Professional Documents
Culture Documents
- Jule Dupuit
- A simple way of weighing up project costs and benefits
- A decision making device for evaluating activities that are not priced by the
market
CBA Tools
PP = IC/NACI
IC= Investment Cost
NACI = Net Annual Cash Inflow
FV = I x (1+ (RxT))
I = Initial Investment
R = Interest Rate
T = Time
FV = I x ((1+R)T)
Excel Formula: fx=A1*((1+B1)^C1)
PV = FV / ((1+R)T)
R = discount rate per period of time
Excel Formula: fx=A1/((1+B1)^C1)
NPV = SP I
SP = Sum of Present Value
Research
IRR Internal rate of return (IRR)
where P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . . n, respectively; and
IRR equals the project's internal rate of return.
where:
To calculate IRR using the formula, one would set NPV equal to
zero and solve for the discount rate r, which is here the IRR.
Because of the nature of the formula, however, IRR cannot be
calculated analytically, and must instead be calculated either
through trial-and-error or using software programmed to calculate
IRR.
Generally speaking, the higher a project's internal rate of return,
the more desirable it is to undertake the project. IRR is uniform for
investments of varying types and, as such, IRR can be used to
rank multiple prospective projects a firm is considering on a
relatively even basis. Assuming the costs of investment are equal
among the various projects, the project with the highest IRR
would probably be considered the best and undertaken first.
The payback period formula is used to determine the length of time it will take to
recoup the initial amount invested on a project or investment. The payback period
formula is used for quick calculations and is generally not considered an end-all
for evaluating whether to invest in a particular situation.
The result of the payback period formula will match how often the cash flows are
received. An example would be an initial outflow of $5,000 with $1,000 cash
inflows per month. This would result in a 5 month payback period. If the cash
inflows were paid annually, then the result would be 5 years.
At times, the cash flows will not be equal to one another. If $10,000 is the initial
investment and the cash flows are $1,000 at year one, $6,000 at year two, $3,000
at year three, and $5,000 at year four, the payback period would be three years as
the first three years are equal to the initial outflow.
Payback Period
Payback period is the time in which the initial cash outflow of an investment is expected to be
recovered from the cash inflows generated by the investment. It is one of the simplest investment
appraisal techniques.
Formula
The formula to calculate payback period of a project depends on whether the cash flow per period
from the project is even or uneven. In case they are even, the formula to calculate payback period is:
Initial Investment
Payback Period =
Cash Inflow per Period
When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and
then use the following formula for payback period:
B
Payback Period = A +
C
Decision Rule
Accept the project only if its payback period is LESS than the target payback period.
Examples
Example 1: Even Cash Flows
Company C is planning to undertake a project requiring initial investment of $105 million. The project
is expected to generate $25 million per year for 7 years. Calculate the payback period of the project.
Solution
Payback Period = Initial Investment Annual Cash Flow = $105M $25M = 4.2 years
1 10 (40)
2 13 (27)
3 16 (11)
4 19 8
5 22 30
Payback Period
= 3 + (|-$11M| $19M)
= 3 + ($11M $19M)
3 + 0.58
3.58 years
Future Value (FV) is a formula used in finance to calculate the value of a cash flow
at a later date than originally received. This idea that an amount today is worth a
different amount than at a future time is based on the time value of money.
The time value of money is the concept that an amount received earlier is worth
more than if the same amount is received at a later time. For example, if one was
offered $100 today or $100 five years from now, the idea is that it is better to
receive this amount today. The opportunity cost for not having this amount in an
investment or savings is quantified using the future value formula. If one wanted to
determine what amount they would like to receive one year from now in lieu of
receiving $100 today, the individual would use the future value formula. See
example at the bottom of the page.
The future value formula also looks at the effect of compounding. Earning .5% per
month is not the same as earning 6% per year, assuming that the monthly
earnings are reinvested. As the months continue along, the next month's earnings
will make additional monies on the earnings from the prior months. For example, if
one earns interest of $40 in month one, the next month will earn interest on the
original balance plus the $40 from the previous month. This is known as
compound interest.
Use of Future Value
The future value formula is used in essentially all areas of finance. In many
circumstances, the future value formula is incorporated into other formulas. As
one example, an annuity in the form of regular deposits in an interest account
would be the sum of the future value of each deposit. Banking, investments,
corporate finance all may use the future value formula is some fashion.
The second portion of the formula would be 1.12683 minus 1. By multiplying the
original principal by the second portion of the formula, the interest earned is
$126.83.
Simple Interest vs. Compound Interest
Using the prior example, the simple interest would be calculated as principal times
rate times time. Given this, the interest earned would be $1000 times 1 year times
12%. After using this formula, the simple interest earned would be $120. Using
compound interest, the amount earned would be $126.83. The additional $6.83
earned would be due to the effect of compounding. If the account was
compounded daily, the amount earned would be higher.
Compound Interest Formula in Relation to APY
The compound interest formula contains the annual percentage yield formula of
This is due to the annual percentage yield calculating the effective rate on an
account, based on the effect of compounding. Using the prior example, the
effective rate would be 12.683%. The compound interest earned could be
determined by multiplying the principal balance by the effective rate.
