Chapter 7.

Evaluation and appraisal of projects

7.1.With and without project comparison

7.2.Separable components

7.3.Undiscounted methods

7.4.Discounted measure of project worth

Chapter 7. Evaluation and appraisal of projects
7.1.With and without project comparison
Project analysis tries to identify and value the costs and benefits
that will arise with the proposed project and compare them with
the situation as it would be without project.
The difference is the incremental net benefit arising from the
project investment. This approach is not the same as comparing
the situation ''before'' and ''after'' the project.
The before-and-after comparison fails to account for changes in
production that would occur without the project and thus leads to
an erroneous statement of the benefit attributable to the project
investment.
Chapter 7. Evaluation and appraisal of projects
7.1.With and without project comparison
Chapter 7. Evaluation and appraisal of projects
7.1.With and without project comparison
 The above figure illustrates a change in output can take place if
production is already increasing (decreasing) and would continue to
increase (decrease) even without project.
 Thus, if production without the project were to increase at 3 percent
per year and with the project at 5 percent per year, the project's
contribution would be an increase of 2 percent per year.
 A before/after comparison would contribute the entire 5 percent
increase in production, and not just the incremental benefits, to the
project.
 Of course if production were to remain stagnant, the before/after
comparison would yield the same result as the with/without
comparison.
Chapter 7. Evaluation and appraisal of projects
7.1.With and without project comparison
 In some cases, an investment to avoid a loss might also lead to an
increase in production, so that the total benefit would arise partly
from the loss avoided and partly from increased production.
 Again a simple before-after comparison would fail to account the
benefits realized by avoiding the loss (Fig.2. depicts this
situation).
Chapter 7. Evaluation and appraisal of projects
7.1.With and without project comparison
Chapter 7. Evaluation and appraisal of projects
7.2. Separable Components
 Sometimes a project consists of several interrelated subprojects or
components.
 When the components are independent of each other, each
component must be treated as if it were a separate project and the
analyst must determine whether each component increases or
decreases the project's net total present value.
 Any component that has a negative net present value should be
dropped, even if the total net present value of all the components
is positive.
Chapter 7. Evaluation and appraisal of projects
7.2. Separable Components
 In other words, each separable component must justify itself as a
marginal part of the overall project.
 Appraising such a project requires several steps.
 First, each separable component needs to be appraised
independently.
 Second, each possible combination must be appraised.
 Finally, the entire project, comprising all of the separable
components, must be appraised as a package.
 Measures of Project Worth
When costs and benefits have been identified, quantified and priced
(valued), the analyst is trying to determine which among various
projects to accept, which to reject.

There are two methods for measuring the worthiness of projects:

1. Undiscounted Methods
2. Discounted Methods.

First, there is no one best technique for estimating project worth; each
has its own strength & weakness.
Second, these financial and economic measures of investment worth are
only tools of decision-making, i.e.,
 They are necessary conditions & are not sufficient condition for
final decision.
 There are many other non- quantitative and non-economic criteria
for making final decision of whether to accept or reject a project.

7.3. Undiscounted measures of project worth

1. Ranking by inspection
2. Payback Period
3. Rate of return on
investment
1. Ranking by inspection
In some cases, we can tell by simply looking at the investment
costs and the ‘shape’ of the stream benefits to accept or reject the
project.
The analyst can sometimes simply choose one project among
alternatives projects by examining the following:

Total cost of investment and investment period;

The structure, & amount of costs and benefits;

The structure & total amount of the net incremental benefit;

The lifetime of the project, and etc.

The problem with this method is that the selection lacks

objectivity/ actual existence.
2. Payback Period

 The payback period is the length of time from the beginning of the
project until the sum of net incremental benefits of the project equal
to total capital investment.

 It is the length of time that the project requires to recover the

investment cost.

 Then it is a measure of cost recovery, not profitability.

 The method is very simple. Moreover, it is a good measure when the

project has problem of liquidity.
 The pay-back period is also a common, rough means of choosing
among projects in business enterprise, especially when the choice
entails high degree of risk.

 Since risk generally increases with futurity, the criterion seems to

favor projects that are clear less risky.

 This method has two important weaknesses:

 First, it fails to consider the time & amount of net benefits after
the payback period.

 Second, it does not adequately take into account the time value
of money even in the payable periods.
Payback period = Initial payment / Annual cash inflow

