Project Evaluation Methods

Future value (FV) of the investment and present value (PV)of the investment is
important part of the project evaluation.

Future Value of the Investment

What is the future value of the investment or compounded value of an investment?
FVn= PV (1+r)n
Where
PV= Present value
FVn= The future value or compounded value of an investment after ‘n’ years
i = Interest rate
Future value of the investment is calculating assuming that reinvesting the interest
earned. The process of investing money as well as reinvesting the interest earned
theorem is called compounding.

Example-
We deposited 1000 rupees in a bank at 10% annual interest rate. Assume that
interest earned is reinvested. What is the future value of our investment after 3
years?
r = 1+10/100
=110/100
=1.1

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Year Amount of Interest rate (10%) Future value
investment
0 1000 1.000 1000
1 1000 1.1 1100
2 1000 (1.1)2 =1.21 1210
3 1000 (1.1)3= 1.331 1331

After 3 years we can earn Rs. 1331

Present Value of the Investment

We can use following formula to calculate the present value of investment.
PV= FVn {1/(1+r)n}
Where
PV = Present value
FV= Future value
{1/(1+r)n} = Discounting factor

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Example
what is the present value of the Rs 1000 after 6 years? Discount rate 10% is used.
Year Amount(Rs) Discount factor Present value (Rs)
0 1000 1 1000
1 1000 0.909 909
2 1000 0.826 826
3 1000 0.751 751
4 1000 0.683 683
5 1000 0.621 621
6 1000 0.564 564

Present value of Rs 1000 after 6 years is Rs 564

Let’s look at an example of how to calculate the present value of a series of cash
flows. Assume that an investment will return $10,000 per year over a period of 10
years, and discount rate is 10%.

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The value of this investment is worth $61,446 today. It means a rational investor
would be willing to pay up to $61,466 today to receive $10,000 every year over 10
years.
When we calculate the present value of the investment we have to select
appropriate discount rate. How do we select the appropriate discount rate? When
we select the appropriate discount rate we have to pay attention for following
factors
1. Interest rate in the market
2. Opportunity cost of the capital
3. Average interest rate in the economy

Net Present Value

Net Present Value (NPV) is the value of all future cash flows (positive and
negative) over the entire life of an investment discounted to the present. NPV
analysis is a form of intrinsic valuation and is used extensively across finance and
accounting for determining the value of a business, investment security, capital
project, new venture, cost reduction program, and anything that involves cash flow.
In short, NPV is used in capital budgeting and investment planning to analyze the
profitability of a projected investment or project.

NPV = ∑nt=1 Ct/(1+r)t – Initial investment (1)

Where
Ct= Net cash flow at the end of year t
n= Life of the project
r= discount rate

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Decision rule

If... It means... Then...

the investment
NPV > 0 would add value to the project may be accepted
the firm

the investment
NPV < 0 would subtract the project may be rejected
value from the firm

We should be indifferent in the decision whether

the investment
to accept or reject the project. This project adds
would neither gain
NPV = 0 no monetary value. Decision should be based on
nor lose value for
other criteria, e.g., strategic positioning or other
the firm
factors not explicitly included in the calculation.

Money in the present is worth more than the same amount in the future due to
inflation and to earnings from alternative investments that could be made during
the intervening time. In other words, a dollar earned in the future won’t be worth as
much as one earned in the present. The discount rate element of the NPV formula
is a way to account for this.
For example, assume that an investor could choose a $100 payment today or in a
year. A rational investor would not be willing to postpone payment. However,
what if an investor could choose to receive $100 today or $105 in a year? If the
payer was reliable, that extra 5% may be worth the wait, but only if there wasn’t
anything else the investors could do with the $100 that would earn more than 5%.
An investor might be willing to wait a year to earn an extra 5%, but that may not
be acceptable for all investors. In this case, the 5% is the discount rate which will
vary depending on the investor. If an investor knew they could earn 8% from a
relatively safe investment over the next year, they would not be willing to postpone
payment for 5%. In this case, the investor’s discount rate is 8%.
The cash flows of NPV are discounted for two main reasons,
(1) To adjust for the risk of an investment opportunity
(2) To account for the time value of money (TVM)
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The first point (to adjust for risk) is necessary because not all businesses, projects,
or investment opportunities have the same level of risk. Put another way, the
probability of receiving cash flow a US Treasury bill is much higher than the
probability of receiving cash flow from a young technology startup.
To account for the risk, the discount rate is higher for riskier investments and lower
for safer one. The US treasury example is considered to be the risk-free rate, and
all other investments are measured by how much more risk they bear relative to
that.
The second point (to account for the time value of money) is required because due
to inflation, interest rates, and opportunity costs, money is more valuable the
sooner it’s received. For example, receiving $1 million today is much better than
$1 million received five years from now. If the money is received today, it can be
invested and earn interest, so it will be worth more than $1 million in five years’
time.
The NPV rule assumes that the intermediate cash flows of a project that is cash
flows that occur between the initiation and the termination of the project are
reinvested at a rate of return equal to the cost of capital.

