Ch 6 Project Analysis Under

Certainty

Methods of evaluating projects when

the future is assumed to be certain.

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 °ntroduction
The ideal investment decision making technique
is Net Present Value.
N P V measures the equivalent present wealth
contributed by the investment.
NPV is given in
NPV -- relates directly to the firm¶s goal of
wealth maximization
-- employs the time value of money
-- can be used in all types of investments
-- can be adjusted to incorporate risk.
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vther Project Evaluation Techniques:
Slide °
iscounted Cash Flow Techniques
°nternal Rate of Return ± calculates the
discount rate that gives the project an
NPV of $0. °f the °RR is greater than
the required rate, the project is
accepted. °RR is given as % pa.
 


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vther Project Evaluation Techniques:
Slide °°
Modified °nternal Rate of Return ± calculates
the discount rate that gives the project an NPV
of $0, when future cash flows can be re-invested
at the Re-°nvestment Rate, a rate different from
the °RR. °f the M°RR is greater that the
required rate, the project is accepted. M°RR is
given as % pa.
    





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 vther Project Evaluation Techniques:
Slide °°°
Non- iscounted Cash Flow Techniques
Accounting Rate of Return- measures the ratio of
annual average accounting income to an asset base
value. ARR is given as % pa.




Payback Period ± measures the length of time

required to retrieve the initial cash outlay.
PB is given as number of years.
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 Selection of Techniques: Slide °
NPV is the technique of choice; it satisfies the
requirements of: the firm¶s goal, the time value of
money, and the absolute measure of investment.

°RR is useful in a single asset case, where the cash

flow pattern is an outflow followed by all positive
inflows. °n other situations the °RR may not rank
mutually exclusive assets properly, or may have
zero or many solutions.
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 Selection of Techniques: Slide
°°
M°RR is useful in the same situations as the °RR,
but requires the extra prediction of a re-
investment rate.
ARR allows many valuations of the asset base,
does not account for the time value of money, and
does not relate to the firm¶s goal. °t is not a
recommended method.
PB does not allow for the time value of money,
and does not relate to the firm¶s goal. °t is not a
recommended method.

 The Notion of Certainty
Certainty allows demonstration and evaluation of the
capital budgeting techniques, whilst avoiding the
complexities involved with risk.

Certainty requires forecasting, but forecasts which are

certain.

Certainty is useful for calculation practice.

Risk is added as an adaption of an evaluation model

developed under certainty.
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 °nvestment Cash Flow Timing
End vf Year cash flow timing is assumed.
Capital Flows
0 1 2 3 4 5

°nitial Later Terminal

vutlay. vutlay Flow

vperating Flows
0 1 2 3 4 5

vperating Flows.

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 The NPV Process: Slide 
Net annual cash flows are forecast
for each year of the project.
EvY 0 EvY 1 EvY 2 EvY 3

900 300 380 600
The discount rate is then applied.

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 The NPV Process: Slide °°
The NPV is calculated.

-$900 $283.01 $338.19 $503.77

NPV = $ 224.97 Positive: the project is acceptable.

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 vther NPV Applications:
Slide °

Asset
Retirement:

Asset
Replacement:

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 vther NPV Applications:
Slide °°
vptimum cycle length within a replacement chain.
At EvY:

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 vther NPV Applications:
Slide °°°
Correct ranking of mutually exclusive projects.
Where projects have different lives.

Where projects have different outlays.

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 Net Present Value

THE model to use in all investment evaluations.

vther criteria, such as °RR, M°RR, ARR, and

Payback may be used as complementary
measures.

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