Project Evaluation CBA

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Planning & economic evaluation of transportation projects
Planning & Economic Evaluation of Transportation

Projects
Project Economic Evaluation:

Cost Benefit Analysis (CBA)
Ashenafi Aregawi(PhD): Planning & economic of transportation projects Economic Evaluation: CBA : 0
Project economic value
 Market value of future cash flow stream
– Market value of equity and debt financing the
project
– Financial capital that project promoters and
creditors are prepared to invest considering
the size, the timing and the risk of project
expected cash flows
. Planning & economic evaluation of transportation projects
Project evaluation process
 Estimation of relevant cash flows
 Estimation of risk-adjusted opportunity cost of

capital
 Selection of a valuation criteria
Relevant Cash Flows
 The cash flows that should be included in a

capital budgeting analysis are those that will
only occur if the project is accepted
 These cash flows are called incremental cash
flows
 The stand-alone principle allows us to analyze
each project in isolation from the firm simply by
focusing on incremental cash flows
Relevant Cash Flows
 We should always ask ourselves “Will this cash

flow occur ONLY if we accept the project?”
– If the answer is “yes”, it should be included in the
analysis because it is incremental
– If the answer is “no”, it should not be included in the
analysis because it will occur anyway
– If the answer is “part of it”, then we should include the
part that occurs because of the project
Relevant cash flows estimation

 Sunk costs – costs that have accrued in the past
 Opportunity costs – costs of lost options
 Side effects
– Positive side effects – benefits to other
projects
– Negative side effects – costs to other projects
 Changes in net working capital
 Financing costs
 Taxes
Relevant cash flows estimation
 Depreciation
 Working capital needs
 Capital expenditures (capex)
 Inflation
Project terminal value

 Liquidation approach
– Fixed assets residual value:
Market value of individual fixed assets (net of
income tax) in the last period of project’s useful
life
– Working capital residual value:
Recovery of working capital invested over the
project’s useful life
Cash flow growth
g = Reinvestment rate x Return on

assets
Reinvestment rate:
(Capex – Depreciation -  Working Capital) / (RO x (1 –
t)
 Working Capital: Change in working capital
t : corporate tax rate
Return on assets:
RO / Invested capital
RO: Operating income
Discount rate
• Represents the capital opportunity cost

associated with the project
• The rate of returns financiers forego in
alternative investments of equivalent risk
• Equivalent risk in terms of cash flows:
– timing
– size
– liquidity
– taxability
Discount rate
D  E 
V  K D  
1 t  
 V  K E
   
• D: market value of Debt (number of outstanding bonds x market price)

• E: market value of Equity (number of outstanding shares x market price)
• V= D + E
• t: marginal income tax rate
Debtholders required return (kD)

(cost of debt)
Real return
+
Inflation risk premium
=
Risk free rate (rF)
+
Credit risk premium (PC)
=
kD
Equityholders required return (kE)

(cost of equity)
Risk free rate (rF)
+
Coefficient of sistematic risk ()
x
Market risk premium (PM)
(rM - rF)
=
KE
rM: Market return

Annual verage rate of return Risk

a
Nominal Real Average risk Standard Variance
premium deviation
Treasury Bills 3.80% 0.70% 0.00% 3.2 10.2
Treasury Bonds 5.60% 2.60% 1.80% 9.2 84.6
Corporate Bonds 6.10% 3.00% 2.30% 8.4 75.7
Standard & Poors' 13.00% 9.70% 9.20% 20.3 412.1
500
SMEs stocks 17.70% 14.20% 13.90% 33.9 1149.2
Market risk premium = 13,0% - 5,6% = 7,4%
Sistematic risk
•  is the measure of a risky financial asset

sistematic risk em relation to the same risk for the
overall market
– A  < 1 means a lower stock return historical variability
relatively to the one of the market portfolio
– A  > 1 means a higher stock return historical variability
relatively to the one of the market portfolio
– A  = 1 means an identical stock return historical
variability relatively to the one of the market portfolio
– The risk free asset has a  = 0
Discounted cash flow valuation
 Free cash flow