Example
To illustrate the calculation of net present value, consider a project which has
following cash flow stream
Year Cash Flow
0 10 00000
1 200000
2 200000
3 300000
4 300000
5 350000

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Because the equipment is paid for up front, this is the first cash flow included in
the calculation. There is no elapsed time that needs to be accounted for so today’s
outflow of $1,000,000 doesn’t need to be discounted.
The cost of capital ‘r’ for the firm is 10%. The NPV of the proposal is
NPV= 200000/(1.1)+ 200000/(1.1)2+300000/(1.1)3+300000/(1.1)4+350000/(1.1)5 –
1000000= Rs -5273
Since NPV is negative the project is financially not profitable.
The NPV represents the net benefit over and above the compensation for time and
risk. Hence the decision rule associated with the NPV criterion is accept the project
if the NPV is positive and reject the project if the NPV is negative. (If the NPV is
zero, it is matter of indifference).

NPV Calculation Permits Time Varying Discount Rate

In above example we have assumed that the discount rate remains constant over
time. This need not always be the case. The NPV can be calculated using time
varying discount rates. The general formula of NPV is as follows

NPV = ∑nt=1 Ct/ ∏tj=1(1+rj)– Initial investment (2)

Ct = Cash flow at the end of year t
rj = One period discounted rate
n= Life of the project
NPV of a simple project decreases as the discount rate increases.
A simple project involves an initial cash outflow or a series of initial cash out
flows followed by cash inflows. The NPV of a simple project steadily decreases as
the discount rate increases. The decrease in NPV however is at a decreasing rate.

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The discount rate may change over time for the following reasons
1. The level of interest rates may change over time- the term structure of
interest rates sheds light on expected rates in the future
2. The risk characteristics of the project may change over time, resulting in
changes in the cost of capital
3. The financing mix of the project may vary over time causing changes in the
cost of capital
Example
To illustrate that you are evaluating a 5-year project involving software
development. You believe that the technological uncertainty associated with
this industry leads to higher discount rates in the future.
Initial Cash Flow Discount Discount Present
investment rate% Factor (DF) value =
(CF)
CF/DF
-12000
4000 14 1.14 3509
5000 15 1.14*1.15 3814
7000 16 1.14*1.15*1.16 4603
6000 18 1.14*1.15*1.16 3344
*1.18
5000 20 1.14*1.15*1.16 2322
*1.18*1.2

NPV of Project = 3509+3814+4603+3344+2322-12000 = Rs. 5592

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 Advantages and disadvantages of the Net Present Value
Advantages:
• Considers time value of money
• Considers all cash flows
• Good decision criteria

Disadvantages:
• NPV will be erroneous if cash flow estimates are incorrect (requires accurate
cash flow estimations)
Although NPV offers insight and a useful way to quantify a project's value and
potential profit contribution, it does have its drawbacks. Since no analyst has a
crystal ball, every capital budgeting method suffers from the risk of incorrectly
estimated critical formula inputs and assumptions, as well as unexpected or
unforeseen events that can affect a project's costs and cash flows.
• NPV is a dollar return but percent returns are easier to communicate and
understand
• The NPV calculation relies on estimated costs, an estimated discount rate,
and estimated projected return. It also can't factor in unforeseen expenses, time
delays, and any other issues that come up on the front or back end, or during the
project.
• Also, the discount rate and cash flows used in an NPV calculation often
don't capture all of the potential risks, assuming instead the maximum cash flow
values for each period of the project. This leads to a false sense of confidence for
investors, and firms often run different NPV scenarios using conservative,
aggressive, and most-likely sets of assumptions to help mitigate this risk.

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 Internal Rate of Return (IRR)
The internal rate of return (IRR) of a project is the discounted rate which makes its
NPV equal to zero. Put differently, it is the discount rate which equates the present
value of future cash flows with the initial investment. It is the value of ‘r’ in the
following equation
Investment= ∑nt=1 Ct/(1+r)t (3)

Where
Ct= cash flow at the end of year t
r = internal rate of return
n = life of the project
In the NPV calculation we assume that the discount rate (cost of capital) is known
and determine the NPV. In IRR calculation we set the NPV equal to zero and
determine the discount rate satisfies this condition.
A positive IRR means a project or investment is expected to return some value to
the organization. A negative IRR would mean that the proposed project or
investment is expected to cost more than it returns, or lose value for the company.

