Chapter 5

Investment Criteria
and
Cash flow projection
• The key steps involved in
determining whether a project is
worthwhile or not are
• Estimate the cost and benefits of the
project
• assess the riskiness of the project
• Calculate the cost of capital
• Compute the criterion of merit and
judge whether the project is good or bad
 Methods of Financial Evaluation

(a) Net Present Value (NPV) Method

• Is the sum of the present value of all cash flows-
positive and negative that is expected to occur
over the life of project
n
C
NPV  t
 Io
t
(1  K )
t 1

Where; Ct = cash flow at the end of period t

K = required rate of return
n = useful life of project
Io = initial cost of project
• NPV = present value of cash flow – present value
of initial cost
• Decision criteria for NPV
 Cont…..

• NPV > 0, Accept the project – it maximizes

investors wealth
• NPV < 0, Reject the project
• NPV = 0, Indifferent
• Illustration:
• A firm is considering investing in a project which
costs 6,000 Br and has the following cash flows

Year 1 2 3 4
Cash 1500 3000 2000 2500
flow

• The cost of capital is 10%and the project has no

salvage value. Using the NPV method advise the
firm on whether to invest in the project.
 solution
Year Cash Flow PVIF PV
(10%)
1 1500 0.9091 1363.65
2 3000 0.8264 2479.20
3 2000 0.7513 1502.60
4 2500 0.6830 1707.50
Total PV 7053.00
Less Project Costs (6000.00)

NPV = 1053.00
• Decision: Accept the project since NPV
>0
 Cont….

• Advantages of NPV
Considers time value of money
Gives a decision criteria
Recognizes uncertainty of cash flow by
discounting
Uses all project cash flows
• Disadvantages of NPV
Gives absolute values which cannot be used
to compare project of different sizes
There is difficulty in selecting the discount
rate to use
It does not show the exact profitability of the
project
 Cont…..

b) Internal Rate of Return (IRR)

• IRR is the discount rate that equates the NPV
of a project to zero.
• It is the project rate of return (Yield)
n
Ct

t 1 (1  R) t
 I o 0

• Where; R = IRR
• It should be noted that IRR is computed using
a trial and error method.
• However, financial calculators are
programmed to compute IRR
 Cont….

• Steps in the IRR trial and error calculation

method
Compute the NPV of the project using an arbitrary
selected discount rate.
If the NPV so computed is positive then try a higher
rate and if negative try a lower rate.
Continue this process until the NPV of the project is
equal to zero
Use linear interpolation to determine the exact rate
• Linear interpolation is given by
 Cont……
 NPV LR  0 
LR  ( HR  LR ) 
 NPV LR  NPV HR 

• Where; LR = Lower rate and HR = higher rate

• Illustration:
• A project has the following cash flows
Year 1 2 3 4
Cash 300 400 700 900
Flow

• The cost of the project is 1500 Br.

• Determine whether project is acceptable if the
cost of capital is 18% using the IRR method.
 Solution

• We first select an arbitrary discount rate say 9% and

compute the NPV
Year Cash Flow PVIF (9%) PV

1 300 0.9174 275.22

2 400 0.8417 336.68
3 700 0.7722 540.54
4 900 0.7084 637.56
PV 1790.00
Less Cost (1500)
NPV at 9% 290.00

• since, NPV at 9% is positive and large we select another

discount rate larger than 9%, say 15%
 Cont…..
Year Cash Flow PVIF (15%) PV

1 300 0.8696 260.88

2 400 0.7561 302.44
3 700 0.6575 460.25
4 900 0.5718 514.62
PV 1538.19
Less Cost (1500)
NPV at 15% 38.19

• since, NPV at 15% is positive but not large,

we select a slightly higher rate, say, 18%.
 Cont…..

Year Cash Flow PVIF (18%) PV

1 300 0.8475 254.25

2 400 0.7182 287.28
3 700 0.6086 426.02
4 900 0.5158 462.22
PV 1431.77
Less Cost (1500)
NPV at 18% -68.23
• Since NPV at 18 is negative, IRR therefore lies
between 15% and 18%, and since zero NPV
will the between 38.19 and -68.23, to get the
correct (exact) IRR we have to interpolate
between 15% and 18% using interpolation
formula
 Cont….

