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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
AcceptReject 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). Nonuniform 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
AcceptReject 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 AcceptReject 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
AcceptReject Rule: y IRR (r) > cutoff rate » Project accepted y IRR (r) < cutoff 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 CertaintyEquivalent Approach
y
y Probability Distribution Approach
y
y Decisiontree Approach
y
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