Session 1 – Feasibility Studies – 4thY – English

Chapter 7
Introduction:

• Feasibly studies are about studying some techniques to judge that project is feasible
or not.
• Feasible means that it deserves the time and money you spent in that project.
• We have mainly two approaches for capital investment appraisal either traditional
(don't take time value of money into consideration like Payback and ROCE) and
other main technique (Like NPV and IRR) the later are more popular because they
take time value of money into consideration which is an important point for
investment decisions.

NPV:

• Different cash flows happen in diffident point of time cannot be compared directly.
We have to take all the values in one single point of time which is year zero (current
time).
• The basic rule in NPV is to accept all projects which have either zero or positive NPV
and reject the project with negative NPV.

Example 1:

You have the following projects, calculate NPVs and decide which one you should accept and
which you should reject. The company faces a perfect capital market, in which the interest
rate for the projects' risk level is 10%

Project Immediate Year 1 Year2 Year3

Outlay
1 -2500 +1000 +1000 +1000
2 -1000 +100 +1400 0
3 -1000 +800 +600 0
4 -4000 0 0 +5000

Solution:

Project 1:

We have uniform cash flows for the three years, so we can use the discount factor found in
table C from the text book (present value of an annuity)

Y0 -2500X 1 = -2500

Y1:Y3+ 1000X2.4869 = +2487

So NPV = +13 (it's positive NPV so we should accept)

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Session 1 – Feasibility Studies – 4thY – English

Project 2:

We don't have uniform cash flows, so we need to take the discount rates from table 2
respectively according to each year as follows:

Y0 -1000 X1 = -1000

Y1 +100X0.9091 =90.91

Y2 +1400X0.8264 = 1156.96

So NPV = +248 (Accept)

Following the same steps as above for projects 3 and 4, we should get the following:

Project 3 = NPV +223

Project 4 = NPV -243.5

According to the NPV decision rule we should accept projects 1, 2, 3 and reject project 4
because it has negative NPV.

Also Answer Question 1, 2 and 7 from quickie questions in the textbook Page 88

The problem of inflation and NPV:

Inflation is a situation in which prices in the economy are rising over time. This causes two
kinds of problems for the projects appraisal as follows:

First: make the estimation of the projects cash flows more difficult.

Second: the estimation of the suitable discount rate will not be straightforward due to the
existence of inflation rate.

Real and Market interest rates:

Time value of money exits because of a very basic rule which is consumption today is
preferred than consumption in the future. So if I sacrifice 100$ today, I would need a
compensation of that sacrifices in the future. This has nothing to do with inflation.

Example:

100 today with an investment rate 10% so the compensation of the investment is 10 $. Now
let's assume that I have inflation of 5 %, the 10 $ will not buy the same amount of goods
next year due to inflation. I would need the 10$ plus the 5$. So next year I would demand
115$ not only 110$. In that case we have three rates in the market:

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Session 1 – Feasibility Studies – 4thY – English

1 – 15.5% which is called Nominal, Market or Money interest rate

2- 5% the general rate of inflation.

2- 10% which is the real interest rate (purchasing power interest rate). It is real in the sense
that it is the rate deflated to take out the effect of inflation

And we will have the following relationship between the three interest rates:

(1+ Real interest rate)+ (1+General rate of inflation) = (1+Market interest rate)

Remember the above equation is valid only in case of imperfect capital market in which we
have inflation. In perfect capital, however, the real interest rate ids the market interest rate.

Example 2 (quickie questions 1) Page 143:

Assuming market interest rate is 13% General inflation is 4%, so the real interest rate =

1+ real IR = 1.13/1.04

Real IR = 8.6 %.

Example 3 (quickie question 4) Page 144:

First we get the real IR from the equation:

1.55/1.05 -1 = 10% Real IR.

a) To make the rent remains constant after two years in real terms; it means that the only
change will happen is due to inflation (which is not a common case). So after two years the
rent should be: 10 000 X 1.1025 = 11025

b) The rent remains constant in money terms, means that there will not be any change in the
value of money. So 10,000$ will remain the same after two years.

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