Project Management: Unit IV - Project Appraisal Criteria

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Project Management: Unit IV - Project Appraisal Criteria

  1. 1. Project Appraisal Criteria Prepared By Ghaith Al Darmaki gm.al.darmaki@gmail.com MBA for Engineering Business Managers Manchester Business School
  2. 2. Content  Introduction  Pay Back Period-PBP.  NPV –Net Present value  IRR -Internal Rate of Return.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 2
  3. 3. Investment Criteria  It is very important to judge if a project is a worthwhile or not.  Two main categories of Criteria: e c op o fS OutProject Management - Unit IV Prepared By: Ghaith Al Darmaki 3
  4. 4. Payback Period  The payback period: is the period of time that is required to recover the initial investment.  The payback period is stated in terms of number of years. Computation of Payback period:  The pay back period can be calculated in two different situations:  When annual cash inflows are equal: In this case, the cash inflows being generated by a proposal are equal for all time periods. The payback period can be computed by dividing the initial cash outflows by the amount of cash inflows per time period. PB = Initial cash outflow/investment Constant Annual Cash inflowProject Management - Unit IV Prepared By: Ghaith Al Darmaki 4
  5. 5. Payback Period  When the annual cash inflows are unequal: When the cash inflows are unequal, calculate the cumulative cash flows. => Calculate the cumulative inflows.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 5
  6. 6. Payback Period  Examples of equals inflows:  Problem (1): A project requires an initial cash outflow of Ro.5, 00,000 and is expected to generate cash inflows of Ro.1, 00,000 p.a.for 8 years. Solution: PB = Initial cash outflow/investment Constant Annual Cash inflow PB = 5, 00,000 = 5 years 1, 00,000 b) 5th year are considered as profit. The period over and above the pay back period (the 6th, 7th, 8th), year is ignored. The pay back period need not be the whole number.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 6
  7. 7. Payback Period  Examples of equals inflows:  Problem (2) A project requires an initial cash outflow of Ro.5, 00,000 and is expected to generate Cash Inflows of Ro.80, 000 p.a.for 8 years. Solution: PB = Investment = 5, 00,000 Constant cash flows 80,000 = 6.25 years or 6 years and 3 months.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 7
  8. 8. Payback Period  Examples of unequal inflows:  Problem (1)  An investment proposal requires a cash outflow of Ro.2, 00,000 and expected to generate cash flows of Ro.80, 000, Ro.60, 000, Ro.40, 000, Ro.20, 000 and Ro.15000 over next 5 years respectively. Calculate the pay back period. Solution: Thus, the pay back period is 4th year.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 8
  9. 9. Payback Period  Examples of unequal inflows:  Example (2) 600000 400000 e 200000 c op o fS 0 ut 0 1 2 3 -200000O -400000 -600000 -800000 Series1 -1000000 Series2Project Management - Unit IV Prepared By: Ghaith Al Darmaki 9
  10. 10. Payback Period  The Decision Rule: the actual payback is compared with a predetermined pay back, that is, the pay back set by the management in terms of the maximum period during which the investment must recovered.  If the pay back period is less than the predetermined payback, then the project would be Accepted; if not, it would be rejected.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 10
  11. 11. Payback Period Advantages: 1. It is very simple. It is easy to understand and apply. 2. It is cost effective. 3. The payback period measures the direct relationship between annual cash inflows from Proposal and the net investment required. 4. It gives an indication of liquidity. 5. The pay back period also deals with risk. The project with a shorter payback period will be less risky.   Disadvantages: 1. The pay back period entirely ignores the cash inflows that occur after the pay back period. 2. It ignores the concept of required rate of return. 3. The pay back period also ignores salvage value and total economic life of the project. 4. It ignores the time value of money.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 11
