UNIT 4 - PROJECT PREPARATION

4.1 MARKET AND DEMAND ANALYSIS

The Role of Market Analysis in a Feasibility Study

Market research is a special stage in the feasibility study. Market research usually ranks top
in the sequence of the core chapters of a feasibility study.

Engineers, financial analysts as well as Economists, who have to calculate the socio –
economic costs and benefits of a project, can only start their job, if the market analyst has
finished her/his part and has delivered a sales forecast and market strategy to her/his
colleagues. The key steps in market analysis are as follows;
• Situational analysis and specification of objectives
• Collection of secondary information
• Conduct of market survey (primary information)
• Characterization of the market
• Demand forecasting
• Market planning
General Characteristics of the Economy:

– Economic potential
– Production structure
– Foreign trade
– Economic policy
Product

– Characteristic features
– Substitutes and complementary goods
Demand

– Sales and orders

– Buyer’s characteristics
– Demand determining factors
– Purchasing power

Supply

– Supply potential

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 – Local production
– Imports and exports
– Competitor’s position
Marketing environment (marketing strategy, marketing mix)

– Price levels and tendencies

– Distribution channels
– Physical distribution network
– Promotion
• Legal and political environment
4.2. LOCATION and SITE STUDY

Following the assessment of demand and the definition of basic project strategies with
regard to the sales and production program, plant capacity and production program and
inputs requirement, a feasibility study should determine the location and the site suitable
for an industrial project. Location and site are often used synonymously but must be
distinguished. Location refers to a fairly broad area like a city, an industrial zone or a
coastal area, while site refers to a specific piece of land where the project would be set up.

Location Analysis

Location analysis has to identify locations suitable for the industrial project under
consideration. A project can potentially be located in a number of alternative regions, and
the choice of location should be made from a fairly wide geographical area within which
several alternative sites may have to be considered.

Requirements to be identified in location analysis:

• Natural environment,
• geophysical conditions and
• projects requirements
• Ecological impact of the project
• environmental impact assessment
• Socio – economic policies
• incentives and restriction, and
• government plans and polices
• Infrastructure services
• conditions and requirements
• such as the existing industrial infrastructure
• the economic and social infrastructure
• the institutional framework
• Urbanization and literacy

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Final Choice of Location

A good starting point for the final selection of a suitable location is the location of raw
materials and factory supplies or if the project is market - oriented – the location of the
principal consumption centers in relation to the plant. The optimal location is where the
total cost: (raw material transportation cost plus production cost plus distribution cost for
final product) is minimized.

This generally implies that: A resource – based project like a cement plant or a steel mill
should be located close to the source of basic material (limestone in the case of cement
plant and iron- ore in the case of a steel plant).

A project based on imported material may be located near a port and a project
manufacturing a perishable product should be close to the center of consumption or at
some intermediate point.

Site Selection Main Considerations

The following factors determine the selection of the final site;

• Cost of land
• Site preparation cost
• Cost of utility lines extension
• Environmental considerations
• Size and shape of the available area
• Suitability for future extension
• Nature of goods (products) produced (perishables or no)
• Proximity of centers of consumption (market orientation)
• Infrastructure facilities (transport network, houses, power supply etc.)
• Availability of labor in the area (skilled and unskilled)
• Socio – economic factors; Waste disposal, Environmental factors, Taxes and duties,
Public policies (fiscal and legal regulations), Distance to seaport (import and export)

The cost estimates at the site are acquisition of land, Taxes, Legal expenses, Rights of way,
Site preparation and development.

4.3 ENVIRONMENTAL IMPACT ASSESSEMENT

Environmental Impact Assessment (EIA)

Environment includes the conditions under which any individuals or thing exists, live or
develop.

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The Environment of Human Being Includes: Abiotic Factors: - Land, water, atmosphere,
climate, sound, odors and taste.