 38.19  0 
IRR 15  (18  15)   16.08%
 38.19  ( 68.23 

• Decision: Reject the project since IRR is less

than the required rate of return (cost of
capital)
• Advantages of IRR
Can be used to compare projects of different sizes
Considers time value of money
Indicates the exact profitability of the project
Uses project cash flows
 Cont…

• Disadvantages of IRR
Some project have multiple IRRs if their NPV profile
crosses the x-axis more than once (project cash flow signs
change several time)
Assumes re-investment of cash flows occurs at project’s
IRR which could be exorbitantly high
Doesn’t provide a decision criteria
Not conclusive for mutually exclusive projects
 Cont…..

c) Profitability Index (PI)/ present value

index (PVI)/ benefit-cost ratio
• It is the relative measure of project’s
profitability and can be used to compare
project of different sizes
• PI = present value of cash flows/Initial cost
• Decision criteria:
• If, PI >1, Accept project
• PI < 1, Reject project
• PI = 1, Indifferent
 Cont….
• Illustration: A project has the following cash
flows

Year 1 2 3 4
Cash 300 400 700 900
Flow
• If the required rate of return is 9% and the
project initial cost is 1500 Br, calculate the PI
of the project and advice if the project is
acceptable
 Solution
Year Cash PVIF PV
Flow (9%)
1 300 0.9174 275.52
2 400 0.8417 336.68
3 700 0.7722 540.54
4 900 0.7084 637.46
Total PV = 1790

PVofC .F 1790
PI   1.193
int ial cos t 1500
• Decision: The project is acceptable since PI >
0
 Cont….

• Advantages of PI
Recognized time value of money
Compares projects of different sizes
Gives a decision criteria
• Disadvantages of PI
Does not indicate the risk
 Cont….
d) Discounted payback period
• This is the number of year taken to recover the
original (initial) investment from annual cash
flows.
• The lower the payback period the better the
project is
• Illustration:
• Assume a company wants to invest in two
mutually exclusive projects of 1000 Br each
generating the following cash flows.
• If the required rate of return is 10%. Which of the
projects should the company invest in?
 Cont….
Year 1 2 3 4 5 6

A 500 400 300 400 0 0

B 100 200 300 400 500 600

Year DCF of Cum F of DCF of Cum F of

A A B B
1 454.51 454.51 90.91 90.91
2 330.58 785.09 165.29 256.20
3 225.40 1010.49 225.40 481.60
4 273.21 1283.70 273.21 754.81
5 1283.70 310.46 1065.46
6 1283.70 338.68 1403.95
 Cont…..
• Pay back for A =  214.91 
2 
 225.40
 2.95 years


• Pay back for B =  245.19 

4  4.79 years
 310.46 

• The management should undertake project A

since it has a lower pay bock period.
• Advantages of pay back method
Considers time value of money
Useful in assessing risk and liquidity of the project
• Disadvantages of pay back method
Does not use all project cash flows
Does not consider the performance of the project after
the payback period
 Cont…
Average, annual, profits
ARR 100
Average, investiments

e) Accounting (average) rate of return (ARR)

• Where average investment = ½ (cost of project
+ negative Terminal value)
• Illustration:
• Assume 90,000 Br is invested in a project with
the following after tax net profits.

Year 1 2 3
Net 20,00 10,00 30,00
Profit 0 0 0
 Cont….

• The life of the project is 3 years and no salvage

value, compute ARR of the project.
20,000  10,000  30,000
Average _ profits  20,000
3
• Average investment = ½ (90,000 +0) = 45,000
20,000
ARR  100 44%
45,000

• Advantages of ARR
Easy to compute and use
Computed from readily available accounting information
 Cont….

• Disadvantages of ARR
Ignores time value of money
Ignores uncertainty of cash flows and
there is no consideration of risk in
calculation
Uses accounting profits rather than cash
flows
Doesn’t give a decision criteria
Not consistent with investor’s wealth
maximization
 PROJECT
CASH FLOWS
 Project cash flows
• The estimated of cash flows are a key element in
investment evaluation.
• So far we assumed that cash flows were given
because we wanted to focus our discussion on
investment criteria.
• Estimating cash flows-the investment outlays and
the cash inflows after the project is commissioned-is
the most important, but also the most difficult step
in capital budgeting.
• Forecast error can be quite large, particularly in
gigantic, complex project. For example, when
several oil majors decided to construct the
 Cont….

