Tools for Project Evaluation

Nathaniel Osgood
1.040/1.401J
2/11/2004
 Basic Compounding
„ Suppose we invest $x in a bank offering interest
rate i
„ If interest is compounded annually, asset will be
worth
„ $x(1+i) after 1 years
„ $x(1+i)2 after 2 years
„ $x(1+i)3 after 3 years ….
„ $x(1+i)n after n years
 Opportunity Cost &
The Time Value of Money
„ If we assume
„ money can always be invested in the bank (or some other reliable source)
now to gain a return with interest later
„ That as rational actors, we will never make an investment which we know
to offer less money than we could get in the bank
„ Then
„ money in the present can be thought as of “equal worth” to a larger
amount of money in the future
„ Money in the future can be thought of as having an equal worth to a
lesser “present value” of money
 Notation
„ Cost
Time

„ Revenue

„ Simple investment
 Equivalence of Present Values
„ Given a source of reliable investments, we are
indifferent between any cash flows with the
same present value – they have “equal worth”
„ This indifferences arises b/c we can convert
one to the other with no extra expense
 Future to Present Revenue
„ Given Future Revenue in year
r
t…

„ Borrow a smaller amt now from reliable source

r/(1+i)t

„ Transforms future revenue to equivalent present

revenue, at no additional cost burden
r/(1+i)t
 Future to Present Cost
„ Given Future Cost in year t…
c

„ Invest a smaller amt now in reliable source

c

c/(1+i)t

„ Transforms future cost to equivalent present

cost, with no additional cost burden

c/(1+i)t
 Present to Future Revenue
„ Given Present Revenue…
r

„ Invest all now in reliable source; withdraw at t

r(1+i)t

„ Transforms present revenue to equivalent future

revenue, at no additional cost burden
r(1+i)t
 Present to Future Cost
„ Given a present cost…
c

„ Borrow = amt now from source; pay back at t

c

c(1+i)t

„ Transforms current cost to equivalent future,

with no additional cost burden

c(1+i)t
 Summary
„ Given a reliable source offering annual return i
we can shift costlessly between cash flow v at
time 0 and v(1+i)t at time t
„ Because we can flexibly switch from one such
value to another without cost, we can view these
values as equivalent
„ The present value of a cash flow v at time t is
just v/(1+i)t
 Notion of Net Present Value
„ Suppose we had
„ A collection (or stream) of costs and revenues in the
future
„ A certain source of borrowing/saving (at same rate)

„ The net present value (NPV) is the sum of the

present values for all of these costs and revenues
„ Treat revenues as positive and costs as negative
Understanding Net Present Value
„ NPV (and PV) is relative to a discount rate
„ In our case, this is the rate for the “reliable source”
„ NPV specifies the
„ Value of the cash stream beyond what could be gained
if the revenues were returns from investing the costs
(at the appropriate times) in the “reliable source”
„ The “reliable source” captures the opportunity cost against
which gains are measured
„ Key point: NPV of “reliable source” is 0
„ PV(revenue from investment)=PV(investment cost)
Example: High-Yield Investment
„ Assume reliable source with 10% annual interest
„ Invest $100 in high-risk venture at year 0
„ Receive $121 back at year 1
„ What is the net present value of this investment?
„ What is the net future value of this investment?
„ What does this mean?
$121

$100
 Example: Money in Mattress
„ Assume reliable source with 10% annual interest
„ Place $100 in mattress at year 0
„ Retrieve $100 from mattress at year 1
„ What is the net present value of this investment?
„ What does this mean?
$100

$100
 Discounted Cash Flow
„ Computing Present Value (PV) of costs &
benefits involves successively discounting
members of a cash flow stream
„ This is because the value of borrowing or investment
to/from the “reliable source” rises exponentially
„ This notion is formalized through
„ Choice of a discount rate r
„ In the absence of risk or inflation, this is just the interest
rate of the “reliable source” (gain through opportunity
costs)
„ Applying discount factor 1/(1+r)t to values at time t
 Outline
9 Session Objective
9 Project Financing
9 Public
9 Private
9 Project
9 Contractor
9 Additional issues
ƒ Financial Evaluation
9 Time value of money
9 Present value
9 NPV & Discounted cash flow
ƒ Simple Examples
ƒ Formulae
ƒ IRR
ƒ Missing factors
 Develop or not Develop
„ Is any individual project worthwhile?

„ Given a list of feasible projects, which one is

the best?

„ How does each project rank compared to

the others on the list?

„ “Objective: Strive to secure the highest net

dollar return on capital investments which is
compatible with the risks incurred”
 We can EITHER Use NPV to
„ Evaluate a project against some opportunity cost
„ Use this opportunity to set the discount rate r
> Accept the project
NPV = 0 Indifferent to the project
< Reject the project

„ Use NPV to choose the best among a set of

(mutually exclusive) alternative projects
 Rates
„ Discount Rate:
„ Worth of Money + risk
„ Minimum Attractive Rate of
Return (MARR)
„ Minimum discount rate accepted by
the market corresponding to the risks
of a project
Choice of Discount Rate
 Project Evaluation Example
„ Warehouse A „ Warehouse B
„ Construction=10 months „ Construction=20 months
„ Cost = $100,000/month „ Cost=$100,000/month
„ Sale Value=$1.5M „ Sale Value=$2.8M
„ Total Cost? „ Total Cost?
„ Profit? „ Profit?
„ Better than B? „ Better than A?

