LESSON 2

PROJECT ANALYSIS

Introduction:

This lesson seeks to introduce the learner to the concepts and methods used to analyze projects as a way of
assessing project viability.
 Project identification
 Identification of investment opportunities
 Market and demand analysis
 Technical analysis
 Financial analysis
 Institutional analysis,
 Economic analysis
 Other analysis

The lesson covers topic 2 of the course syllabus

Project Analysis
Project analysis is a process of detailed examination of several aspects of a given project before
recommending the same. The institution that is going to fund the project has to satisfy itself before
providing financial assistance for the project. It has to ensure that the investment on the proposed
project will generate sufficient returns on the investments made.

Project analysis is at times referred to Project Appraisal.

Development projects impose a series of costs and benefits on recipient communities or countries. Those
costs and benefits can be social, environmental, or economic in nature, but may often involve all three. In
addition to being financially viable, a development project cannot usually be considered acceptable unless
it is economically, technically and institutionally sound. It should be the least-cost feasible solution to the
problem being solved and should expect to produce net economic and/or social benefits. For example,
irrigation projects may facilitate the growing of cash crops in one locality, but cause water shortages, and
hence economic, social and environmental pressures in another.

Analysis checks that the project is feasible against the situation on the ground that the objectives set
remain appropriate and that costs are reasonable.

The following analyses are done:

1. Technical analysis
Technical appraisal broadly involves a critical study of the following aspects of a project:
 a) Scale of operations: Scale of operation is signified by the size of the plant. The plant size mainly
depends on the market for the output of the project.

b) Selections of process/technology: the choice of technology depends on the number/ types

available and also on the quality and quantity of products proposed to be manufactured.

c) Raw materials: Products can be manufacture using alternative raw materials and with
alternative process. The process of manufacture may sometimes vary with the raw materials
chosen.

d) Technical know-how: When the technical know-how for the project is provided by expert
consultants, it must be ascertained whether the consultants has the requisite knowledge and
experience and whether he has already executed similar projects successfully, care should be
taken to avoid self- styled, inexperienced consultants.

e) Product mix: Consumers differ in their needs and preferences. Hence variations in size and
quality of products are necessary to satisfy the varying needs and preferences of customers.
In order to enable the project to produce goods of varying size nature and quality as per
requirements of the customers, the production facilities should be planned with an element
of flexibility. Such flexibility in the production facilities will help the organization to change
the product mix as per customer requirements, which is very essential for the survival and
growth of any organization.

f) Selection and procurements of plant a machinery: when selecting plant machinery

several factors need to be considered they include output planned, machine hours required
for each operation, machine capacity, machine available in the market etc plant and
machinery form the backbone of any industry the quality of output depends upon the
quality of machinery used in processing the raw materials.

g) Plant layout: This is the arrangement of various production facilities within the production
area, plant layout should be so arranged as to ensure steady flow of production and
minimizes the overall cost. Some of the consideration include: future expansions, supervision
required, inspection, safety requirements etc.

h) Location of projects: Several factors need to be considered in choosing the location of

project they include, regional factors – raw materials, proximity to market, availability of labor,
availability of supporting industries availability of infrastructure facilities, climatic factors etc.

i) Project scheduling : this is the arrangement of activities of the project in the order of time
in which they are to be performed.

2. Commercial/market Analysis
This is concerned with the market for the product /service. Commercial appraisal (or market appraisal of a
project) is done by studying the commercial successfulness of the product/service offered by the project
from the following perspectives:
a) Supply position for the product
b) Distribution channels
c) Pricing of the product
 d) Government policies
e) What is the aggregate demand of the proposed projects product
f) What would be the projects market share

The following information is analyzed:

g) Cost structure
h) Imports and exports
i) Structure of competition
j) Elasticity of demand
k) Distribution channels
l) Past and present supply position
m) Production possibilities and constraints

3. Economic Appraisal
Economic appraisal measures the effect of the project on the whole economy. In the overall interest of the
country, the limited stocks of capital and foreign exchange should be put into the best possible use, hence
policy makers are concerned as to where the scarce resources can be directed to maximize economic
growth of the country, the policy makers make a choice based on economic returns.

Here the appraisers will also seek to establish how well the project fits in the economic times of the day
e.g. a luxury product project is less likely to succeed in the market at times of economic recession but
more likely to succeed during times of economic boom.

Economic analysis will also look at:

 Social cost -benefit analysis
 Direct economic benefits and costs in terms of shadow prices
 Impact of project on distribution of income in society
 Impact on level of savings and investments in society
 Impact on fulfillment of national goals :-

(1) Self-sufficiency (2) Employment and (3) Social order

4. Financial Appraisal
Financial analysis looks at whether the project is financially viable? Will the project be able to:
 Service debts
 Meet return expectations
The following aspects are also examined:
 Means of financing
 Cost of capital
 Project profitability
 Breakeven point
 Cash flows
 Level of risks
 Projected financial position
This include appraising the project using financial analysis tools which include but are not limited to the
following:

Discounted cash flow techniques

 Net present value methods
 Internal Rate of return
 Profitability index methods
 Benefit cost ratio method

Non-discounted cash flow techniques

 Payback period method
 Accounting rate of return method

The selection criteria is as follows:

Criterion Accept project if : Reject project if :
Pay back period (PBP) PBP< target period PBP> target period
Accounting rate of return (ARR) AAR>target rate AAR<target rate
Net present value (NPV) NPV>0 NPV<0
Internal rate of return (IRR) IRR>cost of capital IRR<cost of capital
Benefit cost ratio (BCR) BCR>1 BCR<1

Table 2.1 financial selection criteria

To apply these criteria suitably Cut off values have to be specified. This will be the standards against
which the projects are evaluated and are computed from a combination of risks and financing costs
prevailing in the market. Such cut off values include: hurdle rate, target rate and cost of capital.

