Financial Analysis of

Projects
 Profitability Models

 Present & Future Value

 Benefit / Cost Ratio
 Payback period
 Internal Rate of Return
 Annual Value
 Net Present Value

Net Present Value - Present value of cash

flows minus initial investments.

Opportunity Cost of Capital - Expected rate

of return given up by investing in a project.
 Net Present Value
Example
Q: Suppose we can invest $50 today & receive $60 later
today. What is our increase in value?

A: Profit = - $50 + $60

= $10 $10
Added Value
$50 Initial Investment
 Net Present Value
Example
Suppose we can invest $50 today and receive $60 in one
year. What is our increase in value given a 10%
expected return?
60
Profit = -50 +  $4.55
1.10
$4.55 Added Value
$50 Initial Investment
This is the definition of NPV
 Net Present Value
NPV = PV - required investment

Ct
NPV  C0  t
(1  r )

C1 C2 Ct
NPV  C0  1
 2
... t
(1  r ) (1  r ) (1  r )
 Net Present Value
Terminology
C = Cash Flow
t = time period of the investment
r = “opportunity cost of capital”

 The Cash Flow could be positive or negative at any

time period.
 Net Present Value
Net Present Value Rule
Managers increase shareholders’ wealth by
accepting all projects that are worth more than
they cost.

Therefore, they should accept all projects with

a positive net present value.
 Net Present Value
Example
You have the opportunity to
purchase an office building. You
have a tenant lined up that will
generate $16,000 per year in cash
flows for three years. At the end
of three years you anticipate
selling the building for $450,000.
How much would you be willing
to pay for the building?
 Net Present Value
$466,000

Example - continued $450,000

$16,000 $16,000 $16,000

0 1 2 3

You have a cost of capital of 7 %.

 Net Present Value
$466,000

Example - continued $450,000

$16,000 $16,000 $16,000

Present Value 0 1 2 3

14,953
13,975
380,395
$409,323
 Net Present Value
Example - continued
If the building is being offered for sale at a
price of $350,000, would you buy the building
and what is the added value generated by your
purchase and management of the building?
 Net Present Value
Example - continued
If the building is being offered for sale at a price of
$350,000, would you buy the building and what is the
added value generated by your purchase and
management of the building?
16,000 16,000 466,000
NPV  350,000  1
 2
 3
(1.07) (1.07) (1.07)
NPV  $59,323
 Present Value Example
 Initial Investment: $100,000
 Project Life: 10 years
 Salvage Value: $ 20,000
 Annual Receipts: $ 40,000
 Annual Disbursements: $ 22,000
 Annual Discount Rate: 12%

What is the net present value for this project?

Is the project an acceptable investment?
 Present Value Example Solution
 Annual Receipts
 $40,000(P/A, 12%, 10) $ 226,000
 Salvage Value
 $20,000(P/F, 12%, 10) $ 6,440
 Annual Disbursements
 $22,000(P/A, 12%, 10) -$124,000
 Initial Investment (t=0) -$100,000

 Net Present Value $ 8,140

 Greater than zero, therefore acceptable project
 Future Value
The future value method evaluates a project based upon
the basis of how much money will be accumulated at
some future point in time. This is just the reverse of
the present value concept.

FV
T=0 +/- Cash Flows
 Future Value Example
 Initial Investment: $100,000
 Project Life: 10 years
 Salvage Value: $ 20,000
 Annual Receipts: $ 40,000
 Annual Disbursements: $ 22,000
 Annual Discount Rate: 12%

What is the net future value for this project?

