simple evaluation method to assess the quality

of project in terms of finace.

different complexity level of finacial method to aevlate the project. .

L006: Financial project evaluation How to assess the value of project or activity

Objectives and Learning Outcomes

The objectives are to understand basic aspects of analysing the future cash flows associated with a
project. This lecture will provide the ability to:
time property of money;
 Analyse the relative value of sums of money received at different times in the future
 Apply the concept of opportunity cost
 Apply simple evaluation methods such as the Payback Period, Annual Average Proceeds
(AAP), and Return On Investment (ROI)
 Understand the concepts of compound interest, time preference and discounting
 Use more advanced methods such as the Minimum Acceptable Rate of Return (MARR), Net
Present Value (NPV) and the Internal Rate of Return (IRR)

This money cann't be as valuable as it is today. Money flow;

The basic intuition of time preference the relative value of money will decrease as time goes on ;

When analysing flows of money associated with a product or activity, the aspect of time plays a
crucial role. However, such considerations are common in our everyday lives, not just in business or
project management. To illustrate that everyone is familiar with such questions, one might ask:
would you prefer it if you were given £100 now or £100 in ten years’ time? Almost everyone would
decide to be given the sum of money now and would (perhaps with a little deliberation) be able to
provide reasons for this.
This concept is known as time preference, which reflects the current relative valuation placed on
receiving a good (or sum of money) at an earlier date compared to receiving it at a later date. The
importance of this concept in commercial decision making, where the attractiveness of different
options is often at stake, cannot be overstated. Obviously, this is central to fields such as finance,
commerce and economics but also plays an important role in engineering, particularly in industrial
and civil engineering.

The variable cost of money

The assessment of the value of a project or course of activity can become complex when it runs over
a duration of time, especially when this duration becomes long. In many cases, it will also be necessary
to compare competing projects that may have radically different timescales. A range of concepts and
methods have been developed, largely in the field of finance, to deal with such problems.
For example, project managers might be required to the value of compare a long project starting now
with a short project starting in five years’ time. For an illustration, the following table shows the cash
flows associated with three projects:

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 Table 1: Three alternative projects with identical net cumulative cash flows

project a project b project c

end of incremental cumulative incremental cumulative incremental cumulative
year cash flow in cash flow out cash flow in cash flow out cash flow in cash flow out
0 0 0 0 0 0 0
1 -40000 -40000 -65000 -65000 -30000 -30000
2 12500 -27500 15000 -50000 -30000 -60000
3 17500 -10000 25000 -25000 40000 -20000
4 20000 10000 25000 0 25000 5000
5 17500 27500 20000 20000 20000 25000
6 12500 40000 20000 40000 15000 40000

These figures are contrived so that each project shows a total cumulative cash flow of £40,000 at the
end of year 6. The purpose of this is to demonstrate that projects of similar value can still exhibit
quite different profiles. But on what basis can the optimum project be selected? In this rather unreal
case, the total return is the same and cannot separate the projects.

This leads to a question of criteria that will allow judgements on which project or course of action is
more attractive. A possible measure could be the minimum investment for the return (i.e. the
minimum negative cumulative cash flow at any point during the project’s life). In this case Project A
would be preferred, as illustrated in the below figure. If the project sponsor were in the fortunate
position of being able to invest in two projects, the next favourable project would be Project C.
However, the maximum investment in project C occurs a year after B. Clearly, methods are needed
to accommodate such differences.

CUMULATIVE CASH FLOWS FOR PROJECTS

A, B & C

60000
40000
20000
0
£
-20000 0 2 4 6 8

-40000 project A
project B
-60000 project C
-80000
years

Figure 1: Graphical comparison of the cash flows of the three projects

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The Cost of negative cash flows

A more analysis can be constructed by assuming that negative cash flows (i.e. financial outflows)
result in additional costs, which are, of course, undesirable. In this sense, the next step is to modify
the previous model by including the concept of opportunity cost in the assessment. This adds
realism as in the real world, a company will need to borrow or seek investment to fund a new
project. At the very least, it will have to use cash that could be invested in some other way. Thus, the
basic requirements for a viable project are that is must return:

 the money invested,

 the cost of the investment,
 some additional true earnings.

This represents a minimum threshold. In addition, the project will have to compete with other
projects and possibly quite dissimilar investments.

Sources of investment and opportunity cost

Each means of investment will involve a cost, either in interest or by the loss of income from some
other investment. As a brief summary, likely sources of investment are:

 Owners’ capital (or equity) – the share value of a company,

 Reserve capital (or retained profit) – belongs to the owner’s but is retained for reinvestment
rather than taken as dividends,
 Loan (or debt) capital – raised from banks or venture capitalists for example. All involve an
obligation to pay interest during the term of the loan and the capital at the end.