5. Management Appraisal
Management is the most important factor that can either make a project successful or a failure. A good
project at the hands of poor management may fail while not-so-good project at the hands of an effective
management may succeed. Banks and financial institution that lend money for financing project lay more
emphasis on management appraisal.

Lending institution looks at two points before committing their funds to project financing.
a) Capacity of project to repay the loan along with the interest within stipulated period of time.
b) Willingness of the borrower to repay the loan

While the capacity to repay is assessed by technical, commercial and financial appraisals, the willingness
to repay is assessed by way of management appraisal.

Whereas other appraisal techniques are quantitative and objective in nature, management appraisal is
purely qualitative and subjective in nature. Integrity, foresightedness, leadership qualities, inter-personal
relationship, technical and financial skills, commitment, perseverance etc. are some of the parameters that
needs to be studied in management appraisal.
The following are some of the factors that will reflect the managerial capabilities of person concerned.
a) Industrial relations prevailing in that enterprise
b) Morale of employees, the prevailing superior-subordinate relationship
c) Labour turnover
d) Labour unrest
e) Productivity of employees etc

6. Social Cost Benefit Analysis

There are some projects that may not offer attractive returns as far as commercial profitability is
concerned. But still such project are still undertaken since they have high social benefits e.g. Roads,
Railway, Bridge, Irrigation, power projects e.t.c

The objectives of socio-cost benefit analysis include:

a) Assessing the Contribution of the project to the GDP (Gross domestic product) of the economy.
b) Assessing the Contribution of the project to improve the benefit to the poorer section of the society
and reduces the regional imbalances in growth and development
c) Justifying the use of scarce resources of the economy by the project.
d) Assessing the Contribution of the project in protecting/improving the environment conditions.

This is the kind of appraisal used for government utility projects. Even if the government may at times use
such methods as Net present value and Internal rate of return (see lesson 3) to appraise some projects,
ultimately the cost benefit analysis and its variation: cost benefit ratio will be used for decision making.

7. Ecological Analysis
In recent years, environmental concerns have assumed a great deal of significance-and rightly so.
Ecological analysis should be done particularly for major projects which have significant ecological
implications (like power plants and irrigation schemes) and environment-polluting industries (like bulk
drugs, chemicals, and leather processing). However, today the law requires that virtually all projects go
through environmental impact assessment. The key questions raised in ecological analysis are:

 What is the likely damage caused by the project to the environment?

 What is the cost of restoration measures required to ensure that the damage to the environment is
contained within acceptable limits?
 Is the company able to pay for such damage?
 Analysis of Impact of project on quality of :- Air, Water, Noise, Vegetation, Human life
 Done for Major projects ,such as these, cause environmental damage eg Power plants, irrigation
schemes, fertilizer factories e.t.c

8. Social and Gender Analysis

What will be the effect of the project on different groups, at individual household and community
levels? How will the project impact on women and men? How will they participate in various stages
of the project cycle? Will the social benefits of the project be greater than the social costs over the
life of the investment when account is taken of time?

9. Institutional Analysis:
 Are the supporting institutions in place? Can they operate effectively within the existing legislative
and policy environment? Has the project identified opportunities for institutional strengthening and
capacity building?

10.Political Analysis:
Will the project be compatible with government policy, at both central and regional levels?

11.Sustainability and Risk Analysis:

Will the project be exposed to any undue risks? Will the project benefits be sustainable beyond the life
of the project?

Module prepared by Stephen Kamau

Review questions:

1. Why is it important to analyze proposed projects before planning and implementing then?

2. Which stage of the project cycle does ‘project analysis’ belong? Discuss.

3. Discuss the various project analyses that need to be carried out before a project can be
selected for planning and implementation.

4. Why is institutional and political analysis important for a new project?

5. Market analysis and financial analysis are important and yield a ‘go’ or ‘no go’ decision.
Explain.
 LESSON 3
FINANCIAL PROJECT APPRAISAL

Introduction:

This lesson explores further the concepts of project analysis. The lesson focus on financial
appraisal of projects. The following concepts are covered:
 Financial appraisal of projects,
 Non discounted methods of appraising projects
 Discounted methods of project appraisal
 Appraising utility projects

The lesson covers topic 3 of the course syllabus.

Investments

Any act which involves the sacrifice of an immediate and certain level of consumption in
exchange for the expectation of an increase in future consumption. Investments entail forgoing
the present consumption in order to increase resources in future.

A project is an investment whether for profit or not for profit and hence we shall refer to a
project as an investment in this lesson.

Types of Capital Investments.

Capital investments vary but can be broadly categorized as follows:
a) Replacement of obsolete assets
b) Cost reduction e.g. IT system
c) Expansion e.g new building & equipment
d) Strategic proposal: improve delivery service, staff training.
e) Diversification for risk reduction

Need for Investments Appraisal

The need exists for organisations to apprise their investment projects for among others the
following reasons:
a) Large amount of resources are involved and wrong decisions could be costly.
b) Investment decisions are difficult and expensive to reverse
c) Investment decisions can have a direct impact on the ability of the organisation to meet
its objectives
Investment Appraisal Process
Investment appraisal process follows the following stages:

a) Identify objectives. What is it? Within the corporate objectives?

b) Identify alternatives. E.g. use computer aided design (CAD), computer aided manufacture
(CAM) or use external service.
c) Collect and analyse data. Examine the technical and economic feasibility of the project,
cash flows etc.
d) Decide which one to undertake
e) Get Authorisation
f) Implement
g) Review and monitor: learn from its experience and try to improve future decision -
making.
Investment Appraisal Methods
In undertaking investment appraisal we consider two broad categories of projects by their
objectives:

1. Cash flow projects

This are projects that produce goods or services that are then sold. They can be profit
making projects or nonprofit making projects.

