Fin650:Project Appraisal

Lecture 3
Essential Formulae in Project Appraisal
1

What is Capital Budgeting

Two big questions:
Yes-No: Should you invest money today in a
project that gives future payoffs?
Ranking: How to compare mutually-exclusive
projects? If you have several alternative
investments, only one of which you can choose,
which should you undertake?

Other issues
Sunk costs. How should we account for costs
incurred in the past?
The cost of foregone opportunities.
Salvage values and terminal values.
Incorporating taxes into the valuation
decision.

Benefits and Cost Realized at

Different Times

Benefits and costs realized in different times are

not comparable
Some benefits and costs are recurrent, while
some are realized only for a temporary period
Examples: Roads, built now at heavy costs, to
generate benefits later, Dams, entail
environmental costs long after their economic
benefits have lapsed, A life lost now entails cost
for at least as long into the future as the person
would have lived

Discounting Future Benefits

and Costs
Basic Concepts:
A.

Future Value Analysis

In general, the future value in one year of some amount X is given by:
FV= X(1+i)
where i is the annual rate of interest. This is simple compounding

B.

Present Value Analysis

In general, if the prevailing interest rate is i, then the present value
of an amount Y received in one year is given by:

PV

Y
1 i

Discounting is the opposite of compounding.

5

Discounting Future Benefits and

Costs
Net Present Value Analysis

The NPV of a project equals the difference between the present value
of benefits, PV(B), and the present value of the costs, PV(C):
NPV = PV(B)-PV(C)

Compounding and Discounting Over Multiple Years

Future value over multiple Years

In general, if an amount, denoted X, is invested for n years and
interest is compounded annually at i percent, then the future value is:
FV = X(1+i)n
Present value over multiple years
In general, the present value of an amount received in n years,
denoted Y, with interest discounted annually at rate i percent, then the
present value is:

Y
PV
1 i ) nthe discount factor
The term 1/(1+i) is (called
n

Discounting and Alternative Investment

Criteria
Basic Concepts:
A.
Discounting

Recognizes time value of money

a. Funds when invested yield a return
b. Future consumption worth less than present
consumption
o

PVB = (B /(1+r) +(B 1/(1+r) 1+..+(Bn /(1+r) n

r

PVC = (C /(1+r) +(C 1/(1+r) 1+..+(Cn /(1+r)

r

NPV = (B o-C o)/(1+r) o+(B 1-C 1)/(1+r) 1+..+(B n-C n)/(1+r) n

r

Discounting and Alternative Investment

Criteria (Contd)
B. Cumulative Values

The calendar year to which all projects are

discounted to is important
All mutually exclusive projects need to be
compared as of same calendar year
1

If NPV r= (B o-Co)(1+r) 1+(B 1-C 1) +..+..+(B n-C n)/(1+r) n-1 and

NPV 3r= (B o-Co)(1+r) 3+(B 1-C 1)(1+r) 2+(B 2-C 2)(1+r)+(B 3-C 3)+...(B n-C n)/(1+r) n-3
3

Then NPV r = (1+r) 2 NPV r

10

Examples of Discounting
Year
Net Cash Flow

0
-1000

1
200

2
300

3
350

4
1440

200 300
350
1440
NPV 1000

676.25
2
3
4
1.1 (1.1)
(1.1) (1.1)
0
0.1

NPV01.1 1000(1.1) 200

300 350
1440

743.88
2
3
1.1 (1.1)
(1.1)

350 1440
NPV 1000(1.1) 200(1.1) 300

818.26
1
2
(1.1) (1.1)
2
0.1

11

Financial Calculations
The present value of a single sum is:

PV = FV (1 + r)-t
the present value of a dollar to be received at the end
of period t, using a discount rate of r.

The present value of series of cash flows is:

PV

CFt

(1 r )

t
12

Financial Calculations:
Cash Flow Series
A payment series in which cash flows are Equally
sized and Equally timed is known as an annuity.
There are four types:
1. Ordinary annuities; the cash flows occur at the
end of each time period. (Workbook 5.10 and
5.11)
2. Annuities due; the cash flows occur at the start
of each time period.
3. Deferred annuities; the first cash flow occurs
later than one time period into the future.
(Workbook 5.10 and 5.11)
4. Perpetuities; the cash flows begin at the end of
the first period, and go on forever.

13

Evaluation of Project Cash

Flows.
Cash flows occurring within investment projects

are assumed to occur regularly, at the end of

each year.
Since they are unlikely to be equal, they will not
be annuities.
Annuity calculations apply more to loans and
other types of financing.
All future flows are discounted to calculate a Net
Present Value, NPV; or an Internal Rate of
Return, IRR.

