Professional Documents
Culture Documents
1. Ranking by Inspection
By simple inspection it is possible to determine
which of the two or more investment projects is
more desirable.
2
1. Ranking by Inspection
There are two cases under consideration
(i) When two projects have identical cash flows but
different project life, i.e.,
One has shorter life
while the other has longer project life
then, the project with the longer life would be more
desirable.
(ii) When two projects have the same initial outlay the
same earning life and earn the same total proceeds
(profits), but one project has more of the flow
earlier in the time sequence,
Then we choose the project having higher proceeds
in the earlier period than later.
3
Ranking by Inspection (cont…)
6
The Payback Period (Cont…)
If a project involves cash outlay of Birr 600,000
and generates cash inflows of
Birr 100,000,
Birr 150,000,
13
Proceeds per Unit of Outlay (Cont…)
14
Proceeds per Unit of Outlay (Cont…)
17
The average annual proceeds per unit
of outlay (Cont…)
18
The average annual proceeds per unit
of outlay (Cont…)
19
7.2. Discounting methods of
project selection
The non-discounted criteria failed to take into
account adequately the timing of benefits.
We know that inter-temporal variations of costs
and benefits influence their values and a time
adjustment is necessary before aggregation.
Therefore, a time dimension should be included
in our evaluation.
That means we need to express costs and
benefits by discounting all items in the cash
flows back to year 0.
The need for such a procedure will be apparent
if one considers the following simple argument.
20
Discounting methods of project
selection (Cont…)
Suppose one is offered the choice between
receiving Birr 100 today and receiving the
same amount in a year’s time. It will be
rational to prefer to receive the money today
for several reasons.
1. One may expect inflation to reduce the real
value of Birr 100 in a year’s time.
2. If there is no inflationary effect it would
still be preferable to take the money today
and invest it at some rate of interest, r.
Hence, receiving a total of Birr 100 (1+r) at
the end of the year.
21
Discounting methods of project
selection (Cont…)
3. Even if no investment opportunities are available,
Birr 100 today would still be preferable on the
grounds that there is a high risk of not being around
to collect the money next year.
24
Net Present Value (NPV) (Cont…)
The discounted rate should be either
the actual rate of interest on long term loans in
the capital market
or the interest rate paid by the borrower
Since capital markets do not function properly
in developing countries, the discount rate should
reflect the opportunity cost of capital
This is the minimum rate of return below which
it does not pay to invest (Cut off rate)
25
Net Present Value (NPV) (Cont…)
The discounting period is normally equal to the
life of the project.
This period is the economic life of the project
and varies from project to project.
Having determined discount rate, The project is
acceptable if the discounted net benefits is
greater than or equals to zero.
The economic criterion of project appraisal is to
accept all projects that show positive or zero
NPV at the predetermined discount rate and
reject all projects that show negative NPV.
Thus, the decisions is to accept if NPV > 0.
26
Net Present Value (NPV) (Cont…)
Year 0 1 2 3 4 5
Therefore,
1,000,000 200,000 200,000 300,000 300,000 550,000
NPV 0
1
2
3
4
5
118,913
(1.10) (1.10) (1.10) (1.10) (1.10) (1.10)
27
Net Present Value (NPV) (Cont…)
We can also use the discount factor (PVIF r, n) from
present value tables and compute the NPV as shown in
following table
Year Cash flow PV Discount PV
Factor
0 -1,000,000 1 (1,000,000)
1 200,000 .909091 181,818
2 200,000 .826446 165,259
3 300,000 .751315 225,395
4 300,000 .683013 204, 904
5 550,000 .620921 341,507
28
NPV 118,913
Net Present Value (NPV) (Cont…)
Independent projects are projects that are
not in any way substitutes for each other.
In such cases the decision rule is to
accept the project having positive NPV
Which means, if two projects have
positive NPV and there is no budget
constraint both could be accepted and we
do not need to choose the one with higher
NPV.
29
Net Present Value (NPV) (Cont…)
35
Net Present Value (NPV) (Cont…)
The ratio of the NPV and the present value of initial
investment (PVI) is called the net-present-value ratio
(NPVR)
This should be used for comparing alternative projects.
NPV
NPVR
Given PVIone
alternative projects, the with the highest
NPVR should be chosen.
However, when comparing alternative projects, care
should be taken to use the same discount rate for all
projects.
36
Net Present Value (NPV) (Cont…)
If the construction period does not exceed one year,
the value of investment will not have to be
discounted.
37
2. The Internal Rate of Return of
a Project (IRR)
The Internal Rate of Return (IRR): is the
discount rate at which the present value of all
cash flows is equal to the present value of the
initial cash outflows.
In other words, it is the discount rate for which
the present value of the net receipts from the
project is equal to the present value of the
investment,
Here an attempt is made to find the discount
rate which just makes the net present value of
the cash flow equal to zero
38
The Internal Rate of Return (Cont…)
The IRR of a project is probably the most
commonly used assessment criterion in project
appraisal.
This is because the concept of IRR is in some
way comparable to the profit rate of a project.
The method utilizes present value concept but
will avoid the arbitrary choice of a discount
rate.
The procedure used to determine the IRR is
the same as the one used to calculate the NPV.
39
The Internal Rate of Return (Cont…)
Instead of using a predetermined cut-off rate,
several discount will be tried until the
appropriate rate is found.