A company may develop a new product for sale in the market: this is a profit making
cash flow project. The government may build a hospital and require that the hospital be
self-sustaining- this is a not for profit cash flow project.

The following are the key methods used to appraise such projects:

a) Non-discounted Cash Flow Criteria

 Payback Period (PB)
 Accounting Rate of Return (ARR)
b) Discounted Cash Flow (DCF) Criteria
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Profitability Index (PI)

2. Non cash flow projects

These are projects whose output of goods and or services is not sold but is for utility purposes. In
most cases such projects produce merit goods that are difficult to exclude users. Examples
include: roads, bridges, security services and peace. Usually the government will invest in such
projects without expecting direct returns from the project but expecting indirect returns. A road
constructed in a rural area may not generate income for the government but opens up the area for
more economic activities and development increasing the incomes of the people and
consequently the tax paid to the government.

For such projects the appraisal methods used compare the projects benefits against its costs. Two
variations of this approach are
 Benefit Cost Ratio (BCR) method
 Cost Benefit Analysis (CBA) method

1. Non-discounted Cash Flow methods

2. Payback period

Payback period is the time in which the initial cash outflow of an investment is expected to be
recovered from the cash inflows generated by the investment. It is one of the simplest investment
appraisal techniques. The time can be in months, years, weeks or even days.

The formula to calculate payback period of a project depends on whether the cash flow per
period from the project is even or uneven. In case the cash flow per period are even, the formula
to calculate payback period is:

Initial Investment
Payback Period =
Cash Inflow per Period

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period
and then use the following formula for payback period:

B
Payback Period = A +
C

In the above formula,

A = Last period with a negative cumulative cash flow;
B = Absolute value of cumulative cash flow at the end of the period A;
C = Actual Cash Flow during the period after A

Both of the above situations are applied in examples that follow.

Decision Rule

Accept the project if its payback period is LESS than the target payback period. Do not accept
otherwise. The method favors projects with the shortest payback period in that they present less
risk period of the investment and from an accounting point of view revenue collections is done
early and in a short period of time.
Example 3.1: Even Cash Flows
Company C is planning to undertake a project requiring initial investment of $100 million. The
project is expected to generate $25 million per year for 10 years. Calculate the payback period of
the project.

Solution
Payback Period = Initial Investment / Annual Cash Flow = $100M / $25M = 4 years

Example 3.2: Uneven Cash Flows

Company C is planning to undertake another project requiring initial investment of $50 million
and is expected to generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3,
$19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the project.

Solution

(cash flows in millions) Cumulative

Year Cash Flow Cash Flow
0 (50) (50)
1 10 (40)
2 13 (27)
3 16 (11)
4 19 8
5 22 30

Payback Period = 3 + ( |-$11M| / $19M )

Payback Period = 3 + ( $11M / $19M )
Payback Period = 3 + 0.58
Payback Period = 3.58 years

Example 3.3
A machine costs £600,000. Annual income streams from investment = £255,000 per year
Appraise the investment using the payback period.

Solution

Income Cumulative

Year 1 255,000 255000

Year 2 255,000 510000

Year 3 255,000 765000

Payback formula
2 years = 255,000 + 255,000 = 510,000 = 2 years & some months….

600,000 - 510,000 = 90,000 still owing from years 3’s 255,000 income

Payback = 2 years + 90000/255000 = 2.352 years or 2 years 5months

Alternative method:

Payback formula
Payback period = 600,000/255000 = 2.35 years

Example 3.4

LBS Ltd uses the payback period as its sole investment appraisal method. LBS invests £30,000
to replace its computers and this investment returns £9,000 annually for the five years. From the
information above evaluate the investment using the payback. Assume that £9,000 accrues
evenly throughout the year.

Solution

Year Yearly cash flow cumulative net cash flow

£ £
0 (30,000) (30,000)
1 9,000 (21,000
2 9,000 (12,000) 3
9,000 (3,000)
4 9,000 6,000
5 9,000 15,000

Therefore 3years = 27,000 then 3000/9000 x 12 = 4

Payback period = 3 years 4months

Advantages and Disadvantages of Payback Period:

Advantages:
 Simplicity- it is simple to compute
 Risk shield – it favours projects with less risks
 Liquidity- favours projects that improves the liquidity of the organisation

Disadvantages
 Cash flows after payback are ignored
 Ignores time value of money
  Ignores the risks of future cash flows
 Inconsistent with shareholder value

3. Accounting Rate of Return (ARR)

Accounting Rate of Return method relates average annual profit to either the amount initially
invested or the average investment, as a percentage.

Formulae:

ARR = Average annual accounting profit x 100

Average investment

Or

ARR = Average income x 100

Average investment

Or

ARR = Average annual accounting profit x100

Initial investment

Where:
 Average annual profit = Total profit/Number of years
 Average investment = (initial capital investment + scrap value) / 2

The method is largely used in accounting.

Decision rule

This method will accept all those projects whose ARR is higher than the minimum rate
established by the management and reject those projects which have ARR less than the minimum
rate.

This method would rank a project as number one if it has highest ARR and lowest rank would be
assigned to the project with lowest ARR.

