Chapter 5 Project Evaluation: Principles and Methods

1. Chapter 5Project Evaluation:Principles and Methods

2. Learning Objectives • Explain the importance of each of the steps in the capitalexpenditure process. • Outline the decision rules for each of the main methods of project evaluation. • Explain the advantages and disadvantages of the main project evaluation methods.

3. Learning Objectives (cont.) • Explain why the net present value method is preferred to all other methods. • Understand the link between economic value added (EVA) and net present value (NPV).

4. CapitalExpenditure Process • The capitalexpenditure process involves: • Generation of investment proposals. • Evaluation and selection of those proposals. • Approval and control of capital expenditures. • Post-completion audit of investment projects.

5. Generation of Investment Proposals • Investment ideas can range from simple upgrades of equipment, replacing inefficient exiting equipment, through to plant expansions, new product development or corporate takeovers. • Generation of good ideas for capital expenditure is better facilitated if a systematic means of searching for and developing them exists. • This may be assisted by financial incentives and bonuses for those who propose successful projects.

6. Evaluation and Selection of Investment Proposals • To enable evaluation of a proposal, it should include the following data: • Brief description of the proposal. • Statement as to why it is desirable or necessary. • Estimate of the amount and timing of the cash outlays. • Estimate of the amount and timing of the cash inflows. • Estimate of when the proposal will come into operation. • Estimate of the proposal’s economic life.

7. Approval and Control of Capital Expenditures • Capital expenditure budget (CEB) — maps out the estimated future capital expenditure on new and continuing projects. • CEB has the important role of setting administrative procedures to implement the project (project timetable, procedures for controlling costs). • Timing is important, project delays and cost over-runs will lower the NPV of a project, costing shareholder wealth.

8. Post-completion Audit of Investment Projects • Highlights any cash flows that have deviated significantly from the budget and provides explanations where possible. • Benefits of conducting an audit: • May improve quality of investment decisions. • Provides information that will enable implementation of improvements in the project’s operating performance. • May result in the re-evaluation and possible abandonment of an unsuccessful project.

9. Methods of Project Evaluation • Methods of project evaluation include: • Net present value (NPV) • Internal rate of return (IRR) • Benefit–cost ratio (profitability index) • Payback period • Accounting rate of return

10. Project Evaluation Methods Used by the Entities Surveyed Table 5.1: Selected project evaluation methods used by the CFOs surveyed (a) The aggregate percentage exceeds 100 per cent because most respondents used more than one method of project evaluation. Source: Graham, J.R. & C.R. Harvey (2001)

11. Discounted Cash Flow Methods • Discounted cash flow (DCF) methods involve the process of discounting a series of future net cash flows to their present values. • DCF methods include: • The net present value method (NPV). • The internal rate of return method (IRR).

12. Net Present Value (NPV) • Difference between the PV of the net cash flows (NCF) from an investment, discounted at the required rate of return, and the initial investment outlay. • Measuring a project’s net cash flows: • Forecast expected net profit from project, making an adjustment for non-cash flow items. • Estimate net cash flows directly.

13. Calculation of NPV • The standard NPV formula is given by:

14. Net Cash Flow • Cash inflows: • Receipts from sale of goods and services • Receipts from sale of physical assets • Cash outflows: • Expenditure on materials, labour, and indirect expenses for manufacturing • Selling and administrative • Inventory and taxes

15. Evaluation of NPV • NPV method is consistent with the company’s objective of maximising shareholders’ wealth. • A project with a positive NPV will leave the company better off than before the project and, other things being equal, the market value of the company’s shares should increase. • Decision rule for NPV method: • Accept a project if its net present value is positive when the project’s net cash flows are discounted at the required rate of return.

16. NPV Example Example 5.1 • Investment of $9000 • Net cash flows of $5090, $4500 and $4000 at the end of years 1, 2 and 3 respectively. • Assume required rate of return is 10% p.a. • What is the NPV of the project?

17. NPV Example (cont.) Example 5.1: • Apply the NPV formula given by (5.5). • Thus, using a discount rate of 10%, the project has a NPV = +$2351 > 0, and is therefore acceptable.

18. Internal Rate of Return (IRR) • The internal rate of return is the discount rate that equates the present value of a project’s net cash flows with its initial cash outlay. • IRR is the discount rate (or rate of return) at which the net present value is zero. • The IRR is compared to the required rate of return (k). • If IRR > k the project should be accepted.