Of course, these funds could be used for other purposes, generating additional income elsewhere.
For instance, holding £100 in a tin under the mattress has an associated opportunity cost which is
the income that could be obtained by investing the money effectively.

Simplistic analyses

As a simple method of analysis, the Payback Period technique simply assesses at the time taken to
recoup the initial investment from the subsequent revenues. For example, consider a company that
invests £20,000 in a project which is projected to generate a return of £5,000 per year. The company
can therefore expect a return in £20,000 / £5,000 = 4 years. This simple approach can equally be
used to evaluate projects with varying annual returns. Consider a project with projected cash flows
as summarised in the table below, requiring an initial investment of £100,000. It is immediately clear
that the project will have paid back the initial investment after three years.

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 Table 2: Projected cash flows of a project

Year Projected cash flows

0 -£100,000
1 £45,000
2 £35,000
3 £20,000
4 £20,000
5 £15,000

The Payback Period method can be used to develop slightly more advanced methods of analysis.
Consider again the project with the cash flows described in the above table. A company makes an
initial investment of £100,000. The estimated income over a period of 5 years is £135,000. This is
called the net positive cash flow. From this a metric referred to as the Annual Average Proceeds
(AAP) can be constructed:

𝑁𝑒𝑡 𝑝𝑜𝑠𝑖𝑡𝑖𝑣𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

𝐴𝐴𝑃 = (1)
𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛

In the example above, AAP amounts to £135,000 / 5 = £27,000. Note that this metric applies on a
yearly basis and that the highest possible AAP is desirable.

A similar, and very frequently used, metric is the Return On Investment (ROI). ROI is formulated by
expressing the returns of the project as a proportion of the initial investment required:

𝑁𝑒𝑡 𝑝𝑜𝑠𝑖𝑡𝑖𝑣𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝑅𝑂𝐼 = (2)
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

In the above example, the ROI amounts to (£135,000- £100,000) / £100,000 = 35%. It must be noted
that the Payback Period, AAP and ROI may not give the same ranking if the returns are heavily biased
towards the start or the end of the project. In these cases it is necessary to use experience and
judgement to resolve the decision – or to adopt one of the more advanced methods presented in
the following sections.

Two important concepts: interest rate and discount rate

For any project to attract investors it must offer, at the very least, a higher return than the available
rate of interest and some additional earnings to justify the inconvenience and risk to the investor.
Although the methods presented above are quite simple, it is still possible to carry out some basic
evaluation based on them. Although these methods are less reliable than those discussed in the
remainder of this section, their simplicity means that they are still the most commonly used. To
understand more realistic methods of financial evaluation, however, two fundamental concepts are
indispensable, the interest rate and the discount rate.

The interest rate is an amount of money (i.e. the interest) due per period of time, as a proportion of
an amount loaned, borrowed or deposited. The amount of money loaned, borrowed or deposited is
known as the principal sum or simply the principal. Following from this, the total interest arising

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from such an amount depends on the principal sum, the interest rate, the frequency with which
interest is allocated and the length of time over which the principal sum is loaned, borrowed or
deposited. Annual interest rate is the rate over a period of one year. Other interest rates apply over
different periods, such as a month or a day, but they are usually annualised.

It is crucial to note that in banking, finance, business and economics, the received interest is
normally reinvested, rather than paid out. This implies any interest received in the current or any
future period is earned on the principal sum and all previously accumulated interest. This practice is
known as compound interest and it is an essential practice in the world of finance.

The most important technique for the calculation of compound interest is referred to as periodic
compounding. Here, the total accumulated value of the investment V is formed from the principal
sum P, the annual interest rate r and the duration of the investment in years t:

𝑉 = 𝑃(1 + 𝑟)𝑡 (3)

A numerical example for the calculation of V is straightforward. If £100 is invested for five years at
an interest rate of 8%, the investment will return a final value of V = £100 × (1 + 0.08)5 = £146.93. It
should be noted that the total interest generated I is the final value V minus the initial principal sum:

𝐼 = 𝑃(1 + 𝑟)𝑡 − 𝑃 (4)

Continuing with the numerical example, the total interest amounts to I = £100 × (1 + 0.08)5 - £100 =
£46.93.

It is important to realise that there is a conceptual “opposite” to interest rates. Instead of looking at
investing a principal P and eventually obtaining a total accumulated value V, it is often essential to
be able to calculate how much money needs to be invested now in order to receive a certain total
accumulated value at a specified time in the future. For example, it might be necessary to know how
much money needs to be invested now to obtain £100 in five years’ time. In finance, such questions
are treated using the technique of discounting to Net Present Value (NPV). It is clear that this
practice requires an analogue to interest rate – which is known as the discount rate.

