PROJECT PLANNING AND

MANAGEMENT
CE - 403

Dr. Md Reaz A Mullick

PROJECT EVALUATION

 Analysis of Capital Investment Decision

 The process of investment in land, productive equipment,
buildings, working capitals, raw material deposits and other
assets for future economic gain is particularly difficult and
calls for careful analysis
 We will discuss the analytical techniques which are used to
support investment decisions
 Three elements of investment analysis
 Net investment
 Economic life.
 Operating cash flows

Reaz 1
  Fundamental reason for investment of capital is “to obtain
sufficient economic returns over a future period to justify
the original outlay; i.e. enough receipts to justify
enough cash spent”.

B= Benefit

O
n YEARS

C= Cost

METHOD OF ANALYSIS

Net Investment Refers to the net outlay

Operating Cash Are not economic benefits.

Flow

The time period over which one can

Economic life
expect to obtain the benefits.
Pay back Is a simple relationship of the annual
(Time Period) benefit of a project to the investment
required.

Reaz 2
 METHOD OF ANALYSIS

Net Investment
Pay back =
Av. Annual operating cash flow

Simple Return on Investment: - inverse of the payback

Av. Annual Cash Flow

Return on investment =
Net Investment
Average Return on Investment
Av. Operating Cash Flow
Average Return =
Av. Net Investment

Compounding Growth
Now 1 Year 2 Years 3 Years

$(1+i) (1+I) $(1+i)2 (1+I)

$1 $(1+i)
Or Or
$ (1+i)2 $ (1+i)3

for i = 10% (i.e. 0.1)

$1 $1.10 $1.21 $1.331

Reaz 3
 TIME VALUE OF MONEY

Now 1 Year 3 Years

2 Years

$1

$1.10

$1.21

S 1.331

DISCOUNTING

Now 1 Year 2 Years 3 Years

$1 $1.1

$1 $1.21

$1.33
$1
(1/1.10)
$
$1
0.909
(1/1.21)
$ $1
0.826
$ (1/1.331) $1
0.751

Reaz 4
 SUM OF AMMOUNTS IN DIFFERENT YEARS

Now 1 Year 2 Years 3 Years

$X $A $B $C

Considering the time value of money –

Is $X = $ (A+B+C)
Or, $X Greater than $ (A+B+C)
Or $X Less than $ (A+B+C)

1. Compound Amount (CA): Given P, Find F

F
CA= (1+i)n P

i= interest rate (Cost of Capital)

Opportunity Cost of Capital (OCC) n YEARS

n
F  P1  i 

Reaz 5
 2. Present Worth (PW)

Given F, to find P F

PW P

n YEARS

1
PF
(1  i) n

3. Sinking Fund (SF)

For series amount Given F, to find A

A A
F
A A A

n YEARS
i.e. How much must be deposited at i% each year for n
years to have accumulated F?
i
SF 
(1  i ) n  1
 i 
A  F n 
 (1  i )  1 

Reaz 6
 SINKING FUND PROVISION

 Problem:

 To replace the pumps in 15 years, will cost US $ 875,000.

How much should be the annual collection from the
farmers?, given, i=12%

4. Capital Recovery Factory (CRF)

Given P, to find A,
P
A
A A A A

n YEARS

CRF A=P x CRF

Reaz 7
 5. Compound Amount (Series) Given A, to find F

A A
F
A A A

n YEARS

SCA

6. Present Worth (Series) (SPW)

Given A, to find P
P

A A A A A

n YEARS

SPW
P=A x SPW
SPW= Annuity Factor

Reaz 8
 F F
•Future worth factor/Single payment Compound amount  , i %, N   1  i N 
P  P

P  1 P
•Present worth factor  , i%, N   
 1  i 
N
F F
F
• Series future worth factor/Series compound amount  , i %, N  
N
1  i   1  F
A  i A
 A  i A
•Sinking Fund factor  , i %, N   
 1  i   1 F
N
F
 1  i   1 P
N
P
•Series present worth factor  A , i %, N   i 1  i N  A
 