Biotic Factors: - Fauna (animal life of a region or geological period) Flora (the plants of a
particular region or geological period) Ecology, bacteria and viruses; and all those social
factors which make up the quality of life.
How the Word Environment Emerged: The word environment emerged in response to the
public health:

1. In sanitary (dirty or germ carrying) dwellings and streets.

2. Contaminated public water supplies.
3. Drain and sanitation.
4. Public nuisances.
5. Unhygienic food processing.
6. Overcrowding.
7. Refuse dump.
8. Epidemics (wide spread of diseases)

EIA Definition

Environmental Impact Assessment (EIA) refers to the evaluation of the environmental

impacts likely to rise from a major project significantly affecting the environment. EIA is
assessment of the beneficial and adverse changes in environment resources or values
resulting from a proposed project.

Essential Elements;

1. Identification of possible positive or negative impacts of the project.

2. Quantifying impacts with respect to common base.
3. Preparation of mitigation plan to offset the negative impacts.
4. Most definitions recognize the following four basic principles

Procedural principle; EIA establishes a systematic method for incorporating

environmental considerations into decision-making; Informational principle; EIA provides
the necessary elements to make an informed decision; Preventive principle; EIA should be
applied at the earliest opportunity within the decision-making process to allow the
anticipation and avoidance of environmental impacts wherever possible; and Iterative

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principle; the information generated by EIA is made available to interested parties to elicit
a response which in turn should be fed back into EIA process.

Purpose of the Assessment is;

• To identify and assess any potentially adverse environmental effects of a new

development.
• To make sure that the adverse impacts could be avoided or reduced.
• To ensure that environmental consequences were taken into account during
planning, designing & decision Making process.
• To influence how it is subsequently managed during its implementation.
• EIA report normally include the following information:
• The impact the project would have on the physical environment.
• Any possible pollution of the soil, of waters of all kinds such as surface,
underground, costal and of the atmosphere.
• The impact of the project on wildlife, the natural habitat and all other ecological
factors.
• The project’s likely influence on the qualities of life of the local populations.
• Any influence the project may have on existing industry and employment.
• Any need that may result for new or improved infrastructure such as utilities,
transport, housing, school recreational amenities etc.
EIA Procedure
1. Preparatory Works – study report
2. Data collection – from all sources, survey
3. Data Analysis – convert to change scale
4. Impact Evaluation – relative weight
5. Mitigation and Monitoring Plan
6. Preparation of Report – help decision makers

Review questions
1. What is the purpose of environmental impact assessment in project planning?
2. Describe the four basic principles in environmental impact assessment.
3. Describe the procedures in environmental impact assessment.

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4.4. RISK ANALYSIS

Risk is uncertainty regarding loss. Risk is a condition in which there is a probability of an

adverse deviation from desired outcome that is expected or hopped for. It is the probability
that this hope will not be met that constitutes risk. Risk should be identified in advance and
managed.

Project risk; any event that prevents or limits the achievement of your objectives from
defined at the outset of the project Items in the project plan that are important and that are
uncertain of success should be considered risk areas and given special attention.
Risk management has several important objectives that can be classified into two
categories: Pre loss objective and Post loss objective.

Pre loss objective are; to prepare for the potential loss in the most economical way,
Reduction of anxiety, Meeting external obligation.

Post loss objective

• Survival of the organization

• Continuity of operation
• Stability of earning
• Continued growth
• Social responsibility
Risk minimization process

• STEP 1 - Risk identification and analysis

• STEP 2 - Risk allocation
• STEP 3 - Risk management
Types of risks

• Construction phase risk - Completion risk

• Operation phase risk - Resource / reserve risk
• Market / distribution risk
Risks common to both construction and operational phases

• credit risk
• Technical risk
• Currency risk
• Regulatory / approvals risk
• Political risk
• Force majeure risk
Specific areas that result in or increase risk should be analyzed such areas are;

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– Areas where the scope is not well defined or is subject to change.
– An unproven or immature technical approach, known technical difficulty/complexity.
– Ambitious (pushy) or motivated goals.
– Unfamiliarity with the process, or inexperienced personnel,
– Outdoor organizational dependencies.
– Incomplete planning or optimistic cost or schedule.
– Any area over which the project manager does not have control.
Purposes of project risk management;
• To predict the likelihood that a risk will occur, to quantify its potential shock on the
project, and to develop plans for risk management.
• To reassess risks documented during Project Initiation

