The document discusses various methods for analyzing the financial feasibility of a project, including net present value (NPV), payback period, discounted payback period, average accounting return, and internal rate of return (IRR). It then provides an example calculation of each method for a sample project with an initial investment of $165,000 and cash flows over 3 years. Based on the calculations, the project would be accepted based on the NPV and IRR methods but rejected according to the payback period, discounted payback period, and average accounting return methods.

1. Financial Feasibility
Professor (Dr.) A. Chamaru De Alwis
(Ph.D. (Mgt) TBU in Zlin, Cz, M.Sc (Mgt) Sri J, B.Sc (B.Ad) Sri J.
Professor in Management
University of Kelaniya
ORCID :https://orcid.org/0000-0003-2492-9466
Google Scholar: https://scholar.google.com/citations?user=mAMWuxkAAAAJ&hl=en
ResearchGate: https://www.researchgate.net/profile/A_De_Alwis

2. Learning Outcome
• At the end of this lecture, the student should be able to
• Define Financial Feasibility
• Analysis the project feasibility using different methods

3. Introduction
• Financial feasibility is one of the most important feasibility
analysis required to carry out a new project/ new business.
• Financial lenders put emphasis on this analysis to ensure the
project lives up to its performance expectation.
• It is a process which profitability of the project can be
estimated.

4. Introduction cont…..
• A financial feasibility study projects
• how much start-up capital is needed,
• sources of capital,
• returns on investment
• and other financial considerations.

5. Start-Up Capital Requirements
• Start-up capital is how much cash you need to start your business and
keep it running until it is self-sustaining.
• You should include enough capital funds (cash, or access to cash) to
run the business for one to two years (working capital ) .
• Although many business or sole proprietorships determine their capital
requirements individually,
• Larger corporations may use the help of their respective bank or
capital firm to pinpoint capital requirements

6. Finding Start-Up Capital Funding Sources
• There are many ways to raise capital for your business
• Depending on the size of your business, you may be
able to utilize one of the many Small Business
Administration's (SBA) Microloan programs.
• Using these, you will not need much capital, as the
program allows for a much smaller down-payment on their
lending partner's loans.

7. Potential Returns for Investors Feasibility
Study
• Investors can be a friends, family members, professional
associates, client, partners, share holders, or investment
institutions.
• Any business or individual willing to give you cash can be a
potential investor.
• Investors give you money with the understanding that they
will receive "returns" on their investment, that is, in addition
to the amount that is invested they will get a percentage of
profits.

8. Good Decision Criteria for
financial feasibility
8
 We need to ask ourselves the following
questions when evaluating capital budgeting
decision rules


 Does the decision rule adjust for the time value of
money?
Does the decision rule adjust for risk?
Does the decision rule provide information on
whether we are creating value for the firm?

9. Project Example Information
9
 You are looking at a new project and you
have estimated the following cash flows:




 Year 0: CF = -165,000
Year 1: CF = 63,120; NI = 13,620
Year 2: CF = 70,800; NI = 3,300
Year 3: CF = 91,080; NI = 29,100
Average Book Value = 72,000
 Your required return for assets of this risk is
12%.

10. Net Present Value (NPV)
1
0
 The difference between the market value of a
project and its cost


 The first step is to estimate the expected future
cash flows.
The second step is to estimate the required return
for projects of this risk level.
The third step is to find the present value of the
cash flows and subtract the initial investment.

11. NPV – Decision Rule
 If the NPV is positive, accept the project
 A positive NPV means that the project is
expected to add value to the firm and will
therefore increase the wealth of the owners.
 Since our goal is to increase owner wealth,
NPV is a direct measure of how well this
project will meet our goal.

12. Net Present Value (NPV)
The following is the formula for calculating NPV:
where:
Ct = net cash inflow during the period
Co= initial investment
r = discount rate, and
t = number of time periods

13. Computing NPV for the
Project
 Using the formulas:
 NPV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/
(1.12)3 – 165,000 = 12,627.42
 Using the calculator:
 CF0 = -165,000; C01 = 63,120; F01 = 1; C02 =
70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I =
12; CPT NPV = 12,627.42
 Do we accept or reject the project?

14. Advantages Of NPV
1. NPV gives important to the time value of
money.
2. In the calculation of NPV, both after cash flow
and before cash flow over the life span of the
project are considered.
3. Profitability and risk of the projects are given
high priority.
4. NPV helps in maximizing the firm's value.

15. Disadvantages Of NPV
1. NPV is difficult to use.
2. It is difficult to calculate the appropriate discount rate.
3. NPV may not give correct decision when the projects are
of unequal life.