 Equity cash flow
 Capital cash flow
– Differences relate to cash flow measure and

to discount rate estimation
Project evaluation criteria
 Net Present Value

 Payback Period
 Discounted Payback Period
 Average Accounting Return
 Internal Rate of Return
 Profitability Index
Good decision criteria
 Questions we should ask when choosing a

project valuation criteria
 Does the criteria adjust for the time value of
money?
 Does the criteria adjust for risk?
 Does the criteria provide information on
whether project creates economic value?
Net Present Value (NPV)
 Difference between the market value of the

project cash flow stream and of fixed assets cost
 NPV is a measure value of the economic value
created by an investment project
 Steps in NPV estimation:
– Estimate the expected future cash flows
– Estimate of the risk-adjusted opportunity cost of capital
required by financiers
– Calculate NPV
NPV – Decision criteria
 Adopt the project if NPV > 0

 A positive NPV means that the project is
expected to create economic value and
therefore increase the wealth of project
owners
Computing NPV for a Project: Example
Years
0 1 2
Investment Cost Inflows 1000 Inflows 2000

1100 Outflows 500 Outflows 1000
Computing NPV for the Project:

0 1 2
Investment cost Inflows 1000 Inflows 2000

-1100 Outflows 500 Outflows 1000
Cash flow 500 Cash flow 1000
(1,100)
500 x (1 / (1 + 10%))
455
1 000 x (1 / (1 + 10%)2)
826
(= -1100 + 455 + 826) NPV 181

Calculating NPVs with a Spreadsheet
 Using the NPV function

– The first component is the required return entered as
a decimal
– The second component is the range of cash flows
beginning with year 1
– Subtract the initial investment after computing the
NPV
Payback period criteria
 How long does it take to get the initial cost back

in a nominal sense?
 Computation
– Estimate the cash flows
– Subtract the future cash flows from the initial cost
until the initial investment has been recovered
 Decision Rule – Accept if the payback period is
less than some preset limit
Computing Payback for the project:
Investment cost: 1000
period cash flow

1 200
2 400
3 600
accumulated
period cash flow
1 200
2 600
3 1200
Payback period = 2 2/3

Drawback of Payback period criteria
 Ignores the time value of money

 Requires an arbitrary cutoff point
 Ignores cash flows beyond the cutoff
date
 Difficult to compare payback periods
Discounted Payback Period
 Compute the present value of each cash flow

and then determine how long it takes to
payback on a discounted basis
 Compare to a specified required period

 Decision Rule - Accept the project if it pays
back on a discounted basis within the
specified time
Drawbacks of discounted Payback Period
 Requires an arbitrary cutoff point

 Ignores cash flows beyond the cutoff
date
 Difficult to compare payback periods
 May reject positive NPV investments
Average Accounting Return

 Many different definitions for average
accounting return
 A possible one:
– Average net income / average book value
• Average book value depends on how the asset is
depreciated.
 Need to have a target cutoff rate
 Decision Rule: Accept the project if the
AAR is greater than a preset rate.
Computing AAR For The Project
• Assume we require an average accounting

return of 25%
• Average Net Income:
– (13,620 + 3,300 + 29,100) / 3 = 15,340
• AAR = 15,340 / 72,000 = .213 = 21.3%
• Do we accept or reject the project?
Drawbacks of Average Accounting Return
 Not a true rate of return

 Time value of money is ignored
 Uses an arbitrary benchmark cutoff rate
 Based on accounting net income and
book values, not cash flows and market
values
Internal Rate of Return
 This is the most important alternative to

NPV
 It is often used in practice and is
intuitively appealing
 It is based entirely on the estimated cash
flows and is independent of interest rates
found elsewhere
IRR – Definition and Decision Rule
• Definition: IRR is the return that makes

the NPV = 0
• Decision Rule: Accept the project if the
IRR is greater than the required return
Computing IRR For a Project