N
A  i 1  i  A
•Capital Recovery factor  , i %, N   
 1  i   1
N
 P P

PRESENT WORTH METHOD

Benefits Benefits, Bt

PWB

Time, t

PWC
OM&R costs, Ct
C0

Costs

Reaz 9
 ANNUAL WORTH METHOD

Benefits

PWB
Annual Benefits, Bt

Time, t

PWC
Annual costs, Ct

Costs

PRESENT WORTH METHOD

 Same base year

 Same discount rate

 Same period of analysis

 Only projects with positive present worth to be

considered

Reaz 10
 EXAMPLE -1
Purchasing a piece of equipment a company may have the
option of paying in two different ways. Each way involve
payments over a five year period but the actual payments
per year vary in each option as follows:
Year 1 Year 2 Year 3 Year 4 Year 5
Option A 10,000 20,000 30,000 40,000 60,000
Option B 45,000 30,000 20,000 20,000 20,000

If payments are made at the end of

each year and the discount (interest)
rate is constant over the five years
and is equal to 10% p.a., which
payment option should the company
choose?

EXAMPLE – 2

 Two alternative plans for a Plan A Plan B

section of an aqueduct – Life 50 years 50 years
Plan A uses tunnel and Plan
B uses a lined canal with Initial $450,000 $260,000
steel flume (interest rate is Cost
6% per annum) Annual $4,000 $10,500
O&M
Cost

Reaz 11
 EXAMPLE – 2 PRESENT WORTH METHOD

 Calculate SPW (N = 50 years; i = 6%)

 Present worth of A
 450,000 + SPW*4000
 Present worth of B
 260,000 + SPW*10,500
 Compare the PWs of the two projects and the one
with least PW is to be selected

EXAMPLE – 2 ANNUAL COST METHOD

 Calculate Capital recovery factor (N = 50 years and i = 6%)

 Annual cost of A
 CRF*450,000 + 4,000
 Annual cost of B
 CRF*260,000 + 10,500
 The project with least annual cost is to be selected

Reaz 12
 EXAMPLE – 3

 Once a cement factory is in full production in 1997, the

sixth year of the project (t6). It produces cement value Tk.
1,475,000 annually over the economic life of the plant,
taken to be 15 years.

 What is the Present Worth of the cement production

from 1997 through 2006 (t6-t15) discounted at 12%?

15
1 2 3 4 5 6

0 1997 2006

SPW=
A= 1,475,000
PWB= (SPW15- SPW5)*A

Here,
SPW15= 6.811
SPW 5 = 3.605

Reaz 13
 PW of Total Cement Production
= PWB
=(Spw15- Spw5)*A
= (6.811-3.605)*1,457,000
= 3.206*1,457,000

Alternative method
PW of total cement production
= (P/A, 12%, 10)*(P/F, 12%, 5)*1,457,000
= 5.6502*0.5674*1,457,000
= 3.206*1,457,000

EXERCISE – 4

 An irrigation project
 Initial cost = 1x106 $
 Annual O&M cost = $ 5,000 for yr 1-5
 = $ 10,000 for yr 6-10
 = $ 15,000 for yr 10-20
 Interest rate is 7%
 Salvage value = 0
 Sale of water = 1x106 m 3/yr 1-10
 = 2x106 m 3/yr 11-20
 What is the price of the water to liquidate the project
without any debt or profit?

Reaz 14
 PROJECT EVALUATION – BCR METHOD

 Ratio of present worth of benefits to present

worth of costs
N
P 
PWb    , i %, t  Bt
t 1  F 
N
P 
PWc    , i %, t Ct
t 1  F 
B PW b

C PW c

RATE OF RETURN METHOD

 Discount rate at which the present worth of the project is

zero

N
P 
PW    , r %, t Bt  Ct   0
t 1  F 
 The value of r which satisfies the equation is rate of
return or internal rate of return (IRR)
 To be found by trial and error
 IRR should be more than minimum acceptable level for
the project to be feasible

Reaz 15
 CBA (COST BENEFIT ANALYSIS) & BCR

Computational Exercise

Calculation of –

I. Payback Period,
II.Benefit-Cost Ratio,
III.
Net Present Value(NPV),
IV.Internal Rate of Return (IRR) or Discounted Cash
Flow (DCF) Return,
V. First Year Rate of Return(FYRR)