Risk Management Process

1. Risk identification
– Focuses on risks associated with implementation of the project as well as external
risks to the project.
– Risks frequently associated with resource and schedule constraints.
2. Risk Quantification/measurement
– estimating the likelihood of occurrence of the risk event and,
– Measuring the effect the risk will have on the project.
3. Risk response and monitoring.
– Assigning risk priorities based on the level of impact and the probability of
occurrence.
4. Risk mitigation costs
– Requires the estimation of cost by budget category for the mitigation actions planned
in risk response planning.

Risk management tools

 Retention- Loss prevention

 Risk control- Loss reduction
 Avoidance
 Non-insurance transfers
 Insurance Etc.

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Selection of appropriate risk control tools based on the frequency and severity

Frequency
Severity High Low
High AVOIDANCE INSURANCE AND RISK
CONTROL
Low RETENSION AND RISK RETENSION
CONTROL

4.5. PROJECT FINANCING

Project financing is an innovative and timely financing technique that has been used on
many high-profile corporate projects. Project financing discipline includes: Understanding
the rationale for project financing, how to prepare the financial plan, assess the risks,
design the financing mix, and Raise the funds.

In addition, one must understand the logical analyses of why some project financing plans
have succeeded while others have failed.

A knowledge-base is required to validate (confirm) projects feasibility: regarding the

design of contractual arrangements to support project financing, issues for the host
government legislative provisions, public/private infrastructure partnerships,
public/private financing structures, credit requirements of lenders, and how to determine
the project's borrowing capacity, how to prepare cash flow projections and use them to
measure expected rates of return, tax and accounting considerations.

Negative impact on the financial performance of the project could result in;

1. The project not being completed on time, on budget, or at all

2. The project not operating at its full capacity
3. The project failing to generate sufficient revenue to service the debt; or
4. The project prematurely coming to an end.

The minimization of such risks involves a three step process. The first step requires the
identification and analysis of all the risks that may bear upon the project. The second
step is the allocation of those risks among the parties. The last step involves the creation
of mechanisms to manage the risks.

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Sources of Finance

• Equity
• Loan financing
• Suppliers credit
• Leasing

Equity

A generally applied financing pattern for an industrial project is to cover the initial capital
investment by equity. Additional short and medium term loans from national banking
sources, in situation where institutional capital is scarce and available only at high cost,
equity capital covers the initial capital investment and net working capital.

Anyway, a balance needs to be made between long-term debt and equity. The higher the
proportion of equity the less the debt service obligations and the higher the gross profit
before taxation. The higher the proportion of loan finance, the higher the interest payable
on liabilities

Loan Financing

Short and medium term borrowings from commercial bank for working capital or
suppliers’ credit and Long-term borrowings from national or international development
finance institutions. An important source of finance is also available at government-to-
government level in developing countries. An important financial category at the
operational stage is the internal cash generated by the project itself.

Supplier Credits; Imported machinery and spares can often be financed on deferred credit
term. Machinery suppliers in developed countries are willing to sell machinery on
deferred – payment terms with payments spread over 6 to 10 years.

Leasing: Instead of borrowing financial means it is sometimes possible to lease plant

equipment or even complete production units that are productive assets are borrowed.
Leasing (borrowing of productive assets) requires usually a Down payment and the
payment of an annual rent, the leasing fee.

Discussion questions
1. What is a project risk?
2. Why is risk management important in project management?

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 3. What type of possible financing methods is available for projects?

4.6. Financial and Economic Analysis

Basically, financial analysis should accompany the design of the project from the very
beginning. This is only possible when the financial analysis is integrated into the feasibility
study team at an early stage.

From a financial and economic point of view, investment can be defined as a long term
commitment of economic resources made with the objectives of producing and obtaining
net gains (exceeding the total initial investment) in the future.

