Week 4 : Project selection NPV or IRR?

APS 1016 H Summer 2024

Week 4 1
¡ Introducing BA II Plus Financial calculator
¡ PV of future CF. Concept of trade off money
now or money in the future
¡ How do we determine the appropriate discount
rate?
¡ Calculating NPV and IRR of a mining project.
Some challenges of NPV & IRR evaluation
methods in project selection
¡ Calculating terminal value. Use of Gordon
Growth model

APS 1016 H Summer 2024

Week 4 2
¡ Calculating pay back period
¡ Impact of depreciation on CF
¡ Learn the difference between accounting
cash flow and actual cash flow
¡ Cash flow analysis using real rate or
nominal rate. Impact of inflation on
discounted cash flow analysis
¡ Project expansion and its impact on cash
flow. Use of incremental CF analysis
APS 1016 H Summer 2024
Week 4 3
¡ Press 2nd format
¡ Type 9 Enter
¡ Sets the calculator to 9 decimal places
¡ Instead of 9 you can type any figs from 0
to 9 to set the desired number of decimal
places

APS 1016 H Summer 2024

Week 4 4
¡ To calculate FV
¡ Given
¡ PV = $100
¡ Interest : 8 % paid annually
¡ No. of years : 5
¡ Calculate :FV
¡ Set the calculator as follows
¡ Mode: End P/Y= 1 C/Y = 1 N = 5 I/Y= 8 PV =
100 PMT = 0 CPT FV
¡ Calculator answer: -146.93

APS 1016 H Summer 2024

Week 4 5
¡ FV= $200
¡ Interest : 7% paid annually
¡ No of years : 10
¡ Calculate PV
¡ Set the calculator as follows
¡ Mode: End P/Y= 1 C/Y = 1 N = 10 I/Y= 7
FV = 200 PMT = 0 CPT PV
¡ Calculator answer:-101.67

APS 1016 H Summer 2024

Week 4 6
¡ Year: CF
¡ 0: -7000
¡ 1: 3000
¡ 2: 4000
¡ 3: 5000
¡ 4: 5000
¡ 5: 5000
¡ 6: 5000

APS 1016 H Summer 2024

Week 4 7
¡ CF
¡ 2nd Clr. Work
¡ 7000 +/- choose – Enter
¡ ¯ 3000 Enter
¡ ¯
¡ ¯ 4000 Enter
¡ ¯
¡ ¯ 5000 Enter
¡ ¯
¡ ¯ 5000 Enter
¡ ¯
¡ ¯ 5000 Enter
¡ ¯
¡ ¯ 5000 Enter
¡ ¯
¡ NPV
¡ 20 Enter . 20 % is the discount rate
¡ ¯ CPT
¡ Displays NPV = 7,266.439….

APS 1016 H Summer 2024

Week 4 8
¡ CF
¡ 2nd clear work
¡ 7000 +/- choose – Enter
¡ ↓ 3000 Enter
¡ ↓
¡ ↓4000 Enter
¡ ↓
¡ ↓5000 Enter
¡ ↓ 4 Enter ( enters same cf for 4 years)
¡ ↓
¡ NPV
¡ 20 Enter ( enters 20% discount rate)
¡ ↓ CPT
¡ Displays NPV = 7,266.439…
¡ IRR
¡ CPT
¡ Displays IRR = 52.7053….

APS 1016 H Summer 2024

Week 4 9
¡ CF
¡ 2nd Clr. Work
¡ 7000 +/- choose – Enter
¡ ¯ 3000 Enter
¡ ¯
¡ ¯ 4000 Enter
¡ ¯
¡ ¯ 5000 Enter
¡ ¯
¡ ¯ 5000 Enter
¡ ¯
¡ ¯ 5000 Enter
¡ ¯
¡ ¯ 5000 Enter
¡ ¯
¡ IRR
¡ CPT
¡ Displays IRR = 52.7053….