• Alsaka pipeline, the initial cost estimate was about

US$ 70 million.
• The final cost, however, was about US$ 7 billion.
• While this may be an extreme example, it highlight
the pitfalls of forecasting.
• Forecasting project cash flows involves numerous
variables and many participate in this exercise.
• Capital outlays: Engineering and product
development department.
• Revenue: Marketing groups
 Cont…..
• Operating costs: Production people, cost accountants,
purchase managers, personnel executives, tax expert and
others.
• The role of finance manager is to:
 coordinate the efforts of various
departments and obtain information from
them,
ensure that the forecasts are based on a
set of consistent economic assumptions,
keep the exercise focused on relevant
variables, and
minimise the biases inherent in cash flow
forecasting
 Element of cash flow stream

• To evaluate a project you must determine the

relevant cash flows, which are the incremental after-
tax cash flows associated with the project.
• The cash flow stream of a conventional project-a
project which involves cash outflows followed by
cash inflows-comprises three basic components:
i. Initial investment,
ii. Operating cash inflows, and
iii. Terminal cash flows

• The initial investment is the after-tax cash outlay

on capital expenditure and NWC when the project is
set up.
 Cont….
• The operating cash inflows are the after-tax cash
inflows resulting from operations of the project
during its economic life.
• The terminal cash inflow is the after-tax cash flow
resulting from the liquidation of the project at the
end of its economic life.
• BASIC PRINCIPLES OF CASH FLOW
ESTIMATION
• The following principles should be followed while
estimating the cash flows of a project:
1. Separation principle
2. Incremental principle
3. Post-tax principle
4. Consistency principle
 1. Separation principle

• There are two parts of a project, viz., the investment

(or asset) side and the financing side.
• So the cash flows associated with these side should
be separated. Fore example,
• Suppose a firm is considering a one year project that
requires an investment of Birr 1,000 in fixed assets
and WC at time 0.
• The project is expected to generate a cash inflow of
Birr 1,200 at the end of year 1-this is the only cash
inflow expected from the project.
 Cont….

• The project will be financed entirely by debt carrying

an interest rate of 15% and maturing after 1 year.
• Assuming that there are no taxes, determine the:
i. cash flows associated with the investment side of
the project,
ii. the rate of return on the investment side of the
project,
iii. the cash flows associated with the financing side of
the project, and
iv. the cost of capital on the financing side are as
follows:
 Solution
Financing side: Investing side:
Time Cash flow Time Cost
0 +1,000 0 -1,000
1 -1,150 1 +1,200
Cost of capital Rate of Return
15% 20%

• Note that the cash flows on the investment side of

the project do not reflect financing costs (Interest) .
• The financing cost are included in the cash flows on
the financing side and reflected in the cost of capital
figure (which is 15%)
 Cont……

• The cost of capital is used as the hurdle rate against

which the rate of return on the investment side
(which is 20%) is judged.
• The important point to be emphasised is that while
defining the cash flows on the investment side,
financing cost should not be considered because
they will be reflected in the cost of capital figure
against which the rate of return figure will be
evaluated.
• Operationally, this means that interest on debt is
ignored while computing profits & taxes thereon.
 Cont….

• Alternatively, if interest is deducted in the process of

arriving at profit after tax, an amount equal to
‘interest(1-tax rate)’ should be added to ‘profit after
tax’.
• Note that:
• PBIT(1-tax rate)=(PBT + Interest)(1-tax rate)
• = (PBT)(1-Tax rate) + Interest(1-tax rate)
• = PAT + Interest(1-tax rate)
• Thus, whether the tax rate is applied directly to the
PBIT figure or whether the tax adjusted interest,
which is simply ‘Interest(1-tax rate)’ is added to the
‘PAT’ figure we get the same result.
 2. Incremental principle

• The cash flow of a project must be measured in

incremental terms.
• To ascertain a project’s incremental cash flows you
have to look at what happens to the cash flows of
the firm with the project and without the project.
• The difference between the two reflects the
incremental cash flows attributable to the project.
That is,
• (PCF for year t) = (CF for the firm with the
project for year t) - (CF for the firm without the
project for year t).
 Cont……

 In estimating the ICF of a project, the ff guidelines

must borne in mind;
a) Consider all incidental effects: in addition to
the cash flows of the project, all its incidental
effects on the rest of the firm must be considered.
• The project may enhance the profitability of some
existing activities of the firm because it has a
complementary relationship with them; or
• It may detract from the profitability of some of the
existing activities of the firm because it has a
competitive relationship with them-all these effects
must be taken in to account.
 Cont…….