Example 3.5

Using the data below, calculate the ARR

Year 0 1 2 3 4
Cash flows (£45,000) 11,000 12,250 12,250 32,000
Depreciation (11,250) 11,250) (11,250) (11,250)
Accounting profit (250) 1,000 1,000 20,750

Solution

Average Accounting Profit is calculated as (- 250 +1000 + 1000 + 20,750) / 4 = 5625

Average investment = 45,000 / 2 = 22500

ARR = (5625/22,500 x 100) = 25%

Example 3.6

A project involves the immediate purchase of plant at a cost of £110,000. It would generate
annual profits before depreciation of £24,000 for five years. Scrap value will be £10,000 at the
end of the fifth year.

Requirement
Calculate the ARR using the initial and average investment.

Solution
(a) Using initial investment
Average profit = Profits before depreciation – depreciation
5

= (£24,000 × 5) – (£110,000 – £10,000)

5
= £4,000 p.a.

ARR = £4,000×100%
£110,000

= 3.6%

(b) Using average investment

= £4,000×100%
£(110,000 + 10,000)/2

= 6.7%

Advantages and disadvantages of ARR

The ARR method has the serious disadvantage that it does not take account of the timing of the
profits from a project. Whenever capital is invested in a project, money is tied up until the
project begins to earn profits which pay back the investment. Money tied up in one project
cannot be invested anywhere else until the profits come in. Management should be aware of the
benefits of early repayments from an investment, which will provide the money for other
investments.

Other disadvantages.
a) It is based on accounting profits rather than cash flows, which are subject to a number of
different accounting policies
b) It is a relative measure rather than an absolute measure and hence takes no account of the
size of the investment
c) It takes no account of the length of the project
d) Like the payback method, it ignores the time value of money

Advantages of the ARR method.

a) It is quick and simple to calculate
b) Accounting profits can be easily calculated from financial statements
c) It looks at the entire project life
d) Managers and investors are accustomed to thinking in terms of profit, and so an appraisal
method which employs profit may be more easily understood
e) It allows more than one project to be compared

Discounted Cash Flow methods

Present Value
What is present value of a sum of cash flow? It can be looked at as today’s value of a
payment (or cash inflows) to be received at future dates. It is the value in today’s
money value of a future payment or series of payments, discounted at the appropriate
discount rate.

What determines this present value?

a) The amount of the payment or payments, of course
b) When in the future the payment(s) is to be made
c) The earning power of money over that future period of time-—the appropriate
interest rate to use to discount the future dollar amounts.

Specifically: (other things constant)

a) The greater the amount of the payment(s), the greater the present value.
b) The more distant the future payment(s), the lower the present value.
c) The higher the interest/discount rate, the lower the present value.

Present value can also been seen to answer the question of how much money would have to be
set aside today—and invested (at the appropriate interest rate)—in order to accumulate the target
(payment) amount by the payment date.
Money loose value overtime due to inflation, changes in exchange rates and variations of the
economic environment. The concept of real value of money (how much it can buy) and nominal
value (face value) of money is in use here. If you take a sum of money e.g. shillings 1000 in a
market where the price of bread is shillings 40; the nominal value is 1000 shillings but the real
value is 25 loaves of bread. A year later if the price of bread rise to 50 shillings, then 1000
shillings has a real value of 20 loaves. So the nominal value remains but the real value has
reduced. Simply put 1000 shillings today is more than 1000 shillings next year in an inflationary
economy.

In a project, a cash flow to be realised in year 5 for example cannot be compared with a cash
flow to be realised in year 2 or the investment in year 0 as they all represent different real value
of money. They then have to be converted to one value of money usually the present value of
money at the time of investing i.e. year 0.

Discounting

Discounting starts with the future value (a sum of money receivable or payable at a future date),
and converts the future value to a present value, which is the cash equivalent now of the future
value.

For example, if a company expects to earn a (compound) rate of return of 10% on its
investments, how much would it need to invest now to have the following investments?
(a) £11,000 after 1 year
(b) £12,100 after 2 years
(c) £13,310 after 3 years

The answer is £10,000 in each case, and we can calculate it by discounting.

The discounting formula to calculate the present value (PV) of a future sum of money (FV) at the
end of n time periods is:

PV = FV/(1+r)n

Since 10%= 0.1 then 1+ r = 1.1

(a) After 1 year, £11,000/1.10 = £10,000

(b) After 2 years, £12,100/(1.10)2 = £10,000
(c) After 3 years, £13,310/(1.10)3 = £10,000

The timing of the cash flows is taken into account by discounting them. The effect of discounting
is to give a bigger value per £1 for cash flows that occur earlier: £1 earned after one year will be
worth more than £1 earned after two years, which in turn will be worth more than £1 earned after
five years, and so on.
The discount rate (r) used when calculating the present value is the relevant interest rate (or cost
of capital) to the entity in question, it is also the return rate of the opportunity cost of the
investment being apprised. In the exam this will always be made clear.

Discounting therefore allows comparison of an investment by valuing cash payments on the

project and cash receipts expected to be earned over the lifetime of the investment at the same
point in time, i.e. the present.

The discounting formula we will be using is therefore:

Future Value
Present Value = -----------------
(1 + r)n
Where r = interest rate
n = number of years

Which can be re-written as:

Present Value = future value x 1/(1+r)n

In this case 1/(1+r)n is a multiplier called the discounting factor. Discounting factors can be
calculated and used to discount cash flows by multiplying the future value with the respective
discounting factor.

The Present Value of £1 at 10% in 1 years’ time is 0.9090. i.e. 1/(1+0.1)1

In this case 0.9090 is a discounting factor corresponding to a discounting rate of 10% in year 1.

