CHAPTER 5
FINANCIAL ANALYSIS OF PROJECTS
5.1. INTRODUCTION
• Once the stream of costs and benefits for a project is defined
in the form of cash flows, the attention shifts to the issue of
examining estimated costs and benefits of the project and
deciding whether it is worthwhile or not.
• The key steps involved in determining whether a project is
worthwhile or not are the following:
Identify the estimated costs and benefits of the project,
• This is done in accordance with the
conceptual/theoretical aspects
Assess the riskiness of the project and calculate the cost of
capital, and
Compute the criteria of merit and judge whether the
project is good or bad.
5.2 PROJECT APPRAISAL METHODS
There are two important methods for judging weather capital projects
are worthwhile or not.
1. Traditional methods (Non-discounting criteria)
• Pay back period (PBP)
• Accounting rate of return (ARR)
2. Discounted cash flow methods (Discounting criteria)
• Net present value (NPV)
• Profitability Index (PI)
• Internal Rate of Return (IRR)
1. Traditional methods (Non-discounting criteria)
A. Pay Back Period:
• This is one of the widely used methods for evaluating the
investment proposals.
• Under this method the focus is on the recovery of original
investment at the earliest possible.
• It determines the number of years to get back the original cash out
flow, disregarding the salvage value and interest.
• This method do not take into account the cash inflows that are
received after the pay back period.
There are two methods in use to calculate the Pay back period
1) Where annual cash inflows are not consistent and vary from year to
year
2) Where the annual cash inflow are uniform
1. Unequal cash flows
B
P=E+
C
where, P stands for pay back period.
E stands for number of years immediately preceding the year of
final recovery.
B stands for the balance amount still to be recovered.
C stand for cash flow during the year of final recovery.
Decision rule:
Shorter is the payback period better is the project
Project A Project B
Year Cash flow $ Year Cash flow $
0 -700 0 -700
1 100 1 400
2 200 2 300
3 300 3 200
4 400 4 100
5 500 5 0
Calculate payback period
Project A Cumulative Project B Cumulative
Year Cash flow cash flow Year Cash flow Cash flow
0 -700 -700 0 -700 -700
1 100 -600 1 400 -300
2 200 -400 2 300 0
3 300 -100 3 200 200
4 400 300 4 100 300
5 500 800 5 0 -
B
P=E+
C
100
=3+
400
= 3.25 year
B
P=E+
C
=2+0
= 2 years
2. Where the annual cash flows are uniform
PBP =
Decision rule:
Shorter is the payback period better is the project
EX: A project requires an investment of $ 100,000, it will generate
annual cash flow of $25,000 per year. Calculate the pay back
period
Solution: PBP=100,000/25000
= 4 years
B. Accounting Rate of Return
• This method is based on the financial accounting practices of the
company working out the annual profits.
• Here, instead of taking the annual cash flows, we take the annual
profits into account.
• The net annual profits are calculated after deducting depreciation
and taxes.
• The average of annual profits thus derived is worked out on the
basis of the period
• ARR =
• Average investment = Net working capital + Salvage value +
(Initial cost of plant – salvage value)
• Net working capital = current assets – current liabilities
• Average annual profits after taxes =
Ex: Initial investments of plant $ 10, 000
Installation costs $ 1, 000
Salvage value $ 1, 000
Working capital $ 1, 000
Life of plant 5 years
Annual profit per year $ 2, 500
Calculate ARR
12,500
Average profit = 2, 500 x 5 = = 2, 500
5
1
Average investment = Wc + Sal.V. + (Cost + Inst. Charges – Salv. Val)
2
=1,000+1,000+ ½ ((10,000+1,000)-1,000)
=1,000+1,000+5,000
=7,000
ARR = (2500/7000)*100
= 35.71%
• Decision rule:
• The ARR is compared to the predetermined rate.
• The project will be accepted if the actual ARR is higher than
the desired ARR. Otherwise it will be rejected
Assume in previous case that the desired ARR was 30%.
Since the actual ARR is 35.71%, the project is accepted.
2. Discounted cash flow techniques:
• This concept is based on the time value of money.
• The flow of income is spread over a few years.
• Three methods of appraisal of investment project are based on this
concept.
A. Net Present Value
• Net present value may be defined as the total of present value of
the cash proceeds in each year minus the total of present values of
cash outflows in the beginning.
NPV= - CF0 + CF1 + …..+ CFn
(1+K)0 (1+K)1 (1+K)n
•In general, the decision rule is:
Accept the project if the net present value is positive
Reject the project if the net present value is negative
If the NPV is zero, it is a matter of indifference
EXAMPLE:
• ABC PLC is considering investing in a cement project. It has on
hand $180, 000.
• It is expected that the project may work for seven years and
likely to generate the following annual cash flows.
• Calculate the Net present value.
Year ACF
1 30,000
2 50,000
3 60,000
4 65,000
5 40,000
6 30,000
7 16,000
The cost of capital is 8%
Present value table
Solution
Year ACF PV factor Present value
1 30, 000 .926 27, 780
2 50, 000 .857 42, 850
3 60, 000 .794 47, 640
4 65, 000 .735 47, 775
5 40, 000 .681 27, 240
6 30, 000 .630 18, 900
7 16, 000 .583 9, 328
221, 513
- Original investment 180, 000
Net present value 41, 513
• In the above problem, the NPV is greater than zero hence, it may
be accepted.
• You have already learned in mathematics for finance to calculate
the time value of money and the usage of present value tables.
Hence, you may directly use the present value factors from
tables.
B. Profitability Index Method
• Profitability index method is the relationship between the present
values of net cash inflows and the present value of cash outflows.
• It can be worked out either in unitary or in percentage terms.
Present va lue of cash inflows
Profitability Index =
Pr esent value of cash outflows
PI > 1 Accept
PI = 1 indifference
PI < 1 reject
Decision rule:
Higher the profitability index more is the project preferred.
• From the above example we can calculate the profitability index as
below
Present value of cash out flows $ 180, 000
Present value of cash inflows $ 221, 513
= 221513/180000 = 1.23
C. Internal Rate of Return (IRR)
• Internal rate of return is nothing but the rate of interest which
equates the present value of future earnings with the present
value of present investment.
NPVL
IRR = LRD + R
PV
where; IRR = Internal Rate of Return
LRD = Lower Rate of Discount
NPVL = Net present value at lower rate of discount
(i.e., difference between present values of cash)
PV = The difference in present values at lower and higher discount values at
lower.
R = The difference between two rates of discount.
Decision Rule:
Accept the project if the IRR is greater than the cost of capital.
Reject the project if the IRR is less than the cost of capital.
We are indifferent to accept or reject the project when the IRR is equal to the cost
of capital.
Example:
• Nissan Plc. has $100, 000 on hand.
• This amount is invested in a project, where the annual benefits
after taxes are as below.
• It would like to know the rate of return earned by the company at
the end of the life of the project.
• LRD=10% HRD= 20%
Year ACFS Year ACFS
1...........................40, 000 4...........................25, 000
2...........................35, 000 5...........................20, 000
3...........................30, 000
IRR= LRD+ NPVL/PV*R
= 10%+(117,300/(117,300-95100))*10%
= 10%+(117,000/22,200) *10%
=10.53%
Decision:
• If the cost of capital in the previous example is 10%, the project is
accepted as IRR (10.53 %>10% cost of capital)
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