The discount rate reflects the return that could be obtained per unit of time, normally per year, on
an investment with equal risk. Because it forms a variation of the concept of an interest rate, the
symbol used for the discount rate is also r. Thus, the NPV of a sum S can be calculated using the
discount rate r and the time t at which S is paid out:

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𝑁𝑒𝑡 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 = 𝑆 = 𝑆(1 + 𝑟)−𝑡 (5)
(1 + 𝑟)𝑡

Again providing a simple numerical example, a NPV of £100 receivable in three years’ time subject to
a discount rate of 6% amounts to NPV = £100 × (1 + 0.06)-3 = £83.96. It is helpful to note that while r
denotes the discount rate, as defined above, the term (1+r)-t is known as the discount factor.

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The Minimum Acceptable Rate of Return (MARR)

The core family of metrics used in financial evaluations by experts is based on the concept of rate of
return and makes use of the concepts of compound interest and discounting to net present value. In
fact, it is important to realise that the idea of NPV applies to both inflows and outflows of cash. For
example, if an investor knowns that she will get a bill of £100 in 5 years’ time then she can meet that
requirement by investing £62 now, at 10% interest. Vice versa, if she were to be paid £100 in 5 years
that would be equivalent to being paid £62 now and investing this amount at 10% for the same
period.

A simple method to evaluate cash flows associated with a project in this way is by using the
Minimum Acceptable Rate of Return (MARR), also known as the hurdle rate or the Minimum
Attractive Rate of Return. MARR reflects the minimum rate of return on a project a manager or
company is willing to accept before starting a project, given its risk and the opportunity cost of
forgoing other projects. Thus, MARR represents the threshold annual rate of return that a project
must cross to be financially acceptable. A project is viable if it returns the money invested, i.e. the
principal sum, plus the MARR.

MARR is based on being able to define such a rate of return, effectively serving as a discounting rate
for future cash flows. However, in practice this is a complex issue since it requires knowledge of
many different factors, including the current interest rate, current levels of inflation, the level of risk
of the investment and some form of surplus to entice investors. Therefore, where cash flow
projections are investigated with MARR, the model effectively includes the return. In consequence,
any project that reaches a cumulative discounted cash flow above zero will be considered
worthwhile.

Using MARR to assess the projected cash flows is not complicated. The first step is to reflect the
projected cash flows of the project, starting with the current year (Year 0) in which the investment is
made and thus a large negative cash flow occurs. Over the duration of a project of, say, five years,
further (most likely positive) cash flows are projected to occur. The key step in applying MARR is to
discount each of these cash flows (from Year 1 to Year 5) to NPV. As a final step, these discounted
cash flows are cumulated, allowing the analyst to determine if the overall cumulative present value
of the project in five years’ time is positive. If so, the project can be deemed worthwhile. The
following table presents a worked example with MARR set at 18%:

Table 3: Application of MARR at 18% to establish net cumulative present value

Year Cash flow Discount factor Cash flow at NPV Cumulative present value
0 -£65,000 1.000 -£65,000 -£65,000
1 £15,000 0.847 £12,712 -£52,288
2 £25,000 0.718 £17,955 -£34,334
3 £25,000 0.609 £15,216 -£19,118
4 £20,000 0.516 £10,316 -£8,802
5 £20,000 0.437 £8,742 -£60

As can be seen from the above table, the project is indeed assumed to generate positive cash flows,
for example from sales income, in every year after the initial investment in Year 0. It should be noted
that the initial investment in Year 0 is not discounted because it is paid instantaneously, i.e. the
nominal cash flow equates to its present value. Also, it is evident that the overall cumulative present

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value of the project is slightly below zero, so the decision makers are not likely to initiate this project
based on this analysis.

Internal Rate of Return (IRR)

The final, and most advanced, method presented in this section is the Internal Rate of Return (IRR),
which forms an approach to the evaluation of cash flows that avoids setting and arbitrary rate of
return, such as MARR. While the method may initially appear complex, its logic is closely related to
that of MARR and it is a frequently used tool used in the evaluation of projects in practice. The most
intuitive way to explain IRR is to provide a numerical example.

From the analyses that we have carried out so far, we can see that the cumulative present value at
the end of a project can be positive, zero or negative. To illustrate this point, the below graph shows
how changing MARR (r) can change the NPV for the project discussed above.