b) Product cannibalisation refers to the erosion in

the sales of the firm’s existing products on account of
a new product introduction.
• The firm may loses sales to a competitor or to itself
(because of the new product).
• If the firm is operating in an extremely competitive
business and is not protected by entry barriers,
product cannibalisation will occur anyway.
• Hence the costs associated with it are not relevant in
incremental analysis.
 Cont….
• On the other hand, if the firm is sheltered by entry
barriers like:
patent protection or
proprietory technology or
brand loyalty,
• the costs of product cannibalisation should be
incorporated in investment analysis.
c) Ignore Sunk costs: A sunk cost refers to an outlay
already incurred in the past or already committed
irrevocable.
• So it is not affected by the acceptance or rejection of
the project under consideration.
 Cont….

• Suppose, fore example, a company is debating

whether it should invest in a project.
• The company has already invest 1nillion birr for
preliminary work meant to generate information
useful for this decision.
• Is this 1 million birr a relevant cost for the proposed
project?
• Clearly not.
• 1millon birr represent a sunk cost as it can not be
recovered irrespective of whether the project is
accepted or not.
 Cont….

• Include opportunity cost: if a project uses a

resources already available with the firm, there is a
potential for an opportunity cost-this is the cost
created for the rest of the firm as a consequence of
undertaking the project.
• The opportunity cost of a resource is the benefit that
can be derived from it by putting it to its best
alternative use.
• So, to analyse the opportunity cost, ask the question
“is there any alternative use of the resource if the
project is not undertaken?”
 Cont....

• For most resources, there will be an alternative use:

a) The resource may be rented out: In this case the
opportunity cost is the rental revenue foregone by
undertaking the project.
For example, if a project uses a vacant factory building
owned by the firm, the revenue that can be derived from
renting out this building represents the opportunity cost.
b) The resource may be sold: In this case the
opportunity cost is the value realised from the sale of
the resource after paying tax.
 Cont….

For example, if the project uses an equipment which is

currently idle, its opportunity cost is its sales price, net of
any tax liability.

• The resource is required elsewhere in the firm: In this

case the cost of replacing the resource represent its
opportunity cost
Fore example, if a project requires the services of some
experienced engineers from an existing division of the firm,
the cost that is borne by that division to replace those
engineers represents the opportunity cost.
 Cont…

• Question the allocation of overhead cost: Costs

which are only indirectly related to a product (or
service) are referred to as overhead costs.
• They include items like general administrative
expenses, managerial salaries, legal expenses, rent,
and so on.
• Accountants normally allocate overhead costs to
various products on some basis like labour hours, or
machine hours, or prime cost which appear
reasonable.
• Hence when a new project is proposed, a portion of
the OHCs of the firm is usually allocated to it.
 Cont….

• The OH allocated to it, however may hardly have any

relationship with the incremental OHC, if any,
associated with it.
• For purposes of investment analysis, what matters in
the incremental OHCs (along with other incremental
costs) attributable to the project and not the
allocated OHCs.
• Estimate Working Capital Properly: A part from
fixed assets, a project requires working capital.
• Outlays on WC have to be properly considered while
forecasting the project cash flows.
 Cont….

• In this context, the following points must be

remembered:
Working capital (or more precisely, NWC) is defined as: CA-
CL and provision. Note that CL & provisions, also referred to
as non-interest bearing current liabilities, are deducted from
CA because they represent non-investor claims.
The requirement of WC is likely to change overtime. When a
project is set up, there is an initial investment in the WC.
This tend to change over time as the output of the project
changes.
 Cont….

While fixed asset investment are made during the early

years of the project and depreciated over time, working
capital is renewed periodically and hence is not subject to
depreciation. Thus the WC at the end of the project life is
assumed to have a salvage value equal to its book value.
 3. Post-tax principle
• Cash flow should be measured after-tax basis.
• Some firm may ignore tax payments and try to
compensate this mistake by discounting the
pre-tax cash flows at a rate that is higher than
the cost of capital of the firm.
• Since there is no reliable way of adjusting the
discount rate, you should always use after-tax
cash flows along with after tax-discount rate.
• The important issues in assessing the impact of
taxes are:
What tax rate should be used to assess tax liability?
How should losses be treated?
What is the effect of noncash charges?
 Cont…
• Tax Rate: Let us examine the choices in terms of
taxes.
• The average tax rate is the total tax burden as a
proportion of the total income of the business.
• The marginal tax rate (MTR) is typically higher
than the average tax rate because tax rates are
often progressive.
• The income from a project typically is marginal.
• Put differently it is additional to the income
generated by the asset of the firm already in
place.
• Hence, the MTR of the firm is the relevant rate
for estimating the tax liability of the project.
 Cont….

