Cost-benefit evaluation techniques

1. Net Profit:
 Net profit of a project is the difference between the total costs and
the total income over the life of the project

2. Payback period:
 The time taken to break even or pay back the initial investment
3. Return on investment(ROI):
Also known as the accounting rate of return (ARR), provides a way of
comparing the net profitability to the investment required
4. Net Present value(NPV)
 The calculation of net present value is a project evaluation
technique that takes into account the profitability of a project and
the timing of cash flows that are produced
5. Internal Rate of Return(IRR)
 Calculated as that percentage discount rate that would produce an
NPV of zero.
1
• Example:
An exercise...(1)
• Consider the project cash flow estimates for 3 projects. Negative values
represent expenditure and positive values income. The discounted rates for the
projects are 8%, 10%, 12% respectively.

• Rank the 3 projects in order of financial desirability and make a note of your
reasons for ranking them in that way.

Year Project A Project B Project C

0 - 8000 - 8000 -10000
1 4000 1000 2000
2 4000 2000 2000
3 2000 4000 6000
4 1000 3000 2000
5 500 9000 2000
6 500 - 6000 2000

2
• 1. Net Profit: Solution..(1)...
• Net profit of a project is the difference between the total
costs and the total income over the life of the project.

• NP(Project A) = 4,000+4,000+2,000+1,000+500 +500–

8,000 = 4,000/-
• NP(Project B) = 1,000+2,000+4,000+3,000+9,000 - 6,000–
8,000 = 5,000/-
• NP(Project C) = 2,000+2,000+6,000+2,000+2,000
+2,000– 10,000 = 6,000/-

3
 Net profit...Contd...

• Net profit
Year Project A Project B Project C
0 -8000 -8000 -10000
1 4000 1000 2000
2 4000 2000 2000
3 2000 4000 6000
4 1000 3000 2000
5 500 9000 2000
6 500 - 6000 2000
Net profit 4000 5000 6000

4
 Net profit...Conclusion...
Year Project Project B Project C
A
0 -8000 -8000 -10000
• With a same initial investment 1 4000 1000 2000
 B is giving higher profit than A 2 4000 2000 2000
3 2000 4000 6000
4 1000 3000 2000
5 500 9000 2000
6 500 -6000 2000
Net profit 4000 5000 6000
• With little higher investment
 C is giving little higher profit than A&B

• Net profit takes no account on timing of cash

flows

5
• 2. Payback Pay
period:back period...Contd..
• The time taken to break even or pay back the initial investment.
Year Project Project B Project C
A
0 -8000 -8000 -10000
1 4000 1000 2000
2 4000 2000 2000
3 2000 4000 6000
4 1000 3000 2000
5 500 9000 2000
6 500 -6000 2000
Net profit 4000 5000 6000

• PBP(Project A) = 2 years
• PBP(Project B) = 4 years
• PBP(Project C) = 3 years

• Though Project A gets the initial investment back in 2 years, the overall profitability of
Project A is less compared to B & C...

6
 Payperiod
• Pay back backisperiod...Conclusion...
 Simple to calculate

 But
oIgnores the overall profitability of the project

7
• 3. Return on investment (ROI):
ROI...Contd...
• Also known as the accounting rate of return (ARR), provides a way of
comparing the net profitability to the investment required.
Year Project Project B Project C
A
0 -8000 -8000 -10000
1 4000 1000 2000
2 4000 2000 2000
3 2000 4000 6000
4 1000 3000 2000
5 500 9000 2000
6 500 -6000 2000
Net profit 4000 5000 6000

• ROI(Project A) = (4000/6) / 8000 x 100 = 8.33%

• ROI(Project B) = (5000/6) / 14000 x 100 = 5.95%
• ROI(Project C) = (6000/6) / 10000 x 100 = 10%
8
 ROI...Conclusion...
• Project C gives higher ROI...
• ROI is ...
 Simple and easy to calculate
 But,

oSimilar to Net profitability, it takes no account of

timing of cash flows...

9
 NPV....Contd...
• 4. Net Present value (NPV):

• The calculation of net present value is a project

evaluation technique that takes into account the
profitability of a project and the timing of cash flows
that are produced.