Total investment costs

Initial investment costs are defined as the sum of fixed assets (fixed investment costs plus
pre-production expenditures) and net working capital. Fixed assets constituting the
resources required for constructing and equipping an investment project, and net working
capital corresponding to the resources needed to operate the project totally or partially.

Investment required during plant operation

The economic life time is different for the various investments (buildings, plant, machinery
and equipment, transport equipment etc). In order to keep a plant in operation, each item
must therefore be replaced at the appropriate time and the replacement costs must be
included in the feasibility study.

Pre-production expenditures
• In every industrial project certain expenditure due, for example, to the acquisitions or
generation of assets are incurred prior to commercial production.
• These expenditures, which have to be capitalized, include a number of items originating
during the various stages of project preparation and implementation.
i. Preliminary capital-issue expenditures. These are expenditures incurred during the
registration and formation of the company, including legal fees for preparation of
the memorandum and articles of association and similar documents and for capital
issues.
ii. Expenditures for preparation studies. There are three types of expenditures for
preparatory studies: Expenditures for pre-investment studies; consultant fees for
preparing studies, engineering and supervisor of erection and construction and
other expenses for planning the project.

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iii. Other pre-production expenditures. Included among other pre-production expenditures
are the following: Salaries, fringe benefits and social security contributions of
personnel engaged during the pre-production period, Travel expenses, Preparatory
installation, such as workers, camps, temporary offices and stores.
Pre-production marketing costs, promotional activities, creation of the sales network etc.

Training costs including fees, travel, living expenses, salaries and stipends of the trainees
and fees payable to external institutions; Know-how and patent fees, Interest on loans
accrued or payable during construction, Insurance costs during construction.

iv. Trial runs, start-up and commissioning expenditures.

This item includes fees payable for supervision of starting-up operation, wage, salaries,
fringe benefits and social security contributions of personnel employed, consumption of
production materials and auxiliary supplies, utilities and other incidental start- up costs.

Operating losses incurred during the running period up to the stage when satisfactory
levels are achieved also have to be capitalization.

v. Plant and equipment replacement costs. Such costs included all pre-production
expenditure as described above and related to investment needed for the replacement
of fixed assets.
A gain the estimates include the supply, transport, installation and commissioning of
equipment, together with any costs associated with down time, production losses as well as
allowance for physical contingencies.

vi. End-of life costs. The costs associated with the decommissioning of fixed assets at the end
of the project life, minus any revenues from the sale of the assets at end of the assets
life.
• Major items are the costs of: dismantling, disposal and land reclamation.
• It is often reasonable to assume that these costs can be offset against the salvage
value of the corresponding asset
Fixed assets

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As indicated above fixed assets comprise fixed investment costs and pre-production
expenditures. Fixed investment costs: Fixed investment should include the following main
cost items, which may be broken down further, if required Land purchases, site preparation
and improvements, Building and civil works, Plant machinery and equipment, including
auxiliary equipment, certain incorporated fixed assets such as industrial property rights
and lump – sum payments for know-how and patents.

Net working capital: Net working capital is defined to embrace current assets (the sum of
inventories, marketable securities, prepaid items, accounts receivable and cash) minus
current liabilities (accounts payable). It forms an essential part of the initial capital outlays
required for an investment project because it is required to finance the operations of the
plant.

Production Costs

It is essential to make realistic forecasting of production or manufacturing costs for a

project proposal in order to determine the future viability of the project

Definition of production cost items

The definition of production costs divides production costs in to four major categories;
factory costs, administrative overhead costs, depreciation costs, and cost of financing. The
sum of factory and administrative overhead costs is defined as operation costs.

Factory costs: Factory costs include the following:

 Materials predominantly variable costs such as raw materials factory supplies and
spare parts.
 Labor (production personnel) fixed or variables costs depending on type of labor
and cost elements)
 Factory overheads (in general fixed costs).
Administrative overheads:
This includes salaries and wages, social costs rents and leasing costs etc.
Depreciation costs.
• Depreciation costs are charges made in the annual net income statement (profits
loss account) for the productive use of fixed assets.