• Treatment of losses: because the firm as well as the

project can incur losses, let us look at various
possible combinations and the ways to deal with
Scen Projec Firm Action
them.
ario t
• The
1 different
Incur scenarios
Incur
losses losses
are
Defer taxsummarised
savings below:
2 Incur Makes Take tax saving in the year of
losses profits loss
3 Make Incur Defer taxes until the firm
profit losses makes profit
4 Incur ---- Defer taxes saving until the
losses project makes profits
 Cont….

• Effect of noncash charges: noncash charges can have

an impact on cash flows if they affect liability.
• The most important of such noncash charges is
depreciation.
• The tax benefit of depreciation is:
Depreciation * marginal tax rate
 4. Consistency principle

• Cash flows and the discount rates applied to these

cash flows must be consistent with respect to the
investor group and inflation.
• Investor group: The cash flow of a project may be
estimated from the point of view of all investors
(equity shareholders as well as lenders) or from the
point of view of equity shareholders.
• The cash flow of a project from the point of view of all
investors is the cash flow available to all investors
after paying taxes and meeting investment needs of
the project, if any.
 Cont……

• It is estimated as follows:
• Cash flow to all investor =PBIT(1-Tax rate)
+ Depreciation & non cash
charges
- Capital Expenditure
- Change in working capital
• The cash flow of a project from the point of view of
equity shareholders is the cash flow available to
equity shareholders after paying taxes, meeting
investment needs, and fulfilling debt-related
commitments.
• It is estimated as follows:
 Cont….

• Cash flow to equity shareholders = Profit after tax

+ Depreciation & other noncash charges
- Preferred dividend
- capital expenditures
- change in working capital
-repayment of debt
+ proceeds from debt issues
- redemption of preferred capital
+ proceeds from preferred issue
 Cont….
The discount rate must be consistent with the
definition of cash flow:
Cash flow Discount
rate
Cash flow to all WACC
investors
Cash flow to equity Cost of
Equity
• Generally, in capital budgeting we look at the cash
flow to all investors and apply the WACC of the firm.
• Inflation: In dealing with inflation, you have two
choices.
 Cont….
• You can incorporate expected inflation in the
estimates of future cash flows and apply a nominal
discount rate to the same.
• Alternatively, you can estimate the future cash flows
in real terms and apply a real discount rate to the
same.
• Note that the following relationship holds b/n
nominal & real values:

• Nominal CFt = Real CFt (1-Expected inf.

Rate)t
• Nominal DR = (1+ Real DR) (1+ Expected
Inf. Rate)-1
 Cont…

• The consistency principle, in essence, suggests the

following match up:

Cash flow Discount Rate

Nominal cash Nominal Discount
flow rate
Real cash flow Real discount rate

• Generally, in capital budgeting analysis nominal cash

flows are estimated and nominal discount rate is
used.
 Cash flow illustration

• Illustration 1.
• ABC enterprises is considering a capital project about
which the following information is available:
The investment outlay on the project will be 100
million Birr. This consists of 80 million on plant and
machinery and 20 million on net working capital. The
entire outlay will be incurred at the beginning of the
project.
The project will be financed with 45 million of equity
capital, 5 million of preference capital, and
 Cont…..

50 million of debt capital. Preferred capital will carry a

dividend rate of15%, debt capital will carry an
interest rate of 15%.
The life of the project is expected to be 5 years. At
the end of 5 years, fixed asset will fetch a net
salvage value of 30 million whereas net working
capital will be liquidated at its book value.
The project is expected to increase the revenue of
the firm by 120 million per year. The increase in
costs on account of the project is expected to be 80
million per year (this includes all items of
 Cont…..