10
 NPV – an analogy...
• Receiving Rs.100 today is better than receiving the
same amount next year.
• Or...
• Invest Rs.100 today and have Rs.100 + interest next
year
• The present value of Rs. 100 in a years time is
equivalent to Rs.91...with a discounted rate 10%
(similar to investing Rs.100 and getting back Rs.110 in next year)

11
• The financial tool that captures the concept of the
Interesting facts about NPV...
relationship between the present and future value of money
is NPV: Net Present Value

• The monetary element between the present and the future

is interest rates or discount rates.
• If you have a present value and you want to calculate a future
value, we call it an interest rate.
• If you have future values and you want to estimate their
worth today, we use a discount rate.
• Interest rates and discount rates are two sides of the same
coin, to use a money metaphor.

12
• Net Present value (NPV):
NPV...Contd...
• The calculation of net present value is a project evaluation technique that takes into
account the profitability of a project and the timing of cash flows that are produced.

• Discount factor = 1 / (1+ r)t

13
 NPV calculation...
NPV(Project A) : Discount factor = 1 / (1+ r)t
Year Project A Discount factor @8% Discounted cash flow or
present value of future
money
0 -8000 1.0000 -8000
1 4000 0.9259 3703.6
2 4000 0.8573 3429.2
3 2000 0.7938 1587.6
4 1000 0.7350 735
5 500 0.6806 340.3
6 500 0.6302 315.1
Net Profit 4,000 NPV 2110.8
14
 NPV calculation...
NPV(Project B) :
Year Project B Discount factor @10% Discounted cash
flow
0 -8000 1.0000 -8000
1 1000 0.9091 909.1
2 2000 0.8264 1652.8
3 4000 0.7513 3005.2
4 3000 0.6830 2049
5 9000 0.6209 5588.1
6 -6000 0.5645 -3387
Net Profit 5,000 NPV 1817.2
15
 NPV calculation...
NPV(Project C) :
Year Project C Discount factor @12% Discounted cash
flow
0 -10000 1.0000 -10000
1 2000 0.8929 1785.8
2 2000 0.7972 1594.4
3 6000 0.7118 4270.8
4 2000 0.6355 1271
5 2000 0.5674 1134.8
6 2000 0.5066 1013.2
Net Profit 6,000 NPV 1070
16
 NPV...conclusion...
• We need to determine whether NPV is greater than
0.

• If it’s greater than 0, then the costs are less

than the benefits and we should do the project or
make the investment.

17
 Final conclusion...
• Based on Net profit...
 C>B>A
• Based on Pay back period...
 A>C>B
• Based on Return on Investment...
 C>A>B
• Based on NPV...
 C>B>A

18
 An exercise...(2)
• Consider the project cash flow estimates for four projects.
Negative values represent expenditure and positive
values income. The discounted rate for all the projects is
10%.
• Rank the four projects in order of financial desirability and
make a note of your reasons for ranking them in that
Year Project 1 Project 2 Project 3 Project 4
0way. -1,00,000 -1,000,000 -1,00,000 -1,20,000
1 10,000 2,00,000 30,000 30,000
2 10,000 2,00,000 30,000 30,000
3 10,000 2,00,000 30,000 30,000
4 20,000 2,00,000 30,000 30,000
5 1,00,000 3,00,000 30,000 75,000

321
9
 Solution...contd..

• Technique 1 – Net Profit - Net profit of a project is

the difference between the total costs and the total income
over the life of the project.
Year Project 1 Project 2 Project 3 Project 4
0 -1,00,000 -1,000,000 -1,00,000 -1,20,000
1 10,000 2,00,000 30,000 30,000
2 10,000 2,00,000 30,000 30,000
3 10,000 2,00,000 30,000 30,000
4 20,000 2,00,000 30,000 30,000
5 1,00,000 3,00,000 30,000 75,000
Net 50,000 1,00,000 50,000 75,000
profit

20
 Solution...contd..
• Technique 2 – Payback period - The time taken to break
even or pay back the initial investment.
Year Project 1 Project 2 Project 3 Project 4
0 -1,00,000 -1,000,000 -1,00,000 -1,20,000
1 10,000 2,00,000 30,000 30,000
2 10,000 2,00,000 30,000 30,000
3 10,000 2,00,000 30,000 30,000
4 20,000 2,00,000 30,000 30,000
5 1,00,000 3,00,000 30,000 75,000
Net 50,000 1,00,000 50,000 75,000
profit
Payback 5 years 5 years 4 years 4 years
period

