Professional Documents
Culture Documents
INSTRUCTOR:
Philipos Lamore (PhD)
CHAPTER ONE
1. INTRODUCTION
Project Goals
Virtually every project has three overriding
goals: to accomplish work for a client or
end-user in accordance with budget,
schedule, and performance requirements.
(i) Budget: the budget is the specified
or allowable cost for the project.
-It is the target cost of the work to be
done.
Introduction…Cont’d
a) Project Initiation
b) Project Planning
c) Project Execution, and
d) Project Closure
6. Complexity
A project is complex set of activities relating to
diverse areas. Technology survey, choosing the
appropriate technology, procuring the
appropriate machinery and equipment, hiring
the right kind of people, arranging for financial
resources, execution of the project in time by
proper scheduling of the different activities,
etc. contribute to the complexity of the project.
Project Closure…Cont’d
I. The pre-investment
II. The investment, and
III. The operational phase
I. Qualitative Methods
These methods rely essentially on the judgment of
experts to translate qualitative information into
quantitative estimates. The important qualitative
methods are:
…Cont’d
(1) Jury of Executive Method: Involves soliciting the
opinions of a group of managers on expected future sales
and combining them into a sales estimate.
Advantages
(i) It is an speedy method for developing a demand forecast
(ii) It permits consideration of a variety of factors like
economic climate, competitive environment, consumer
preferences, technological developments etc. to be
included in subjective estimates provided by the experts.
Limitations
(iii) The biases underlying subjective estimates cannot be
unearthed easily.
(iv) The reliability of this technique is questionable.
…Cont’d
Y = a + bX
…Cont’d
b = ∑xy – n ̅XῩ
∑x2 – n̅ X2
a = Ῡ – b̅ X
Where, ̅X = Mean of X
Ῡ = Mean of Y
…Cont’d
Advantages of the LSM
(i) It uses all the observations
(ii) The straight line is derived by an objective,
statistical procedure
(iii) A measure of goodness of fit is available
Disadvantages of LSM
(i)It is more complex compared to other methods
Illustration – Trend Projection Method
To illustrate the use of Trend Projection Method, the
following demand data for a product will be used as
shown in Exhibit 3.1 below:
Table 2.2 Demand Data (in thousand units)
Year Demand Year Demand
2003 10* 2010 20
2004 13 2011 22
2005 14 2012 23
2006 17 2013 22
2007 18 2014 24
2008 18 2015 24
2009 19 2016 25
*Base year data
…Cont’d
(2) Exponential Smoothing Method:
In this method forecasts are modified in the light of
observed errors.
Ft + 1 = α Dt + (1 - α ) Ft
The net present value (NPV) has certain properties that make it
a very attractive decision criterion.
Decision Criteria
If NPV is greater than zero accept the project
If NPV is less than zero reject the project
Advantages
1. time value of money is considered
2. It measures the benefits directly
3. It is an objective method of selecting and
evaluating projects(By considering cash flows, NPV is not
affected by the Co.’s accounting policies, unlike net profit).
…Cont’d
Limitations
1. The NPV method does not consider the life of the
project. Hence, when mutually exclusive projects
with different lives are being considered, the NPV
rule is biased in favor of the longer term project.
2. In practice it may be difficult to determine the
discount rate. This should relate to the cost of
finance, but calculating the costs of the different
elements of finance (share capital and loans)is
difficult.
3. The NPV is an absolute figure and it does not
consider for the size of the project.
…Cont’d
Example
To illustrate the calculation of the NPV
consider a project which has the following
cash flow streams.
Year Cash Flow
0 $(1,000,000)
1 200,000
2 200,000
3 300,000
4 300,000
5 350,000
The cost of capital, r, for the firm is 10%. The NPV of proposal is?