Pena-Mora 2003
 Drawing out the examples
„ Project A $1,500,000
10 Months

$100,000 $100,000 $100,000 $100,000 … $100,000

$2,800,000
„ Project B 20 Months

$100,000 $100,000 $100,000 $100,000 $100,000

 Outline
9 Session Objective
9 Project Financing
9 Public
9 Private
9 Project
9 Contractor
9 Additional issues
ƒ Financial Evaluation
9 Time value of money
9 Present value
9 NPV & Discounted cash flow
9 Simple Examples
ƒ Formulae
ƒ IRR
ƒ Missing factors
 Interest Formulas
„ i = Effective interest rate per interest period
(discount rate of MARR)

„ t = Number of compounding periods

„ PV = Present Value

„ NPV = Net Present Value

„ FV = Future Value

„ A = Annuity
 Interest Formulas: Payments
„ Single Payment Compound Amount Factor
„ (F/P, i%, n) = (1 + i )n

„ Single Payment Present Worth Factor

„ (P/F, i%, n) = 1/ (1 + i )n = 1/ (F/P, i%, n)

„ Uniform Series Compound amount Factor

„ (F/A, i%, n) = (1 + i )n - 1 / i

„ Uniform Series Sinking Fund Factor

„ (A/F, i%, n) = i / (1 + i )n - 1 = 1 / (F/A, i%, n)
Pena-Mora 2003
Interest Formulas: Series
„ Uniform Series Present Worth Factor

„ (P/A, i%, n) = 1/ i - 1/ i (1 + i )n

„ Uniform Series Capital Recovery Factor

„ (A/P, i%, n) = [i (1 + i )n] / [(1 + i )n – 1] =

1 / (P/A, i%, n)
Pena-Mora 2003
 Note on Continuous Compounding
„ To this point, we have considered annual compounding of
interest
„ Consider more frequent compounding
„ Interest is in %/year
„ Fraction of interest gained over time ∆t (measured in years)=i∆t
„ For n compounding periods/year, effective rate for entire year is
n
⎛ i⎞
⎜ 1 + ⎟
⎝ n⎠
„ As n→∞ we approach continuous compounding and quantity
approaches ei
„ Over t years, we have eit
 Equipment Example
„ $ 20,000 equipment expected to last 5 years

„ $ 4,000 salvage value

„ Minimum attractive rate of return 15%

„ What are the?

„ A - Annual Equivalent

„ B - Present Equivalent

Pena-Mora 2003
Equipment Example
 Outline
9 Session Objective
9 Project Financing
9 Public
9 Private
9 Project
9 Contractor
9 Additional issues
ƒ Financial Evaluation
9 Time value of money
9 Present value
9 NPV & Discounted cash flow
9 Simple Examples
9 Formulae
ƒ IRR
ƒ Missing factors
 Internal Rate of Return (IRR)
„ Identifies the rate of return on an investment
„ Example: Geometrically rising series of values
„ Typical means of computing: Identify the
discount rate that sets NPV to 0
IRR Investment Rule
> Accept
r- =
r* Indifferent
< Reject

“Accept a project with IRR larger than the

discount rate.”
Alternatively,

“Maximize IRR across mutually exclusive

projects.”
Pena-Mora 2003
Internal Rate-of-Return Method
(IRR) Example

„ 0(r%) = -20,000 + 5,600 (P/A, r%, 5) +

4,000 (P/F, r%, 5)

„ i = +/- 16.9% > 15% then the project is

justified
Internal Rate-of-Return Method
(IRR) Graph
 IRR vs. NPV
„ Most times, IRR and NPV give the same decision /
ranking among projects.
„ IRR does not require to assume (or compute)
discount rate.
„ IRR only looks at rate of gain – not size of gain
„ IRR ignores capacity to reinvest
„ IRR may not be unique (payments in lifecycle):

Trust NPV: It is the only criterion that ensures

wealth maximization
Pena-Mora 2003
 Other Methods I
„ Benefit-Cost ratio (benefits/costs) or reciprocal
„ Discounting still generally applied
„ Accept if <1
„ Common for public projects
„ Does not consider the absolute size of the benefits
„ Can be difficult to determine whether something counts as a
“benefit” or a “negative cost”
„ Cost-effectiveness
„ Looking at non-economic factors
„ Discounting still often applied for non-economic
„ $/Life saved
„ $/QALY
 Other Methods II
„ Payback period (“Time to return”)
„ Minimal length of time over which benefits repay
costs
„ Typically only used as secondary assessment

„ Drawbacks
„ Ignores what happens after payback period

„ Does not take discounting into account

„ Discounted version called “capital recovery period”

„ Adjusted internal rate of return (AIRR)
 Outline
9 Session Objective
9 Project Financing
9 Public
9 Private
9 Project
9 Contractor
9 Additional issues
ƒ Financial Evaluation
9 Time value of money
9 Present value
9 NPV & Discounted cash flow
9 Simple Examples
9 Formulae
9 IRR
ƒ Missing factors
 What are we Assuming Here?
„ That only quantifiable monetary benefits
matter
„ Certain knowledge of future cash flows
„ Present value (discounting) using equal
rates of borrowing/lending
 Money is not Everything
„ Social Benefits
„ Hospital
„ School
„ Employment opportunities
„ Intangible Benefits
„ New cafeteria
„ Strategic benefits
„ Partnering with firm for long-term
relationship
We are missing critical uncertainties
„ Revenue
„ Level of occupancy
„ Elasticity and Level of cost
„ Duration of project
„ Post-construction revenue
„ Sale of building
„ Costs
„ Construction costs
„ Environmental conditions
„ Labor costs
„ Size of lowest bid
„ Variable interest rates
„ Maintenance costs
„ Energy costs
„ How quickly items wear out
„ Labor costs