EXERCISE - 5

 Capital cost in yr 1 and yr 2 is 7500 and 6000 respectively

 O&M cost for yr 3-7 is 1300 annually
 Gross benefit for yr 3 – 7 is 6000 annually
 Salvage value is 600
 Interest rate 10%
 Find pay back period
 Find BCR
 Find NPV
 Find IRR

Reaz 16
 CASE-A (DISCOUNT FACTOR-10%)
Yr Capital O+M1 Total D.F2 PWC Gross D.F2 PWB Net
cost cost 10% benefit 10% benefit

1 7500 - 7500 .909 6818 - .909 - (6818)

2 6000 - 6000 .826 4956 - .826 - (4956)
3 - 1300 1300 .751 976 6000 .751 5606 3530
4 - 1300 1300 .683 888 6000 .683 4098 3210
5 - 1300 1300 .621 807 6000 .621 3726 2919
6 - 1300 1300 .564 733 6000 .564 3384 2651
7 - 1300 1300 .513 667 66003 .513 3386 2719
Total 13500 6500 - - 15845 - - 19100 3255
1 Operation and maintenance (O&M) costs
2 Discount Factor (1/(1+i)n)
3 Includes Salvage value of 600

Results of Worksheet

Solution:

1. Payback (i) at 10% 3.8 yrs.

(ii) at 0% 2.9 yrs.

2. B/C ratio –at 10% 19100

= 1.21
15845

3. Net Present Worth(NPW) or NPV

= Present Worth of Total Benefits - Present Worth of Total Costs
= PWB - PWC =19100-15845=3255

Reaz 17
 O+M1 Total D.F2 Gross D.F2 Net
Yr Capital PWC PWB
cost cost 10% benefit 10% benefit
1 7500 - 7500 0.8333 6250 - 0.8333 -6250
2 6000 - 6000 0.6944 4166 - 0.6944 -4166
3 - 1300 1300 0.5787 7526000 0.5787 3472 2720
4 - 1300 1300 0.4823 6276000 0.4823 2894 2267
5 - 1300 1300 0.4019 5226000 0.4019 2411 1889
6 - 1300 1300 0.3349 4356000 0.3349 2009 1574
7 - 1300 1300 0.2791 3636600 0.2791 1842 1479
Total 13500 6500 - - 13116 - - 12629 -487

Computation of IRR (Graphical Method)

NPV

487

Reaz 18
 IRR

4. Internal Rate of Return or Discounted Cash Flow

Return, (at NPV=0)

= Lower discount rate + Difference between discount rates

NPV at lower discount rate
X
difference between NPVs rate
 3255 
= 10+(20-10)  
 3740 
= 10+8.7
= 18.719% NPV at 20% (487)
IRR= 19%

IRR

Algebraically,

IRR = Low DR + Difference of DR’s (NPV at Lower

DR/Total Difference between NPVs)
=10%/(20%-10%)*(3255/3742)
=10+ 10 (0.87)
=18.7
=19%

Reaz 19
 ECONOMIC APPRAISAL OF PROJECT

 NPV Method
 NPV Method is recommended as the best of the above five
techniques for economic analysis.
 It is subjected to the least ambiguity, it produces information
which is readily understood.
 It is least likely to be affected by assumptions (definition of
costs, benefits and is easiest to calculate).
 IRR can be compared with yields from investments, and is
readily understood by decision markers.

ECONOMIC APPRAISAL OF PROJECT

 Internal Rate of Return (IRR)

 Another way of using discounted case flow for measuring the
worth of a project
 It is the discount rate which just makes the net present worth of
the cash flow equal zero.
 This discount rate is termed the internal rate of return
 and in a sense, It represents the average earning power of the
money used in the project over the project life

Reaz 20
 PROJECT EVALUATION – EQUIPMENT REPLACEMENT

 Replacement Studies

 One of the problems which individuals and business

encounter frequently is deciding whether existing
equipment or property should be replaced with new and
more modern facilities.

 Wear and tear of equipment, coupled with rapid

technological progress which results in new and
improved devices, make this an ever present problem.

