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Investment Analysis

Financial Costs and Benefits


Based on Time Value of Money
Benefit Cost Ratio
Net Present Worth or Net Present Value (NPV)
Internal Rate of Return (IRR)
Risk Analysis
Debt coverage Service Ratio (DCSR)

Cost-Benefit Analysis
Scientific criteria to evaluate projects
Determines the scale of the project on the basis of maximation of the
differences between benefit and cost
Cost-benefit analysis (CBA), or benefitcost analysis (BCA), is used to
assess benefits and costs of a project
Purpose of CBA is;
Determine if it is a sound investment/decision
Basis to compare projects.
Compares the total expected cost of each option against the total
expected benefits, to see whether the benefits outweigh the costs,
and by how much.
CBA focuses on economic efficiency
Calculates net benefits for each project

to describe and quantify the social advantages and disadvantages of the policy
in terms of a common monetary unit
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Criteria for CBA

There are 4 CBA; - B-C, B-C/1, B/C & B/C


B/C is ratio method used to evaluate the project
If B/C=1; the project is marginal.(i.e. just covering the costs)
If B/C>1; (Accepted) widely used in markets to reap maximum benefits
If B/C<1; (Rejected)

Evaluation of Benefits:
Benefits ------ increase income of the people --------Increase production &
consumption.
Real and Nominal Benefits : Real benefits play a vital role.

Improvement in irrigation - increase in productivity of land per acre economic benefits - income rises

Direct and Indirect Benefits : Direct are Immediate benefits

Ex: Irrigation Project flood control, irrigation, development of fisheries, power etc
Employment, new road way, livelihood etc are some of the indirect benefits

Evaluation of Costs:

Value of resources used in different activities


Project Cost, Associated Cost, Real & Nominal Cost , Direct and Indirect Cost,

Need of CBA
Recent government decisions give renewed focus to CBA
Agencies need to build their capacity to use CBA to improve the
quality of regulatory and financial analysis
Greater use of CBA expected by government for regulatory
proposals

Why is CBA useful?


Takes a community-wide perspective
Allows the consideration of a range of policy options
Determines which proposal maximises net benefits to the

community
Allows benefits and costs to be compared over time
Represents the costs and benefits accruing to different groups
within the community
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Financial Costs and Benefits


In B/C Ratio, we try to assess how much of our
present costs and benefits are worth at a future
point of time.
The costs and benefits are discounted and
assessed for the present.
Rs.1000 today is not the same as it would be
five years from now.

Financial Costs and Benefits


Rs.1000 today would have to be something
more than Rs.1000 next year.
How much it should be depend upon the
premium we place on that Rs.1000.
In other words, how much we want to use it
for the present (present consumption) and
how much we want to use it in future?

Option 1
You have a proposal to build a 3 power generating station of
10 MW each costing 3 million. The expected life of the project
is 10 years, during which, there is adequate demand Site
available is perfectly suited
Expected life of project
Each 10 Mega Watt Plant costs
Accessories and Other costs
Initial Investment ( 3 power stations * each 10 MW cost +
accessories cost)
Over next 10 yrs expected revenue
Each year expected revenue
Incurring costs for 10 years
Incurring cost per year (O&M costs)
Total Cost (for DBFO) of the plant (Costs) (3*3+1+15)
Benefits for 10 years
Benefits> Costs

3 Power Plants
10 Years
3 million
1 million
10 million
35 million
3.5 million/annum
15 million
1.5 million/annum
25 million
35 million

Option 2
You have a proposal to build a 1 power generating station of 60
MW. The expected life of the project is 10 years, during which,
there is adequate demand Site available is perfectly suited
Expected life period
Each 60 Mega WattPlant costs
Accessories and Other O&M costs
Initial investment (1 * each 60 megawatt cost +accessories cost)
Over next 10 yrs expected revenue
each year expected revenue
Incurring costs for 10 years
Incurring cost per year
Total Cost for DBFO of the plant (Costs) - (1*13+2+20)
Benefits for 10 years

1
10
13
2
15
48
4.8
20
2
35
48

Power Plants
years
million
million
million
million
million/annum
million
million/annum
million
million