For year zero the discounting factor is always=1, found as 1/(1+r)0

If you invested 0.9090p today and the interest rate was 10% you would have £1 in a years’ time

Discounting factors are then calculated at various discounting rate for various years to produce a
table as the one below. We then use the table to discount by multiplying the discounting factors
with cash flows as an alternative to applying the formula as a whole. This makes calculations
easy for projects with long life in years.

TABLE 1: Discounting factors table.

PV of $1 discounting rate
year 1% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% 12.0%

0 1 1 1 1 1 1 1 1 1 1 1
 1 0.99010 0.98039 0.97087 0.96154 0.95238 0.94340 0.93458 0.92593 0.91743 0.90909 0.89286

2 0.98030 0.96117 0.94260 0.92456 0.90703 0.89000 0.87344 0.85734 0.84168 0.82645 0.79719

3 0.97059 0.94232 0.91514 0.88900 0.86384 0.83962 0.81630 0.79383 0.77218 0.75131 0.71178

4 0.96098 0.92385 0.88849 0.85480 0.82270 0.79209 0.76290 0.73503 0.70843 0.68301 0.63552

5 0.95147 0.90573 0.86261 0.82193 0.78353 0.74726 0.71299 0.68058 0.64993 0.62092 0.56743

6 0.94205 0.88797 0.83748 0.79031 0.74622 0.70496 0.66634 0.63017 0.59627 0.56447 0.50663

7 0.93272 0.87056 0.81309 0.75992 0.71068 0.66506 0.62275 0.58349 0.54703 0.51316 0.45235

8 0.92348 0.85349 0.78941 0.73069 0.67684 0.62741 0.58201 0.54027 0.50187 0.46651 0.40388

9 0.91434 0.83676 0.76642 0.70259 0.64461 0.59190 0.54393 0.50025 0.46043 0.42410 0.36061

10 0.90529 0.82035 0.74409 0.67556 0.61391 0.55839 0.50835 0.46319 0.42241 0.38554 0.32197

11 0.89632 0.80426 0.72242 0.64958 0.58468 0.52679 0.47509 0.42888 0.38753 0.35049 0.28748

12 0.88745 0.78849 0.70138 0.62460 0.55684 0.49697 0.44401 0.39711 0.35553 0.31863 0.25668

13 0.87866 0.77303 0.68095 0.60057 0.53032 0.46884 0.41496 0.36770 0.32618 0.28966 0.22917

14 0.86996 0.75788 0.66112 0.57748 0.50507 0.44230 0.38782 0.34046 0.29925 0.26333 0.20462

15 0.86135 0.74301 0.64186 0.55526 0.48102 0.41727 0.36245 0.31524 0.27454 0.23939 0.18270

Table 2: present values

4. Discounted Payback Method

Unlike simple payback this method takes into account the fact that money values change with
time. It recognises the time value of money.

The method entails discounting the cash flows first then calculating payback period using the
discounted cash flows (present value cash flows) using procedures discussed earlier (under
payback period)

Example 3.7

Two projects P and Q have an initial investment of 4000 rupees and the following cash flows

Cash Flows (Rs) Ci

Year 1 Year 2 Year3 Year 4
P 3,000 1,000 1,000 1,000
Q 0 4,000 1,000 2,000

Appraise the two projects using

i. Simple payback
ii. Discounted payback
The opportunity cost of capital is 10%
Solution

Cash Flows
(Rs) Simple Discounted
C0 C1 C2 C3 C4 PB PB
P -4,000 3,000 1,000 1,000 1,000 2 yrs –
PV of cash flows -4,000 2,727 826 751 683 2.6 yrs
Q -4,000 0 4,000 1,000 2,000 2 yrs –
PV of cash flows -4,000 0 3,304 751 1,366 2.9 yrs

5. Net Present Value (NPV)

Net Present Value (NPV) - the difference between the present values of cash inflows and
outflows of an investment. Present value as seen earlier refers to the amount of money you must
invest or lend at the present time so as to end up with a particular amount of money in the future.

Net Present Value of an Investment is the present value of all its present and future cash flows,
discounted at the opportunity cost of those cash flows. NPV is mathematically represented as:

CF1 CF2 CF3 CFn

NPV  CF0    .....
(1  r ) (1  r ) (1  r )
1 2 3
(1  r )n
Where: CF0 = Cash flow at time zero (t0)- usually a negative value since it represents cash
outflow in the form of initial investment

CF1 = Cash flow at time one (t1), or year 1

r is the discounting rate

Discounted cash flow (DCF) techniques are used in calculating the net present value of a series
of cash flows. This measures the change in shareholder wealth now as a result of accepting a
project.

NPV = present value of cash inflows - present value of cash outflows

Decision rule
If the NPV is positive, it means that the cash inflows from a project will yield a return in excess
of the cost of capital, and so the project should be undertaken if the cost of capital is the
organisation's target rate of return.

If the NPV is negative, it means that the cash inflows from a project will yield a return below the
cost of capital, and so the project should not be undertaken if the cost of capital is the
organisation's target rate of return.
If the NPV is exactly zero, the cash inflows from a project will yield a return which is exactly
the same as the cost of capital, and so if the cost of capital is the organisation's target rate of
return, the project will have a neutral impact on shareholder wealth and therefore would not be
worth undertaking because of the inherent risks in any project.

The NPV method can be used to select between mutually exclusive projects; the one with the
higher NPV should be selected.

Example 3.8

Assume that Project X costs Rs 2,500 now and is expected to generate year-end cash inflows of
Rs 900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1 through 5. The opportunity cost of the
capital may be assumed to be 10 per cent.

