
period, and then works out what rate of return would cause the
magnitude of the discounted negative cash flows at time zero to
be equivalent to the future value of the positive cash flows at
the final time period.
BITS Pilani, Hyderabad Campus

MIRR versus IRR

MIRR correctly assumes reinvestment at opportunity cost =
WACC
MIRR avoids the multiple IRR problem
Managers like rate of return comparisons, and MIRR is
better for this than IRR

BITS Pilani, Hyderabad Campus