BCOM/BPL/BPM/BSC.

IBM

BAM 2205/CAM 205: PROJECT MANAGEMENT

CAPITAL PROJECT EVALUATION TECHNIQUES:

Introduction
A capital project is a long-term investment which requires the use of huge amounts of capital,
both financial and labour, to undertake and complete. E.g. a new building, acquisition of land or
property, l ease of property, the refurbishment of an existing building, purchase of an equipment,
etc The commitment of funds to capital projects gives rise to a management decision problem,
the solution of which, if incorrectly arrived at, may seriously impair company profitability and
growth. The proper use of evaluation techniques and criteria should enable management to make
more effective decisions which result in future success. The purpose of investment appraisal is to
evaluate whether or not the current sacrifice is worthwhile. The techniques are broadly classified
into two categories;
1. Traditional techniques:-They do not consider time value for money thus no discounting.
a. Cost/benefit analysis (CBA)
b. Accounting rate of return method (ARR)
c. Payback period method (PBP)
2. Modern techniques: - They consider time value for money, the cash flows are therefore
discounted.
d. Net present value method (NPV)
e. Profitability index method (PI)
f. Internal rate of return method (IRR)

1. Cost/benefit analysis
Cost–benefit analysis (CBA), sometimes called benefit–cost analysis (BCA), is a systematic
process for calculating and comparing benefits and costs of a project. It has two purposes:
 To determine if it is a sound investment project
 To provide a basis for comparing projects.
It involves comparing the total expected cost of each option against the total expected benefits, to
see whether the benefits outweigh the costs, and by how much.
The following is a list of steps that comprise a generic cost–benefit analysis.
i. List alternative projects.
ii. List the stakeholders.
iii. Select measurement(s) and measure all cost/benefit elements.
iv. Predict outcome of cost and benefits over relevant time period.
v. Convert all costs and benefits into a common currency.
vi. Apply discount rate.
vii. Calculate net present value of project options.

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viii. Perform sensitivity analysis.
ix. Adopt recommended choice.

2. Accounting rates of return (ARR)

This technique uses accounting information as revealed by the financial statements to measure
the profitability of the investment.
Averageincomeaftertaxanddepreciation
ARR= ×100
Average investment

Initial Investment +residual value

Average investment =
2
Acceptance criterion
 Management should establish the minimum ARR for its projects
 A project whose ARR is higher than the management’s ARR should be accepted and vice
versa.
 If the projects are mutually exclusive, chose the one with the highest ARR
Strengths of ARR
i. Simple to understand and use.
ii. Calculate from accounting data which is readily available from financial statements
of a business organization.
iii. Uses returns from entire life of the project to determine project profitability.

Weaknesses of ARR
i. Ignores time value of money.
ii. Uses accounting profits and not cash flows in appraising. Projects. Accounting profits
include non-cash items.
iii. There is no universally acceptable way of computing ARR and this means different
parties can come up with different rates depending on the formula used.

QUESTION ONE
The management of ABC Ltd anticipates purchasing one of the two pump models below. Model
X has an initial cost outlay of Ksh 1,500,000 while Model Y has an initial cost outlay of Ksh
1,800,000. Both have a useful life of 5 years.
The corporation tax rate is 30% and the required rate of return (cost of capital) is 20%. The
pumps are depreciated using straight line method. The cash flows before tax and depreciation
expected to be generated by the projects are as follows:

Year 1 2 3 4 5
Model X 600,000 800,000 700,000 800,000 900,000
Model Y 800,000 800,000 800,000 800,000 800,000

Required:
a) Determine the cash flows after tax

Solution: CAT = (CBT – Dep.) 1-t + Dep. Or CAT = (CBT) 1-t + Dep. Tax shield

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MODEL X CBT TAX TAX SHIELD CAT PVIF PV
30% 30%300,000 (1+r)-n
1 600,000 -180,000 90,000 510,000 (1.2)-1 425,000
2 800,000 -240,000 90,000 650,000 (1.2)-2 451,389
3 700,000 -210,000 90,000 580,000 (1.2)-3 335,648
4 800,000 -240,000 90,000 650,000 (1.2)-4 313,469
5 900,000 -270,000 90,000 720,000 (1.2)-5 289,352
760,000 PVCIF 1,814,858
PVCOF -1,500,000