Period 0 1 2 3 4 5
Cash flows -600 -141 172 230 299 918
IRR (Excel) 22,06%
Discount NPV
rate
21,00% 19,99
23,00% --16,78
22,00% 1.05
Interpolation 1,08%
IRR 22,08%
NPV versus IRR

$400.00
$300.00 IRR
$200.00
$100.00
NPV
$0.00
0% 10% 20% 30% 40% 50% 60%
($100.00)
($200.00)
($300.00)
Discount rate
Advantages of IRR
 Knowing a return is intuitively appealing

 It is a simple way to communicate the value of a
project to someone who doesn’t know all the
estimation details
 If the IRR is high enough, you may not need to

estimate a required return, which is often a
difficult task
Summary of Decisions For The Project
Summary
Net Present Value Accept
Payback Period Reject
Discounted Payback Period Reject
Average Accounting Return Reject
Internal Rate of Return Accept

Calculating IRRs with A Spreadsheet
• Use the IRR function

– Enter the range of cash flows, beginning with
the initial cash flow
– You can enter a guess, but it is not necessary
NPV Vs. IRR
 NPV and IRR will generally give us the same

decision
 Exceptions
– Non-conventional cash flows – cash flow signs
change more than once
– Mutually exclusive projects
 Initial investments are substantially different
 Timing of cash flows is substantially different
IRR and Non-conventional Cash Flows
 When the cash flows change sign more than once, there
is more than one IRR
 When you solve for IRR you are solving for the root of
an equation and when you cross the x-axis more than
once, there will be more than one return that solves the
equation
 If we have more than one IRR, which one should we

use?
NPV Profile
IRR = 10.11% and 42.66%
$4,000.00
$2,000.00
$0.00
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
($2,000.00)
NP
V
($4,000.00)
($6,000.00)
($8,000.00)
($10,000.00)
Discount Rate
IRR and Mutually Exclusive Projects
 Mutually exclusive projects

– If you choose one, you can’t choose the other
 Intuitively you would use the following decision
rules:
– NPV – choose the project with the higher NPV
– IRR – choose the project with the higher IRR
Example With Mutually Exclusive Projects
Period Projec Projec

t A t B The required return
for both projects is
0 -500 -400 10%.
1 325 325
Which project should
you accept and why?
2 325 200
IRR 19.43 22.17

% %
NPV 64.05 60.74
NPV Profiles
What if a fixed required return?
$160.00 IRR for A = 19.43%

$140.00
IRR for B = 22.17%
$120.00
$100.00 Crossover Point = 11.8%
$80.00
A
$60.00
NP
B
V
$40.00
$20.00
$0.00
($20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3
($40.00)
Discount Rate
Conflicts Between NPV and IRR
 NPV directly measures the increase in value to the firm
 Whenever there is a conflict between NPV and another
decision rule, you should always use NPV
 IRR is unreliable in the following situations
– Non-conventional cash flows
– Mutually exclusive projects

Profitability Index
 Measures the benefit per unit cost, based on the

time value of money
 A profitability index of 1.1 implies that for every

$1 of investment, we create an additional $0.10
in value
 This measure can be very useful in situations in

which we have limited capital
Drawbacks of Profitability Index
 May lead to incorrect decisions in comparisons
of mutually exclusive investments

Capital Budgeting In Practice
 We should consider several investment criteria

when making decisions
 NPV and IRR are the most commonly used

primary investment criteria
 Payback is a commonly used secondary

investment criteria
Summary – Discounted Cash Flow

Criteria
 Net present value
– Difference between market value and cost
– Take the project if the NPV is positive
– Has no serious problems
– Preferred decision criterion
 Internal rate of return
– Discount rate that makes NPV = 0
– Take the project if the IRR is greater than the
required return
– Same decision as NPV with conventional cash flows
– IRR is unreliable with non-conventional cash flows or
mutually exclusive projects
Summary – Discounted Cash Flow