14

Calculating NPV and IRR

With Excel -- Basics.
1.
2.
3.
4.

Ensure that the cash flows are recorded with the

correct signs: -$, +$, -Tk, +Tk. etc.
Make sure that the cash flows are evenly timed:
usually at the end of each year.
Enter the discount rate as a percentage, not as a
decimal: e.g. 15.6%, not 0.156.
Check your calculations with a hand held calculator
to ensure that the formulae have been correctly set
up.

15

Calculating NPV and IRR

With Excel -- The Excel
Worksheet.

16

Calculating MIRR and PB

With Excel.
Modified Internal Rate of Return the cash flow cell

range is the same as in the IRR, but both the required

rate of return, and the re-investment rate, are entered
into the formula: MIRR( B6:E6, B13, B14)

Payback there is no Excel formula . The payback

year can be found by inspection of accumulated
annual cash flows.

17

ARR and Other

Evaluations With Excel.

Accounting Rate of Return there is no Excel formula.

Average the annual accounting income by using the
AVERAGE function, and divide by the chosen asset
base.

Other financial calculations use Excel Help to find the

appropriate function. Read the help information
carefully, and apply the function to a known problem
before relying on it in a live worksheet.
18

Calculating Financial
Functions With Excel -Worksheet
Errors.
Common worksheet errors
are:

Cash flow cell range wrongly specified.

Incorrect entry of interest rates.
Wrong NPV, IRR and MIRR formulae.
Incorrect cell referencing.
Mistyped data values.
No worksheet protection.

19

Calculating Financial
Functions With Excel -Error
Control.
Methods
to reduce
errors:

Use Excel audit and tracking tools.

Test the worksheet with known data.
Confirm computations by calculator.
Visually inspect the coding.
Use a team to audit the spreadsheet.

20

Alternative Investment
Criteria
1.
2.
3.
4.

Net Present Value (NPV)

Benefit-Cost Ratio (BCR)
Pay-out or Pay-back Period
Internal Rate of Return (IRR)

21

Net Present Value (NPV)

1.

The NPV is the algebraic sum of the discounted values of the

incremental expected positive and negative net cash flows
over a projects anticipated lifetime.

2.

What does net present value mean?

Measures the change in wealth created by the project.

If this sum is equal to zero, then investors can expect to

recover their incremental investment and to earn a rate of
return on their capital equal to the private cost of funds
used to compute the present values.

Investors would be no further ahead with a zero-NPV

project than they would have been if they had left the
funds in the capital market.

In this case there is no change in wealth.

22

Alternative Investment
Criteria
First Criterion: Net Present Value (NPV)
Use as a decision criterion to answer
following:
a. When to reject projects?
b. Select project (s) under a budget
constraint?
c. Compare mutually exclusive projects?
d. How to choose between highly profitable
mutually exclusive projects with different
lengths of life?
23

Net Present Value

Criterion
a. When to Reject Projects?
Rule: Do not accept any project unless it generates a positive
net present value when discounted by the opportunity cost of
funds
Examples:
Project A: Present Value Costs $1 million, NPV + $70,000
Project B: Present Value Costs $5 million, NPV - $50,000
Project C: Present Value Costs $2 million, NPV + $100,000
Project D: Present Value Costs $3 million, NPV - $25,000
Result:
Only projects A and C are acceptable. The investor is made
worse off if projects B and D are undertaken.
24

Net Present Value Criterion (Contd)

b. When You Have a Budget Constraint?

Rule: Within the limit of a fixed budget, choose that subset of the
available projects which maximizes the net present value
Example:
If budget constraint is $4 million and 4 projects with positive
NPV:
Project E:
Costs $1 million, NPV + $60,000
Project F:
Costs $3 million, NPV + $400,000
Project G:
Costs $2 million, NPV + $150,000
Project H:
Costs $2 million, NPV + $225,000
Result:
Combinations FG and FH are impossible, as they cost too much. EG
and EH are within the budget, but are dominated by the
combination EF, which has a total NPV of $460,000. GH is also
possible, but its NPV of $375,000 is not as high as EF.
25

Net Present Value Criterion (Contd)

c. When You Need to Compare Mutually Exclusive
Projects?
Rule: In a situation where there is no budget constraint but
a project must be chosen from mutually exclusive
alternatives, we should always choose the alternative that
generates the largest net present value
Example:
Assume that we must make a choice between the following
three mutually exclusive projects:
Project I: PV costs $1.0 million, NPV $300,000
Project J: PV costs $4.0 million, NPV $700,000
Projects K: PV costs $1.5 million, NPV $600,000
Result:
Projects J should be chosen because it has the largest NPV.
26

Shortcut Methods for Calculating

the Present Value of Annuities and
Annuities and Perpetuities
Perpetuities
1/2
An annuity is an equal, fixed amount received (or paid) each

year for a number of years.

