Lecture 3

Decision Rules
 Although we use the term “cash flow”, the dollar
values used might not be the same as the actual cash
amounts.
  In some instances, actual ‘market prices’ do not
reflect the true value of the project’s input or output.
  In other instances there may be no market price at
all.
  We use the term ‘shadow price’ or ‘accounting price’
when market prices are adjusted to reflect true
values.
 Three processes in any cash-flow analysis
  identification
  valuation
 comparison
 Comparing Costs and Benefits

We cannot compare dollar values that accrue at

different points in time
To compare costs and benefits over time we use the
concept “discounting”
The reason is that $1 today is worth more than $1
tomorrow

WHY
Discounting a net Benefit Stream

Which Project?
 Using Discount Factors
 If i = 10% then year 1 DF = 1/(1+0.1)1 = 0.909
  PV of $50 in year 1 = $50 x 0.909 = $45.45

What about year 2 and beyond?

  PV of $40 in year 2 = $40 x 0.909 x 0.909

=$40 x 0.826
= $33.05

 PV = $30 in year 3 = $30 x 0.9093

=$30 x 0.751
= $22.53
 Calculating Net Present Value
 Net present value (NPV) is found by subtracting the
discounted value of project costs from the discounted value of
project benefits
 Once each year’s amount is converted to a discounted present
value
 we simply sum up the values to find net present value (NPV)
 NPV of Project A
 = -100(1.0) + 50(0.909) + 40(0.826) + 30(0.751)
 = -$100 + 45.45 + 33.05 + 22.53
 = $1.03
 Comparing Net Present Values
If NPV ≥ 0, accept project
If NPV < 0, reject project
Once each project’s NPV has been derived we can
compare them by the value of their NPVs
NPV of A = -100 + 45.45 + 33.05 + 22.53= $1.03
NPV of B = -100 + 27.27 + 37.17 + 37.55 = $1.99

As NPV(B) > NPV(A) choose B

Will NPV(B) always be > NPV(A)?

Remember, we used a discount rate of 10% per annum.

 Changing the Discount Rate
 As the discount rate increases, so the discount factor
decreases.
 Remember, when we used a discount rate of 10% per
annum the DF was 0.909.
If i = 15% then year 1 DF = 1/(1+0.15)1= 0.87
 This implies that as the discount rate increases, so the
NPV decreases.
 If we keep on increasing the discount rate, eventually the
NPV becomes zero.
 The discount rate at which the NPV = 0 is the “Internal
Rate of Return” (IRR).
 The NPV Curve and the IRR
Where the NPV curve intersects the horizontal axis gives
the project IRR
 The IRR Decision Rule
 Once we know the IRR of a project, we can compare this
with the cost of borrowing funds to finance the project.
 If the IRR= 15% and the cost of borrowing to finance the
project is, say, 10%, then the project is worthwhile.
 If we denote the cost of financing the project as ‘r’, then
the decision rule is:
 If IRR ≥ r, then accept the project

 • If IRR < r, then reject the project

 NPV vs. IRR Decision Rule
 With straightforward accept vs. reject decisions, the NPV
and IRR will always give identical decisions.
 If IRR ≥ r, then it follows that the NPV will be > 0 at
discount rate ‘r’
 If IRR < r, then it follows that the NPV will be < 0 at
discount rate ‘r’
 Using NPV and IRR Decision Rule to
Compare/Rank Projects

If we have to choose between A and B which one is best?

 Choosing Between Mutually Exclusive
Projects
 In example 3.8, you need to assume the cost of capital is:
(i) 4%, and then,
(ii) 10%

 IRR (A) > IRR (B)

 At 4%, NPV(A) < NPV (B)
 At 10%, NPV(A) > NPV (B)
 Other Problems With IRR Rule
 Multiple solutions (see figure 2.8)
 No solution (See figure 2.9)
 Further reason to prefer NPV decision rule.
 Problems With NPV Rule
 Capital rationing
 – Use Profitability Ratio (or Net Benefit Investment
Ratio (See Table 3.3)
 Indivisible or ‘lumpy’ projects

– Compare combinations to maximize NPV (See Table 3.4)

 Projects with different lives

– Renew projects until they have common lives: LCM (See

Table 3.5 and 3.6)
– Use Annual Equivalent method (See Example 3.12)
Project and Private Benefit-Cost
Analysis
 Private Benefit-Cost Analysis
 Deriving ‘Project’ and ‘Private’ cash flows:
 Project cash flow refers to cash flow for the overall
project
 At market prices

 Irrespective of who gains or loses.

 Private Cash Flow
 Private cash flow refers to cash flow to the individual
investor engaged in project.
 after allowing for loan service costs

 after payment of profits taxes

 Deriving Private Cash Flow
 To derive private cash flow, we begin by calculating
overall project cash flow.

