Evaluation of Financial Analysis of Project

Financial Analysis of Project
y Pertains to long term assets and yield a return over a period of time y Involves a series of cash outlays for an anticipated inflow of future benefits y Evaluation of expenditure decisions y Benefits : (i). Increased revenues

(ii). Reduced costs y Features (i). Large anticipated benefits (ii). Relatively high risk (iii). Relatively long period

‡ Financial Decision Making ‡ Profitability of the Firm ‡ Fixed Asset (Not current asset) ‡ Strategic Investment ‡ Future Destiny of Company

‡ Selecti

f r ject - xa le ( la t) - H e ixe st Use a r, Salary, I s ra ce, etc.. - If Successful/ ess r fit are t e e tire ixe st f r ject eter i es, uture st rea ve i t Sales r fit

‡ Selecti

-

y Once Project Selected is not Reversible. y Need For Correct Selection of Project

- It involves Cost - Capital Resources
y So if not properly selected, have to bare loss

DIFFICULTIES
y Benefits from project financial are received in future

and future is uncertain.
y Cost incurred and benefits received occur in different

time periods, - It is not comparable because of time value of money.

Evaluation Techniques
1. Traditional y ARR method y Payback period method 2. Time Adjusted ( Discounted Cash Flow) y NPV method y IRR method y PI

method

Average Rate of Return (ARR)
y Avg annual yield for the project y PAT ARR = Avg annual PAT Avg investment y Avg annual PAT = ™ PAT / Years annuity = constant PAT / Years y Avg investment = WC + Net investment 2

Example
Machine A Cost PAT Year 1 2 3 4 5 Estimated life 3000 5000 7000 9000 11000 35,000 5 11000 9000 7000 5000 3000 35,000 5 50,000 Machine B 50,000

ARR = Avg annual PAT Avg investment = 7000 / 27000 = 25.93 %

ARR
Accept-Reject Rule: y Actual ARR • Min desired ARR
y Projects with highest ARR preferred over Projects with

lower ARR

Evaluation of ARR
y Merits - Easy calculation y Demerits - use of PAT instead of cash flow - ignores time value of money - no differentiation between size of investment
Machines A B C PAT 6,000 2,000 4,000 Avg Investment 30,000 10,000 20,000 ARR (%) 20 20 20

Pay Back Method
y Time period required for complete recovery of the initial y y y y

investment in the project Period within which total cash inflows = total cost of investment The project with a lowest payback period is preferred Cash benefits = CFAT Two ways: (1). Annuity(uniform CFAT) PB = Investment const CFAT

(2). Non-uniform CFAT Initial investment = 50,000

y For Project A:

PB period = a fraction more than 3 years sum of 48,000 is recovered by the end of 3rd year Balance = 2,000 to be recovered in the 4th year PB fraction = 2,000 / 20,000 = 0.1 PB period = 3.1 years
y For Project B:

PB period = a fraction more than 2 years sum of 42,000 is recovered by the end of 2nd year Balance = 8,000 to be recovered in the 3rd year PB fraction = 8,000 / 18,000 = 0.44 PB period = 2.44 years

Accept-Reject Rule: y Actual PB • Min desired PB
y Projects with shortest PB preferred over Projects with

longest PB

Evaluation of PB y Merits:
- based on cash flow analysis y

Demerits: - ignores all cash inflows after PB period - ignores the time value of money - does not consider the entire life of the project
Project A Cost Cash inflow Year 1 2 3 4 5 PB period 3 yrs 15,000 5,000 6,000 4,000 0 0 3 yrs Project B 15,000 4,000 5,000 6,000 6,000 4,000

Discounted Cash Flow (Time Adjusted Techniques)

DCF
y Considers Time Value of Money - discount rate i.e cost of capital y Considers all benefits and costs occuring during entire

life of the project

Net Present Value (NPV)
y ™ PV of all future cash inflows ²

™ PV of all cash outflows Accept-Reject Rule: y NPV > 0 » Project accepted y NPV < 0 « Project rejected

Project A NPV (69,645 50,000) = 19,645 Accepted Cash outlay = 30,000 NPV (69,645 80,000) = - 10,355 Rejected

Project B (71,521 50,000) = 21,521 Accepted (71,521 80,000) = - 8,479 Rejected

y Merits: - recognises time value of money - considers the total benefits of the project - useful for mutually exclusive projects - affects the market price of share y Demerits: - involves tedious calculation of discount rate - focus only on NPV

Internal Rate of Return (IRR)
y Rate of return that a project earns y

PV of cash inflows = PV of cash outflows i.e. rate which gives NPV = 0

Accept-Reject Rule: y IRR (r) > cut-off rate » Project accepted y IRR (r) < cut-off rate » Project rejected

Example
The project costs Rs. 36,000 and is expected to generate cash inflows of Rs. 11,200 annually for 5 yrs. Calculate IRR of the project. Solution y PB period = 36000/11200 = 3.214 y Discount factors closest to 3.214 for 5 years are 3.274 and 3.199 i.e. 16% and 17% interest rate respectively y IRR = r PB 3.199 = 16.8 % 0.075

Annuity table
Periods 15% 1 .8696 2 1.6257 3 2.2832 4 2.8550 5 3.3522 6 3.7845 7 4.1604 8 4.4873 9 4.7716 10 5.0188 16% .8621 1.6052 2.2459 2.7982 3.2743 3.6847 4.0386 4.3436 4.6065 4.8332 17% . 8547 1.5852 2.2096 2.7432 3.1993 3.5892 3.9224 4.2072 4.4506 4.6586 18% 19% .8475 .8403 1.5656 1.5465 2.1743 2.1399 2.6901 2.6386 3.1272 3.0576 3.4976 3.4098 3.8115 3.7057 4.0776 3.9544 4.3030 4.1633 4.4941 4.3389

Risk
y Sensitivity Analysis: y Accounts for the estimation errors y Best, Most possible, Worst
y

Additions: (a) Assigning Probability, (b) Standard Deviation

Relative Risk- Coefficient of Variation

Continued..
y Risk Evaluation Approaches y Risk Adjusted Discount Rate Approach
y

Rate of return is adjusted for risk Future cash flows are subjected to risk adjustments Normal Distribution of returns Interdependency in projects

y Certainty-Equivalent Approach
y

y Probability Distribution Approach
y

y Decision-tree Approach
y

THANK YOU..

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