…Cont’d
NPV=Io - 200,000+200,000+300,000+300,000+350,000
(1.10)1 (1.10)2 (1.10)3 + (1.10)4 + (1.10)5
= -Br. 5,273
IO - PV (NCF) = O
Year 0 1 2 3 4
Year 1 2 3 4 5
CFs 120 120 120 150 150
(in thousands)
…Cont’d
Solution
i. Find (guess) the starting rate
500000/120000=4.167=7%
500000/150000=3.333=15%
ii. A better approximate (guess) can be found by
0.07+0.15 = 11% or 0.11
2
iii. Compute the PV of the cash flow at this rate,
120,000x2.444 = $293,280
150,000x0.659 = 98,850
150,000x0.593 = 38,950
PVCF ………………….481,080
Io ……………………….500,000
NPV …………………… $-18920
…Cont’d
Now, NPV is negative, which means the actual IRR is
less than 11%. The following are the next trials at
9% and 10%
9% 10%
120,000x2.531=303,720 x2.487=298,440
150,000x0.708=106,200 x0.683=102,400
150,000x0.650=97,000 x0.621=93,150
507,420 494,040
-500,000 -500,000
NPV……... +7,420 -5,960
…Cont’d
iv. Now, IRR is above 9% but below 10%; apply
interpolation to approximate the true IRR,
7420 = 0.55
13380
Thus, IRR 9.55%
Exercise
A project requires a new investment of 20,000 and
produces the following cash flows. Compute the IRR of
the project
…Cont’d
Year 1 2 3 4 5
CFs 5000 4000 3000 2000 8000
NPV Vs IRR
For making choice between two projects competing for
the funds at the disposal of a concern, the NPV method
can give a better choice because it can give idea of
ranking of the projects.
…Cont’d
Advantages of IRR
(1)Like NPV, it deals with discounted cash flows and is
based on the time value of money.
(2)The difference between the IRR and the cost of capital
indicates the additional return for risk that the project
provides.
Disadvantages of IRR
(3)If there are negative annual cash flows later than year
0, this may lead to more than one possible IRR. In such
a case, IRR must be used with great care.
(4)If a firm has to rank mutually exclusive projects,
choosing the project with the highest IRR may result in
suboptimal outcome.
…Cont’d
C. Benefit-Cost Ration (Profitability Index)
The profitability index, also called benefit - cost
ratio, is the ratio of the PV of the future net cash
inflows to the initial outlay of the project.
It measures the desirability of the project and
evaluates the worth of an investment.
PI= PV (NCF)
PV (IO)
In the application of PI, a project is accepted if PI
> 1, rejected if PI < 1 and we remain indifferent
if PI = 1. It should be noted that when PI > 1,
NPV is positive; PI < 1, NPV is negative and PI=1
when NPV is zero.
…Cont’d
Example
After tax cash flows of a small scale tannery
project is given below. Find the profitability index
if discount rate is assumed to be 12%?
Year 0 1 2 3 4 5
Example 2
If the project cash inflow is not in “annuity form”,
cumulative cash inflow method may be used to compute
that PBP. Assuming an initial investment of Br. 30,000 for
the following stream of cash flows and compute the PBP.
…Cont’d
Year Cash inflows Cumulative
1 10,000 10,000
2 8,000 18,000
3 12,000 30,000
4 7,000 37,000
5 9,000 46,000
6 3,000 49,000
Cont.
Example 3
If the project cumulative cash flow does not
exactly match to the investment outlay, but
in annuity form of inflow, then compute the
PBP in the following way (assuming initial
investment of $10,000)
…Cont’d
Year Cash inflow Cumulative
1 4,000 4,000
2 4,000 8,000
3 4,000 12,000
4 4,000 16,000
5 4,000 20,000
Example 4
In case the cumulative inflow does not
exactly match the amount of investment
and the inflow is not in annuity form use
the interpolation method (assume an
investment outlay of 15,000); compute the
PBP.
…Cont’d
Year Cash in flow Cumulative
1 3,000 3,000
2 5,000 8,000
3 10,000 18,000
4 2,000 20,000
5 4,000 24,000
Advantages
1. It simple to calculate
2. It is based on accounting information, which is readily
available, and familiar to businessman
3. It considers benefits over the entire life of the project.
Limitations
4. It is based upon accounting profit, not cash flow
5. It does not take into account the time value of money.