11th

Lecture

Topic Today: Project Evaluation (Principles and Methods)

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 GENERATION OF INVESTMENT PROPOSALS

Investment ideas can range from simple upgrades of equipment,

replacing existing inefficient equipment, plant expansions, new
product development or corporate takeovers.
 EVALUATION AND SELECTION OF
INVESTMENT PROPOSALS

In order to evaluate a proposal, the following data should be

considered:

o Brief description of the proposal.

o Statement as to why it is desirable or necessary.
o Estimate of the amount and timing of the cash outlays.
o Estimate of the amount and timing of the cash inflows.
o Estimate of when the proposal will come into operation.
o Estimate of the proposal’s economic life.
 APPROVAL AND CONTROL OF CAPITAL
EXPENDITURES

• Capital-expenditure budget maps out the estimated

future capital expenditure on new and continuing projects.

• This has the important role of setting administrative

procedures to implement the project (project timetable,
procedures for controlling costs).

• Timing is important because project delays and cost

over-runs will lower the NPV of a project, costing shareholder
wealth.
 METHODS OF PROJECT EVALUATION

Different methods of project evaluation include:

o Payback period (Pb).

o Net present value (NPV).
o Internal rate of return (IRR).
o Benefit-cost ratio (profitability index).
 METHODS OF PROJECT EVALUATION

Payback Period (Pb). The payback period method is the

easiest investment evaluation method to perform, but the
theoretically worst method available. The payback is simply the
number of years it takes to recover the initial investment. The
timing and riskiness of the cash flows are ignored. The reason it
continues to be used is that it is easy to understand and explain
to other. Small business are especially likely to use the payback
method if the owners or managers are not well versed in
financial principles.
 PAYBACK PERIOD COMPUTATION

Payback Period (Pb)

Payback Period = Investment

Annual Cash Savings

Pb = Complete Years + Fraction

Fraction = Amount Required

Amount Received
 Investment - ICOF(Initial Cash Out Flow)

 Cash Inflows + ve or No Sign

or
Receipt
or
Revenue

 Cash Outflows - ve
or
Disbursement ( )
or
Payment
18-11-2018 18-11-2019 18-11-2020 18-11-2021 18-11-2022

Today 1st 2nd 3rd 4th

0
(50 Million) Revenue 100M 130M 140M 120M
Expenses 80M 110M 120M 100M
Cost Saving 20M 20M 20M 20M

Payback Period = Investment = 50,000,000

Annual Cash Saving 20,000,000

Pb = 2.5 Years or 2 Years 06 Months

Note:
If decision is based on ‘Pb’ then Pb should be ‘less’
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 PRACTICE QUESTIONS
Q1.

Initial Investment = Rs 40M

Annual Cash Saving for next = Rs 7.0M Per year
08 x Years
Pb = ?

Q2.

Initial Investment = US$ 17M

Duration of Project = 07 Years
Average Annual Cash Saving = US$ 15M
Pb = ?
 PRACTICE QUESTIONS
Q3. Two investment proposals w.r.t project A & B having
following details:
Initial Investment A B
1 42,000 45,000
2 14,000 28,000
3 14,000 120000
4 14,000 10,000
5 10,000
Required:
a. Find Pay Back Period for both choices.
b. Which choice is better?
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 PRACTICE QUESTIONS

Q4. Two investment proposals involving same COF of

US$210,000 in each case as on 01-01-2018;

End of Year CIFAT Cash Inflows after Tax in US$

2018 2019 2020 2021 2022 2023
Choice $50,000 $40,000 $40,000 $50,000 $30,000 $35,000
1
Choice US$ 65,000 each year for next 5 years
1
Required:
a. Find Pay Back Period for both choices.
b. Which choice is better?
 PRACTICE QUESTIONS

Q5. D a project manager is evaluating two mutually exclusive

project proposals ( X and Y) with the following End of Year
Annual Cash Flow;

Year Net CFs Project X Net CFs Project Y

2018 -$100,000 -$150,000

2019 $40,300 $75,200
2020 $50,400 $59,300
2021 $35,500 $65,400

Required: Indicate which project is acceptable based on

Payback period of projects.
Thank You
 Payback Period for Equal annual Cash Flows

You want to install an ice cream machine in your restaurant. It is

expected to cost $60,000, has a 4-year life. You think it will
generate net annual cash inflows of $22,000. Determine the
payback period.

Payback period = Initial investment

Annual operating cash flow amount
$60,000 = 2.73 Years
$22.000
Interpretation: You expects to recover its cash investment in
approximately 2.73 years.

Evaluation: Because the cash is expected to be recovered in less

than 4 years, the investment is acceptable based on this analysis.
 Payback Period
Table Relevant Cash Flows and Payback Periods for
DeYarman Enterprises’ Projects
Project Gold Project Silver
Initial Investment $50,000 $50,000
Year Operating cash inflows
1 $ 5,000 $40,000
2 5,000 2,000
3 40,000 8,000
4 10,000 10,000
5 10,000 10.000
Payback Period 3 years 3 years
 Payback Period for unequal Cash Flows

A project requires initial investment of $200,000 and is expected

to generate cash savings of $85,000, 75,000, 90,000 and 40,000
respectively in coming years. What is the payback period?

Year Cash Flow Cumulative

0 ($200,000) ($200,000)
1 $85,000 (115,000)
2 $75,000 (40,000)
3 $90,000 50,000
2 + 40,000 = 2.44 Years
4 $40,000 90,000 90,000
 Payback Period for unequal annual Cash Flows

Y wants to install an ice cream machine with an expected cost of

$60,000, a 4-year life. The net annual cash inflows are given
below. Determine the payback period.

Step 1: Step 2: Track recoveries by year:

Determine the annual cash flows: Amount to be recovered $60,000

Year 1 $15,000 Recovered in Year 1 (15,000)

45,000
Year 2 $16,500
Recovered in Year 2 (16,500)
Year 3 $18,150 28,500
Recovered in Year 3 (18,150)
Year 4 $19,965
Balance at end of Year 3 $10,350

Proration of Year 4: $10,350/S19,965 = 0.5184

Interpretation: Y expects to
recover its cash investment in
approximately 3.52 years. Payback period = 3.52 years