  12. 12. Net Present Value (NPV)  The Net present value of a proposal is the sum of present values of all cash inflows related to a proposal, less the sum of present values of all cash outflows associated with a proposal.  Thus, NPV is the sum of the discounted values of all cash flows pertaining to a proposal.  The present value factors are multiplied to their respective net cash flows to arrive at the present value of each net cash flow. When all such present values are added the resultant figure is the Net Present Value.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 12
  13. 13. Net Present Value (NPV)  NPV of a project is the sum of the present value of all cash flows that are expected to occur over the life of the project.  It converts future values to present values  Future values are usually net benefits from investment  It compares sum of present values against investment n Ct NPV = ∑ − Intial Investment t =1 (1 + r ) t Ct = cash flow at the end of year t  n = life of the project  r = discount rate e  If NPV > 0  Accept the project. c op ofS  If NPV < 0  Reject the project. O utProject Management - Unit IV Prepared By: Ghaith Al Darmaki 13
  14. 14. Net Present Value (NPV) Present Value of A Single Amount  Discounting applies an interest rate to a future value to get a present value  PV0 = FVn / (1+r)n (1+r)n : The discount factor.  Example: You are supposed to get 1000OMR after two years, what is the present value of this amount if the interest rate is 10%? e c op PV0 = FVn / (1+r)n o fS t Ou PV0 = 1000/(1.1)2 = 826.45 OMRProject Management - Unit IV Prepared By: Ghaith Al Darmaki 14
  15. 15. Net Present Value (NPV)  Example Four year project (project discount rate = 10%) t0 t1 t2 t3 t4 Project Outlay - 10000 Project net cash flows 4000 4000 3000 1000 Discounted cash flows: /(1.1)1 /(1.1)2 /(1.1)3 /(1.1)4 year 1 3636 year 2 3306 year 3 2254 year 4 683 Net Present Value (NPV) = - 121 e c op ofS O utProject Management - Unit IV Prepared By: Ghaith Al Darmaki 15
  16. 16. Net Present Value (NPV)  The Decision Rule: The NPV is positive accept the project  Reject the project if the NPV is negative.  The positive NPV of a proposal signifies the present worth of its inflows is more than the present worth of its out flows. Thus; the NPV represents the excess of benefits over the costs in real term.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 16
  17. 17. Net Present Value (NPV)  Advantages: 1. It recognizes the time value of money. 2. It is capable of evaluating proposals that is profit seeking. 3. The discount rate is most appropriate to ensure the minimum expectations of share 4. Holders are adequately met. 5. The NPV allows for both the recovery of the initial investment and the earnings at a Pre-stipulated rate. 6. It is based on accounting information which is readily available and familiar to businessman  Disadvantages: 1. It involves lengthy and difficult calculation. 2. Determination of the required rate of return is a difficult job. 3. It is difficult to estimate economic life of a project with full accuracyProject Management - Unit IV Prepared By: Ghaith Al Darmaki 17
  18. 18. Internal Rare of Return (IRR)  The IRR of a proposal is defined as the discount rate at which the NPV of the proposal works out to zero.  IRR is the discount rate that equates present value of cash inflows with present value of cash outflows.  First find out the PV of cash outflows at chosen original discount rate. Depending upon whether the NPV so arrived at positive or negative, another PV of cash inflows is calculated by taking a discount rate that is higher or lower than the original rate. Now two rate and two corresponding PVs.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 18
  19. 19. Investment Criteria Internal Rate of Return (IRR)  It is the discount rate which gives a net present value of zero.  It is the discount rate which equates the present value of cash flow with the initial investment. n Ct Intial Investment = ∑ t =1 (1 + r )t r = IRR  If IRR > Cost of Capital  Accept the project.  If IRR < Cost of Capital  Reject the project e c op ofS O utProject Management - Unit IV Prepared By: Ghaith Al Darmaki 19
  20. 20. Investment Criteria Internal Rate of Return (IRR)  One way of discovering the IRR is to calculate the NPV of the project for different interest rates and graph the result. The cutover point on the interest axis of the graph is the internal rate of return 25000 20000 15000 10000 Internal Rate of Return 5000 discount rate 0 0 2 4 6 8 10 12 14 16 18 20 22 24 -5000 e -10000 c op ofS -15000 O utProject Management - Unit IV Prepared By: Ghaith Al Darmaki 20