Criteria
 Profitability Index
– Benefit-cost ratio
– Take investment if PI > 1
– Cannot be used to rank mutually exclusive projects

– May be used to rank projects in the presence of
capital rationing
Summary – Payback Criteria

 Payback period
– Length of time until initial investment is recovered
– Take the project if it pays back in some specified
period
– Doesn’t account for time value of money and there is
an arbitrary cutoff period
 Discounted payback period
– Length of time until initial investment is recovered on
a discounted basis
– Take the project if it pays back in some specified
period
– There is an arbitrary cutoff period
Summary – Accounting Criterion
 Average Accounting Return

– Measure of accounting profit relative to book
value
– Similar to return on assets measure
– Take the investment if the AAR exceeds some
specified return level
– Serious problems and should not be used
Pro Forma Statements and Cash Flow
 Capital budgeting relies heavily on pro forma

accounting statements, particularly income
statements
 Computing cash flows – refresher
– Operating Cash Flow (OCF) = EBIT + depreciation –
taxes
– OCF = Net income + depreciation when there is no
interest expense
– Cash Flow From Assets (CFFA) = OCF – net capital
spending (NCS) – changes in NWC
EBIT: Income Before Interest and Taxes

Case study: inputs

Inputs
Investment Cost (103 Birr) 5000 Riskless interest rate 4%
Project useful life (Years) 5 Credit risk premium 4%
Fixed assets residual (103) 60 Coefficient of systematic risk 2
Depreciation rate 20% Return on Market portfolio 9%
Initial market size (units) 50000 Equityholders required return 14%
Product market growth rate 10% Debtholders required return 8%
Target market share 15% Target equity ratio 56%
Unit sale price (Birr) 1000 Target debt ratio 44%
Unit variable c o s t (Birr) 6 0 0 Weighted average Cost of Capita 10%
Operating costs/Sales 15% Marginal Income tax rate 40%
Fixed Costs 500 Expected inflation rate 3%
Determine the product market data
1 2 3 4 5
Market 50000
Sales forecast (Units)
Unit Sale Price (Birr) 1000
Unit variable cost (Birr) 600
Determine the product market data
1 2 3 4 5
Market 50000 55000 60500 66550 73205
Sales forecast (Units) 7500 8250 9075 9982.5 10980.8
Unit Sale Price (Birr) 1000 1030 1060.9 1092.73 1125.51
Unit variable cost (Birr) 600 618 636.54 655.636 675.305
Operating income
Unit: 103 Birr 1 2 3 4 5

Sales
Cost of sales
Operating costs
Fixed costs
Depreciation
Operating Income
Income taxes
Net Operating income
Operating income
1 2 3 4 5
Market 50000 55000 60500 66550 73205
Sales forecast 7500 8250 9075 9982.5 10980.75
unit sales price 1000 1030 1060.9 1092.727 1125.50881
Unit variable cost 600 618 636.54 655.6362 675.305286
Operating Income
Sales 7500000 8497500 9627668 10908147 12358931
Cost of sales 4500000 5098500 5776601 6544888 7415359
Operating costs 1125000 1274625 1444150 1636222 1853840
Fixed costs 500000 515000 530450 546364 562754
Depreciation 1000000 1000000 1000000 1000000 1000000
Operating Income 375000 609375 876467 1180673 1526978
Income taxes 150000 243750 350587 472269 610791
Net Operating income 225000 365625 525880 708404 916187
Working capital needs
Working capital needs Unit: 103 Birr 1 2 3 4 5

Average collection period (month) 2
Average inventory (month) 1
Average payable period (month) 0.5
Change in workingg capital needs

Sales 7500000 8497500 9627668 10908147 12358931
Cost of sales 4500000 5098500 5776601 6544888 7415359
Operating costs 1125000 1274625 1444150 1636222 1853840
Fixed costs 500000 515000 530450 546364 562754
Depreciation 1000000 1000000 1000000 1000000 1000000
Income taxes 150000 243750 350587 472269 610791