Costs other than depreciation, interest, and tax). The

effective tax rate will be 30%.
Plant and machinery will be depreciated at the rate
of 25% per year as per the declining book value
method of depreciation. Hence the depreciation
charges will be
First year 25% of 80 20 million
million
Second 25% of 60 15 million
year million
Third year 25% of 45 11.25
million million
Fourth year 25% of 33.75 8.44 million
 Cont……

• Required:
given the above
detail, prepare
the project
cash flows
 Solution

Years 0 1 2 3 4 5
1. FA (80.00) - - - - -
2. NWC (20.00) - - - - -
3. Revenues 120 120 120 120 120
4. Cost (other than depr. & 80 80 80 80 80
int)
• Project cash flow (in millions20of Birr0
5. Deprec. 15 11.25 8.44 6.33
6. PBT 20 25 28.75 31.56 33.67
7. Tax (30%) 6 7.5 8.63 9.47 10.10
8. PAT 14 17.5 20.12 22.09 23.57
9. Net salvage value of FA - - - - 30
10. Recovery of NWC - - - - 20
11. Initial outlay (100.00
)
12. Operating Cash 34 32.5 31.37 30.53 29.90
inflow(8+5)
 Illustration 2

• FARMID Ltd. Is engaged in the manufacture of

pharmaceuticals. The company was established in
1991 and has registered a steady growth in sales
since then. Presently the company manufactures 16
products and has an annual turnover of 2200 million
birr.
• The company is considering the manufacture of a
new antibiotic preparation. K-cin, for which the
following information has been gathered:
1. K-cin is expected to have a product life cycle of five
years and thereafter it would be withdrawn from
the market.
 Cont….

• The sales from this preparation are expected to be

as follows:
Yea Sales (birr in
r millions)
1 100
2 150
3 200
4 capital
2. The 150equipment required for manufacturing
K-cin
5 is birr
100100 million and it will be depreciated at
the rate of 25% per year as per DBV method for tax
purpose.
 Cont…

• The expected net salvage value after 5 years is birr

20 million.
3. The WC requirement for the project is expected to
be 20% of sales. At the end of five years, WC is
expected to be liquidated at par, barring an
estimated loss of birr 5 million on account of bad
debt. The bad debt loss will be a tax deductable
expense.
4. The accountant of the firm has provided the
following cost estimate for K-cin:
 Cont……
RM Cost 30% of
sales
Variable labour cost 20% of sales
Fixed annual operating & 5 Million birr
maintenance cost
OH allocation (Excluding 10% of sales
Deprec, Maintenance &
5. The manufacture of K-cin would also require some of
Interest
the common facilities of the firm. The use of these
facilities would call for reduction in the production of
other pharmaceutical preparation of the firm. This
would entail a reduction of 15 million birr of CM.
 Cont…..
6. The tax rate applicable to the firm is 40%.

•Required: based on
the above
information
prepare the cash
flow for the project
 Cash flow for the K-cin project
Year 0 1 2 3 4 5
1. Capital Requirement (100) - - - - -
2. Level of WC (ending) (20) 30 40 30 20 0
3. Revenues 100 150 200 150 100
4. RMC 30 45 60 45 30
5. Labour cost 20 30 40 30 20
6. Oper. & Maint. cost 5 5 5 5 5
7. Loss of Contribution 15 15 15 15 15
8. Depreciation 25 18.8 14.1 10.5 7.9
9. Bad debt loss - - - - 5
10. PBT 5 36.2 65.9 44.5 17.1
11. Tax 2 14.5 26.4 17.8 6.8
12. PAT 3 21.7 39.5 26.7 10.3
 Cont….

Year 0 1 2 3 4 5
12. Profit after tax (BBF) - 3 21. 39. 26. 10.3
7 5 7
13. Net salvage value of - - - - 20
capital Requirement
14. Recovery of WC - - - - 20
15. Initial Inv ‘t (100 - - - - -
)
16. Operating Cash inflow - 2 57. 53. 37. 23.2
(12+8+9) 8 9 6 2
17. Increase in WC 20 1 10 (10 (10 -
0 ) )
18.
TheTerminal
loss ofcash in flow
contribution (120
(item 7) 1 47.opportunity
is an 63. 47. 63.2
(14+15 - 16+17 ) 8 9 6 2
cost.
OH expenses allocated to the project have been
ignored as they do not represent incremental OH
expense for the firm as a whole.
 Cont…

 It is assumed that the level of WC is adjusted at the

beginning of the year in r/n to the expected sales for
the year.
Fore example, WC at the beginning of year 1 (i.e at
the end of year 0) will be 20 million birr that is 20%
of the expected revenue of 100 million birr for year
1.
Like wise, the level of WC at the end of year one (i.e
at the beginning of year 2) will be 30 million that is
20% of the expected revenue of 150 million for year
2.