Is the project an acceptable investment?
Future Value Example Solution
 Annual Receipts
 $40,000(F/A, 12%, 10) $ 701,960
 Salvage Value
 $20,000(year 10) $ 20,000
 Annual Disbursements
 $22,000(F/A, 12%, 10) -$386,078
 Initial Investment
 $100,000(F/P, 12%, 10) -$310,600

 Net Future Value $ 25,280

 Positive value, therefore acceptable project
 Can be used to compare with future value of other projects
 PV/FV
No theoretical difference if project is
evaluated in present or future value

PV of $ 25,282
$25,282(P/F, 12%, 10) $ 8,140

FV of $ 8,140
$8,140(F/P, 12%, 10) $ 25,280
 Annual Value
 Sometimes it is more convenient to evaluate a
project in terms of its annual value or cost.
For example it may be easier to evaluate
specific components of an investment or
individual pieces of equipment based upon
their annual costs as the data may be more
readily available for analysis.
 Annual Analysis Example
 A new piece of equipment is being evaluated for
purchase which will generate annual benefits in the
amount of $10,000 for a 10 year period, with annual
costs of $5,000. The initial cost of the machine is
$40,000 and the expected salvage is $2,000 at the end
of 10 years. What is the net annual worth if interest
on invested capital is 10%?
 Annual Example Solution
 Benefits:
 $10,000 per year $10,000
 Salvage
 $2,000(P/F, 10%, 10)(A/P, 10%,10) $ 125
 Costs:
 $5,000 per year -$ 5,000
 Investment:
 $40,000(A/P, 10%, 10) -$ 6,508
 Net Annual Value -$1,383

Since this is less than zero, the project is expected to earn less than the acceptable rate of 10%,
therefore the project should be rejected.
 Other Investment Criteria
Internal Rate of Return (IRR) - Discount rate at
which NPV = 0.
 Other Investment Criteria
Internal Rate of Return (IRR) - Discount rate at
which NPV = 0.

Rate of Return Rule - Invest in any project offering a

rate of return that is higher than the opportunity cost
of capital.

C1 - investment
Rate of Return =
investment
 Internal Rate of Return
Example
You can purchase a building for $350,000.
The investment will generate $16,000 in
cash flows (i.e. rent) during the first three
years. At the end of three years you will
sell the building for $450,000. What is the
IRR on this investment?
 Internal Rate of Return
Example
You can purchase a building for $350,000.
The investment will generate $16,000 in cash
flows (i.e. rent) during the first three years. At
the end of three years you will sell the building
for $450,000. What is the IRR on this
investment? 16,000 16,000 466,000
0  350,000  1
 2

(1  IRR ) (1  IRR ) (1  IRR ) 3
 Internal Rate of Return
Example
You can purchase a building for $350,000. The
investment will generate $16,000 in cash flows (i.e.
rent) during the first three years. At the end of three
years you will sell the building for $450,000. What is
the IRR on this investment?
16,000 16,000 466,000
0  350,000  1
 2

(1  IRR ) (1  IRR ) (1  IRR ) 3

IRR = 12.96%
 Internal Rate of Return
200

150

100 IRR=12.96%
NPV (,000s)

50

0
0 5 10 15 20 25 30 35
-50

-100

-150

-200
Discount rate (%)
 Rate of Return Rule
 The rate of return is the discount rate at which
NPV equals zero.
 If the opportunity cost of capital is less than
the project rate of return, then the NPV of the
project is positive.

 The NPV rule and the rate of return rule are

positive.
 Payback Method
Payback Period

Time until cash flows recover the initial investment of

the project.
 Payback Method
Payback Period - Time until cash flows recover the
initial investment of the project.

 The payback rule specifies that a project be accepted

if its payback period is less than the specified cutoff
period. The following example will demonstrate the
absurdity of this statement.
 Payback Method
Example
The three project below are available.
The company accepts all projects with a 2
year or less payback period. Show how
this decision will impact our decision.
 Payback Method
Example
The three project below are available. The company accepts
all projects with a 2 year or less payback period. Show how
this decision will impact our decision.

Cash Flows
Prj. C0 C1 C2 C3 Payback NPV@10%
A -2000 +1000 +1000 +10000
B -2000 +1000 +1000 0
C -2000 0 +2000 0
 Payback Method
Example
The three project below are available. The company accepts
all projects with a 2 year or less payback period. Show how
this decision will impact our decision.

