Case Study

11/22/2022 ECONOMIC DESCSION IN

ENGINEERING

Submitted By:
Haitham Riyadh

2022-MS-EM-1

USAMA KHALID

2022-MS-EM-7

Submitted To:
DR. SADAF ZAHOOR

Department of Manufacture Engineering

UNIVERSITY OF ENGINEERING AND TECHNOLOGY, LAHORE
Contents
Implementation of rate of return in a majority project..........................................................................2
Problem Statement....................................................................................................................................2
Relative Theory..........................................................................................................................................2
Net Present Value (NPV)..........................................................................................................................2
NPV Drawbacks........................................................................................................................................2
Internal Rate of Return (IRR)..................................................................................................................2
Drawbacks of IRR.....................................................................................................................................2
Profitability Index.....................................................................................................................................2
Advantages of PI........................................................................................................................................2
Disadvantages of PI...................................................................................................................................3
NPV Comparison.......................................................................................................................................3
Discussion...................................................................................................................................................3
IRR Comparison........................................................................................................................................4
Discussion...................................................................................................................................................5
Suitable Project..........................................................................................................................................5
Reasons.......................................................................................................................................................5
Conclusion...................................................................................................................................................6

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 Implementation of rate of return in a majoritys
projects
Problem Statement
In this study, we have cash flow of three majority projects. Analyse the NPV, IRR , NFV and PI
of all three projects and conclude that which project is suitable.

Relative Theory
Net Present Value (NPV)
NPV is the difference between present value of cash inflows to the present value of cash
outflows. It is used in investment budgeting and planning to analyse the profitability of the
investment. A positive NPV indicates that the earnings generated by a project is greater than the
anticipated cost. A positive NPV will be profitable while negative NPV will lead to the loss. This
indicates that the NPV only with positive values will be considered.

NPV Drawbacks
 NPV relies heavily on the assumptions and estimates, so there can be substantial room of error
 NPV method does not prove useful for comparing two projects of different sizes

Internal Rate of Return (IRR)

IRR is a discount rate at which the NPV of cash flow equal to zero in a discounted cash flow.
Higher the IRR for an investment, more desirable to take it.

Drawbacks of IRR
 IRR does not consider the size of project, while comparing two projects
 IRR method concerns to projected cash flow generated by capital investment and ignores the
future cost that affect the profit
 IRR method ignores reinvestment rates

Profitability Index
It is also referred to as value investment ratio or profit investment ratio. It is the ratio of present
value of future expected cash flow and the initial amount invested in the project. At higher value
of profitability index, project will be more attractive.

Advantages of PI
 Profitability index will provide you information about how investment will change value of a firm
 PI will take all cash flow from a project into its con sideration

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  It considers risks involved with future cash flows

Disadvantages of PI
 Information generated by profitability index is based on estimates instead of facts
 For certain projects, it may not provide correct decision-making criteria
 It may be difficult to estimate opportunity cost

NPV Comparison
Block-A
Year NCF (MM$) t NPV Year NCF(MM$) t NPV
2015 -80 0 -80 Block-B 2015 -120 0 -120
2016 20 1 17.85714 2016 30 1 26.78571
2017 15 2 11.95791 2017 40 2 31.88776
2018 35 3 24.91231 2018 35 3 24.91231
2019 30 4 19.06554 2019 30 4 19.06554
2020 35 5 19.85994 2020 40 5 22.69707
NPV 13.65284 NPV 5.348395

Year NCF(MM$) t NPV

2015 -100 0 -100 Block-C
2016 50 1 44.64286
2017 10 2 7.971939
2018 40 3 28.47121
2019 50 4 31.7759
2020 80 5 45.39415
NPV 58.25606

Discussion
A positive NPV indicates that the earnings generated by a project is greater than the anticipated
cost. Therefore, the NPV with positive value will generate profit for the project. If the NPV of

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cash flows have negative values because of larger discount rate or smaller net cash flow, then the
project should be avoided.

In all above three cases, value of NPV is positive which indicates that all three projects will be
profitable. In that situation, we must select the project with higher value of NPV. In above three
cases, Block-C has greater value of NPV therefore we will select the project in Block-C because
it will generate more profit than other cases.

IRR Comparison

Block-A

Block A
NCF(MM$) Percent NPV
-80 5% $33.33
20 12% $12.19
15 12% $12.19
35 15% $5.48
30 20% ($3.44)
35 25% ($10.18)
  IRR 18%

Figure 1

Block-B

Block B
NCF(MM$) Percent NPV
-120 5% $29.63
30 10% $10.87
40 12% $4.78
35 15% ($3.14)
30 20% ($13.69)
40 25% ($21.67)
IRR 14%

Figure 2

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 Block-C

Block C
NCF(MM$) Percent NPV
-100 10% $61.45
50 20% $23.35
10 25% $10.86
40 30% $1.26
50 35% ($6.17)
80 40% ($11.94)
IRR 31%

Figure 3

Discussion
IRR is not the actual dollar value of the project, but it is the annual return that makes the NPV
value equal to zero. Higher the value of IRR, more desirable the project will be. In general, when
comparing the multiple investment options, the investment with higher value of IRR would be
considered the best. In our study, the Block-C has the highest value of IRR due to which Block-
C will be best option to invest.

Suitable Project
From the above data the Feasible project is block C.

Reasons
 We have three projects that have same useful life (5 years) and same cost of capital (10%). Block-
A has IRR=18%, Block-B has IRR=14% and Block-C has IRR=31%. All the investments have
the IRR that exceeds the capital cost, so they all should be selected according to IRR, but we have
to accept only one investment. Intuition suggests that we have to select the Block-C because it has
higher value of IRR than other projects.
 If the NPV of a project is greater than $0 then accept that project. In this study, all the three
projects have the NPV greater than $0. In this situation, we have to select the project with the
NPV greater than other projects. Block-C has the NPV of $58.26, which is greater than all the
other projects.
 If PI is greater than 1, it means that present value of future cash flow that is to be derived from
project is greater than the amount of investment. In this study, all the projects have the PI greater
than 1, so it means all the projects are feasible for us, but we have to select only one project. In
this situation, we have to select the investment with high profitability index (Block-C) because it
will generate more return than other investments.

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Conclusion
 We should to use more than one process to study the rate of return for majority projects
because one process it may not show us the size of the investment.

 Some projects result higher NPVs, but those projects may be passed over because they do not
have the highest value of PI. In this study, Block-C has highest values for both NPV and PI,
therefore Block-Csss is to be most suitable project.