EQUIPMENT REPLACEMENT

 Reasons for Replacement

 Four basic reasons for replacement
 Physical impairment: Existing equipment is completely or
partially worn out.
 Inadequacy: do not have sufficient capacity.
 Obsolescence: caused either by or lessening in demand
or by the availability of more efficient equipment
 Rental possibilities: to rent identical or comparable
equipment; thus freeing capital for other and more
profitable use.

Reaz 21
 EQUIPMENT REPLACEMENT

Diesel vs Gasoline
 For your Project you need a piece of equipment (e.g. a
truck, generator, bull-dozer, or pump).
 As you consider what type of equipment to purchase, you
realize that you are faced with a choice between gasoline and
diesel powered models.
 The diesel model offers the advantage of longer life and
lower operating costs. However, a gasoline engine is
considerably cheaper to buy.
 Assume that the work output of both units will be equal,
and that the cost and availability of diesel and gasoline will
be the same.

EQUIPMENT REPLACEMENT

DIESEL Versus GALOLIN

 Given the Following assumptions on costs and the
working life of the respective equipment engines, make a
decision on which model to purchase
 if you have alternative investment opportunities that yield
10% interest compounded annually;
 if you have alternative investment opportunities that yield
20% interest compounded annually.

Reaz 22
 EXERCISE – 6

DIESEL MODEL
Operating life 10 years
Price per Engine 100,000
Ann. operating & maint. costs 10,000

GASOLINE MODEL
Operating life 5 years
Price per Engine 50,000
Ann. operating & maint. costs 15,000

Note: There is no salvage value at the end of operating

life for either model.
Which Model to Buy?

DIESEL:
End of Annual
Year Outlay DF 10% PW DF 20% PW
1 110000 0.9091 100001 0.8333 91663
2 10000 0.8264 8264 0.6944 6944
3 10000 0.7513 7513 0.5787 5787
4 10000 0.683 6830 0.4823 4823
5 10000 0.6209 6209 0.4019 4019
6 10000 0.5645 5645 0.3349 3349
7 10000 0.5132 5132 0.2791 2791
8 10000 0.4665 4665 0.2326 2326
9 10000 0.4241 4241 0.1938 1938
10 10000 0.3855 3855 0.1615 1615
Total PW 152355 125255

Reaz 23
 GASOLINE
End of Annual
Year Outlay DF 10% PW DF 20% PW
1 65000 0.909 59092 0.833 54165
2 15000 0.826 12396 0.694 10416
3 15000 0.751 11270 0.579 8681
4 15000 0.683 10245 0.482 7235
5 15000 0.621 9314 0.402 6029
6 65000 0.565 36693 0.335 21769
7 15000 0.513 7698 0.279 4187
8 15000 0.467 6998 0.233 3489
9 15000 0.424 6362 0.194 2907
10 15000 0.386 5783 0.162 2423
Total PW 165848 121298
Conclusion: At 10%, Diesel is Preferable
At 20%, Gasoline is Preferable

DIESEL Versus GALOLIN

CROSSOVER DISCOUNT RATE:

DISCOUNT Total Present Worth Difference between

RATE DIESEL GASOLINE PWs

10% 152,340 165,810 13,470

20%
Cross over Discount
125,230 121,295
Rate: 3,935

Between 10% and 20% there is a

Total Present Worths of the two models will be equal (point of
discount rate which will make us
indifference) at a discount rate of:
indifferent between two
alternatives.(Present
 13 , 470  Worth of
 10 %  ( 20 %  10 %)   
costs will be same)
 13 , 470  3,935 
=10%+7·7% = 17·7%18%

Reaz 24
 Graphical Solution

Total Total
PWs PWs
Gasoline
Crossover
165,810 Discount Rate
152,340

Diesel 125,230
121,295
110,000
10% 17.7% 20%
Discount Rate

 From the Figure, Crossover Discount Rate = 17.7%

 Crossover Discount Rate
 Between 10% and 20%, there is a discount rate which will
make rate which will make us indifferent between two
alternatives.
 The Preference ranking of the alternatives (indicated by the
cost stream with the lowest present worth) may change
between lower and higher discount rates.
 The discount rate at which the preference changes is know as
the crossover discount rate.
 This is also called as “equalizing” discount rate, at which the
total Present Worth of two alternatives will be approximately
equal.
 In the replacement example, between 10% and 20%, there is a
discount rate which will make us indifferent between the two
alternatives.

