Using a Financial Model to Select

Projects
Basic Income Statement Equation
Project cash flow
• Two dissimilar types of amounts
• First, investment – usually at the beginning of
the project.
• Investment made “today” is called “time 0”.
• Second, there is a stream of cash benefits that
are expected to result from the investment
over some years in the future.
Loan versus Project Cash Flow
• The essential characteristic: funds are committed today
in the expectation of their earning a return in the future.
• The loan cash flow is the future return takes the form of
interest plus repayment of the principal.
• In the case of fixed assets, the future return takes the
form of cash generated by productive use of the assets.
• The project cash flow is the representation of future
earnings, along with capital expenditures and annual
expenses (such as wages, raw materials, operating costs,
maintenance costs and income taxes).
Figure 5.1 A bank loan versus an investment project.
Example 5.1 (summary of the cash flow------
see the note)
Year (n) Cash inflows Cash Net Cash
(Benefits) $ Outflows Flows $
(Costs) $
0 0 650,000 - 650,000
1 215,500 53,000 162,500
2 215,500 53,000 162,500

.
.
8 215,500 53,000 162,500
Independent versus Mutually Exclusive
Investment Projects
• Independent Project: The decision regarding
any one project has no effect on the decision
to accept or reject another project.
• Mutually exclusive project: Selecting the most
economically attractive project from a number
of alternative projects.
Numeric Models

• Payback period
• Benefit cost ratio (BC Ratio)
• Return on investment (ROI)
• Net Present Value (NPV)
• Internal rate of return (IRR).
Initial Project Screening Method
(The payback period)
• The payback period is the time taken to gain a
financial return to the original investment.
• Determines how long it takes for a project to
reach a breakeven point
• The time period is usually expressed in years
and months.
• Calculation: how long it will take recover the
initial investment.
• Lower numbers are better (faster payback)
Types of the payback period
• Conventional payback period: Ignore time
value of money.
• Discounted payback period: Include time value
of money.
Payback Period

Investment
Payback Period 
Annual Cash Savings

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Education, Inc. Publishing as 3-12
Prentice Hall
Payback Period
Year Cash-flow Machine A ($) Cash-flow Machine B ($)
0 ($ 35,000) ($ 35,000)
1 20,000 10,000
2 15,000 10,000
3 10,000 15,000
4 10,000 20,000
Payback Period 2 years 3 years

Cash-flow= Cash inflow/income-cash outflow/expenditure/costs

Conventional Payback Period Example
A project requires an initial investment of $200,000 and will
generate cash savings of $75,000 each year for the next five
years. What is the payback period?
Year Cash Flow Cumulative Divide the cumulative
amount by the cash flow
0 ($200,000) ($200,000) amount in the third year
1 $75,000 ($125,000) and subtract from 3 to
find out the moment the
2 $75,000 ($50,000) project breaks even.

3 $75,000 $25,000
25, 000
3  2.67 years
75, 000
Copyright © 2010 Pearson
Education, Inc. Publishing as 3-14
Prentice Hall
Discounted Payback Period Example
Benefit-Cost Analysis
• The Benefit-cost analysis is commonly used to
evaluate public projects.
• Benefits of a nonmonetary nature need to be
quantified in dollar terms as much as possible and
factored into the analysis.
• A broad range of project users distinct from the
sponsor can and should be considered—benefits and
disbenefits to all these users can and should be taken
into account.

Contemporary Engineering Economics, 5th edition,

© 2010
Framework of Benefit-Cost Analysis
 Step 1: Identifying all the
users and sponsors of the
project.
 Step 2: Identifying all the
benefits and disbenefits of
the project.
 Step 3: Quantifying all
benefits and disbenefits in
dollars or some other unit
of measure.
 Step 4: Selecting an
appropriate interest rate at
which to discount benefits
and costs in future to a
present value.
Contemporary Engineering Economics, 5th edition,
© 2010
Benefit-Cost Ratio Criterion

Equivalent Users' Net Benefits

Benefit-Cost Ratio =
Equivalent Sponsor's Net Cost

If this BC ratio exceeds 1, the project can be justified.

Contemporary Engineering Economics, 5th edition,

© 2010
Definition of Benefit-Cost Ratio
N
B   bn (1  i) n
n0
N
C   cn (1  i) n
n0

bn=Benefit at the end of period n, bn ≥ 0

cn=Expense at the end of period n, cn ≥ 0
An= bn – cn
N = Project life
i =Sponsor’s interest rate (discount rate)

Contemporary Engineering Economics, 5th edition,

© 2010
Discounted Cash-Flow (DCF)
• The DCF technique considers the time value of
money
• Eg. $ 100 today will not have the same value
or buying power as a $ 100 next year because
of inflation.
• Two basic DCF: net present value (NPV) and
internal rate of return (IRR).
Net Present Value (NPV)
• NPV is the reserve of compound interest.
• Compound interest: Invest $ 100 at 20%
interest, after one year it will be worth $ 120
and after two years compounded it will be
worth $ 144.
• NPV= If you were offered $ 120 one year from
now and the inflation and interest rate was
20%, working backwards its value in today’s
term would be $ 100.
Net Present Value (NPV)
• Present value= discount factor x cash flow
• Discount factor =1 (1+ i)n
• Where i = the forecast interest rate
• n= the number of years from start date.
• The discount factor is usually read from a table.
• The NPV is positive, the project merits further
consideration.
• Preference should be given to the project with
the highest NPV.
Net Present Value