Cash Flows
Prj. C0 C1 C2 C3 Payback NPV@10%
A -2000 +1000 +1000 +10000 2
B -2000 +1000 +1000 0 2
C -2000 0 +2000 0 2
 Payback Method
Example
The three project below are available. The company accepts
all projects with a 2 year or less payback period. Show how
this decision will impact our decision.

Cash Flows
Prj. C0 C1 C2 C3 Payback NPV@10%
A -2000 +1000 +1000 +10000 2 +7,249
B -2000 +1000 +1000 0 2 - 264
C -2000 0 +2000 0 2 - 347
Payback Period
 Book Rate of Return
Book Rate of Return - Average income divided by
average book value over project life. Also called
accounting rate of return.
 Book Rate of Return
Book Rate of Return - Average income divided by
average book value over project life. Also called
accounting rate of return.

book income
Book rate of return =
book assets
Managers rarely use this measurement to make
decisions. The components reflect tax and accounting
figures, not market values or cash flows.
 Internal Rate of Return
Example
You have two proposals to choice between. The initial proposal (H) has a
cash flow that is different than the revised proposal (I). Using IRR, which
do you prefer?
16 16 466
NPV  350  1
 2
 3
0
(1  IRR) (1  IRR) (1  IRR)
 12.96%

400
NPV  350  1
0
(1  IRR )
 14.29%
 Internal Rate of Return
Example
You have two proposals to choice between. The initial proposal (H) has a
cash flow that is different than the revised proposal (I). Using IRR, which
do you prefer?

Project C0 C1 C2 C3 IRR NPV@7%

H -350 400 14.29% $ 24,000
I -350 16 16 466 12.96% $ 59,000
 Internal Rate of Return
Pitfall 1 - Mutually Exclusive Projects
 IRR sometimes ignores the magnitude of the project.
 The following two projects illustrate that problem.

Pitfall 2 - Lending or Borrowing?

 With some cash flows (as noted below) the NPV of the project increases as
the discount rate increases.

This is contrary to the normal relationship between NPV and discount rates.

Pitfall 3 - Multiple Rates of Return

 Certain cash flows can generate NPV=0 at two different discount
rates.

The following cash flow generates NPV=0 at both (-50%) and 15.2%.
 Project Interactions
When you need to choose between mutually
exclusive projects, the decision rule is simple.
Calculate the NPV of each project, and, from
those options that have a positive NPV, choose
the one whose NPV is highest.
 Mutually Exclusive Projects
Example
Select one of the two following projects, based
on highest NPV.
System C0 C1 C2 C3 NPV
Faster  800 350 350 350  118 .5
Slower  700 300 300 300  87.3

assume 7% discount rate

 Investment Timing
Sometimes you have the ability to defer an
investment and select a time that is more ideal
at which to make the investment decision. A
common example involves a tree farm. You
may defer the harvesting of trees. By doing
so, you defer the receipt of the cash flow, yet
increase the cash flow.
 Investment Timing
Example
You may purchase a computer anytime within the
next five years. While the computer will save your
company money, the cost of computers continues to
decline. If your cost of capital is 10% and given the
data listed below, when should you purchase the
computer?
 Investment Timing
Example
You may purchase a computer anytime within the next five years. While the
computer will save your company money, the cost of computers continues to
decline. If your cost of capital is 10% and given the data listed below, when
should you purchase the computer?

Year Cost PV Savings NPV at Purchase NPV Today

0 50 70 20 20.0
1 45 70 25 22.7
2 40 70 30 24.8
3 36 70 34 Date to purchase 25.5
4 33 70 37 25.3
5 31 70 39 24.2
 Equivalent Annual Cost
Equivalent Annual Cost - The cost per period
with the same present value as the cost of
buying and operating a machine.

present value of costs

Equivalent annual cost =
annuity factor
 Equivalent Annual Cost
Example
Given the following costs of operating two machines
and a 6% cost of capital, select the lower cost machine
using equivalent annual cost method.