Solution

 Rs 900 Rs 800 Rs 700 Rs 600 Rs 500 

NPV    2
 3
 4
 5 
 Rs 2,500
 (1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10) 
NPV  [Rs 900(PVF1, 0.10 ) + Rs 800(PVF2, 0.10 ) + Rs 700(PVF3, 0.10 )
+ Rs 600(PVF4, 0.10 ) + Rs 500(PVF5, 0.10 )]  Rs 2,500
NPV  [Rs 900  0.909 + Rs 800  0.826 + Rs 700  0.751 + Rs 600  0.683
+ Rs 500  0.620]  Rs 2,500
NPV  Rs 2,725  Rs 2,500 = + Rs 225

Note: the same question can be done using discounting factors as given in table 1.

Example 3.9

A company can purchase a machine at the price of £2200. The machine has a productive life of
three years and the net additions to cash inflows at the end of each of the three years are £770,
£968 and £1331. The company can buy the machine without having to borrow and the best
alternative is investment elsewhere at an interest rate of 10%.

Evaluate the project using the

a) Net present value method.
b) Internal rate of return

Solution

NPV = 770 + 968 + 1331 -2,200 = 300

(1.1) (1.1)2 (1.1)3
 OR
Year Cash flow Discount Factor(DF) (10%) PV= cashflow x DF
0 (2200) 1.000 (2200)
1 770 0.9091 700
2 968 0.8264 800
3 1331 0.7513 1000
NPV 300
Comments:
The project is worthwhile and the machine should be bought.

Example 3.10

Revisit example 3.7 and complete the NPV for project P and Q. which project should be
implemented and why?

Solution

Cash Flows
(Rs) NPV at
C0 C1 C2 C3 C4 10%
P -4,000 3,000 1,000 1,000 1,000 –
PV of cash flows -4,000 2,727 826 751 683 987
Q -4,000 0 4,000 1,000 2,000 –
PV of cash flows -4,000 0 3,304 751 1,366 1,421

Project Q is chosen because it has a higher NPV than P

Example 3.11

A firm invest £180,000 in a project that will give a net cash inflow of 50,000 in real terms in
each of the next six years. Its real pre-tax cost of capital is 13%. Calculate NPV. Is the
investment viable?

Solution

Year Cash Flow PV factor 13% Present value

0 (180,000) 1.00 (180,000)
1 50,000 0.885 44,250
2 50,000 0.783 39,150
3 50,000 0.693 34,650
4 50,000 0.613 30,650
5 50,000 0.543 27,150
 6 50,000 0.480 24,000
NPV 19,850

The NPV is positive so the investment is viable.

OR

Use the annuity table: Table D. (see appendix)

Year Cash flow DF @13% PV
0 (180,000) 1 (180,000)
1-6 50,000 3.998 199,900

NPV 19,900
The discounting factor 3.998 is found by adding the discounting factors for 13% for years 1 to 6.
This method is used when a project is returning the same value of cash inflows over the years.

Advantages and disadvantages of NPV

NPV is most acceptable investment rule for the following reasons:

a) It considers the time value
b) It is a measure of true profitability
c) It has Value-additivity
d) All cash flows are considered
e) It considers and accounts for shareholder value
Limitations:
a) Most of the cash flows used are estimation
b) Discount rate difficult to determine

6. Internal Rate of Return (IRR)

This is the most commonly used technique other than the NPV technique. The internal rate of
return (IRR) technique looks at the return generated by the project. In other words, the IRR
measures the return a project needs to generate such that the discounted cash flows completely
offset the cost of the project.

The internal rate of return is the rate that equates the investment outlay with the present value of
cash inflow received after one period. This also implies that the rate of return is the discount rate
which makes NPV = 0.
 C1 C2 C3 Cn
C0     
(1  r ) (1  r ) 2 (1  r )3 (1  r ) n
n
Ct
C0  
t 1 (1  r )t
n
Ct
 (1  r )
t 1
t
 C0  0

Where ‘r’ is the IRR

In order to determine the IRR of a project, we need to solve the equation:

CFt
Iinitialinvestment  
(1  IRR)t
Decision rule

Since the IRR represents the return generated by the project, this represents the benefit of the
project. We need to compare it to the cost of the project that is represented by the project’s cost
of capital. We know that a firm will not accept a project if the cost outweighs the benefits. As a
result, the following is the decision rule for the IRR technique:

Accept project if the IRR  r (cost of capital )

Reject project if the IRR < r (cost of capital )
Methods of calculating IRR

The following methods can be used to calculate IRR:

i. Forming and solving quadratic, cubic and other equations
ii. Graphical method
iii. Trial and error
iv. Use of a financial calculator
v. Interpolation formula
vi. Extrapolation formula

Example 3.12

An investment would cost Rs 20,000 and provide annual cash inflow of Rs 5,430 for 6 years.
Compute IRR

NPV  Rs 20,000 + Rs 5,430(PVAF6,r ) = 0

Rs 20,000  Rs 5,430(PVAF6, r )
Rs 20,000
PVAF6, r   3.683
Rs 5,430

Using table D (see appendix) we can complete IRR as 16% by looking across year 6 row for the
value 3.683
Using interpolation method

To use interpolation method to calculate the IRR. The formula is as follows:

NL
IRR  L   ( H  L)
NL  NH

Where:
L = Lower rate of interest
H = Higher rate of interest
NL = NPV at lower rate of interest
NH = NPV at higher rate of interest

The higher and lower rate are picked by the person calculating. Picking a rate that yields a
slightly positive NPV and another that yields a slightly negative NPV gives a more accurate
estimate of IRR. Usually NPV value is inversely related to the discounting factor value. i.e. to
seek a lower NPV value- you increase the discounting rate.