Figure 2: Graphical comparison of the cash flows of the three projects

As is evident from the above example, for the predicted cash flows, a MARR of 18% yields a
cumulative present value at the end of the project at -£60, which is close to zero. The specific rate at
which the cumulative present value of the projected cash flows is zero is the Internal Rate of Return
(IRR). At this rate the sum of the discounted investments (negative cash flow) is equal to the sum of
the discounted returns (positive cash flow). In other words, at this rate the outgoing and incoming
cash flows of the project are in balance, subject to discounting. In the example provided above, the
IRR is approximately 17.96%. With periodic compounding across T time periods, IRR is thus the

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discounting rate r at which the sum of all future sums St in the cash flow discounted to net present
value equals zero:

𝑆0 + 𝑆1 (1 + 𝑟)−1 + 𝑆2 (1 + 𝑟)−2 + ⋯ + 𝑆𝑇 (1 + 𝑟)−𝑇 = ∑ 𝑆𝑡 (1 + 𝑟)−𝑡 = 0 (6)

𝑡=0

Since the above equation is difficult to solve for r a graphical method of finding the IRR is advisable.
The first step in the graphical method is to compute cumulative present values for the project at
three different levels of r. The below figure uses the levels 10%, 18% and 25%. IRR is then identified
by the intersection of the graph and the X-axis. Numerically, this method can be approximated by
interpolation between two sets of interest rates (r1 and r2) and corresponding levels of cumulative
present values (V1 and V2).

Figure 3: Graphical determination of IRR (r=10%, r=18% and r=25%)

It is clear that, as a measure of profit, the investor or project initiator will choose a project with the
highest possible IRR, assuming that the size of the initial investment is the same. However, there is
an additional relationship that is of interest when using the IRR to compare a project against
alternative “fixed income investment” investments, such as bonds. In fixed income investments, the
principal sum is deposited once but interest on this deposit is paid to the investor at a specified
interest rate in every time period (e.g. annually). Therefore the original deposit neither increases nor
decreases (i.e. it is not compounding).The IRR equates to the interest received annually on such an
investment and can thus be used to understand the structure of an equivalent bond (one
investment, fixed annual interest).

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A numerical example for such an alternative fixed income investment can be constructed in a
straightforward way. If the interest rate payable annually on this type of investment is set at the
level of the IRR exhibited by the project discussed above (17.96%), a yearly interest payment of
£11,674 will be generated. Note that, by definition, the total cumulative present value of the cash
flows of such a fixed income investment with an interest rate set at IRR is equal to the cumulative
present value of the investment discussed above. The table below illustrates this relationship. This
method can be used to measure the annual interest required for a fixed interest investment to carry
the same level of return as the project.

Table 4: Cash flows of an equivalent fixed income investment

Year Incremental cash flow Cumulated cash flow Cumulative present value
0 -£65,000 -£65,000 -£65,000
1 £11,674 -£53,326 -£55,103
2 £11,674 -£41,651 -£46,713
3 £11,674 -£29,977 -£39,601
4 £11,674 -£18,302 -£33,571
5 £76,674 £58,372 £0

The advantage of IRR over MARR is that an arbitrarily determined minimum interest rate is not
required. Moreover, alternative projects with different cash flows can be compared on the basis of
IRR. The main drawback of IRR is that it is difficult to calculate – the most intuitive way of estimating
IRR is via graphical approximation, as done in the above. Most financial software packages and
spreadsheet applications contain a function for the calculation of IRR.

Adjusting future cash flows for inflation

The remaining factor must be considered in the evaluation of future cash flows is inflation. Generally
the cost of items will, on average, increase each year – which is captured in the inflation rate f.
Inflation can be included in both the MARR and IRR calculations by forming an inflation factor
analogous to the discount factor, deflating a future cash flows S over t years:

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𝐷𝑒𝑓𝑙𝑎𝑡𝑒𝑑 𝑉𝑎𝑙𝑢𝑒 = 𝑆 = 𝑆(1 + 𝑓)−𝑡 (7)
(1 + 𝑓)𝑡

The below table illustrates the calculation in the example project discussed in this section, using an
inflation rate f of 6% and a discounting rate r of 12%. As can be seen, adjusting future cash flows in
this manner forms a case of double discounting in which cash flows are modified twice, once to
account for inflation and once to discount to net present value. The fact that the cumulative present
value of the project is negative (-£1,139) indicates that the project is not attractive if inflation is
considered and MARR is set to 12%.

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 Table 5: Cash flows adjusted for inflation (f=6%) and discounted (r=12%)

Year Cash flow Inflation factor Deflated cash flow Discount factor Cash flow at NPV Cumulative present value
0 -£65,000 1.000 -£65,000 1.000 -£65,000.000 -£65,000
1 £15,000 0.943 £14,151 0.893 £12,634.771 -£52,365
2 £25,000 0.890 £22,250 0.797 £17,737.493 -£34,628
3 £25,000 0.840 £20,990 0.712 £14,940.611 -£19,687
4 £20,000 0.792 £15,842 0.636 £10,067.797 -£9,619
5 £20,000 0.747 £14,945 0.567 £8,480.287 -£1,139

--- END OF THE LECTURE ---

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