Average collection period (month) 2 1250000 1416250 1604611 1818025 2059822
Average inventory (month) 1 375000 424875 481383 545407 617947
Average payable period (month) 0.5 187500 212438 240692 272704 308973
Working capital needs 1437500 1628688 1845303 2090728 2368795
Change in workingg capital needs 1437500 191188 216615 245425 278067
Calculated cash
flow
Calculated Cash flow
0 1 2 3 4 5
Investment cost
Change in working capital needs
Operating cash flow
Recovery of working capital needs
Fixed assets residual value
Free cash flow
Discount factors
Free cash flow present value
Sales 7500000 8497500 9627668 10908147 12358931
Cost of sales 4500000 5098500 5776601 6544888 7415359
Operating costs 1125000 1274625 1444150 1636222 1853840
Fixed costs 500000 515000 530450 546364 562754
Depreciation 1000000 1000000 1000000 1000000 1000000
Income taxes 150000 243750 350587 472269 610791

Average collection period (month) 2 1250000 1416250 1604611 1818025 2059822
Average inventory (month) 1 375000 424875 481383 545407 617947
Average payable period (month) 0.5 187500 212438 240692 272704 308973
Change in workingg capital needs 1437500 191188 216615 245425 278067
Calculated Cash flow

0 1 2 3 4 5
Investment cost -5000000
Change in working capital needs -1437500 -191188 -216615 -245425 -278067
Operating cash flow 1225000 1365625 1525880 17084041916187
Recovery of working capital needs 2368795
Fixed assets residual value 60000
Free cash flow -5000000 -212500 1174438 1309265 1462979 4066915.2
Discount factors 1 0.9091 0.8264 0.7513 0.6830 0.6209
Free cash flow present value -5000000 -193182 970610 983670 999234.1 2525234.4
IRR 11.53%
NPV $259,605.58
Making the decision
 NPV = 258,8 103 Birr
 IRR = 11,3%
 Should we accept or reject the project?

Evaluating NPV Estimates
 NPV estimates are just that – estimates

 A positive NPV is a good start – now we need to
take a closer look
– Forecasting risk – how sensitive is our NPV to
changes in the cash flow estimates; the more
sensitive, the greater the forecasting risk
– Sources of value – why does this project create

value?
Scenario Analysis
 What happens to the NPV under different cash flows

scenarios?
 At the very least look at:
– Best case – high revenues, low costs
– Worst case – low revenues, high costs
– Measure of the range of possible outcomes

 Best case and worst case are not necessarily probable,
but they can still be possible
New Project Example
 Consider the project discussed in the text

 The initial cost is $200,000 and the project has a
5-year life. There is no salvage. Depreciation is
straight-line, the required return is 12% and the
tax rate is 34%
 The base case NPV is 15,567

Sensitivity Analysis
 What happens to NPV when we vary one variable at a

time
 This is a subset of scenario analysis where we are

looking at the effect of specific variables on NPV
 The greater the volatility in NPV in relation to a specific

variable, the larger the forecasting risk associated with
that variable and the more attention we want to pay to
its estimation
Summary of Sensitivity Analysis for New

Project
Scenario Unit Sales Cash Flow NPV IRR
Base case 6000 59,800 15,567 15.1

%
Worst case 5500 53,200 -8,226 10.3

%
Best case 6500 66,400 39,357 19.7

%
Simulation Analysis
 Simulation is really just an expanded sensitivity and

scenario analysis
 Monte Carlo simulation can estimate thousands of
possible outcomes based on conditional probability
distributions and constraints for each of the variables
 The output is a probability distribution for NPV with an
estimate of the probability of obtaining a positive net
present value
 The simulation only works as well as the information that
is entered and very bad decisions can be made if care is
not taken to analyze the interaction between variables
Making A Decision
 Beware “Paralysis of Analysis”