Example 3.13

Refer to example 3.9 and calculate the IRR for the project:

Trying 15%
Year Cash flow Discount Factor (15%) PV
0 (2200) 1.000 (2200)
1 770 0.8696 69.59
2 968 0.7561 31.90
3 1331 0.6575 75.13
NPV 76.62

Npv is positive

Try 16%
Year Cash flow DC (16%) PV
0 (2200) 1.000 (2200)
1 770 0.8621 663.83
2 968 0.7432 719.42
3 1331 0.6407 852.77
NPV 36.01
NPV is positive but lesser in value

Try 17%

Year Cash flow DCF (17%) PV

0 (2200) 1.000 (2200)
 1 770 0.8475 652.58
2 968 0.7305 711.48
3 1331 0.6244 831.08
NPV (4.86)

NPV is negative implying the IRR is between 17% and 16%

Interpolation
Using the formula with 16% and 17% rates and NPVs you get 16 + 36.01 / 40.87 = 16.88% for
IRR

Using the trial and error method

For a project you can calculate NPV at various discounting rate as shown below until you get
NPV =0. The discounting rate that gives you NPV = 0 is the IRR as illustrated below:

NPV Profile
Discount
Cash Flow rate NPV
-20000 0% 12,580
5430 5% 7,561
5430 10% 3,649
5430 15% 550
5430 16% 0
5430 20% (1,942)
5430 25% (3,974)

Example 3.14

A project has the following cash flows. The initial investment is a loan of $ 10,000 to be repaid
at the rate of 8%. Determine the IRR.

Year After-tax cash flow

0 -$10,000
1 2,000
2 4,000
3 3,000
4 3,000
5 1,000
Solution:

In order to solve for the IRR, we need to solve the following equation:

2000 4000 3000 3000 1000

10000     
1  IRR (1  IRR) 2
(1  IRR) 3
(1  IRR) 4
(1  IRR) 5
Using a financial calculator, we know that the IRR that solves the above equation is 10.2%.
Since the firm has a cost of capital of 8%, we know that this project will be accepted.

Without a financial calculator, we can still determine the IRR of a project if it generates the same
amount of cash flow every period. In that case, we can simply treat the cash flows as an annuity.

Example 3.15

The initial investment needed for a project is $45,555. The after-tax cash flow is expected to be
$15,000 a year for the next four years. What is the IRR of this project?
45555  PV (all cash flows)
 15000  PVIFA4, IRR
 PVIFA4, IRR  3.037

 IRR  12%
See from table D in the appendix across the year 4 row.

The relationship between NPV and IRR (the NPV profile)

Based on our previous discussion, we know that there is a relationship between the NPV and
IRR techniques.
CFt
NPV    IO
(1  r ) t
CFt
0  IO
(1  IRR) t
IO represents the amount invested

From the above equations, we know that when the internal rate of return (IRR) is identical to the
firm’s cost of capital (r), the firm will break even, i.e. the project does not bring any value to the
firm (NPV = 0). The IRR of a project is where the NPV profile intersects the x-axis (i.e. when the
NPV = 0). From the graph below, we know that the project will bring a positive value to the firm
(i.e. NPV > 0) if the cost of capital is below the IRR, it will bring a negative value (i.e. NPV < 0)
if the cost of capital is above the IRR.
NPV

IRR

Cost of capital

Merits and demerits

IRR method has following merits:

 Time value
 Profitability measure
 Shareholder value
IRR method may suffer from:
 Multiple rates
 Mutually exclusive projects
 Value additivity

7. Profitability Index (PI)

Profitability index is the ratio of the present value of cash inflows, at the required rate of return,
to the initial cash outflow of the investment.

PI = Total present value cash inflows

Present value cash outflows

Decision rule

The following are the PI acceptance rules:

 Accept the project when PI is greater than one. PI > 1
 Reject the project when PI is less than one. PI < 1
 May accept the project when PI is equal to one. PI = 1

The project with positive NPV will have PI greater than one. PI less than means that the project’s
NPV is negative.

Example 3.16
The initial cash outlay of a project is Rs 100,000 and it can generate cash inflow of Rs 40,000,
Rs 30,000, Rs 50,000 and Rs 20,000 in year 1 through 4. Assume a 10 per cent rate of discount.
Calculate the profitability index

Solution

The PV of cash inflows at 10 per cent discount rate is:

PV  Rs 40,000(PVF1, 0.10 ) + Rs 30,000(PVF2, 0.10 ) + Rs 50,000(PVF3, 0.10 ) + Rs 20,000(PVF4, 0.10 )

= Rs 40,000  0.909 + Rs 30,000  0.826 + Rs 50,000  0.751 + Rs 20,000  0.68
NPV  Rs 112,350  Rs 100,000 = Rs 12,350
Rs 1,12,350
PI   1.1235.
Rs 1,00,000

Merits of profitability index

a) It recognises the time value of money.

b) It is consistent with the shareholder value maximisation principle. A project with PI
greater than one will have positive NPV and if accepted, it will increase shareholders’
wealth.
c) In the PI method, since the present value of cash inflows is divided by the initial cash
outflow, it is a relative measure of a project’s profitability.
d) Like NPV method, PI criterion also requires calculation of cash flows and estimate of the
discount rate. In practice, estimation of cash flows and discount rate pose problems.

Cost Benefit Analysis (CBA)

Is used to apprise utility projects whose output will not be sold and such other social and
community projects

It is a tool to estimate the real cost and benefits for a solution under consideration.

It is mainly used during the design phase to demonstrate whether a design alternative is practical
from the cost point of view, to help choose a solution by making comparisons, and to uncover
benefits and costs associated with a design alternative that are not evident.