 We then subtract from the project cash flow:

 Debt/financing inflows and outflows to creditors

 Taxes paid to government

 Cash Flow on Equity
 The private cash flow is the cash flow on the investor’s
own funds or ‘equity’.
 Project cash flow minus debt cash flow = cash flow on
equity (before tax).
 Cash flow on equity is the residual: what is left over after
servicing debt.
 Deriving Project Cash Flow
To derive project cash flow we need to be mindful of some
important concepts and conventions:
Incremental rather than total cash flow: ‘with project’ less
‘without project’ cash flow. See table 4.2.
Inflation: usual to use constant prices with a real discount
rate (otherwise, nominal prices with nominal interest rate).
See table 4.1.
 Nominal vs real cash flow
Table: Nominal vs real cash flow
 incremental cash flows
Table: incremental cash flows
 Deriving Project Cash Flow
 Depreciation excluded from cost to avoid double
counting. (See table 4.3)
 Changes in working capital appear under investment
costs at the beginning and end of the project. (See table
4.4)
 Interest on debt excluded from cost to avoid double
counting.
Table: Calculating Depreciation Using straight Line Method

Table: Investment in Working Capital

 Debt Financing Cash Flow

 To derive debt financing flow, for each period, from the

borrower’s perspective, begin with project cash flow,
then:
 Add all loan receipts in each period

 Subtract all interest payments in each period

 Subtract all principal repayments in each period

 Private Cash Flow (Equity)

 To derive private cash flow, for each period, before tax:

 Add debt financing flow to project cash flow. (See
table 4.5)
 Project = Debt + Equity
 Cash flow from the perspective of lenders and investors
adds up to Project Cash Flow.
 Deriving IRR on Equity
 We can calculate IRR on each ‘component’ of cash flow:
project, debt and equity.
 First, calculate IRR on Project Cash Flow:
when NPV = 0
-5000 (1.0) + 1000(AF10) = 0
AF10 = 5000/1000
=5
IRR = 15%
 Deriving IRR on Equity
 •Second, calculate IRR on Debt Financing Cash Flow:
when NPV = 0
3512(1.0) - 500(AF10) = 0
AF10 = 3512/500
= 7.024
IRR = 7%
 Deriving IRR on Equity
 Third, calculate IRR on Equity Cash Flow:
when NPV = 0
-1488(1.0) + 500(AF10) = 0
AF10 = 1488/500
= 2.976
IRR = 31%
 Gearing and Debt: Equity Ratio
 IRR on Equity + IRR on Debt = Project IRR
 Project IRR minus IRR on Debt = IRR on Equity
– By changing the ratio of debt to equity, you can
change the IRR on equity, given the Project IRR and
IRR on debt.
 An Example of Gearing
 An Example of Gearing
 Assume debt : equity is $60:$40

 Assume Project IRR = 10%, and, cost of debt = 5%

– What is the IRR on equity?

HINT: IRR on Debt + IRR on Equity = Project IRR
 IRR on project = 0.6(IRR on debt) + 0.4(IRR on equity)

10% = 0.6(5%) + 0.4(x%)

0.4(x%) = 10% - 3%
IRR on equity = x% = 7/0.4
= 17.5%
 Implications of Gearing
 If an investor can borrow on concessional terms, a ‘bad’
project can appear ‘good’.
 If an investor borrows on unfavourable terms, a ‘good’
project might appear ‘bad’.
 Calculating After Tax Cash Flow
 Some items of project cost that do not enter into a project's
cash flow directly affect the net cash flow indirectly through
their effect on the project's taxable profits.
 The analyst needs to prepare a separate statement to calculate
the project's taxable profits.
 The two items that are not part of the project’s cash flow that
enter into the calculation taxable profits are:
– depreciation
– interest on debt
 These should be added to the operating costs in the project
cash flow for the purpose of calculating taxable profits.
 Taxes due are then calculated as some % of taxable profits
and are deducted from the private cash flow to derive the
after tax private cash flow.
 Calculating Taxes
 It should be noted that tax laws vary from one country or
state to another. In most cases, losses can be written off
profits earned elsewhere or of future profits.
 This implies that there could be negative taxes in some
project years.
To Summarise
Project cash flow
minus debt finance
minus taxes
equals private cash flow
(on equity after tax)
 Using Private BCA
 Why would the project analyst who is concerned with the
wider public or social interest be concerned with the
return on private equity?
– When the private investor is one of the stakeholder’s
whose gains are part of the ‘Referent Group’ net
benefits.
– Because the policy maker needs to know what is ‘in it’
for the investor: need incentives or tax concessions? etc
 Distribution of Net Benefits

 •The project net benefits (at market prices) can be

disaggregated among three stakeholder groups:
– equity holders (private or public sector)
– lenders
– recipients of taxes (government)
Shares of Project’s Capital
Shares of Project’s Net Benefits
(hypothetical)
 Distribution of Net Benefits

 At a later stage we will be looking at the distribution of all

project net benefits among stakeholders, including those not
included in the project’s net benefits at market prices.
 At this stage it is still useful to distinguish between Referent
Group and Non-Referent Group Net Benefits.
 Distribution of Project Benefits

A B
(referent (non-referent
group net group net benefits)
benefits)

i. Government i. Lenders (eg.

foreign bank)
ii. Local Private
firm
The END