  21. 21. Investment Criteria Internal Rate of Return (IRR)  Example 8.3-8.4: Excel Formula: IRR(values) e c op ofS O utProject Management - Unit IV Prepared By: Ghaith Al Darmaki 21
  22. 22. Internal Rare of Return (IRR)  The IRR is calculated by interpolating the two rates with the help of the following formula: IRR=r1% +PV of cash inflows at r1 - PV of cash outflows * (r2-r1) PV of cash inflows at r1- PV of cash inflows at r2  r1=rate of interest that is lower of the two rates at which PV of cash inflows is calculated  r2=rate of interest that is higher of the two rates at which PV of cash inflows is calculatedProject Management - Unit IV Prepared By: Ghaith Al Darmaki 22
  23. 23. Internal Rare of Return (IRR)  The original discount rate can be chosen in a manner that can help us in reducing the number of iterations. This can be done by following the steps. 1. Calculate the pay back period. Incase the project generate the uneven streams of cash flows, then the weighted average of cash inflows should be calculated. The original investment must be divided by the weighted average cash flow to arrive at the artificial payback period. 2. Then, search for the PVAF factor as near as possible to the figure obtained as payback period in the row that stands for the life of the project. The interest rates that correspond to the PVAF value should be taken as the range with in which the IRR lies.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 23
  24. 24. Internal Rare of Return (IRR)  The Decision Rule:  The IRR is compared with the required rate of return. This rate is also known as the cut off rate or the hurdle rate. A proposal may be accepted if its IRR is more than the required rate.  If the IRR is less than Required rate, the proposal is rejected. If the required rate of return is equal, the firm is indifferent as to whether accept or reject the proposal.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 24
  25. 25. Internal Rare of Return (IRR)  Advantages: 1. It takes into account the time value of money. 2. It is profit oriented concept. 3. The IRR of the proposal is expressed as a percentage and is compared with the cut of rate, This is also expressed as a percentage. 4. It is based on the cash flows rather than the accounting profit.  Disadvantages: 1. It involves a complicated calculation hence it is difficult to use. 2. It is difficult to use in decision making 3. The estimate of cash inflows are based on the estimates of sales and cost which are uncertain. 4. A critical shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 25
  26. 26. Internal Rare of Return (IRR)  Problem: A chemical company is considering investing in a project costs Ro.4, 00,000.The estimated salvage value is zero. Tax rate is 50%.The company uses straight line depreciation and the proposed project has cash Flow before tax (CFBT) as follows. Year CFBT (Ro.) 1 1, 00,00 2 1, 50,000 3 2, 00,000 4 2, 50,000 5 3, 00,000  Determine the following :( i) Internal Rate of Return (IRR) (ii) Net Present Value (NPV) at 15%Project Management - Unit IV Prepared By: Ghaith Al Darmaki 26
  27. 27. Internal Rare of Return (IRR)  Solution:  CFBT (Cash Flow Before Tax) =profit before Tax + Depreciation  PBT (Profit Before Tax) = CFBT - Depreciation  PAT (Profit After Tax) =PBT - Tax  CFAT (Cash Flow After Tax) = PAT + DepreciationProject Management - Unit IV Prepared By: Ghaith Al Darmaki 27
  28. 28. Internal Rare of Return (IRR)CFBT Deprecia PBT Tax PAT CFAT Pvf@15 PVof tion CFBT- 50% PBT- PAT+ % CFA Depreciation Tax Depreciation T100000 80000 20000 10000 10000 90000 0.8696 78261150000 80000 70000 35000 35000 115000 0.7561 86957200000 80000 120000 60000 60000 140000 0.6575 92052250000 80000 170000 85000 85000 165000 0.5718 94339300000 80000 220000 110000 110000 190000 0.4972 94464 446073 Project Management - Unit IV Prepared By: Ghaith Al Darmaki 28
  29. 29. Internal Rare of Return (IRR) n Ct NPV = ∑ − Intial Investment t =1 (1 + r ) t  PV of cash outflows = Ro.4, 00,000  NPV = Ro.4, 46,073- Ro.4, 00,000 = Ro.46, 073.  The NPV is positive, hence the project is accepted.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 29