And this (IRR) represents the exact
profitability of the project
41
The Internal Rate of Return (Cont…)
This can be written as,
1 1 1 1 1
10,000 3,000
(1 r ) 1
(1 r ) 2
(1 r ) 3
(1 r ) 4
(1 r ) 5
This is a present value of annuity which can
be solved as 5
10,000 1
3000 (1 r ) t 1
t
2000
1671 at 5%
1000
91 @ at 13%
Discount rate
1 5 10 15 20
IRR -221 @ 15%
49
The Internal Rate of Return (Cont…)
Once the IRR is identified, the decision rule is
‘accept the project if the IRR is greater than
the cost of capital, say r (cost of borrowing).
That is, all projects with an internal rate of
return greater than some target rate of return,
should be accepted.
The target rate is usually the same rate used as
the discount rate employed in the computation of
the projects net present value.
Note that the use of IRR does not preclude the
need for discount rate, as sometimes claimed,
but merely delays the need to use it until the IRR
has been computed
50
The Internal Rate of Return (Cont…)
From our discussions it is clear that both the
NPV and the IRR methods can and do rank
investment projects in more rational manner
than the other methods previously considered.
In general, it can be said that the NPV method
is simpler, easier, and more direct and more
reliable.
In some situations, both the NPV and the IRR
criteria give the same accept or reject
decision.
51
The Internal Rate of Return (Cont…)
Disadvantages of IRR
The IRR is inappropriate to use for
mutually exclusive projects
It assumes that cash flows over the life
of the project are reinvested at the IRR
Requires detailed long term forecasts of
the projects incremental costs and
benefits
53
Modified Internal Rate of Return
The major drawback of the IRR relative to the NPV is
the reinvestment rate assumption made by the IRR.
The IRR assumes that all cash inflows over the life of
the project are reinvested at IRR until the termination
of the project.
The MIRR will correct this shortcoming by making
alternative assumption that,
all cash inflows over the life of the project are
reinvested at the required rate of return .
The MIRR, will take all the annual after cash inflows
(ATCI) and find their future value at the end of the
projects life, compounded at the required rate of
return.
54
Modified Internal Rate of Return (Cont…)
(1 r ) t
t 0
ACIFt (1 k ) t
/(1 MIRR ) t
55
Modified Internal Rate of Return (Cont…)
TV
PVoutflows
(1 MIRR) t
Where,
ACOFt = all cash outflow in time period t
ACIFt = the annual after tax cash inflows in time
period t
TV = terminal value of the project
n = Project’s expected value
MIRR = Modified IRR
56
Modified Internal Rate of Return (Cont…)
58
Modified Internal Rate of Return (Cont…)
0 1 2 3
4000
3300
2420
9720 = TV
-6000
MIRR = 17.45%
59
Modified Internal Rate of Return (Cont…)
6000= 9720/(1+MIRR)3
MIRR= 17.45%
=1 =0 Indifferent
?
71
Problem with Project Ranking (Cont…)
1. Size Disparity Problem
The size disparity problem occurs when mutually
exclusive projects of unequal size are compared.
72
Problem with Project Ranking (Cont…)
The NPV, the IRR, and BCR for each of them is
presented below
Project A Project B
300 inflow
1900 inflow
Year 1 1 year
200 outflow
1500 outflow
74
Problem with Project Ranking (Cont…)
If there is capital constraint,
then focuses is on what can be done with
the additional 1300 (1500-200=1300) that
is freed if project A is chosen?
76
Problem with Project Ranking (Cont…)
2. Unequal Projects’ life
The other problem of project ranking of
mutually exclusive projects is problem
associated with unequal life.
Is it appropriate to compare two projects
having different life span?
Example
Suppose a firm with a 10% required rate of
return is faced with the problem of selecting
between two projects having different life
time.
77
Project A Project B
1 2 3 years
1 2 3 4 5 6years
1000 outflow
1000 outflow
78
Problem with Project Ranking (Cont…)
When we examine these two projects we find
that the NPV, and BCR criteria indicate that
project B is better project.
But the IRR criteria favors project A.
In this case the decision is a difficult one as
the two projects are not comparable.
The problem of incomparability of projects with
different life time arises, because
future profitable project proposals may be
rejected without being included in the analysis.
In our example, the comparison of the NPV
alone would be misleading. .
79
Problem with Project Ranking (Cont…)
If the project A is taken, the firm could replace
it at its termination by another project and
receive additional benefits.
But acceptance of the project with longer life
span would exclude this probability.
As a result the key question here becomes,
Does today’s investment decision include all
future profitable investment proposals in its
analysis?
82
Problem with Project Ranking (Cont…)
iii) The final technique is to assume that
reinvestment opportunity in the future will be
similar to the current one.
Meaning creating a replacement chain to
equalized life span.
In the replacement chain, we can create two chain
cycle for project A.
That is, we can assume that project A can be
replaced with a similar investment at the end of
three years.
Thus, project A would be viewed as two A projects
occurring back to back as illustrated below.
83
Problem with Project Ranking (Cont…)
Project A
1 2 3 4 5 6 years
87
Problem with Project Ranking (Cont…)
For project A
The PVIFA10%, 3years = 2.4869
EAA = 243.5/2.487 = 97.91
For project B
The PVIFA10%, 6years = 4. 3553
EAA = 306.5/4.355 = 70.38
Since both EAA are annual annuity they
are now comparable
88
Problem with Project Ranking (Cont…)