Evaluation of Financial Analysis of

Project
Financial Analysis of Project
Pertains to long term assets and yield a return over a period
of time
Involves a series of cash outlays for an anticipated inflow of
future benefits
Evaluation of expenditure decisions
Benefits : (i). Increased revenues
(ii). Reduced costs
Features (i). Large anticipated benefits
(ii). Relatively high risk
(iii). Relatively long period
 IMPORTANCE
• Financial Decision Making
• Profitability of the Firm
• Fixed Asset (Not current asset)
• Strategic Investment
• Future Destiny of Company
• Selection of Project
- Example (Plant)
- Huge Fixed Cost Used – Labour, Salary,
Insurance, etc..
- If Successful/Less Profit – bare the entire
Fixed Cost

• Selection of Project Determines,

- Future Cost
- Break Even Point
- Sales
- Profit
Once Project Selected is not Reversible.

Need For Correct Selection of Project

- It involves Cost
- Capital Resources

So if not properly selected, have to bare loss

DIFFICULTIES
Benefits from project financial are received in future
and future is uncertain.

Cost incurred and benefits received occur in different

time periods,
- It is not comparable because of time value of
money.
Evaluation Techniques
1. Traditional
 ARR method
 Payback period method

2. Time Adjusted ( Discounted Cash Flow)

 NPV method
 IRR method
 PI method
Average Rate of Return (ARR)
Avg annual yield for the project
PAT
ARR = Avg annual PAT
Avg investment

 Avg annual PAT = ∑ PAT / Years

annuity = constant PAT / Years

 Avg investment = WC + Net investment

2
 Example
Machine A Machine B
Cost 50,000 50,000
PAT
Year 1 3000 11000
2 5000 9000
3 7000 7000
4 9000 5000
5 11000 3000
35,000 35,000
Estimated life 5 5

ARR = Avg annual PAT

Avg investment
= 7000 / 27000
= 25.93 %
ARR
Accept-Reject Rule:
Actual ARR ≥ Min desired ARR

Projects with highest ARR preferred over Projects with

lower ARR
 Evaluation of ARR
Merits
- Easy calculation
Demerits
‐ use of PAT instead of cash flow
‐ ignores time value of money
‐ no differentiation between size of
investment

Machines PAT Avg ARR (%)

Investment
A 6,000 30,000 20
B 2,000 10,000 20
C 4,000 20,000 20
Pay Back Method
Time period required for complete recovery of the initial
investment in the project
Period within which total cash inflows = total cost of
investment
The project with a lowest payback period is preferred
Cash benefits = CFAT
Two ways:
(1). Annuity(uniform CFAT)
PB = Investment
const CFAT
(2). Non-uniform CFAT

Initial investment = 50,000

 For Project A:
PB period = a fraction more than 3 years
sum of 48,000 is recovered by the end of 3rd year
Balance = 2,000 to be recovered in the 4th year
PB fraction = 2,000 / 20,000 = 0.1
PB period = 3.1 years

 For Project B:
PB period = a fraction more than 2 years
sum of 42,000 is recovered by the end of 2nd year
Balance = 8,000 to be recovered in the 3rd year
PB fraction = 8,000 / 18,000 = 0.44
PB period = 2.44 years
Accept-Reject Rule:
Actual PB ≥ Min desired PB

Projects with shortest PB preferred over Projects with

longest PB
Evaluation
 Merits: of PB
- based on cash flow analysis
 Demerits:
- ignores all cash inflows after PB period
- ignores the time value of money
- does not consider the entire life of the project

Project A Project B
Cost 15,000 15,000
Cash inflow Year 1 5,000 4,000
2 6,000 5,000
3 4,000 6,000
4 0 6,000
5 0 4,000
PB period 3 yrs 3 yrs
 Discounted Cash Flow
(Time Adjusted Techniques)
DCF
Considers Time Value of Money
- discount rate i.e cost of capital

Considers all benefits and costs occuring during entire

life of the project
Net Present Value (NPV)
∑ PV of all future cash inflows —
∑ PV of all cash outflows

Accept-Reject Rule:
 NPV > 0 » Project accepted
 NPV < 0 « Project rejected
 Project A Project B
NPV (69,645 – 50,000) (71,521 – 50,000)
= 19,645 = 21,521
Accepted Accepted
Cash outlay = 30,000
NPV (69,645 – 80,000) (71,521 – 80,000)
= - 10,355 = - 8,479
Rejected Rejected
Merits:
- recognises time value of money
- considers the total benefits of the project
- useful for mutually exclusive projects
- affects the market price of share

 Demerits:
- involves tedious calculation of discount rate
- focus only on NPV
Internal Rate of Return (IRR)
Rate of return that a project earns
∑ PV of cash inflows = ∑ PV of cash outflows
i.e. rate which gives NPV = 0

Accept-Reject Rule:
 IRR (r) > cut-off rate » Project accepted
 IRR (r) < cut-off rate » Project rejected
 Example
The project costs Rs. 36,000 and is expected to generate
cash inflows of Rs. 11,200 annually for 5 yrs.
Calculate IRR of the project.

Solution
 PB period = 36000/11200 = 3.214
Discount factors closest to 3.214 for 5 years are 3.274 and
3.199 i.e. 16% and 17% interest rate respectively
IRR = r – PB – 3.199 = 16.8 %
0.075
Annuity table
Periods 15% 16% 17% 18% 19%
1 .8696 .8621 . 8547 .8475 .8403
2 1.6257 1.6052 1.5852 1.5656 1.5465
3 2.2832 2.2459 2.2096 2.1743 2.1399
4 2.8550 2.7982 2.7432 2.6901 2.6386
5 3.3522 3.2743 3.1993 3.1272 3.0576
6 3.7845 3.6847 3.5892 3.4976 3.4098
7 4.1604 4.0386 3.9224 3.8115 3.7057
8 4.4873 4.3436 4.2072 4.0776 3.9544
9 4.7716 4.6065 4.4506 4.3030 4.1633
10 5.0188 4.8332 4.6586 4.4941 4.3389
Risk
Sensitivity Analysis:
Accounts for the estimation errors
Best, Most possible, Worst
 Additions: (a) Assigning Probability, (b) Standard Deviation

Relative Risk- Coefficient of Variation

Continued..
Risk Evaluation Approaches
Risk Adjusted Discount Rate Approach
 Rate of return is adjusted for risk
Certainty-Equivalent Approach
 Future cash flows are subjected to risk adjustments
Probability Distribution Approach
 Normal Distribution of returns
Decision-tree Approach
 Interdependency in projects
THANK YOU..