So, if ETB 4 million is invested with the aim of earning ETB

500 000 per year (net cash earnings), the payback period is
calculated thus

P = ETB 4, 000, 000 / ETB 500 000 = 8 years

But what if the project has more uneven cash inflows? Then
we need to work out the payback period on the cumulative cash
flow over the duration of the project as a whole.
 Consider the following alternative projects
Alternative Year Investment cost Net incremental Commutation net
projects benefits incremental
benefits
I 0 20000 -
1 2000
2 8000
3 12000
4 6200 28200
II 0 20000 -
1 2000
2 12000
3 8000
4 12000 32000
III 0 20000 -
1 1000
2 5000
3 6000
4 8000
5 10000
6 5000
7 2000 37000
Project I & II have a payback period of 3 years. But project III has
a payback period of 4 years.
Thus, based on this criterion, project I & II have equal higher rank
than project III.
Therefore, the method fails to consider the time & amount of net
incremental benefit after the payback period- project III.
In addition, the method results equal rank for both project I and II.
Yet we know by inspection that we would choose project II over
project I because more of the returns to project II are realized
earlier.
This method is a measure of cash recovery, not profitability.
3. Rate of return on investment
 The rate of return, also referred to as the average rate of return, has
many alternatives due to differences in how it is computed.
 All the alternatives, however, have two features in common;
(i) use of accounting concepts in calculating benefits and
(ii) no adjustment for time value of money.
A. Proceeds per unit of outlay
 Investments are ranked by the proceeds (cumulative of net incremental
benefits) per unit of outlay (investment cost).
 It is the total net value of incremental net benefits divided by the total
amount of investment.
 In the previous example, project I, II & III have a proceeds per outlay of
1.55, 1.7 and 1.85, respectively.
 Hence, according to this criterion, project III will be ranked first.
B. Average annual proceeds per unit of outlay

 To calculate this measure, first the total net incremental benefits

will be divided by the time it will be realized to arrive at average
annual net incremental benefits, and then this average value will be
divided by total investment costs.

 In this method, project I, II & III will have average annual

proceeds per unit of outlay of 0.38, 0.42 and 0.30, respectively.

 Hence, project II will be chosen. This criterion has serious flaws.

 By failing to take into consideration the length of time of the benefit

stream, it automatically introduces a serious bias toward short-lived
investments with high cash proceeds.
C. Average income on book value of the investment

 This is the ratio of average income to the book value of the assets (i.e.
the value after subtracting depreciation) stated in percentage terms.

 This measure is useful and commonly used way of assessing the

performance of an individual firm.

 It is also sometimes used as an investment criterion.

 This measure, as the previous one, does not take into consideration the
timing of the benefit stream.

 In the above example, assuming strait-line deprecation for all projects,

average income on book value can be calculated as follows:
C. Average income on book value of the investment

Project Average net value of Annual Net Average Average

incremental benefit deprecation average book value income on
income book value

I 7050 5000 2250 10000 0.225

II 8000 5000 3000 10000 0.300

III 5285.7 2857.1 2428.6 10000 0.242

7.4. Discounted measure of project worth
1. Time value of money
Present values are better than the same values in the future and
earlier returns are better than later. This shows that money
has time value.
Thus, to include the time dimension in our project evaluation,
we have to use discounting methods.
Discounting is essentially a technique that ‘reduces’ future
benefits and costs to their ‘present worth’.
The rate used for discounting is called discount rate.
 Suppose a bank lends 1567.05 Birr for a project at 5% interest rate.
The project owner is supposed to repay the principal & interest rate
after 5 years. How much the owner will have to pay at the end of 5
years.

At = P(1 + r) t
At = total amount after t years , r = interest rate , t = time
A5 = 1567.05 (1 + 0.05)5 = 2000 Birr

Suppose again a project is expected to obtain 2000 Birr after 5

years. Value of this money today can be calculated as:
2. Net present values -NPV

 The NPV of an investment proposal is the present value of expected

future net cash flows, discounted at the costs of capital, less the
initial outlay.
n
At
NPV   I
t 1 1  r t

 NPV - net present value

 At = net cash flow for the year t

 I - investment cost

 n - life of the project

 Single Project Decision Criteria:

 Accept investment: if the NPV is positive

 What positive NPV means is that the Return from the investment is
more than the risk inherent in the investment or

 A positive NPV indicates that the investment will lead to an increase

in the wealth to the investor/project owner

 Reject investment: if the NPV is negative (that is the risk is more

than the return)

Two or More Competing Projects Decision Criteria:

 Accept investment: with the highest NPV and such NPV is positive
otherwise reject the investment
Cont.
 Cont.
NPV= 25,000/(1+0.08) + 25,000/(1+0.08) 2 + 25,000/(1+0.08) 3+
25,000/(1+0.08) 4 + 25,000/(1+0.08) 5 - 1 million
3. Internal Rate of Return (IRR)
The internal rate of return is defined as the rate of discount,
which brings about equality between the present value of future
net benefits & initial investment.
It is the value of r in the following equation.
n
At
I   1 r 
t 1
t

 I – investment cost
 At – Net benefit for year t
 r - IRR
 n - Life of the project
4. Benefit Cost Ratio

This is the ratio obtained when the present worth of the benefit
stream is divided by the present worth of the cost stream.

The mathematical formula is given below.

Bt - are the benefits in period t
n
Bt
 (1  r ) t Ct - are the costs in period t
B  C  t n1
Ct

t 1 (1  r ) t
n - Project life

r - Discount rate

 The formal selection criterion is to accept all independent

projects if B/C > 1.
 Cont’d
Example 1: B- C ratio calculations for 1 hypothetical 1 hectare horticulture projects (all
figures in Birr)
Year Costs Benefits DF (12%) PV of costs PV of benefits
1 38,900 - 0.8929 34,733.81 -
2 9239 28,475 0.7972 7,365.33 22,700.27
3 10,575 32,550 0.7118 7,527.29 23,169.09
4 11,952 35,610 0.6355 7,595.50 22,630.16
5 12,858 39,802 0.5675 7,295.63 22,583.65
Total = 64,517.56 91,083.17

B -C ratio = Present worth of total benefits = 91,083.17 = 1. 41

Present worth of total costs 64,517.56.

29
 The End
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