Costs and Benefits


The total cost of the project is 100 invested in first two years. i.e.50, 50
The total benefits of the project is 175 in which payments are received
for the next three years i.e. 40, 60, 75 respectively. Life period of the
project is 5 years. Calculate CBR taking 10% as an DF and convey
whether Project is accepted or rejected.
Total
Total Costs benefits

Year 1

Discounting
@10%

NPW
NPW Costs Benefits

50

0.91

45.45

0.00

50

0.83

41.32

0.00

40

0.75

0.00

30.05

60

0.68

0.00

40.98

75

0.62

0.00

46.57

100

175

86.78

117.60

Benefits - Costs ratio 1.36 (i.e. PV of B / PV of C)

The total cost of the project is 300 invested in first


two years i.e. 175,125. The total benefits of the
project is 600 in which payments are received for
the next three years i.e. 150, 200, 250 respectively.
Life period of the project is 5 years. Calculate CBR
taking 10% as an DF and convey whether Project is
accepted or rejected.

Present value
The current worth of a future sum of money or
stream of cash flows given a specified rate of return
Future cash flows are discounted at the discount
rate, and the higher the discount rate, the lower the
present value of the future cash flows
Present value, also known as present discounted
value
Used to make comparisons between cash flows

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Present Value
To calculate the present value of any future
amounts
Single amount
Varying amounts
Annuities

Present value formula for a single amount is:


1) PV = FV (1 + i)-n
(or)
2) PV = FV x [ 1 (1 + i)n ]
PV = Present value
FV = Future Value
i= rate of interest
n= number of years

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Single Amount - Calculation 1


1) Calculate the present value (the value at time period) of receiving a single amount of
1,000 in 20 years. The interest rate for discounting the future amount is estimated at
10% per year compounded annually.
PV= ??

FV= 1,000

.....

1 year
0

1 year
1

1 year
2

1 year
3

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20

n = 20 years; i = 10% per year

The answer tells us that receiving 1,000 in 20


years is the equivalent of receiving 148.64
today, if the time value of money is 10% per
year compounded annually.

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Method 1:
PV = FV (1 + i)-n

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Calculation 2
Calculate the present value of a single amount
of 1,00 at the end of 2 years assuming the
interest rate of 8% per year compounded
annually.

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Calculation 3
What is the present value of receiving a single amount of 5,000
at the end of three years, if the time value of money is 8% per
year, compounded quarterly
PV= ??

FV= 5,000

.....
3 months

3 months

3 months

3 months

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12

n = 12 quarters (3 years X 4 quarters each year); i = 2% per quarter

PV = 3,942.45

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Future Value
Value of an asset or cash at a specified date in the
future that is equivalent in value to a specified
sum today
Two ways of calculating future value:
Simple interest
For an asset with simple annual interest = Original
Investment x (1+(interest rate*number of years))

Compound interest
For an asset with interest compounded annually=
Original Investment x ((1+interest rate)^number of
years)
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Calculation -1 (using Simple Interest)


FV= PV*(1+rt)
PV=Present value
R= rate of interest
T= time period

1000 invested for 5 years with simple annual


interest of 10% what will be the future value?

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Calculation -1 (using Compound


Interest)
1000 invested for 5 years with compounded
annual interest of 10% what will be the future
value?
FV= PV*(1+i)t
PV=Present value
i= rate of interest
t= time period

= 1000*(1+0.10)5
= 1000*(1.10)5
= 1000*(1.610)
=1610.51
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Annuities
Annuities - series of fixed payments required from
you or paid to you at a specified frequency over
time period.
Payment frequencies - Yearly, Semi-annually (twice
a year), Quarterly and Monthly.
There are two basic types of annuities:
Ordinary annuities : Payments are required at the end of each period.
Future Value
Present Value

Annuities due: Payments are required at the beginning of each period.


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Present Value (PV) Ordinary annuities


To determine today's value of a future payment
Calculates the PV of the payments that you will receive in the
future.