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 • Depreciation costs present investment expenditures (cash outflow during the
investment phase) instead of production expenditures (cash outflow production).
• Depreciation charges must therefore be added back to net cash flows.
Factory costs: Factory costs include the following:
 Materials predominantly variable costs such as raw materials factory supplies and
spare parts.
 Labor (production personnel) fixed or variables costs depending on type of labor
and cost elements)
 Factory overheads (in general fixed costs).
Administrative overheads: This include salaries and wages, social costs rents and leasing
costs etc.

Unit costs of production

• For the purpose of cash flow analysis it is sufficient to calculate the annual costs.
• At the feasibility stage, however, an attempt should also be made to calculate unit
costs to facilitate the comparison with sales prices per unit.
• For single product projects units costs are calculated simply by dividing production
costs by the number of units produced (therefore unit costs usually vary with
capacity utilization).

Direct and indirect costs

• Direct costs are easily attributable to a production unit or service in terms of costs of
production, materials and production labor.
• Since indirect costs (factory administration overheads such as management and
supervision, communications, depreciation and financial charges) cannot be easily
allocated directly to a particular unit of output.
• They must first be apportioned to cost centers and thereafter to the unit’s cost price
by way of surcharges obtained from the cost accounting department.

Marketing costs; marketing cost comprises the costs for all marketing activities. It may be
divided into;

1. Direct marketing costs for each product or product group, such as:
 packaging and storage (if not included in the production costs)

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  sales costs (salesmen commissions, discounts, returned products, royalties, product
advertisement etc)
 Transport and distribution costs.

2. Indirect marketing costs such as:

 overhead costs of the marketing department (personnel material and
communications,
 markets research,
 public relations, and
 Promotional activities, not directly related are a product etc).
The analysis of these costs involves their assignments to various cost group such as
territories, certain classes of customers (wholesalers, retailers, government institutions
etc) and products or product group. Marketing and distribution costs fall into the category
of period costs even if variable and as such are charged against the operations of the
accounting period in which they are occurred. For depreciable investments as required, for
marketing and distribution (for example delivery trucks), depreciation charges are to be
included in the computation of total marketing costs

Time Value of Money

If we assume that money can always be invested in the bank (or some other reliable source)
now to gain a return with interest later that as rational actors, we never make an
investment which we know to offer less money than we could get in the bank.
Then
– Money in the present can be thought as of “equal worth” to a larger amount of money
in the future
– Money in the future can be thought of as having an equal worth to a lesser “present
value” of money
t
– Rates Difference between PV (v) and FV ( =v(1+i) ) depends on i and t.
• Interest Rate
– Contractual arrangement between a borrower and a lender
• Discount Rate (real change in value to a person or group)
– Worth of Money + Risk

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 – Discount Rate > Interest Rate
• Minimum Attractive Rate of Return (MARR)
– Minimum discount rate accepted by the market corresponding to the risks of a project
(i.e., minimum standard of desirability)

Choice of Discount Rate

r = rf + ri + rr

Where:

r is the discount rate

rf the risk free interest rate. Normally government bond
ri Rate of inflation. It is measured by either by consumer price
index or GDP deflator.
rr Risk factor consisting of market risk, industry risk, firm
specific risk and project risk
Market Risk
rr = Industry Risk
Firm specific Risk
Project Risk

A. Net Present Value

Suppose we had a collection (or stream, flow) of costs and revenues in the future, the net
present value (NPV) is the sum of the present values for all of these costs and revenues
treat revenues as positive and costs as negative.

Net present value is the present value of net cash inflows generated by a project including
salvage value, if any, less the initial investment on the project. It is one of the most reliable
measures used in capital budgeting because it accounts for time value of money by using
discounted cash inflows.

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Before calculating NPV, a target rate of return is set which is used to discount the net cash
inflows from a project. Net cash inflow equals total cash inflow during a period less the
expenses directly incurred on generating the cash inflow.
Calculation Methods and Formulas
• The first step involved in the calculation of NPV is the determination of the present
value of net cash inflows from a project or asset.
• The net cash flows may be even (i.e. equal cash inflows in different periods) or
uneven (i.e. different cash flows in different periods).
• When they are even, present value can be easily calculated by using the present
value formula of annuity. However, if they are uneven, we need to calculate the
present value of each individual net cash inflow separately.
• In the second step we subtract the initial investment on the project from the total
present value of inflows to arrive at net present value.

