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    Financial Evaluation

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    Abebe Getaneh
    1) The document discusses various methods for evaluating investment proposals, including payback period, net present value (NPV), profitability index, and internal rate of return (IRR). 2) It provides an example calculation of payback period for two projects, Project A and Project B. It then calculates the NPV of each project using cash flows over 5 years with a 12% discount rate, finding that Project A has a higher NPV. 3) Additional methods discussed include calculating the profitability index and IRR for an example cement project with $180,000 initial investment and 7 years of cash flows. Formulas and calculations are provided for each evaluation method.

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    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd

    Financial Evaluation

    Uploaded by

    Abebe Getaneh
    23 views5 pages
    1) The document discusses various methods for evaluating investment proposals, including payback period, net present value (NPV), profitability index, and internal rate of return (IRR). 2) It provides an example calculation of payback period for two projects, Project A and Project B. It then calculates the NPV of each project using cash flows over 5 years with a 12% discount rate, finding that Project A has a higher NPV. 3) Additional methods discussed include calculating the profitability index and IRR for an example cement project with $180,000 initial investment and 7 years of cash flows. Formulas and calculations are provided for each evaluation method.

    Original Description:

    FINANCIAL EVALUATION WORKSHEET

    Original Title

    Financial evaluation

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    1) The document discusses various methods for evaluating investment proposals, including payback period, net present value (NPV), profitability index, and internal rate of return (IRR). 2) It provides an example calculation of payback period for two projects, Project A and Project B. It then calculates the NPV of each project using cash flows over 5 years with a 12% discount rate, finding that Project A has a higher NPV. 3) Additional methods discussed include calculating the profitability index and IRR for an example cement project with $180,000 initial investment and 7 years of cash flows. Formulas and calculations are provided for each evaluation method.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    23 views5 pages

    Financial Evaluation

    Uploaded by

    Abebe Getaneh
    1) The document discusses various methods for evaluating investment proposals, including payback period, net present value (NPV), profitability index, and internal rate of return (IRR). 2) It provides an example calculation of payback period for two projects, Project A and Project B. It then calculates the NPV of each project using cash flows over 5 years with a 12% discount rate, finding that Project A has a higher NPV. 3) Additional methods discussed include calculating the profitability index and IRR for an example cement project with $180,000 initial investment and 7 years of cash flows. Formulas and calculations are provided for each evaluation method.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 5

    1) Traditional criteria (techniques)

    a) Payback Period:
    This is one of the widely used methods for evaluating the investment proposals. Under this
    method the focus is on the recovery of original investment at the earliest possible. It determines
    the number of years to recoup the original cash out flow, disregarding the salvage value and
    interest. This method does not take into account the cash inflows that are received after the
    payback period. There are two methods in use to calculate the payback period

    1) Where annual cash flows are not consistent vary from year to year.
    2) Where the annual cash flow are uniform.

    1. Unequal cash flows


    B
    P=E+
    C
    Where, P stands for payback period.
    E stands for number of years immediately preceding the year of final recovery.
    B stands for the balance amount still to be recovered.
    C stands for cash flow during the year of final recovery.

    Example: The following is the information related to a company

    Project A Project B
    Year Cash flow $ Year Cash flow $
    0 -700 0 -700
    1 100 1 400
    2 200 2 300
    3 300 3 200
    4 400 4 100
    5 500 5 0

    Calculate Payback Period


    Project A Cumulative Project B Cumulative
    Year Cash flow cash flow Year Cash flow Cash flow
    0 -700 -700 0 -700 -700
    1 100 -600 1 400 -300
    2 200 -400 2 300 0
    3 300 -100 3 200 200
    4 400 300 4 100 300
    5 500 800 5 0 -
    B
    P=E+
    C
    100
    =3+
    400
    = 3.25 year
    B
    P=E+
    C
    =2+0
    = 2 years

    The Net Present Value (NPV)

    Year Project A Project B


    0 (80,000) (100,000)
    1 20,000 25,000
    2 25,000 20,000
    3 25,000 30,000
    4 30,000 35,000
    5 20,000 40,000
    The required rate of return on both projects is 12%. Then, evaluate these projects using the Net
    Present Value Method.

