Project Evaluation

Fundamentals
I.S.M.- Dhanbad 18.09.2010
Sanjay Singh

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Corporate Finance

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 Corporate finance
• Invest in projects that yield a return greater than the required
rate of return (cost of capital). Returns on projects should be
measured based on cash flows generated and the timing of
these cash flows.

• Choose a financing mix that minimizes the hurdle rate and

matches the assets being financed.

• If there are not enough investments that earn the cost of

capital, return the cash to the shareholders in the form of
dividends and stock buybacks

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 What is Strategic Planning?
• Where organisation wants to fulfill its purpose
and achieve its mission,
– it provides the framework for guiding choices
which determines the organisation’s nature and
direction and these choices relates to
• Organisation’s products or services
• Markets
• Key capabilities
• Growth
• Return on capital
• Allocation of resources
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 Complexity in decision making, why?
• Uncertainty
– Possible course of action unidentifiable
– Outcome/payoff of the course of action
• Complexities/ many variables
• Limited access of information

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 Before selection of a project
• Rough estimate of the project cost
• Capability to mobilise the necessary resources
• Study about the market size & growth potential
• Availability of input and market for output
• Costs involved in production, administration &
marketing.
• Access to the technology
• Risk involved with the project

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 During the project
• Time & Cost trade-off
– PERT/CPM
• Monitoring of Capital expenditure
– Capital budgeting
• Variance & performance analysis

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 Incentive to the projects
• Govt. subsidy
– Solar
– Food processing etc.
• Incentive for EOUs/SEZ
• Incentive for Backward Areas
• Incentive for Small Scale Units

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 Project Evaluation Techniques

• Discounted Cash flow method

• Marginal costing
• Cost benefit analysis
• Risk analysis
• Probability estimates
• Simulation

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 Discounted Cash flow
• Value (intrinsic) of asset is a function of
expected cash flow of an asset.
• Assets with high & predictable cash flow have
high values.
• Cash flow is discounted with the discount rate
reflecting the riskiness of the cash flow.
• Intrinsic value means value attached to an
asset by an well informed analyst with
seamless access to all information available.
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 Discount Cash Flow (NPV)
• As per present value method, where the Value of any asset is
the present value of expected future cash flows generated by
assets.
t=n
Value =∑ CFt
t=1 (1+r)t

If the discounted cash flow is more than the cost of project then
project is acceptable.

where,
• n = Life of the asset
• CFt = Cash flow in period t
• r = Discount rate reflecting the riskiness of the estimated cash
flows
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 Discount Cash Flow (NPV)
• Care must be taken for projecting
– Cash flow
– Growth
– Discounting rate (Cost of capital)

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 Discount Cash Flow (NPV)
• Growth
– Growth depends on return on assets and
retention ratio.
– Stable or high growth?
• For a firm which have growth rate more than the
growth rate of economy then two stage DCF model
should be adopted

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 Growth rate
Growth i.e. g= b*ROE
• Where b= retention ratio
• ROE=return on equity
or g=b* [ROA+D/E{ROA-i(1-t)}]
Where ROA is return on assets.
D/E is debt equity ratio.
Nominal growth rate=(1+Real growth rate)(1+inflation rate)-1

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 Discount Cash Flow (NPV)
• Discounting rate
– Cash flow is discounted with Cost of Capital
– Cost of capital or WACC

– WACC=Ke*E + Kd*D
E+D

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 Cost of Equity: Ke
• The cost of equity is the rate of return that
shareholders expect to get on equity
investment. There are two approaches to
estimating the cost of equity.
– risk and return model (CAPM,APM).
– dividend-growth model.

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 Cost of Equity: Ke
• As per CAPM
Ke= Rf + β(Rm-Rf)
Where Rf = risk free rate of interest
(The long-term government discount bond rate is the appropriate risk free rate)

β = risk (non diversifiable)

Rm= expected market return.

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 Cost of Equity: β
• Beta is a non-diversifiable risk and it depends
on
– Type of business.
– Operating leverage.
– Financial leverage.

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 Βeta (Risk)
• Unlevered beta is also called as firm’s beta.
• Levered beta is called as equity beta.
• Beta levered = Beta unlevered [1+ (1-t) D/E]
• As per equation of a straight line :
Firm’s return= a + slope(risk)* (market return)
• β= ∑xy- n * mean of x * mean of y
∑ X2 – n * (mean of x)2
• Beta =Cov (x,m)
Var m

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• Firm with same cash flow but lower standard
deviation or coefficient of variation will be
preferred.

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The journey begins
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