Alternative Compound Interest Formula
The ending balance of an account with compound interest can be calculated
based on the following formula:
As with the other formula, the rate per period and number of periods must match
how often the account is compounded.
Using the prior example, this formula would return an ending balance of $1126.83.
Simple Interest
The simple interest formula is used to calculate the interest accrued on a loan or
savings account that has simple interest. The simple interest formula is fairly
simple to compute and to remember as principal times rate times time. An
example of a simple interest calculation would be a 3 year saving account at a
10% rate with an original balance of $1000. By inputting these variables into the
formula, $1000 times 10% times 3 years would be $300.
Simple interest is money earned or paid that does not have compounding.
Compounding is the effect of earning interest on the interest that was previously
earned. As shown in the previous example, no amount was earned on the interest
that was earned in prior years.
As with any financial formula, it is important that rate and time are appropriately
measured in relation to one another. If the time is in months, then the rate would
need to be the monthly rate and not the annual rate.
Ending Balance with Simple Interest Formula
The ending balance, or future value, of an account with simple interest can be
calculated using the following formula:
Using the prior example of a $1000 account with a 10% rate, after 3 years the
balance would be $1300. This can be determined by multiplying the $1000 original
balance times [1+(10%)(3)], or times 1.30.
Instead of using this alternative formula, the amount earned could be simply
added to the original balance to find the ending balance. Still using the prior
example, the calculation of the formula that is on the top of the page showed $300
of interest. By adding $300 to the original amount of $1000, the result would be
$1300.
Present Value
When we solve for PV, she would need $95.24 today in order to reach
$100 one year from now at a rate of 5% simple interest.
Alternative Formula
The Present Value formula may sometimes be shown as
Net Present Value
When solving for the NPV of the formula, this new project would be
estimated to be a valuable venture.
Net Present Value, Benefit Cost
Ratio, and Present Value Ratio for
project assessment
Print
Net Present Value (NPV)
As explained in the first lesson, Net Present Value (NPV) is the cumulative present worth of
positive and negative investment cash flow using a specified rate to handle the time value of money.
NPV = Present Worth Revenue or Saving @i* - Present Worth Costs @i*
Or
NPV = Net Present Worth Positive and Negative Cash Flow @i*
Or
NPV = Present Worth of All Cash Flows @i*
If the calculated NPV for a project is positive, then the project is satisfactory, and if NPV is
negative then the project is not satisfactory.
The following video, NPV function in Excel , explains how NPV can be calculated using
Microsoft Excel (8:04).
0 1 2 3 ... 10
C: Cost, I:Income
i* = 10%: NPV = -60,000 50,000*(P/F10%,1) + 24,000*(P/F10%,1)*(P/A10%,9) = 20,196.88 dollars
i* = 15%: NPV = -60,000 50,000*(P/F15%,1) + 24,000*(P/F15%,1)*(P/A15%,9) = - 3,897.38 dollars
If using spreadsheet, following method can be more convenient:
i* = 10%: NPV = -60,000 50,000*(P/F10%,1)+ 24,000*(P/F10%,2)+ 24,000*(P/F10%,3) + ...
+24,000*(P/F10%,10)= 20,196.88 dollars
i* = 15%: NPV = -60,000 50,000*(P/F15%,1)+ 24,000*(P/F15%,2) ++ 24,000*(P/F15%,3) + ...
+24,000*(P/F15%,10)= - 3,897.38 dollars
Figure 3-5 illustrates the calculation of the NPV function in Microsoft Excel. Please note that
in order to use the NPV function in Microsoft Excel, all costs have to be entered with
negative signs.
Total $139,750
Benefits
Benefit Within
Benefit
12 Months
Total $305,500
He calculates the payback time as shown below:
$139,750 / $305,500 = 0.46 of a year, or approximately 5.5 months.
Inevitably, the estimates of the benefit are subjective, and there is a degree of
uncertainty associated with the anticipated revenue increase. Despite this, the
owner of Custom Graphic Works decides to go ahead with the expansion and
hiring, given the extent to which the benefits outweigh the costs within the first
year.
Flaws of Cost-Benefit Analysis
Cost-Benefit Analysis struggles as an approach where a project has cash
flows that come in over a number of periods of time, particularly where returns
vary from period to period. In these cases, use Net Present Value (NPV)
and Internal Rate of Return (IRR) calculations together to evaluate the
project, rather than using Cost-Benefit Analysis. (These also have the
advantage of bringing "time value of money" into the calculation.)
Also, the revenue that will be generated by a project can be very hard to
predict, and the value that people place on intangible benefits can be very
subjective. This can often make the assessment of possible revenues
unreliable (this is a flaw in many approaches to financial evaluation). So, how
realistic and objective are the benefit values used?
Key Points
Cost-benefit analysis is a relatively straightforward tool for deciding
whether to pursue a project.
To use the tool, first list all the anticipated costs associated with the
project, and then estimate the benefits that you'll receive from it.
Where benefits are received over time, work out the time it will take for
the benefits to repay the costs.
You can carry out an analysis using only financial costs and benefits.
However, you may decide to include intangible items within the analysis.
As you must estimate a value for these items, this inevitably brings more
subjectivity into the process.