Ft
NPV  I o  
(1  r  pt )t
where
Ft = net cash flow for period t
R = required rate of return
I = initial cash investment
Pt = inflation rate during period t
Copyright © 2010 Pearson
Education, Inc. Publishing as 3-23
Prentice Hall
Simple Project Evaluation
• A positive NPV means that the equivalent
worth of the inflows is greater than the
equivalent worth of outflows, so the project
makes a profit.
• If the PV (i) is positive for a single project, the
project should be accepted; if the PV (i) is
negative, the project should be rejected.
Simple Project Evaluation
(the decision rule)
• If PV (i) > 0 accept the investment.
• If PV (i) = 0 remain indifferent .
• If PV (i) < 0 reject the investment.
Comparing Multiple Alternatives
• Compute the PV (i) for each alternative and
select the one with the largest PV (i).
• When we compare mutually exclusive project
with the same revenues, they are compared
on a cost only basis.
• Since we are minimizing costs, rather than
maximizing profits, project that results the
smallest or least negative NPV should be
accepted.
The steps for computing NPV:
• Insert the cash-flow
• Transfer the discounting factors from the table
• Calculate present value – multiflying cash-inflow by
discount factor
• Aggregate the present values to give the NPV.
• Results of the table: the NPV for machine A is $ 2692
and for machine B is ($1396). NPV analysis would
select machine A in preference to machine B
because it has a higher NPV. Machine B would be
rejected in any case because it has a negative NPV.
NPV using variable interest rate.
• The true world market are quite volatile.
• The interest rates can fluctuate considerably
over some periods.
• Need to use NPV using different interest rates.
NPV using variable interest rate
Return on Investment (ROI)
• The total outcome of the investment is
expressed as a profit and percentage return
on investment.
• Average Annual Profit= total gains-total
outlays/number of years
• Return on investment= Average annual
profit/original investment x 100
• Higher percentage is better (higher return)
Return on Investment (ROI)
Year Cash-flow Machine A ($) Cash-flow Machine B ($)
0 ($ 35,000) ($ 35,000)
1 20,000 10,000
2 15,000 10,000
3 10,000 15,000
4 10,000 20,000
Total Gains 55,000 55,000
Return on Investment (ROI)
• Profit = $ 55,000 - $35,000
• Annual Profit= $20,000/4 years=$5,000 per
year (Same for both machines)
• Return on investment= $5,000/$35,000 x
100=14 %
• Though both project have the same ROI, the
project with high initial profits should take
preference.
Internal Rate of Return (IRR)
• The IRR is also called DCF yield or DCF return
on investment.
• The IRR is the value of the discount factor
when NPV is zero.
• The preference should be given to the project
with higher IRR.
Internal Rate of Return (IRR)
(computational methods)
• Direct solution method
• Trial and error method
IRR – Direct solution method
• Market interest rate, required rate of return or
minimum attractive rate of return (MARR) has
to be determined by management of the
project.
• Criteria:
• If IRR > MARR accept the investment.
• If IRR = MARR remain indifferent .
• If IRR < MARR reject the investment.
Internal Rate of Return (IRR)
Direct solution method

• A project requiring an initial outlay of RM 15

000 is guaranteed to produce a return of RM
20 000 in three years’ time.
• Use the IRR method to decide whether this
investment is worthwhile if the prevailing
market rate is 5% compounded annually.
Internal Rate of Return (IRR)
Given S = RM 20 000 
S  P 1 
r 
t


t = 3 r = 5% :  100 
3
 r 
20,000  15,0001  
EXAMPLE  100 
3
 r 
 1    1.3333
4  100 
r
1  3 1.3333
100
ANSWER r
 1 .1  1
100
r  0.1 100%  10%

This project is therefore to be recommended

because this value exceeds the market rate of
5%.
Internal Rate of Return (IRR):
(Trial and error method )
• Trial and error method is used when cash flows
are more complicated.
• If NPV positive: reduce NPV by increasing the
discounting factor in small steps until NPV
becomes negative.
• If NPV negative: increase NPV by decreasing
the discounting factor in small steps until NPV
becomes positive.
• Find the discount factor when NPV is zero.
Internal Rate of Return (IRR)
• As the discount factor increases the NPV is
reducing.
• The NPV becomes negative between 24% and
25% for machine A.
• For Machine B the NPV is already negative at
20%, so decrease the discounting factor until
NPV becomes positive-try 18% to start with.
Which method should be employed ?
• Use all the methods with “payback period”
method as an initial filter.
• If IRR and NPV provide conflicting results, NPV
must be used because fundamental objective
of the analysis is not for profitability but to
maximize the present value of institution’s
investment portfolio.