APS 1016 H Summer 2024

Week 4 10
¡ See Excel file posted on course website

APS 1016 H Summer 2024

Week 4 11
APS 1016 H Summer 2024
Week 4 12
¡ A dollar in hand today is worth more than
a dollar promised some time in the future
¡ PV = FV/(1+r)n
¡ Where PV= present value
¡ FV= future value
¡ r= required rate of return
¡ n = no. of periods

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Week 4 13
¡ The discount rate is generally denoted by
“r” the required rate of return by investors
¡ All engineering projects will not have the
same required rate of return
¡ The required rate of return is a function of
risk inherent in the project
¡ In general r is determined by how “certain”
are the estimated CF. the greater the
certainty, the lower is the “r” value
APS 1016 H Summer 2024
Week 4 14
¡ Some rules of thumb in determination of “r”
¡ 1. standard deviation is defined as the degree of
deviation from the mean. The higher the standard
deviation the higher will be the value of r. There is a
linear relationship between r and sigma( standard
deviation) . Standard deviation is a mathematical
measure of risk.
¡ 2. At early stage in a project, the required rate of return
will be higher, so a higher discount rate can be used? It
is debatable.
¡ 3. Projects in politically unstable regions will demand
higher r.
¡ 4. Stronger management team will translate into lower
“r”

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Week 4 15
¡ 5. Market determination of “r” can be calculated using CAPM

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Week 4 16
¡ Capital asset pricing model or CAPM
¡ Corporations utilize a combination of debt and equity to
finance their projects. The combined return that both the
shareholders and bondholders need is known as
WACC( weighted average cost of capital)
¡ WACC= ( cost of debt x weight of debt) + ( cost of equity
x weight of equity). Note the cost of debt is generally
lower than the cost of equity. Elaborate.
¡ For example if the total capital employed by the firm = $
100 and if the debt holders contribute $40 and the
shareholders contribute $ 60.
¡ Weight of debt= .4 and weight of equity = .6

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Week 4 17
¡ Cost of debt = rb( 1 – t)
¡ Where rb = bond yield , T = corp. tax rate

¡ Re = rf + β( Rm – Rf)
¡ Where rf = risk free rate = 3 month T bill rate. Rm =
Average return on the market
¡ β= stocks beta
¡ Beta value is calculated using regression analysis.
Data required are returns on the stock and
corresponding returns on the market. Use Excel to
calculate Beta. Go to www.globeinvestor.com

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Week 4 18
¡ By definition beta of market = 1. A risky
stock will have a beta of greater than 1
whereas a less risky stock will have a beta
value of less than 1. The greater the risk,
the higher will be the return demanded by
equity investors. This required rate of
equity return will be equal to the cost of
equity

APS 1016 H Summer 2024

Week 4 19
¡ Dividend growth model can be utilized in
calculating the required rate of return on
common equity
¡ P 0 = D 1/ r – g
¡ Rearranging r = D1/ P0 + g
¡ r = cost of equity D1= dividend paid 1 year from
now
¡ P0= price of 1 share of stock today
¡ g= constant growth rate of company’s dividends on
common shares
APS 1016 H Summer 2024
Week 4 20
¡ The cost of equity can be also calculated
as:
¡ Cost of equity = Bond yield + market
premium
¡ The market premium is in the range of 3 to
4 %. Currently the 10 year Govt. of
Canada bonds yield around 1.34%
¡ https://www.bankofcanada.ca/rates/interes
t-rates/canadian-bonds/
APS 1016 H Summer 2024
Week 4 21
¡ NPV is defined as “the difference between
an investments market value and its cost”.
Ross
¡ NPV is a measure of how much value is
created by undertaking an investment in a
project
¡ A positive NPV project would therefore
create value for a corporation, resulting in
higher share price
APS 1016 H Summer 2024
Week 4 22
¡ NPV = - initial $ investment + CF1/ (1 + k) +
CF2/ (1 +k)2 + CF3/ ( 1+k)3 …….

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¡ Payback period is defined as “The amount of
time required for an investment to generate
cash flow to recover its initial cost”. Ross
¡ Example: stream of CF received at the end of
each year is: -2,000, 100, 1500, 1700, 2000
¡ Payback is = -2,000+ 100 + 1500 + 400
¡ 400/1700 = 0.23 how long to get money abck

¡ Therefore payback is 2.23 years

¡ The major drawback is it ignores time value of
money and any future cash flows

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Week 4 24
¡ “The discount rate that makes the NPV of
an investment equal to zero”. Ross
¡ Example: What is the IRR of the following CF received
at the end of each year:
¡ -100, 50, 70
¡ At 0 discount rate the NPV= $20
¡ At 5 % discount rate the NPV= $14.28
¡ At 10 % discount rate the NPV = $ 9.1
¡ At 15 % discount rate the NPV = $ 4.35
¡ At 20 % discount rate the NPV = $ 0
¡ Therefore the IRR for the project is 20 %

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Week 4 25
¡ Cannot determine the magnitude of value
creation
¡ Can give multiple IRR values. In some
engineering projects initial cash flows will
be negative, the intermediate CF will be
positive and at the end it will have
negative CF( example mine closure and
reclamation costs).