A perpetuity is an annuity that continues indefinitely.
Present value of an annuity
n

A
PV
t
(
1

i
)
t 1
or PV = A x
Where

n
i

n
i is the annuity factor,

n
1

(
1

i
)
ain
i

n
i , which equals the present value of an annuity of

The term
$/Tk. 1 per year for n years when the interest rate is i
percent, is called the annuity factor.

27

Shortcut Methods for Calculating

the Present Value of Annuities and

Perpetuities
2/2
Present value of a perpetuity
PV = A/i, if i>0
Present value of an annuity that grows or declines at
a constant rate
PV(B) = [B1/ (1+g)]x ai0n , i0 = 1-g/1+g
if i>g
If g is small, B1/1+g is approximately equal to B1,
and i0 = 1-g
Present value of benefits (or costs) that grow or
decline at a constant rate in perpetuity
PV(B) = B1/ (1-g), if i>g

28

Long-Lived Projects and Terminal

Values
It is generally assumed that projects have finite economic
Life.
For projects with infinite life, we may calculate NPV using

The formula:
NB

NPV
t 0

(1 i )t

Assumes that the net benefits are constant or grow at a constant rate.
Not a very realistic assumption.
For most long lived projects, select a relatively short discounting
period (useful life of the project) and include a terminal value to
k
reflect all subsequent benefits and costs.
NB
Where T(k) denotes the terminal value.

NPV
t 0

(1 i )

T (k )

29

Alternative Methods for

Estimating Terminal Values

Terminal Values Based on:

Simple Projections
Salvage or Liquidation Value
Depreciated Value, economic depreciation
Percentage of Initial Constructions Cost

Setting the Terminal Value equal to zero

Note: Accounting depreciation should never be included as
a cost (expense) in CBA

30

Comparing Projects with Different Time

Frames

Two Methods for Comparing Projects with Different Time Frames

Rolling Over the Shorter Project

Comparison between a cogeneration power plan and a hydroelectric

project

Equivalent Annual Net Benefit Method (EANB)

EANB of an alternative equals its NPV divided by the annuity
factor
That has the same life as the project

NPV
EANB n
ai

Where

ain

is the annuity factor,

n
1

(
1

i
)
ain
i
31

Real Versus Nominal Currency

Constant currency

Use CPI as the deflator

If benefits and costs are measured in nominal currency, use

nominal discount rate
If benefits and costs are measured in real currency, use real
discount rate
To convert a nominal interest rate i, to a real interest rate, r,
with an expected inflation rate, m, use the following equation

im
r
1 mthe real interest rate is approximately equals the
If m is small,
Nominal interest rate minus the expected rate of inflation:
r = i-m
32

Alternative Investment
Criteria: Benefit Cost Ratio

As its name indicates, the benefit-cost ratio (R),

or what is sometimes referred to as the
profitability index, is the ratio of the PV of the net
cash inflows (or economic benefits) to the PV of
the net cash outflows (or economic costs):

PV of Net Cash Inflows (or Economic Benefits)

R
PV of Net Cash Outflows (or Economic Costs)

33

Basic Rule
If benefit-cost ratio (R) >1, then the project
should be undertaken.
Problems?

Sometimes it is not possible to rank projects

with the benefit-cost Ratio

Mutually exclusive projects of different sizes

Not necessarily true that if RA>RB, that

project A is better than project B
34

Benefit-Cost Ratio (Contd)

Problem:The Benefit-Cost Ratio does not adjust for mutually exclusive
projects of different sizes. For example:
Project A:
PV0of Costs = $5.0 M, PV0 of Benefits = $7.0 M
NPVA = $2.0 M
RA = 7/5 = 1.4
Project B:
M

PV0 of Costs = $20.0 M,

PV0 of Benefits = $24.0

NPVB

RB = 24/20 = 1.2

= $4.0 M

According to the Benefit-Cost Ratio criterion, project A should be chosen

over project B because RA>RB, but the NPV of project B is greater than
the NPV of project A. So, project B should be chosen

Conclusion: The Benefit-Cost Ratio should not be used to

rank projects

35

Alternative Investment Criteria

Pay-out or Pay-back period

The pay-out period measures the number of years it will

take for the undiscounted net benefits (positive net
cashflows) to repay the investment.
A more sophisticated version of this rule compares the
discounted benefits over a given number of years from
the beginning of the project with the discounted
investment costs.
An arbitrary limit is set on the maximum number of
years allowed and only those investments having
enough benefits to offset all investment costs within this
period will be acceptable.