Net Present Value (NPV) is a formula used to determine the present value of an investment
by the discounted sum of all cash flows received from the project. The formula for the
discounted sum of all cash flows can be rewritten as:

When a company or investor takes on a project or investment, it is important to calculate an

estimate of how profitable the project or investment will be. In the formula, the -C is the
0

initial investment, which is a negative cash flow showing that money is going out as
opposed to coming in. Considering that the money going out is subtracted from the
discounted sum of cash flows coming in, the net present value would need to be positive in
order to be considered a valuable investment.

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Example of Net Present Value
To provide an example of Net Present Value, consider a company who is determining
whether they should invest in a new project. The company will expect to invest $500,000
for the development of their new product.

Further, The Company estimates that the first year cash flow will be $200,000; the second
year cash flow will be $300,000, and the third year cash flow to be $200,000. A 10%
interest rate is used as the discount rate.
The following table provides each year's cash flow and the present value of each cash flow.

Year Cash Flow Present Value

0 -$500,000 -$500,000
1 $200,000 $181,818.18
2 $300,000 $247,933.88
3 $200,000 $150,262.96
Net Present Value = $80,015.02

The net present value of this example can be shown in the formula

• When solving for the NPV of the formula, this new project would be estimated to be a
valuable venture.

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Net Present Value Decision Rule

• Accept a project which has 0 or positive NPV. Alternatively, Use NPV to choose the best
among a set of (mutually exclusive) alternative projects.
– Mutually exclusive projects: the acceptance of a project precludes the acceptance of
one or more alternative projects.
Advantages of NPV

– Considers time value of money

– Gives a decision criteria
– Recognizes uncertainty of cash flow by discounting
– Uses all project cash flows

Disadvantages of NPV
– Gives absolute values which cannot be used to compare project of different sizes
– There is difficulty in selecting the discount rate to use
– It does not show the exact profitability of the project

Internal Rate of Return

• The internal rate of return (IRR) is the discount rate that equates the PV 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.
• By setting the NPV formula to zero and treating the rate of return as the unknown, the
IRR is given by:
n
Ct
 1  r 
t 1
t
 C0  0

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Example
Find the IRR of an investment having initial cash outflow of $213,000. The cash inflows
during the first, second, third and fourth years are expected to be $65,200, $96,000,
$73,100 and $55,400 respectively.

Solution
Assume that r is 10%

NPV at 10% discount rate = $18,372

Since NPV is greater than zero we have to increase discount rate, thus
NPV at 13% discount rate = $4,521

But it is still greater than zero we have to further increase the discount rate, thus
NPV at 14% discount rate = $204

NPV at 15% discount rate = ($3,975)

Since NPV is fairly close to zero at 14% value of r, therefore

IRR ≈ 14%

Steps in the IRR trial and error calculation method

 Compute the NPV of the project using an arbitrary selected discount rate.
 If the NPV so computed is positive then try a higher rate and if negative try a lower
rate.
 Continue this process until the NPV of the project is equal to zero
 Use linear interpolation to determine the exact rate
Linear interpolation is given by

Where; LR = Lower rate and HR = higher rate

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Illustration:
A project has the following cash flows

Year 1 2 3 4

Cash Flow 300 400 700 900

The cost of the project is 1500 Br.

Determine whether project is acceptable if the cost of capital is 18% using the IRR method.

Solution

We first select an arbitrary discount rate say 9% and compute the NPV

Year Cash Flow PVIF (9%) PV

1 300 0.9174 275.22

2 400 0.8417 336.68

3 700 0.7722 540.54

4 900 0.7084 637.56

PV 1790.00

Less Cost (1500)

NPV at 9% 290.00

Since, NPV at 9% is positive and large we select another discount rate larger than 9%, say
15%

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Year Cash Flow PVIF (15%) PV
1 300 0.8696 260.88
2 400 0.7561 302.44

3 700 0.6575 460.25

4 900 0.5718 514.62

PV 1538.19
Less Cost (1500)
NPV at 15% 38.19
Since, NPV at 15% is positive but not large; we select a slightly higher rate, say, 18%.