16. Payback Period
 How long does it take to get the initial cost back
in a nominal sense?
 Computation
 Estimate the cash flows
 Subtract the future cash flows from the initial cost until
the initial investment has been recovered
 Decision Rule – Accept if the payback
period is less than some preset limit

17. Computing Payback For The Project
 Assume we will accept the project if it pays
back within two years.


 Year 1: 165,000 – 63,120 = 101,880 still to
recover
Year 2: 101,880 – 70,800 = 31,080 still to recover
Year 3: 31,080 – 91,080 = -60,000 project pays
back in year 3
 Do we accept or reject the project?

18. Advantages Of Pay Back Period
1. Pay back period is simple and easy to understand
and compute.
2. Pay back period is universally used and easy to
understand.
3. Pay back period gives more importance on liquidity for
making decision about the investment proposals.
4. Pay back period deals with risk. The project with a
shortest PBP has less risk than with the project with
longest PBP.

19. Disadvantages Of Pay Back Period
1. In the calculation of pay back period, time value of
money is not recognized.
2. Pay back period gives high emphasis on liquidity
and ignores profitability.
3. Only cash flow before the pay back period is
considered. Cash flow occurred after the PBP
is not considered.

20. Discounted Payback
Period
 Compute the present value of each cash flow
and then determine how long it takes to
payback on a discounted basis
 Compare to a specified required period
 Decision Rule - Accept the project if it pays
back on a discounted basis within the
specified time

21. Computing Discounted Payback for the
Project
 Assume we will accept the project if it pays
back on a discounted basis in 2 years.
 Compute the PV for each cash flow and
determine the payback period using
discounted cash flows



Year 1: 165,000 – 63,120/1.121 = 108,643
Year 2: 108,643 – 70,800/1.122 = 52,202
Year 3: 52,202 – 91,080/1.123 = -12,627 project
pays back in year 3
 Do we accept or reject the project?

22. Advantages and Disadvantages of
Discounted Payback



 Includes time value of
money
Easy to understand
Biased towards liquidity
 Advantages Disadvantages



 May reject positive NPV
investments
Requires an arbitrary
cutoff point
Ignores cash flows
beyond the cutoff point
Biased against long-term
projects, such as R&D
and new products

23. Average Accounting
Return
 There are many different definitions for
average accounting return
 Average net income / average book value
 Note that the average book value depends on
how the asset is depreciated.
 Need to have a target cutoff rate
 Decision Rule: Accept the project if the
AAR is greater than a preset rate.

24. Computing AAR For
The Project
24
 Assume we require an average accounting
return of 25%
 Average Net Income:
 (13,620 + 3,300 + 29,100) / 3 = 15,340
 AAR = 15,340 / 72,000 = .213 = 21.3%
 Do we accept or reject the project?

25. Advantages and Disadvantages of AAR
25


Easy to calculate
Needed information will
usually be available
 Advantages Disadvantages


 Not a true rate of return;
 time value of money is
ignored
Uses an arbitrary
benchmark cutoff rate

26. Internal Rate of Return
26
 This is the most important alternative to NPV
 It is often used in practice
 It is based entirely on the estimated cash
flows and is independent of interest rates
found elsewhere

27. IRR – Definition and
Decision Rule
27
 Definition: IRR is the return that makes the
NPV = 0
 Decision Rule: Accept the project if the IRR
is greater than the required return

28. Internal Rate of Return
•The discount rate often used in capital budgeting that makes the net
present value of all cash flows from a particular project equal to
zero. Generally speaking, the higher a project's internal rate of
return, the more desirable it is to undertake the project. The formula
for IRR is:
• 0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 +P3/(1+IRR)3
• + . . . +Pn/(1+IRR)n
• where,
•P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . . n,
respectively; and
• IRR equals the project's internal rate of return.

30. Computing IRR For
The Project
30
 If you do not have a financial calculator, then
this becomes a trial and error process
 Calculator


 Enter the cash flows as you did with NPV
Press IRR and then CPT
IRR = 16.13% > 12% required return
 Do we accept or reject the project?

31. NPV Profile For The
Project
-20,000
31
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
-10,000 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22
Discount Rate
NPV IRR = 16.13%

32. Advantages of
IRR
 Knowing a return is naturally appealing
 It is a simple way to communicate the value
of a project to someone who doesn’t know all
the estimation details
 If the IRR is high enough, you may not need
to estimate a required return, which is often a
difficult task

33. Summary of Decisions For The Project
33
Summary
Net Present Value Accept
Payback Period Reject
Discounted Payback Period Reject
Average Accounting Return Reject
Internal Rate of Return Accept