 At some point you have to make a decision
 If the majority of your scenarios have positive
NPVs, then you can feel reasonably comfortable
about accepting the project
 If you have a crucial variable that leads to a
negative NPV with a small change in the
estimates, then you may want to forego the
project
Free cash flow (FCF)
 Cash flow measure: free cash flow
 Discount rate: wacc

 Recommended for valuating relatively stable
and low leveraged projects partially funded with
investment grade rating debt
Free cash flow
Operating income x (1 – Income tax rate)

- Interest (after tax)
= Net income
FCF from Net income
+ Operating income x (1 – income tax rate)

- Change in working capital
- Capex
+ Depreciation
= Free Cash Flow
FCF from Net income

+ Net income
+ Interest (after tax)
- Capex
+ Depreciation
= Free Cash Flow
Equity cash flow (ECF)
 Cash flow measure: equity cash flow
 Discount rate: shareholder required return

ECF from FCF
+ Free cash flow

- Interest (after tax)
- Interest tax shield
- Depreciation
+ New debt
= Equity Cash Flow
ECF from Net income
+ Net income
- Capex
+ Depreciation
+ Interest (pre-tax)
- Debt repayment
+ New debt
= Equity Cash Flow
Capital cash flow (CCF)
 Cash flow measure: capital cash flow

 Discount rate: asset expected return; pre-
tax wacc
 Recommended to be used with aggressive
and variable leverage strategies
CCF versus FCF
 Interest tax shields are a relevant cash

flow
 The risk of the cash flow stream is the risk
of project’s assets
– Asset expected return = Risk free rate + (Asset beta x Market risk premium)
CCF from FCF
+ Free Cash Flow

+ Interest tax shields
= Capital Cash Flow
CCF from Net income
+ Net income
- Capex
+ Depreciation
+ Interest
= Capital Cash Flow

Project Evaluation CBA

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Planning & economic evaluation of transportation projects

Planning & Economic Evaluation of Transportation

Project Economic Evaluation:

Project evaluation process

 Estimation of relevant cash flows

 Estimation of risk-adjusted opportunity cost of

Relevant Cash Flows

 The cash flows that should be included in a

Relevant Cash Flows

 We should always ask ourselves “Will this cash

Relevant cash flows estimation

Relevant cash flows estimation

Project terminal value

Cash flow growth

g = Reinvestment rate x Return on

• Represents the capital opportunity cost

• D: market value of Debt (number of outstanding bonds x market price)

Debtholders required return (kD)

Equityholders required return (kE)

rM: Market return

Annual verage rate of return Risk

•  is the measure of a risky financial asset

Discounted cash flow valuation

 Free cash flow

– Differences relate to cash flow measure and

Project evaluation criteria

 Net Present Value

Good decision criteria

 Questions we should ask when choosing a

Net Present Value (NPV)

 Difference between the market value of the

NPV – Decision criteria

 Adopt the project if NPV > 0

Computing NPV for a Project: Example

Investment Cost Inflows 1000 Inflows 2000

Computing NPV for the Project:

Investment cost Inflows 1000 Inflows 2000

(= -1100 + 455 + 826) NPV 181

Calculating NPVs with a Spreadsheet

 Using the NPV function

Payback period criteria

 How long does it take to get the initial cost back

Computing Payback for the project:

Investment cost: 1000

period cash flow

Payback period = 2 2/3

Drawback of Payback period criteria

 Ignores the time value of money

Discounted Payback Period

 Compute the present value of each cash flow

 Compare to a specified required period

Drawbacks of discounted Payback Period

 Requires an arbitrary cutoff point

Average Accounting Return

Computing AAR For The Project

• Assume we require an average accounting

Drawbacks of Average Accounting Return

 Not a true rate of return

Internal Rate of Return

 This is the most important alternative to

IRR – Definition and Decision Rule