The analysis involves calculating or estimating the known costs and potential benefits associated
with a proposed alternative.

Costs are those costs associated with implementing the alternative.

Benefits are those associated with implementation of the alternative that will result in savings for
the organization, like increased productivity, elimination of positions, reduced man-hours, or less
rework. This often requires making assumptions (for example, that the proposed solution will
result in a 25% improvement in productivity or will speed up the process by 50%) so that dollar
figures can be assigned to each cost or benefit.

Some “costs” or benefits do not lend themselves to quantitative evaluation (e.g., lowered morale
as a cost or improved morale as a benefit). In these cases, the comparison will need to done on
the basis of qualitative information.

Cost and Benefit Categories

In performing Cost benefit analysis it is important to identify cost and benefit factors. Cost and
benefits can be categorized into the following categories.

Costs

There are several cost factors/elements. These are hardware, personnel, facility, operating, and
supply costs.

Benefits

We can define benefit as: Profit or Benefit = Income - Costs

Benefits can be accrued by: Increasing income, decreasing costs, or both

Benefits can be tangible or intangible, direct or indirect. In cost benefit analysis, the first task
is to identify each benefit and assign a monetary value to it.

Tangible and Intangible Costs and Benefits

Tangible cost and benefits can be measured. Hardware costs, salaries for professionals, software
cost are all tangible costs in a software project. They are identified and measured. The purchase
of hardware or software, personnel training, and employee salaries are example of tangible costs.
Costs whose value cannot be measured are referred as intangible costs. The cost of breakdown of
an online system during banking hours will cause the bank lose deposits.

Benefits are also tangible or intangible. For example, more customer satisfaction, improved
company status, etc are all intangible benefits. Whereas improved response time, producing error
free output such as producing reports are all tangible benefits. Both tangible and intangible costs
and benefits should be considered in the evaluation process.

Direct or Indirect Costs and Benefits

From the cost accounting point of view, the costs are treated as either direct or indirect. Direct
costs are having shilling value associated with it. Direct benefits are also attributable to a given
project. For example, if the proposed system that can handle more transactions say 25% more
than the present system then it is direct benefit.
Indirect costs result from the operations that are not directly associated with the system.
Insurance, maintenance, heat, light, air conditioning are all indirect costs.

Fixed or Variable Costs and Benefits

Some costs and benefits are fixed. Fixed costs don't change. Depreciation of hardware,
Insurance, etc are all fixed costs. Variable costs are incurred on regular basis. Recurring period
may be weekly or monthly depending upon the system. They are proportional to the work
volume and continue as long as system is in operation.

An example of a Cost-Benefit Analysis follows:

A design team was looking at a design solution to see if it was practical from the cost point of
view. The organization involved published documents and had to do a lot of rework due to
printing errors. One solution involved buying new equipment at the cost of $100,000.

The team did a cost-benefit analysis—considering all the costs associated with getting the new
equipment up and running—to find out if the alternative was cost-effective. Their work is shown
below.
 SAMPLE COST-BENEFIT ANALYSIS
Costs

Equipment $100,000
Rewiring and installation 50,000
Cost of retraining operators 25,000
Cost of lost production 50,000

Total Cost $225,000

Benefits – Year 1

Reduce rejects by 10% $75,000

Reduce man-hours for the job 50,000
Reduce startup time 25,000

Total Benefits $150,000

Comparing the costs and benefits over 2 years shows:

Costs Benefits Profit/Loss

Year 1 $225,000 $150,000 ($ 75,000)

Year 2 — 150,000 150,000

Total $225,000 $300,000 $ 75,000

In 2 years, the new equipment will pay back its original cost and generate additional income.

Table 3: cost benefit analysis

Module prepared by Stephen Kamau

Review Questions
1. You are faced with two investment opportunities which each cost £30,000 and which have
the net cash inflows shown in the table below.

Year Project A cash flows (£) Project B cash flows (£)

1 7500 5,000
2 7500 5,000
3 7500 6,000
4 7500 6,000
5 5000 8,000
6 0 15,000
7 0 15,000

Required:

iii. Use the payback method to choose between the two projects.
iv. Using a discounting rate of 12 % which project has a faster payback?

2. An Investment of £600 returns as follows: year 1 = 100, year 2 = 400, year 3 = 400 year 4 =
180 pounds. Appraise using payback period and ARR.

3. Slogger has a cost of capital of 15% and is considering a capital investment project, where
the estimated cash flows are as follows.
Year Cash flow (£)
0 (ie now) (100,000)
1 60,000
2 80,000
3 40,000
4 30,000
Calculate the NPV of the project, and assess whether it should be undertaken.
4. You are a financial analyst for a Company. The director of capital budgeting has asked you
to analyze two proposed capital investments, Projects X and Y. You know each project has a
cost of $10,000, and the cost of capital for each project is 12%. The after-tax cash flows for
the two projects are as follow:

Years Project X ($) Project Y ($)

0 -10,000 -10,000
1 6,500 4,000
2 3,000 3,500
3 3,000 3,000
4 1,000 2,000

Using the IRR of each project, can you determine which project should be undertaken by
the firm?
5. If $ 1000 is invested today and generates $700, in the first year and $600 in the second year.
Find IRR
6. An investment of $ 2,000 today will yield $ 320 in one year’s time and $2320 in two years’
time. Compute IRR
7. A project is costing $ 800 in year 0 and is expected to earn $400 in year 1, $300 in year 2 and
$200 in year 3. Find IRR
8. Conduct a cost benefit analysis for:
a) A community water project
b) A women’s self-help group
c) Construction of a local dispensary in a village.