    The Net Present Value (NPV) for Project A is:

    Year Cash Flows Discounting Factor (12%) Present Values


    1 20,000 0.893 17,860
    2 25,000 0.797 19,925
    3 25,000 0.712 17,800
    4 30,000 0.636 19,080
    5 20,000 0.567 11,340

    PV of cash inflows (sum) 86,005


    PV of cash outflows 80,000
    Net Present Value (NPV) 6,005 birr
    The Net Present Value (NPV) for Project B is:
    Year Cash Flows Discounting Factor (12%) Present Values
    1 25,000 0.893 22,325
    2 20,000 0.797 15,940
    3 30,000 0.712 21,360
    4 35,000 0.636 22,260
    5 40,000 0.567 22,680

    PV of cash inflows (sum) 104,565


    PV of cash outflows 100,000
    Net Present Value (NPV) 4,565 birr

    Since the two projects are mutually exclusive, the one with the higher NPV has to be accepted.
    Thus, project A is selected as its NPV is higher than that of project B. Had the two projects been
    independent of one another, both of them would be accepted because both projects have positive
    net present values (NPVs).

     Unit 4 Activity 1
    ABC PLC is considering an investment in a cement project. It has on hand $180, 000. It is
    expected that the project may work for seven years and likely to generate the following annual
    cash flows.
    Year Cash Flows
    1 30,000
    2 50,000
    3 60,000
    4 65,000
    5 40,000
    6 30,000
    7 16,000
    The cost of capital is 8%
    Required: - Calculate the Net Present Value.
    a) Profitability Index Method / Benefit Cost Ratio
    Profitability index method is the relationship between the present values of net cash inflows and
    the present value of cash outflows. It can be worked out either in unitary or in percentage terms.
    The formula is

    Present va lue of cash inflows


    Profitability Index =
    Pr esent value of cash outflows
    PI > 1 Accept
    PI = 1 indifference
    PI < 1 reject
    Higher the profitability index more is the project preferred.
    From the above example we can calculate the profitability index as below
    Present value of cash out flows $ 180, 000
    Present value of cash inflows $ 221, 513
    221,513
    : - PI =
    180,000
    b) The Internal Rate of Return
    The IRR is the discount rate at which the NPV for a project equals zero. This rate means that the
    present value of the cash inflows for the project would equal the present value of its outflows.

    Suppose you were looking at an investment with investment costs $100,000 and net cash flow as
    given below. The Required Rate of Return is 20%.

    Year Description Cash Flow


    0 Initial Investment (100,000)
    1 Net Cash Flow 35,000
    2 Net Cash Flow 40,000
    3 Net Cash Flow 45,000
    4 Net Cash Flow 70,000

    What’s the IRR? If we require a 20 percent return, should we take this investment?

    We can set the NPV equal to zero and solve for the discount rate:

    Unfortunately, the only way to find the IRR in general is by trial and error, either by hand or by
    calculator.

    At 10%,

    NPV = (100,000) + 146496


    = 46,496

    At 30 %,

    NPV = (100,000) + 96266


    = -3,734
    The NPV appears to be zero with a discount rate between 10 percent and 30 percent, so the IRR
    is somewhere in that range.

    With a little more effort, we can find the IRR using the following formula

    Where
    • L = Lower discount rate L = Low
    • H = Highest discount rate H = High
    • NPVL = The NPV results for the lower discount rate
    • NPVH = The NPV results for the higher discount rate

    IRR = 10% + 18.5%

    IRR = 28.5%

    So, if our required return were less than 28.5 percent, we would take this investment. If our
    required return exceeded 28.5 percent, we would reject it.

    In our example, the NPV rule and the IRR rule lead to identical accept-reject decisions.

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