Year
Mach. 1 2 3 4 PV@6% Ann. Cost
D -15 -4 -4 -4 -25.69 - 9.61
E -10 -6 -6 -11.45
-21.00
 Equivalent Annual Cost
Example (with a twist)
Select one of the two following projects, based on
highest “equivalent annual annuity” (r=9%).

Project C0 C1 C2 C3 C4 NPV EAA

A  15 4.9 5.2 5.9 6.2 2.82 .87
B  20 8.1 8.7 10.4 2.78 1.10
 Capital Rationing
Capital Rationing - Limit set on the amount of
funds available for investment.

Soft Rationing - Limits on available funds

imposed by management.

Hard Rationing - Limits on available funds

imposed by the unavailability of funds in the
capital market.
 Profitability Index

Profitability
Project PV Investment NPV Index
L 4 3 1 1/3 = .33
M 6 5 1 1/5 = .20
N 10 7 3 3/7 = .43
O 8 6 2 2/6 = .33
P 5 4 1 1/4 = .25
 Project Interactions
When you need to choose between mutually
exclusive projects, the decision rule is simple.
Calculate the NPV of each project, and, from
those options that have a positive NPV, choose
the one whose NPV is highest.
 Numeric Models: Scoring
 In an attempt to overcome some of the
disadvantages of profitability models,
particularly their focus on a single decision
criterion, a number of evaluation/selection
models hat use multiple criteria to evaluate a
project have been developed. Such models
vary widely in their complexity and
information requirements. The examples
discussed illustrate some of the different types
of numeric scoring models.
Some factors to consider
 Unweighted 0–1 Factor Model
 A set of relevant factors is selected by management and then usually
listed in a preprinted form. One or more raters score the project on
each factor, depending on whether or not it qualifies for an
individual criterion.
 The raters are chosen by senior managers, for the most part from the
rolls of senior management.
 The criteria for choice are:
 (1) a clear understanding of organizational goals
 (2) a good knowledge of the firm’s potential project portfolio.
 Next slide: The columns are summed, projects with a sufficient
number of qualifying factors may be selected.
 Advantage: It uses several criteria in the decision process.
 Disadvantage: It assumes all criteria are of equal importance and it
allows for no gradation of the degree to which a specific project
meets the various criteria.
 Unweighted Factor Scoring Model
 X marks in 0-1
scoring model are
replaced by numbers,
from a 5 point scale.
 Weighted Factor Scoring Model
 When numeric weights reflecting the relative importance of
each individual factor are added, we have a weighted factor
scoring model. In general, it takes the form

n
Si   SijWj
j 1

where
Si the total score of the ith project,
Sij the score of the ith project on the jth criterion, and
Wj the weight of the jth criterion.
 Constrained Weighted Factor Scoring
Model
 Additional criteria enter the model as constraints rather than weighted
factors. These constraints represent project characteristics that must be
present or absent in order for the project to be acceptable.
 We might have specified that we would not undertake any project that
would significantly lower the quality of the final product (visible to the
buyer or not).
 We would amend the weighted scoring model to take the form:
n v
Si   SijWj  Cik
j 1 k 1

where Cik 1 if the i th project satisfies the Kth constraint, and 0 if it does not.
 Example: P & G practice
 Would not consider a project to add a new consumer
product or product line:
 that cannot be marketed nationally;
 that cannot be distributed through mass outlets (grocery
stores, drugstores);
 that will not generate gross revenues in excess of $—
million; for which Procter & Gamble’s potential market
share is not at least 50 percent;
 and that does not utilize Procter & Gamble’s scientific
expertise, manufacturing expertise, advertising expertise, or
packaging and distribution expertise.
 Final Thought
 Selecting the type of model to aid the
evaluation/selection process depends on the
philosophy and wishes of management.
 Weighted scoring models preferred for three
fundamental reasons.
 they allow the multiple objectives of all organizations to be
reflected in the important decision about which projects
will be supported and which will be rejected.
 scoring models are easily adapted to changes in managerial
philosophy or changes in the environment.
 they do not suffer from the bias toward the short run that is
inherent in profitability models that discount future cash
flows.