Example
To illustrate the calculation of IRR, consider the cash flows of a project being
considered by ABC company
Year Cash flow
0 100000
1 30000
2 30000
3 40000
4 45000

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The IRR is the value of ‘r’ which satisfies the following equation
100000= 30000/(1+r) + 30000/(1+r)2 + 40000/(1+r)3 +45000/(1+r)4
The calculation of ‘r’ involves a process of trial and error. We try different values
of ‘r’ till we find that the right hand side of the above equation is equal to 100000.
Let us, to begin with try r = 15%. This makes the right hand side equal to
30000/(1.15) + 30000/(1.15)2 + 40000/(1.15)3 +45000/(1.15)4 = 100802
This value is slightly higher than our target value, 100000. So we increase the
value of ‘r’ from 15% to 16%. (In general, a higher ‘r’ lowers and a smaller ‘r’
increases the right hand side value). The right hand side becomes:
30000/(1.16) + 30000/(1.16)2 + 40000/(1.16)3 +45000/(1.16)4 = 98641
Since this value is now less than 100000, we conclude that the value of ‘r’ lies
between 15% and 16%. For most of the purposes this indication suffices.
If a more refined estimate of ‘r’ is needed, use the following procedure
1. Determine the difference between NPV of two closest discount rate and
initial investment
Increased value of the NPV at 15% = 100802-100000 = 802
Reduced value of the NPV at 16% = 98641-100000 = -1359
2. Find the sum of the absolute values of the NPV obtained in step 1.
802+1359 = 2161
3. Calculate the ratio of the net present value of the smaller discount rate,
identified in step 1, to the sum obtained in step 2
802/2161 =0.37
4. Add the number obtained in step 3 to the smaller discount rate
15+0.37 = 15.37%

To explain IRR we have calculated it by hand. In practice, you will find it

convenient to use the EXCEL function IRR.

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Decision rule
Accept : If the IRR is greater than the cost of capital
Reject: If the IRR is less than the cost of capital

Example: Mutually exclusive projects

Often firms have to choose from two or more mutually exclusive projects. In
such case IRR can be misleading
Consider project P and Q
Project C0 C1 IRR NPV
(12%)
P -10000 20000 100% 7857
Q -50000 75000 50% 16964

Both the projects are good, but Q with its higher NPV contributes more to
the value of the firm. Yet from an IRR point of view P looks better than Q.
Hence the IRR rule seems unsuitable for ranking projects of different scales.
The IRR rule, of course can be salvaged in such cases by considering the
IRR on the incremental cash flow. Here is how we do it. Looking at P, the
project which requires the smaller outlay, we find that it is highly attractive
because its IRR is 100%, far above the cost of capital which is 12%. Now
we ask, what is the rate of return on the incremental cash flow if we switch
from P (the low outlay project) to Q (the high outlay project?). The
incremental cash flow associated with such a switch is
C0/-40000, C1/55000
The IRR of this cash flow stream is 37.5%, much above the cost of capital.
Hence it is desirable to switch from P to Q.

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Advantages of the IRR
 IRR is the rate of growth a project is expected to generate. So, IRR gives
good picture about the investment with certain limitation
 The IRR is a good way of judging different investments.
 IRR considered the time value of money
 IRR takes into account whole cash flow of the investment or project

Limitations of the IRR

 While IRR is a very popular metric in estimating a project’s profitability, it
can be misleading if used alone. Depending on the initial investment costs, a
project may have a low IRR but a high NPV, meaning that while the pace at
which the company sees returns on that project may be slow, the project may
also be adding a great deal of overall value to the company.
 A similar issue arises when using IRR to compare projects of different
lengths. For example, a project of short duration may have a high IRR,
making it appear to be an excellent investment, but may also have a low
NPV. Conversely, a longer project may have a low IRR, earning returns
slowly and steadily, but may add a large amount of value to the company
over time.
 Another issue with IRR is one not strictly inherent to the metric itself, but
rather to common misuse of IRR. People may assume that, when positive
cash flows are generated during the course of a project (not at the end), the
money will be reinvested at the project’s rate of return. This can rarely be
the case.
Rather, when positive cash flows are reinvested, it will be at a rate that more
resembles the cost of capital. Miscalculating using IRR in this way may lead
to the belief that a project is more profitable than it actually is. This, along
with the fact that long projects with fluctuating cash flows may have
multiple distinct IRR values, has prompted the use of another metric called
modified internal rate of return (MIRR).

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 MIRR adjusts the IRR to correct these issues, incorporating the cost of
capital as the rate at which cash flows are reinvested, and existing as a single
value. Because of MIRR’s correction of the former issue of IRR, a project’s
MIRR will often be significantly lower than the same project’s IRR.
 The need for the use of NPV in conjunction is considered to be a big
drawback of IRR. Although considered an important metric, it can’t be
useful when used alone. The problem arises in situations where the initial
investment gives a small IRR value but a greater NPV value. This happens
on projects which give profits at a slower pace, but these projects may
benefit in enhancing the overall value of the organization.
 A similar problem is when a project gives a faster-paced result for a short
period of time. A small project may seem like giving a large profit in a short
time, giving a greater IRR value, but a lower NPV value. The project length
has a greater significance in this case.

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