Investing 1000 per year for the next 5 years, and investing that at

the 5%
Present value of an ordinary annuity returned a value of 4,329.48.
The present value of an ordinary annuity is less than that of an
annuity due because the further back we discount a future
payment, the lower its present value
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Future Value (FV) Ordinary annuities


Future value of an ordinary annuity formula To find out how much you
would have in the future by investing at your given interest rate..
Making payments on a loan, the future value is useful in determining the
total cost of the loan.
Investing 1000 per year for the next 5 years, and investing that at the 5%

C=Cash flow per period


i=Interest rate
n = Number of payments

Calculate the future value of each cash flow. Let's assume that you are
receiving 1,000 every year for the next five years, and you invested each
payment at 5%. (C*(1+r)^n (0-4))
Gives an accurate value
This means that if you could get a return on your invested funds of 5% per
year, receiving 5525.63.
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Net Present Value


Net Present Value (NPV):The sum of the present values
of all cash inflows minus the sum of the present values of
all cash outflows.
Appreciates time value of money
Only cash profits are important
Additive method
Provides a direct link between management decision and
shareholder value

Calculation 1:The total cost of the project is 100 RS invested in


first two years. The total benefits of the project is 175 in which
payments are received for the next three years i.e. 40, 60, 75
respectively. Life period of the project is 5 years.
Total Total
Discounting Net
Discounting
Year 1 Costs benefits @10%
benefits NB @10%
1
50
0
0.91
-50
-45.45
2
50
0
0.83
-50
-41.32
3
0
40
0.75
40
30.05
4
0
60
0.68
60
40.98
5
0
75
0.62
75
46.57
100
175
75
117.60

NPV = 30.83???

Internal Rate of Return (IRR)


The internal rate of return (IRR): The rate at
which the sum of discounted cash inflow equals
the sum of discounted cash out flow.
In other words, it is the rate which discounts the
cash flow to zero.
The internal rate of return measures the
investment yield.

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NPV v/s IRR


The acceptance and rejection is done base on
the IRR rate
NPV
It takes interest as a known factor
It calculates the exact amount of
investment (represents in currency)
Generates different results where
discount rates are applicable

IRR
It takes interest as a unknown factor
It calculates the maximum rate of
interest (represents in percentage terms
It gives predictions

NPV is preferred as it is widely used IRR vastly used at corporate level


IRR is a parameter that can be used to
If NPV>0, then project is accepted in rank several projects. The higher the IRR
nature
the most desirable is the project.
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How to Assess
the Internal Rate of Return ?
At what rate the project is profitable?
For this we use the Internal Rate of Return
It is that rate which makes the NPV=0 and the
B/C Ratio =1
IRR represents the average earning power of
money used in the project over the project
life.

Net
DF
NPV
DF
NPV
DF @
NPV
Year Costs Benefits Benefits @10% @10% @25% @25% 19.00% @19%

150

-150

0.91 -136.36

0.80 -120.00

0.84 -126.05

25

20

0.83

16.53

0.64

12.80

0.71

14.12

50

45

0.75

33.81

0.51

23.04

0.59

26.70

75

70

0.68

47.81

0.41

28.67

0.50

34.90

125

120

0.62

74.51

0.33

39.32

0.42

50.28

170

275

105

172.66

103.83

126.02

Formula for IRR


IRR = {(Lower Discount Rate) + (Difference between
Higher and lower discount rate)} * [NPV at lower
Discount rate/Absolute difference between NPV
At two discount Rates that is total NPVs

IRR = (10) + (15) * [36.2 / (36.2+16.2)]


= (10) + 15 * ( 0.69) = 10+10.35

= 20.35%

Once we arrived at the IRR , in this case 20.35%,


we compare that with that of the market rate of
interest.
If the market rate of interest is above this, the
project is rejected.
If it is below this , the project is selected.

Risks and uncertainties


Uncertainties Difficult to incorporate in to
project design just because it is uncertain.
Risks We can take measures to minimise
this.
Risk measurements are very well developed
now.

Risk Analysis
Here we concentrate only on three issues:
Variations in Benefits How much can we
tolerate without dropping a project?
Variations in Costs - How much can we
tolerate without dropping a project?
How much delay the project can afford?

Risk Analysis
Present value of benefits PV of Costs
Variations in Benefits = -----------------------------------------------------Present Value of Benefits

Present value of benefits PV of Costs


Variations in Costs = -----------------------------------------------------Present Value of Costs
Present value of Costs
Variations in time = -----------------------------------------------------Present Value of Benefits

Risk Analysis
9400 4206
Variations in Benefits = ------------------------- = 55%
9400

9400 - 4206
Variations in Costs = -------------------- = 123%
4206
4206
Variations in time = ----------------- = 0.45
9400
Using a 10% discount factor, this 0.45 is equivalent to 8 years.