Cost Benefit Evaluation
techniques
Cost Benefit Evaluation techniques
• It consider
• the timing of the costs and benefits
• the benefits relative to the size of the investment
• Common method for comparing projects on the basic
of their cash flow forecasting.
1) Net profit
2) Payback Period
3) Return on investment
4) Net present Value
5) Internal rate of return
Net profit
• Net profit
• calculated by subtracting a company's total expenses from total
income.
• showing what the company has earned (or lost) in a given period
of time (usually one year).
• also called net income or net earnings.
• Net profit = total costs - total incomes
Calculate net profit
Year Project 1 Project 2 Project 3 Project 4
0 -100000 -1000000 -100000 -120000
1 10000 200000 30000 30000
2 10000 200000 30000 30000
3 10000 200000 30000 30000
4 20000 200000 30000 30000
5 100000 300000 30000 75000
Net Profit 50000 100000 50000 75000
• All the values are end of year totals (Rs)
• Cash flow take place at the end of each year.
• The value of year 0 represents the initial investment made at
the start of the project.
Payback Period
• The payback period is the time taken to recover the initial investment.
Or
• is the length of time required for cumulative incoming returns to equal
the cumulative costs of an investment
• Advantages
• simple and easy to calculate.
• It is also a seriously flawed method of evaluating investments
• Disadvantages
• It attaches no value to cashflows after the end of the payback period.
• It makes no adjustments for risk.
• It is not directly related to wealth maximisation as NPV is.
• It ignores the time value of money.
• The "cut off" period is arbitrary.
Calculate the payback period
Year Project 1 Project 2 Project 3 Project 4
0 -100000 -1000000 -100000 -120000
1 10000 200000 30000 30000
2 10000 200000 30000 30000
3 10000 200000 30000 30000
4 20000 200000 30000 30000
5 100000 300000 30000 75000
Net Profit 50000 100000 50000 75000
• Project1 =10,000+10,000+10,000+20,000+1,00,000=1,50,000 (5th year)
• Project 2= 2,00,000+2,00,000+2,00,000+2,00,000+3,00,000=11,000,00 (5th Year)
• Project 3= 30,000+30,000+30,000+30,000 + 30,000 =1,95,000 (4th year)
• Project 4 = 30,000+30,000+30,000+30,000 + 75,000 =1,95,000 (4th year)
• It ignores any benefits that occur after the payback period and, therefore, does not measure profitability.
• It ignores the time value of money.
RETURN ON INVESTMENT or ACCOUNTING RATE
OF RETURN
• It provides a way of comparing the net profitability to the investment
required.
Or
• A performance measure used to evaluate the efficiency of an
investment or to compare the efficiency of a number of different
investments
• Disadvantages
• It takes no account of the timing of the cash flows.
• Rate of returns bears no relationship to the interest rates offered or changed
by bank.
RETURN ON INVESTMENT
• * 100
• average annual profit
RoI Calculations
Net present value (NPV)
• Discounted Cash Flow (DCF) is a cash flow summary adjusted to reflect
the time value of money. DCF can be an important factor when evaluating
or comparing investments, proposed actions, or purchases. Other things
being equal, the action or investment with the larger DCF is the better
decision. When discounted cash flow events in a cash flow stream are
added together, the result is called the Net Present Value (NPV).
• When the analysis concerns a series of cash inflows or outflows coming at
different future times, the series is called a cash flow stream. Each future
cash flow has its own value today (its own present value). The sum of
these present values is the Net Present Value for the cash flow stream.
• The size of the discounting effect depends on two things: the amount of
time between now and each future payment (the number of discounting
periods) and an interest rate called the Discount Rate.
Calculation
• Formula to calculate the present value of any future cash flow
• r – discount rate expressed as decimal value & t – number of year into
the future that the cash flow occurs.
• The NPV for a project is obtained by discounting each cash flow (both
+ve and –ve ) and summing the discount value.
• NPV > 0 -> accept; NPV < 0 -> Reject; NPV = 0 -> indifferent
Problem
Year Project 1
0 -100000
1 10000
2 10000
3 10000
4 20000
5 100000
Assume a 10% discount rate, Calculate the NPV for the project 1.
Discount cash Discount Year 1 (t) , 10% discount rate (r), inflow cash 10000
flow or factor @
Year Project 1 Present Value 10% Discount cash flow or Present Value=
0 -100000 -100000 1 = =
1 10000 9090.90909 0.909091
Discount factor @10%=
2 10000 8264.46281 0.826446 = =
3 10000 7513.14801 0.751315
4 20000 13660.2691 0.683013
5 100000 62092.1323 0.620921
SUM 50000 620.921323 Year 2 (t) , 10% discount rate (r), inflow cash 10000
Net Profit 50000
Discount cash flow or Present Value=
NPV 620.92 = =
Discount factor @10%=
= =
IRR (Internal Rate Return)
• The IRR compares returns to costs by asking: "What is the discount
rate that would give the cash flow stream a net present value of 0?“
• The IRR may be estimated by plotting a series of guesses
Cont..
• For a particular project, a discount rate of 8% gives a positive NPV of
7,896.
• a discount rate of 12% gives a negative NPV of -5,829.
• The IRR is therefore somewhere between these two values.
• Plotting the two values on a chart and joining the points with a
straight line suggests that the IRR is about 10.25%.
• The true IRR is 10.167%
• IRR as the decision criterion, the one with the higher IRR is the better
choice.