36

Pay-Out or Pay-Back
Period

Projects

with

shortest

payback

period

are

preferred by the criteria

Assumes all benefits that are produced by in

longer life project have an expected value of
zero after the pay-out period.

The criteria may be useful when the project is

subject to high level of political risk.

37

Alternative Investment
Internal
CriteriaRate of Return (IRR)

is the discount rate (K) at which the present

value of benefits are just equal to the present
value of costs for the particular project
IRR

Bt Ct
0

t
i 0 (1 k )
t

Note: the IRR is a mathematical concept, not an

economic or financial criterion

38

Common uses of IRR:

(a)

If the IRR is larger than the cost of funds then the

project should be undertaken

(b)

Often the IRR is used to rank mutually exclusive

projects. The highest IRR project should be chosen

(c)

An advantage of the IRR is that it only uses

information from the project

39

Difficulties With the Internal Rate of Return

Criterion
First Difficulty: Multiple rates internal rate of return for
Project

Bt - C t
+300

Time
-100
-200

Solution 1: K = 100%;

NPV= -100 + 300/(1+1) + -200/(1+1)2 = 0

Solution 2: K = 0%;

NPV= -100+300/(1+0)+-200/(1+0)2 = 0
40

Difficulties With The Internal Rate of Return Criterion (Contd)

Second difficulty: Projects of different sizes and also strict alternatives
Year

...

...

+600
+4,000

+600
+4,000

+600
+4,000

+600
+4,000

+600
+4,000

+600
+4,000

Project A -2,000
Project B -20,000

NPV and IRR provide different Conclusions:

Opportunity cost of funds = 10%
0
NPV A : 600/0.10 - 2,000 = 6,000 - 2,000 = 4,000
NPV 0B : 4,000/0.10 - 20,000 = 40,000 - 20,000 = 20,000
Hence, NPV 0B> NPV

0
A

IRR A : 600/K A - 2,000 = 0 or K A = 0.30

IRR B : 4,000/K B - 20,000 = 0 or K B = 0.20
Hence, K A>K B
41

Difficulties With The Internal Rate of Return Criterion (Contd)

Third difficulty:Projects of different lengths of life and strict alternatives

Opportunity cost of funds = 8%
Project A: Investment costs = 1,000 in year 0
Benefits = 3,200 in year 5
Project B: Investment costs = 1,000 in year 0
Benefits = 5,200 in year 10
NPV 0A : -1,000 + 3,200/(1.08)5 = 1,177.86
NPV 0B : -1,000 + 5,200/(1.08)10= 1,408.60
Hence, NPVB0 > NPVA0
IRRA : -1,000 + 3,200/(1+KA)5 = 0 which implies that KA = 0.262
IRRB : -1,000 + 5,200/(1+KB)10 = 0 which implies that KB = 0.179
Hence, KA>KB
42

Difficulties With The Internal Rate of Return Criterion (Contd)

Fourth difficulty: Same project but started at different times
Project A: Investment costs = 1,000 in year 0
Benefits = 1,500 in year 1
Project B: Investment costs = 1,000 in year 5
Benefits = 1,600 in year 6
NPV A : -1,000 + 1,500/(1.08) = 388.88

NPV B : -1,000/(1.08) 5 + 1,600/(1.08) 6 = 327.68

0

Hence, NPV A> NPV

0
B

IRR A : -1,000 + 1,500/(1+K A) = 0 which implies that K A = 0.5

IRR B : -1,000/(1+K B) 5+ 1,600/(1+K B) 6= 0 which implies that K B = 0.6
Hence, K B >KA

43

IRR FOR IRREGULAR CASHFLOWS

For Example: Look at a Private BOT Project from the perspective of the
Government
Year
Project A
IRR A

1000

1200

800

3600

-8000

3600

-6400

10%
Compares Project A and Project B ?