MODEL Y CBT TAX TAX SHIELD CAT PVIF PV

30% 30%300,000 (1+r)-n
1 800,000 240000 108000 668,000 (1.2)-1 556,667
2 800,000 240000 108000 668,000 (1.2)-2 463,889
3 800,000 240000 108000 668,000 (1.2)-3 386,574
4 800,000 240000 108000 668,000 (1.2)-4 322,145
5 800,000 240000 108000 668,000 (1.2)-5 268,454
PVCIF 1,997,729
PVCOF 1,800,000

Annual Dep. = (Initial capital - residue/salvage value) / useful life

Model X: (1,500,000 – 0 ) / 5yrs = 300,000

Model Y: (1,800,000 – 0 ) / 5yrs = 360,000

b) Compute the AAR, PBP, NPV, PI and IRR for each project

i) ARR = Ave. PAT / Ave. Investment

where Ave. Investment = (Initial capital + Residue) / 2

Where Ave PAT = (CBT – Dep) 1-t

Model X:

Ave PAT = (760,000 – 300,000) 1-0.3 = 322,000

Ave Investment = (1,500,000 + 0) / 2 = 750,000

ARR = 322,000 / 750,000 x 100 = 42.9%

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Model Y:

Ave PAT = (800,000 – 360,000) 1-0.3 = 308,000

Ave Investment = (1,800,000 + 0) / 2 = 900,000

ARR = 308,000 / 900,000 x 100 = 34.2%

ii) PBP

Model X (Capital 1,500,000)

Year Recovery Balance

1 510,000 1.5M – 510,000= 990,000
2 650,000 990,000 – 650,000= 340,000
3 = (0.586) 340,000 / 580,000
PBP = 2.586 yrs or 2 years and 7 months

Model Y: PBP = 1,800,000 / 668,000 = 2.69 yrs or 2 years and 8 months

iii) PI = PVCIF / PVCOF

Model X: 1,814,858 / 1,500,000 = 1.2 > 1

Model Y: 1,997,729 / 1,800,000 = 1.1 > 1

c) Advice the management on the pump model to purchase

3. Payback Period Method

Payback refers to the duration required for the project to recoup or recover the initial
investment cost. Initial investment cost is recovered from the future cash inflows expected
from the project. If the project generates a constant annual cash inflows, its payback period is
computed by dividing the initial investment cost by the annual constant cash inflows.

Initial Investment
PBP=
annual constant cash inflows ¿
¿
If the project undertaken is to yield unequal cash inflows, its PBP can be determined by
adding up the cash inflows until the total cash inflows are equal to the initial investment cost.
It is assumed that the cash inflows are evenly generated and that cash inflows for a fraction
of a year can be calculated proportionately.
PBP=Year befor full recovery +Cash balnce ¿ payback ¿
Cash recieved the following year

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 Acceptance criteria
 The management should fix the maximum acceptable PBP for its future projects
 Project whose PBP is less than the managements PBP should be accepted and vice versa.
 If the projects are mutually exclusive, the one with the smallest PBP

Strengths of payback period method include the following:

i. It is simple to understand and easy to calculate
ii. It chooses ventures with the shortest payback period and this minimizes the risks
associated with returns which will be generated some time in future and which may
be uncertain.
iii. Choosing of the ventures with the shortest payback period improves the liquidity
position of the company
iv. Payback period is realistic for those companies that which to re-invest intermediary
returns.

Weaknesses of payback period method include the following:-

i. It ignores the time value of money.
ii. It ignores cash flows after the payback period
iii. There is no rational basis for setting a maximum payback period
iv. It’s not consistent with the objectives of maximizing the market value of firms shares.
Shares values do not depend on payback period of investment projects.
v. When the project does not yield uniform returns payback period will not be accurate as it
will assume that cash flows occurs evenly throughout the year which is unrealistic

4. Net Present Value (NPV)

This technique recognizes the fact that cash flows arising at different time period differ in value
and are comparable only where their present values are determined. NPV is the difference
between the present value of cash inflows and the present value of cash outflows.