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Week 4 26
¡ Year Project A CF $ Project B CF $
¡ 0 -150 -150
¡ 1 75 40
¡ 2 60 50
¡ 3 60 70
¡ 4 45 90
¡ IRR 24.0 20.6

¡ Based on IRR select project A

APS 1016 H Summer 2024

Week 4 27
¡ Discount rate Project A NPV Project B NPV Select
¡ 0 90 100 B
¡ 5 64.7 67.96 B
¡ 10 43.58 41.75 A
¡ 15 25.77 20.07 A
¡ 20 10.59 1.97 A
¡ Project selection will be dependent upon which discount
rate the company chooses

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Week 4 28
¡ Terminal values can be calculated using Gordon
growth model
¡ For a technology project the initial CF will grow
at an uneven pace thereafter it is assumed that
they will grow at a constant rate forever
¡ PV = CF 1 /r-g where CF 1 is next year’s CF,
thereafter the CF will grow at a constant rate
represented by g . r is the required rate of return

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Week 4 29
¡ Year 0 1 2 3 4 5
¡ CF -100 10 30 60 70 80
¡ After year 5 the CF will grow at a constant
rate of 5 % per year forever. What is the
NPV of this project? Assume a discount
rate of 10%.

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Week 4 30
¡ NPV = -100 + 10/1.1 + 30/(1.1)2 +
60/(1.1)3 + 70/(1.1)4 + 80/(1.1)5 +
(80)(1.05)/0.1 -.05 /(1.1)5
¡ NPV = 1119.60
¡ The terminal value = 1043.15(PV)

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Week 4 31
¡ Canadian Customs and Revenue Agency (
CCRA) determines at what rate a co. can
depreciate its machinery
¡ CCA expense has the effect of reducing the tax
bite and increasing the company’s operating
cash flow. CCA acts as a tax shield. PV of that
tax shield adds value to a project
¡ Since depreciation expense is not a cash outlay,
it must be added back to net income to arrive at
the operating CF value. Here is an example

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Week 4 32
¡ A mining company is developing very
small gold mine in NW BC
¡ The Capex is $ 5 million. The mine has a
4 year life. CCRA has determined that the
machinery is in class 8 which permits 20%
depreciation rate. The tax rule says that in
the first year, the company can only use
50% of the asset value for depreciation
purposes
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Week 4 33
¡ All figures in millions of $

¡ Year Beg UCC CCA rate .2 Ending UCC

¡ 1 5.0 5.0/2 x .2 =.50 4.5
¡ 2 4.5 .9 3.6
¡ 3 3.6 .72 2.88
¡ 4 2.88 .576 2.304

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¡ Years 1 2 3 4
¡ Revenue 10.0 10.0 10.0 10.0
¡ Oper. costs 5.0 5.0 5.0 5.0
¡ Less CCA .5 .9 .72 .576
¡ EBIT 4.5 4.1 4.28 4.424
¡ Taxes @40% 1.8 1.64 1.712 1.7696
¡ Net income 2.7 2.46 2.568 2.6544
¡ Add depre. 0.5 0.9 0.72 0.576
¡ Oper. CF 3.2 3.36 3.288 3.2304

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Week 4 35
¡ Assume a 12 % required rate of return.
¡ NPV = $4,929,025
¡ Depreciation allowance has significantly
improved the value of the project

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Week 4 36
¡ Fundamentals of corporate finance. Eighth Canadian
edition. Ross, Westerfield, Jordan and Roberts.
Publishers McGraw Hill Ryerson
¡ Financial Management and Real Options. Jack Broyles.
Wiley
¡ Engineering Economy. Canadian Edition. Blank, Tarquin
Iversion. McGraw Hill Ryerson
WACC vs D/E as D/E grow WACC goes down because cost of debt is cheaper than cost of equaity in the WACC mode
but aftera while it start rising because the probability of default start rising as debt increase

as company become more profitable it can take on more debt in the balance sheet to
remaina t the optimal debt to equity ratio, on the opposite if profit decrease it can pay back debt to
remain at the d/e ratio optimal

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Week 4 37