Reaz 25
 “COST MINIMIZATION” PROBLEM EXERCISE – 7

 Evaluation of a flood control project

 Avg annual damage from flood = $ 400,000

 Alternative proposals for flood control

 1. no mitigation
 2. channel improvement (life 25 yrs)
 3. Dam at site A (life 100 yrs)
 4. Dam at site B (life 100 yrs)
 5. Dam at site A + No. 2
 6. Dam at site B + No. 2
 Rate of interest 8%

Option of Investment Avg Annual Annual O&M

1. no mitigation flood control cost Damage cost
2. channel improvement (life 1 0 400,000 0
25 yrs) 2 300,000 250,000 100,000
3. Dam at site A (life 100 yrs) 3 1,200,000 190,000 60,000
4. Dam at site B (life 100 yrs) 4 1,600,000 125,000 80,000
5. Dam at site A + No. 2 5 1,500,000 100,000 160,000
6. Dam at site B + No. 2 6 1,900,000 60,000 180,000

Option of Annual Investment Sum of annual damage

flood control cost and project cost
1 --- 400,000
2 28,104 378,104
3 96,048 346,048
4 128,064 333,064
5 124,152 384,152
6 156,168 396,168

Reaz 26
 CHOOSING FROM ALTERNATIVES EXERCISE – 8
A B C

 Flood control
Projects:
Project Initial O&M Damage
 Dam A, Cost (thous.$) (mln.$)
 Dam B, and (mln.$)
 Levees C
A 6 90 1.10
Alternatives
B 5 80 1.30
 A, B, C, AB, AC, BC, ABC
Lives C 6 100 0.70
 Dams = 80 years,
AB 11 170 0.90
 Levee = 60 years

Discount rate AC 10 190 0.40

 i = 4 % per year BC 9 180 0.50

ABC 15 270 0.25

 Choose an alternative
Do 0 0 2.00
nothing

Reaz 27
 INCREMENTAL DB/DC METHOD
A B C

Project Total CRF Annual Annual Total

Investment Investment Operation and Annual
($ mln) Costs Maintenance Cost
($ mln) ($ mln) ($ mln)

A 6 0.04181 0.251 0.090 0.341

B 5 0.04181 0.209 0.080 0.289

C 6 0.04420 0.265 0.100 0.365

AB 11 0.460 0.170 0.630

AC 10 0.516 0.190 0.706

BC 9 0.474 0.180 0.654

ABC 15 0.725 0.270 0.995

Reaz 28
 INCREMENTAL DB/DC METHOD

 Discard alternatives with B/C < 1

 Order alternatives lowest to highest cost, or
according to highest net benefit
 Compute the incremental ΔB/ΔC for contender
versus current best
 If ΔB/ΔC > 1, contender becomes current best
 Repeat until all alternatives have been tested
 Final current best is the preferred alternative

Project Total Lowest Project Damage Benefit

Annual to
Cost highest (mln.$) (mln $)
($ mln) cost
A 1.10 0.90
A 0.341 B B 1.30 0.70
B 0.289 A C 0.70 1.3
C 0.365 C AB 0.90 1.1
AB 0.630 AB AC 0.40 1.6
AC 0.706 BC BC 0.50 1.5
BC 0.654 AC ABC 0.25 1.75
ABC 0.995 ABC Do nothing 2.00 0

Reaz 29
 A B C

Compare Project B C B/C DB DC DB/DC Decision

(mln$) (mln $) (mln $) (mln $)

 B 0.7 0.289 2.42 B>

0.7 0.289 2.4
BA A 0.9 0.341 2.64 A>B
0.2 0.052 3.8
AC C 1.3 0.365 3.56 C>A
0.4 0.024 17
C  AB AB 1.1 0.63 1.75 C > AB
-0.2 0.265 -0.75
C  BC BC 1.5 0.654 2.29 C > BC
0.2 0.289 0.69
C  AC AC 1.6 0.706 2.27 C > AC
0.3 0.341 0.88
C  ABC ABC 1.75 0.995 1.76 C > ABC
0.45 0.63 0.71

Reaz 30