Year Cash Flow PVIF (18%) PV

1 300 0.8475 254.25

2 400 0.7182 287.28

3 700 0.6086 426.02

4 900 0.5158 462.22
PV 1431.77
Less Cost (1500)

NPV at 18% -68.23

Since NPV at 18 is negative, IRR therefore lies between 15% and 18%, and since zero NPV will the
between 38.19 and -68.23, to get the correct (exact) IRR we have to interpolate between 15% and
18% using interpolation formula.

Decision: Reject the project since IRR is less than the required rate of return (cost of capital)

Advantages of IRR

 Can be used to compare projects of different sizes

 Considers time value of money
 Indicates the exact profitability of the project
 Uses project cash flows
Disadvantages of IRR

 Some project have multiple IRRs if their NPV profile crosses the x-axis more
than once (project cash flow signs change several time)

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  Assumes re-investment of cash flows occurs at project’s IRR which could be
exorbitantly high
 Doesn’t provide a decision criteria
 Not conclusive for mutually exclusive projects
c) Profitability Index (PI)/ present value index (PVI)/ benefit-cost ratio
It is the relative measure of project’s profitability and can be used to compare project of
different sizes

PI = present value of cash flows/Initial cost

Decision criteria: If, PI >1, Accept project, PI < 1, Reject project and PI = 1, Indifferent

Illustration: A project has the following cash flows

1 2 3 4
YYear
Cash Flow 300 400 700 900

If the required rate of return is 9% and the project initial cost is 1500 Br, calculate the PI of the
project and advice if the project is acceptable.

Solution

Year Cash Flow PVIF (9%) PV

1 300 0.9174 275.52

2 400 0.8417 336.68

3 700 0.7722 540.54
4 900 0.7084 637.46
Total PV = 1790

Decision: The project is acceptable since PI > 0

Advantages of PI

 Recognized time value of money

 Compares projects of different sizes
 Gives a decision criteria

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Disadvantages of PI

 Does not indicate the risk

d) Discounted payback period
This is the number of year taken to recover the original (initial) investment from annual
cash flows.
The lower the payback period the better the project is
Illustration:
• Assume a company wants to invest in two mutually exclusive projects of 1000 Br
each generating the following cash flows.
• If the required rate of return is 10%. Which of the projects should the company
invest in?
Year 1 2 3 4 5 6
A 500 400 300 400 0 0

B 100 200 300 400 500 600

Year DCF of A Cum F of A DCF of B Cum F of B

1 454.51 454.51 90.91 90.91

2 330.58 785.09 165.29 256.20

3 225.40 1010.49 225.40 481.60

4 273.21 1283.70 273.21 754.81
5 1283.70 310.46 1065.46
6 1283.70 338.68 1403.95

Pay back for A =

Pay back for B =

The management should undertake project A since it has a lower pay bock period.

Advantages of pay back method

 Considers time value of money

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  Useful in assessing risk and liquidity of the project
Disadvantages of pay back method

 Does not use all project cash flows

 Does not consider the performance of the project after the payback period
e) Accounting (average) rate of return (ARR)

Where average investment = ½ (cost of project + negative Terminal value)

Illustration:
Assume 90,000 Br is invested in a project with the following after tax net profits.

Year 1 2 3
Net Profit 20,000 10,000 30,000
The life of the project is 3 years and no salvage value, compute ARR of the project.

Average investment = ½ (90,000 +0) = 45,000

Advantages of ARR

 Easy to compute and use

 Computed from readily available accounting information
Disadvantages of ARR

 Ignores time value of money

 Ignores uncertainty of cash flows and there is no consideration of risk in
calculation
 Uses accounting profits rather than cash flows
 Doesn’t give a decision criteria
 Not consistent with investor’s wealth maximization

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.

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 – 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.
• 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.
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.

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