Project evaluation principles and methods

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Chapter 5 Project Evaluation:

Principles and Methods

• 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

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

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 proposal’s 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 project’s

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

(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)

Table 5.1: Selected project evaluation methods used by the CFOs surveyed (a)

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 project’s net cash flows:

– Forecast expected net profit from project

– Estimate net cash flows directly.

• The standard NPV formula is given by:

( )

∑

=

− +

1

0

1

where:

= initial cash outlay on project

= net cash flow generated by project at time t = life of the project

= required rate of return

t

C C n k

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 company’s

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 company’s shares should increase.

• Decision rule for NPV method:

– Accept a project if its NPV is positive when the

project’s NCFs are discounted at the required rate of return.

NPV Example

• Example 5.1:

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.

• Thus, using a discount rate of 10%, the project’s

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

0 1

n

t

t t

Internal Rate of Return (IRR)

• The internal rate of return (IRR) is the

discount rate that equates the PV of a project’s

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

0

where:

= initial cash outlay on project

= net cash flow generated by project at time t = life of the project

= internal rate of return

t

C C n r

Calculation of Internal Rate of

Return (cont.)

• Using the cash flows of Example 5.1, the IRR is:

% 25

9000 )

1 (

4000 )

1 (

4500 1

5090

3 2

=

=

− +

+ +

+ +

IRR

IRR IRR

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 project’s 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

Choosing Between the Discounted Cash Flow Methods (cont.)

• Independent investments:

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 doesn’t 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

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:

• Decision rule:

– Accept if benefit–cost ratio > 1

– Reject if benefit–cost ratio < 1

PV of net cash flows Benefit Cost Ratio

Initial cash outlay

=

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 project’s life.

Payback Period

• The time it takes for the initial cash outlay on a project to be recovered from the project’s 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 project’s 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 project’s

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:

• 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

• 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.

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