Project B
IRR B

1000

1200

800

-2%

Project B is obviously better than A, yet IRR A > IRR B

Project C
IRR C

1000

1200

800

3600

-4800

-16%

Project C is obviously better than B, yet IRR B > IRR C

Project D
IRR D

-1000

1200

800

3600

-4800

4%
Project D is worse than C, yet IRR D > IRR C

Project E
IRR E

-1325

1200

800

3600

-4800

20%
Project E is worse than D, yet IRR E > IRR D

44

The Social Discount Rate:

Main Issues

How much current consumption society is willing to give up

now in order to obtain a given increase in future
Consumption?
It is generally accepted that societys choices, including the
choice of weights be based on individuals choices
Three unresolved issues

Whether market interest rates can be used to represent how

individuals weigh future consumption relative to present
consumption?
Whether to include unborn future generation in addition to
individuals alive today?
Whether society attaches the same value to a unit of
investment as to a unit of consumption

Different assumptions will lead to choice of different

discount rate

45

Does the Choice of Discount Rate

Matter?

Generally a low discount rate favors projects with

highest total benefits, irrespective of when they
occur, e.g. project C
Increasing the discount rate applies smaller
weights to benefits or (costs) that occur further in
the future and, therefore, weakens the case for
projects with benefit that are back-end loaded
(such as project C), strengthens the case for
projects with benefit that are front-end loaded
(such as project B)

46

NPV for Three Alternative Projects

Year

Project A

Project B

Project C

-80,000

-80,000

-80,000

25,000

80,000

25,000

10,000

25,000

10,000

25,000

10,000

25,000

10,000

140,000

Total benefits

45,000

40,000

60,000

NPV (i=2%)

37,838

35,762

46,802

NPV (i=10%)

14,770

21,544

6,929

47

NPV and IRR

The two basic capital budgeting tools
Note: We usually prefer NPV to IRR, but IRR is
a handy tool

48

Yes-No and NPV

NPV rule: A project is worthwhile if the NPV

>0
NPV CF0

CF1
1

CF2
2

...

CFN

1 r 1 r
1 r
According to the NPV rule:

49

0?

If NPV > 0, project is worthwhile

If NPV < 0, project should not be undertaken

Technical notes

CF0 is usually negative (the project cost)

CF1, CF2, are usually positive (future

payoffs of project)
CF1, CF2, are expected or anticipated
cash flows
r is a discount rate appropriate to the
projects risk

50

Yes-No and IRR

IRR rule: A project is worthwhile if the IRR >

discount rate
CF0

CF1
1

CF2
2

...

CFN

1 IRR 1 IRR
1 IRR
According to the IRR rule:

51

If IRR > r, then the project is worthwhile

If IRR < r, project should not be undertaken

Basic Yes-No example

This project is worthwhile by both NPV and

IRR rules:
NPV > 0
IRR > discount rate of 12%

52

Basic Ranking example

Yes-No: Both projects are worthwhile

NPVA, NPVB > 0
IRRA, IRRB > discount rate of 12%
Ranking: If you can choose only one
project, B is preferred by both NPV and IRR
NPVB > NPVA
IRR > IRR

53

Excels NPV function

Chapter 2: Excels NPV function is really the
present value of future cash flows!
To compute the actual NPV, add in the initial
cash flow as shown below:

54

Summing up

55

In this example:
Both A and B are worthwhile by both NPV and IRR
criteria
If discount rate = 6%
A is preferred to B by NPV rule
56
B preferred to A by IRR rule

 IRRA is always < IRRB: By IRR rule, B is always preferred to

A
For discount rates < 8.5128%: NPVA > NPVB (ranking
conflict)
57
For discount rates > 8.51285: NPVA < NPVB (no ranking

When IRR and NPV conflict,

use NPV
Why: IRR gives the rate of return
NPV gives the wealth increment

NPV CF0
{
Cost of
project

CF1
1

CF2
2

...

CFN
N

11 4 r4 4 4 1 44r2 4 4 4 41 4r 43
Value today of future
project cash flows

1 4 4 4 4 4 4 42 4 4 4 4 4 4 43

Incremental wealth:
How much does the project's
net value add to your wealth?

58

Back to last example:

Calculating the crossover
point

Crossover point is the IRR of the

differential cash flows (column D)
59

Essential Formulae -Summary

1.The Time Value of Money is a cornerstone of finance.
2. The amount, direction and timing of cash flows, and relevant
interest rates, must be carefully specified.
3. Knowledge of financial formulae is essential for project
evaluation.
4. NPV and IRR are the primary investment evaluation criteria.
5. Most financial functions can be automated within Excel.
6. Spreadsheet errors are common. Error controls should be
employed.
7.To reduce spreadsheet errors: -document all spreadsheets, keep a
list of authors and a history of changes, use comments to guide
later users and operators.
8. Financial formulae and spreadsheet operation can be demanding.
60
Seek help when in doubt.