  30. 30. Internal Rare of Return (IRR)  IRR: 1. Calculate the pay back period. Incase the project generate the uneven streams of cash flows, then the weighted average of cash inflows should be calculated. The original investment must be divided by the weighted average cash flow to arrive at the artificial payback period. 2. Then, search for the PVAF factor as near as possible to the figure obtained as payback period in the row that stands for the life of the project. The interest rates that correspond to the PVAF value should be taken as the range with in which the IRR lies.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 30
  31. 31. Internal Rare of Return (IRR)  IRR: 1. Calculate the weighted average of cash inflows Weighted average= [(90000*5)+(115000*4)+(140000*3)+(165000*2)+(190 00*1)] /15 = 1, 23,333.33 2. Measure the artificial pay back period the artificial pay back period=4, 00,000/1, 23,333=3.2432Project Management - Unit IV Prepared By: Ghaith Al Darmaki 31
  32. 32. Internal Rare of Return (IRR)  IRR: 3. search for the PVAF factor as near as possible to the figure obtained as payback period in the row that stands for the life of the project. The interest rates that correspond to the PVAF value should be taken as the range with in which the IRR lies.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 32
  33. 33. Internal Rare of Return (IRR)  IRR: 4. The interest rates corresponding to the figures closet to 3.2432 are 16% and 18% CFAT Pvf@16% PV of CFAT Pvf@18% PV of CFAT 90000 0.8621 77586 0.8475 76271 115000 0.7432 85464 0.7182 82591 140000 0.6407 89692 0.6086 85208 165000 0.5523 91128 0.5158 85105 190000 0.4761 90461 0.4371 83051 434332 412227Project Management - Unit IV Prepared By: Ghaith Al Darmaki 33
  34. 34. Internal Rare of Return (IRR)  IRR: 4. IRR=r1% +PV of cash inflows at r1 - PV of cash outflows * (r2-r1) PV of cash inflows at r1- PV of cash inflows at r2 r1=16%; r2 =18% PV of cash inflows at r1=4, 34,332: PV of cash inflows at r2=4, 12,227 Thus, IRR = 16+ 434332 - 400000 *(18-16) 434332 - 412227 = 16+ (34332*2)/22105=16+3.11 = 19.11%Project Management - Unit IV Prepared By: Ghaith Al Darmaki 34
  35. 35. Exercises  Problem II:  Saud Bhawan Limited company is considering investment in a project requirement a capital outlay of Ro.2,00,000.Forecast for annual income after depreciation but before tax is as follows: Year Ro. 1 1, 00,000 2 1, 00,000 3 80,000 4 80,000 5 40,000 Depreciation taken as 20% on original cost and taxation at 50%of net income. You are required to evaluate the project according to NPV method taking cost of capital as 10%.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 35
  36. 36. Exercises  Inputs  CFBT (Cash Flow Before Tax) =profit before Tax + Depreciation  PBT (Profit Before Tax) = CFBT - Depreciation  PAT (Profit After Tax) =PBT - Tax  CFAT (Cash Flow After Tax) = PAT + Depreciation  Initial Investment= Ro.2,00,000  PBT is given, PBT (Profit Before Tax) = CFBT – Depreciation  Depreciation is 20% of original cost = 0.2 * 200 000 = 40 000  Tax is 50% of the net income  Requirement  NPV at 10% discount rate.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 36
  37. 37. ExercisesDepreciat PBT Tax CFAT Pvf @ PVofion PAT 10% CFAT CFBT- 50% PBT- PAT+ Depreciatio Tax Depreciation n 40,000 100,000 50,000 50,000 90,000 0.9091 81819 40,000 100,000 50,000 50,000 90,000 0.8264 74376 40,000 80,000 40,000 40,000 80,000 0.7513 60104 40,000 80,000 40,000 40,000 80,000 0.6830 54640 40,000 40,000 20,000 20,000 60,000 0.6209 37254 308193 Project Management - Unit IV Prepared By: Ghaith Al Darmaki 37
  38. 38. Exercises n Ct NPV = ∑ − Intial Investment t =1 (1 + r ) t  PV of cash outflows = Ro.200,000  NPV = 308,193 - 200,000 = Ro . 108,193  The NPV is positive, hence the project is accepted.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 38
  39. 39. Exercises n Ct NPV = ∑ − Intial Investment t =1 (1 + r ) t  PV of cash outflows = Ro.200,000  NPV = 308,193 - 200,000 = Ro . 108,193  The NPV is positive, hence the project is accepted.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 39
  40. 40. Assignment  Question 8 from the question bank.  Submission: 6th May 2013.Project Management - Unit IV Prepared By: Ghaith Al Darmaki 40
  41. 41. THANK YOUProject Management - Unit IV Prepared By: Ghaith Al Darmaki 41

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