Decision criterion
 Undertake projects with positive NPV
 Reject projects with negative NPV
 If the projects are mutually exclusive, choose the one with the highest positive NPV

Strengths of NPV
i. It recognizes the time value of money.
ii. It takes into account cash flows over the entire life of the project to determine the
project viability.
iii. It ranks projects according to their true profitability
iv. It uses cash flows and not profits and therefore gives a reasonable assessment of the
investment viability.
v. It is consistent with the value additively principle. The NPV’s of various projects can
be added together to determine the increase in the value of the firm.

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 Weaknesses of NPV
i. It is more difficult to use compared to the traditional methods.
ii. It use the firms cost of capital to discount the cash flows. It thus assumes that the
firms cost of capital is always available for use and is easy to calculate which is not
the case.
iii. It is only ideal in ganging the profitability of investments similar in a number of
aspects such as similar economic life, similar initial cost, etc.
iv. It ignores risks associated with an investment. All the firm’s future projects are
evaluated using the same discount rates irrespective of the differences in their level of
risk.
v. Use of the firms cost of capital as an investment discount rate to be applied to the
firms future project is based on the assumption that the firm’s future projects will bear
the same risks as the current projects which is unlikely.
vi. It involves estimates of future cash flows which is a tedious task.

5. Profitability Index (PI) or benefit Cost Ratio (BCR)

Profitability index is the ratio of cash inflows to the initial cost of the project.
Present Value of cash inflow
PI =
Initial Cost
Decision criterion
 Undertake projects whose PI>1
 Reject projects whose PI<1
 If the projects are mutually exclusive, choose the one with the highest PI

Strengths of PI
i. Recognizes time value of money
ii. Takes into account cash flows over the entire life of the project
iii. Uses cash flows and not profits and therefore gives a reasonable assessment of the
investment viability.

Weaknesses of PI
i. Difficult to use compared to the traditional methods
ii. Assumes that the firm cost of capital is always available for use and easy to calculate
which not the case is.
iii. Involves estimates of feature cash flows which is a tedious task
iv. Ignores risks associated with an investment. All the firms’ future projects are evaluated
using the same discount rates irrespective of the difference in their level of risks.

6. Internal rate of return (IRR)

IRR is the discount rate at which the NPV of a project is zero. IRR is calculated by trial and
error method where two net present values will be calculated one of which will be positive and
the other negative. For better accuracy the two net present values should be as close to zero as
possible. Then the following formula is used to calculate IRR:

NPV at lower rate

IRR=Lower rate+
Absolute ∑ ¿ ×(Higher rate−Lower rate)¿

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Steps to follow when calculating IRR
i. Calculate the NPV of the project using the cost of capital given.
ii. If the NPV calculated above is positive, recalculate NPV of the project using a higher
trial discounting rate in order to obtain a negative NPV.
iii. If the NPV obtained in (i) above is negative recalculate NPV of the project using a lower
trial discounting rate to obtain a positive NPV.
iv. Use the formula given above to calculate IRR of the project.

Decision criterion
 Undertake projects whose IRR> cost of capital
 Reject projects whose IRR<Cost of capital
 If the projects are mutually exclusive, chose the one with the highest IRR

Strengths of IRR
ii. Takes into account time value of money.
iii. Considers cash flows occurring over the entire life of the project.
iv. Ranks projects according to their true profitability giving the same result as NPV method.
v. It is consistent with shareholders wealth maximization objectives
vi. Uses cash flows and not profits and therefore it gives a reasonable assessment of the
project profitability.

Weakness of IRR
i. May involve tedious calculations
ii. May yield multiple and negative rates of return which may not have any meaning.
iii. Not consistent with value addivity principle. IRR of various projects cannot be added
together to give the firms additional wealth from the projects.
iv. Requires estimates of cash flows which is a difficult task.

Lecturer: Kimani JM (CPA)

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