21
 Solution...contd...
• Technique 3 – ROI- provides a way of comparing the net profitability to the investment
required.
Year Project 1 Project 2 Project 3 Project 4
0 -1,00,000 -1,000,000 -1,00,000 -1,20,000
1 10,000 2,00,000 30,000 30,000
2 10,000 2,00,000 30,000 30,000
3 10,000 2,00,000 30,000 30,000
4 20,000 2,00,000 30,000 30,000
5 1,00,000 3,00,000 30,000 75,000
Net profit 50,000 1,00,000 50,000 75,000
Payback 5 years 5 years 4 years 4 years
period
ROI ((50,000/5)/ 2% 10% 12.5
100000)x100
=10%

22
 Solution...contd...
• Technique 4 – NPV- considers both profitability of a
project and the timing of cash flows that are
produced.

• Discount factor = 1 / (1+ r)t

23
 Solution...Contd...

Year
Project 1 Discount factor
@10%
Discounted cash
flow

0 -1,00,000 1.0000 -1,00,000

1 10,000 0.9091 9091
2 10,000 0.8264 8264
3 10,000 0.7513 7513
4 20,000 0.6830 13660
5 100,000 0.6209 62090
Net Profit 50,000 NPV 618

24
 Solution....Contd...

Year Project 2 Discount factor

@10%
Discounted
cash flow
0 -10,00,000 1.0000 -10,00,000
1 2,00,000 0.9091 1,81,820
2 2,00,000 0.8264 1,65,280
3 2,00,000 0.7513 1,50,260
4 2,00,000 0.6830 1,36,600
5 3,00,000 0.6209 1,86,270
Net Profit 1,00,000 NPV -1,79,770

25
 Contd...

Year Project 3 Discount factor Discounted

@10% cash flow
0 -1,00,000 1.0000 -1,00,000
1 30,000 0.9091 27,273
2 30,000 0.8264 24,792
3 30,000 0.7513 22,539
4 30,000 0.6830 20,490
5 30,000 0.6209 18,627
Net Profit 50,000 NPV 13,721

26
 Contd...

Year Project 4 Discount factor Discounted

@10% cash flow
0 -1,20,000 1.0000 -1,20,000
1 30,000 0.9091 27,273
2 30,000 0.8264 24,792
3 30,000 0.7513 22,539
4 30,000 0.6830 20,490
5 75,000 0.6209 46,568
Net Profit 75,000 NPV 21,662

27
 Solution...contd...
Year Project 1 Project 2 Project 3 Project 4
0 -1,00,000 -1,000,000 -1,00,000 -1,20,000
1 10,000 2,00,000 30,000 30,000
2 10,000 2,00,000 30,000 30,000
3 10,000 2,00,000 30,000 30,000
4 20,000 2,00,000 30,000 30,000
5 1,00,000 3,00,000 30,000 75,000
Net profit 50,000 1,00,000 50,000 75,000
Payback 5 years 5 years 4 years 4 years
period
ROI 10% 2% 10% 12.5
NPV 618 -1,79,770 13,721 21,662

28
• To conclude...Solution...contd...
 It is interesting to note that Project 1 and Project 3 have
same initial investment, same net profit, same ROI
but...their NPV values are different

 Project 2 is having NPV less than 0, so it is not worth

doing...though it gives a profit...

 With same discount rate, Project 4 is giving higher

NPV...so preferably in rank 1...

29
 An exercise...(3)..to do...

• Refer the table for the cash flow forecasts of

Project X. Whether it’s worth to do this
project? (assume the discount rate as 15%)
Year Project X
0 -$3000
1 $1500
2 $1800

30
• IRR attempts to provide a profitability measure as a percentage return
IRR – Internal Rate of Return
that is directly comparable with interest rates

• IRR is calculated as that percentage discount rate that would

produce an NPV of zero

• Internal rate of return (IRR) is the discount rate at which a project’s

returns become equal to its initial investment.

• In other words, it attains a break-even point where the total cash

inflows completely meet the total cash outflow.

31
Limitations of the IRR:
 It does not indicate the absolute size of the return.

 A project with an NPV of £100,000 and an IRR of 15% can be more attractive than
one with an NPV of £10,000 and an IRR of 18%.

– the return on capital is lower but the net benefits greater.

 Under certain conditions, it is possible to find more than one rate that will produce a
zero NPV.

3
2