19. Calculation of InternalRate of Return • By setting the NPV formula to zero and treating the rate of return as the unknown, the IRR is given by:

20. Multiple and Indeterminate Internal Rates of Return • Conventional projects have a unique rate of return. • Multiple or no internal rates of return can occur for non-conventional projects with more than one sign change in the project’s series of cash flows. • Thus, care must be taken when using the IRR evaluation technique. • Under IRR: accept the project if it has a unique IRR > the required rate of return.

21. Choosing Between the Discounted Cash Flow Methods • Independent investments • Projects that can be considered and evaluated in isolation from other projects. • This means that the decision on one project will not affect the outcomes of another project. • Mutually exclusive investments • Alternative investment projects, only one of which can be accepted. • For example, a piece of land is used to build a factory, which rules out an alternative project of building a warehouse on the same land.

22. Choosing Between the Discounted Cash Flow Methods (cont.) • Independent investments: • For independent investments, both the IRR and NPV methods lead to the same accept/reject decision, except for those investments where the cash flow patterns result in either multiple or no internal rate(s) of return. • In such cases, it doesn’t matter whether we use NPV or IRR.

23. Choosing Between the Discounted Cash Flow Methods (cont.) • Evaluating mutually exclusive projects • NPV and IRR methods can provide a different ranking order. • The NPV method is the superior method for mutually exclusive projects. • Ranking should be based on the magnitude of NPV.

24. Benefit–Cost Ratio (Profitability Index) • The profitability index is calculated by dividing the present value of the future net cash flows by the initial cash outlay: • Decision rule: • Accept if benefit–cost ratio > 1 • Reject if benefit–cost ratio < 1

25. Other Methods of Project Evaluation • There are two major non-discounted cash flow methods that are used: • Accounting rate of return method • Payback period method • These methods are usually employed in conjunction with the discounted cash-flow methods of project evaluation.

26. Accounting Rate of Return • Earnings (after depreciation and tax) from a project expressed as a percentage of the investment outlay. • The calculation involves: • Estimating the average annual earnings to be generated by the project. • Investment outlay (initial or average).

27. Accounting Rate of Return (cont.) • Fundamental problems of ARR as a basis for project evaluation: • Arbitrary measure — based on accounting profit as opposed to cash flows, depends on some accounting decisions like treatment of inventory and depreciation. • Ignores timing of the earnings stream — no time value of money concepts are applied, as equal weight is given to accounting profits in each year of the project’s life.

28. Payback Period • The time it takes for the initial cash outlay on a project to be recovered from the project’s after-tax net cash flows. • Decision: • Compare payback to some maximum acceptable payback period. • What length of time represents the ‘correct’ payback period as a standard against which to measure the acceptability of a particular project?

29. Payback Period (cont.) • Popular because: • It is simple to apply. • It provides information on how long funds are committed to a project. • Weaknesses: • Inferior to discounted cash flow techniques because it fails to account for the magnitude and timing of all the project’s cash flows. • Does not consider how profitable a project will be, just how quickly outlay will be recovered.

30. Summary of Evaluation Methods • Discounted cash flow methods are superior investment appraisal methods as they account for timing of cash flows and the time value of money. • DCF methods will always give the same accept/reject decision for a conventional project. • In practice, the abovementioned alternative project evaluation methods (most likely payback period) may be used in conjunction with DCF methods: see Table 5.1.

31. Economic Value Added • Alternative to discounted cash flow methods, accounting rate of return and payback period. • Key factor is the required rate of return. • EVA is the difference between the project’s accounting profit and the required return on the capital invested in the project. • EVA can be improved by increasing accounting profit or by reducing capital employed.

32. Economic Value Added (cont.) • EVA is given by: • Discounted sum of EVA s equals NPV of project.

33. Summary • NPV method is recommended for investment evaluation. • NPV is consistent with maximisation of shareholder wealth. • NPV is also simple to use and gives rise to fewer problems than the IRR method —such as non-uniqueness. • Independent projects — accept if NPV > 0, reject if NPV < 0.

34. Summary (cont.) • Mutually exclusive projects — accept project with the highest NPV. • In practice, other valuation methods such as accounting rate of return, payback period and economic value added are used in conjunction with NPV, despite a preference for DCF methods. • This may be to measure some other effect, like the effect of the project on liquidity — payback period.