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PROJECT PLANNING AND ANALYSIS
 
 
 CHAPTER 5. MEASURE OF PROJECT WORTH
 
PREPARED BY: ABDI SHAKUR M. HUSSEIN ELMI
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INTRODUCTION

 A wide range of criteria have been suggested for choosing investment proposals, which are suitable for both
financial and economic analysis. These criteria may be classified into two categories:
1. Non-discounting criteria:
A. Urgency
B. Payback period;
C. Accounting rate of return.
2. Discounting criteria:
A. Net present value/NPV/
B. Internal rate of return/IRR/
C. Discounted benefit-cost ratio
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D. Profitability index.
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Non-Discounted Measures of Project Worth

1. Ranking by Inspection: It is possible, in certain cases, to determine by mere inspection

which of two or more investment projects is more desirable. There are two cases under which
this might be true.
A. two investments have identical cash flows each year up to the final year of the short-lived
investment, but one continues to earn cash proceeds (financial results or profits) in
subsequent years. The investment with the longer life would be more desirable

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 project B is better than investment A, since all things are equal except that B continues to
earn proceeds after A has been retired.
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B. Two investments have the same initial outlay (same earning), but one project has more of the
flow earlier in the time sequence, we choose the one for which the total proceeds is greater
than the total proceeds for the other investment earlier.
• Thus investment D is more profitable than investment C, since D earns 2000 more in year 1
than investment C.

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2. Urgency: According to this criterion projects which are deemed to be more urgent get
priority over projects which are regarded as less urgent.
 The problem with this criterion is: How can the degree of urgency be determined?
3. The Payback Period: Is length of time required for the stream of cash proceeds produced by
the investment (project) to be equal to the original cash outlay required by the investment
(capital investment). Or It is the period of time that the investor recovers its initial total
outlay.

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 Example: if a project requires an original outlay of 300 and is expected to produce a stream of
cash proceeds of 100 per year for 5 years, the payback period would be 300/100 = 3 years
 Example: consider project C. 10,000 - 3762 = 6238. Then 6238/7762 = 0.8 So the pay back
period is 1.80 years.
 Exercise: consider the previous irrigation project calculate payback period of project A, B and
D.

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 Payback period Limitations:

o It fails to give any considerations to cash proceeds earned after the payback date.
o It fails to take into account differences in the timing of receipts and earned proceeds prior to
the payback date.
4. Proceeds per Unit of Outlay: According to this method investments are ranked according to
their total proceeds divided by the amount of the corresponding investments.

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 Accordingly project C and D must be implemented. However, both projects are given the same
rank. Although we know by inspection that project D is superior because D generates 2000 of
proceeds in year 1.
 This method is again deficient because it still fails to consider the timing of proceeds
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5. Output - Capital Ratio: It is defined as the average (undiscounted) value added produced per
unit of capital expenditure.
 Under this criterion we select the project with the highest output capital ratio or the lowest
capital output ratio (capital coefficient).
 The main problem with this approach is that it ignores other factors of production such as
labour and land and concentrates only on the productivity of capital.
 Also it does not consider the timely spread of costs and proceeds.

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6. The average annual proceeds per unit of outlay: This is similar to the proceeds per unit of
outlay except that the average proceeds per year is expressed as a ratio of the original
investment.
 Example:

 We know hat project D is superior to c although this method gives them equal ranks. 9/13/21
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 investment A and B are also incorrectly ranked by ranking A above B in spite of the fact that
the latter is obviously superior.
 One of the problems of this method fails to take properly into considerations the timing of
proceeds and exhibits a built in bias for short-lived investment with high cash proceeds.
7. Average Income on the Book Value of Investment: This is the ratio of the income to the
book value of its assets. The value of assets as recorded in the operation’s financial account
books.

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 DISCOUNTED PROJECT ASSESSMENT CRITERIA AND 13
DISCOUNTING FUTURE INCOME FLOWS IN PROJECT
ANALYSIS

First: Discounting Future Income Flows:

 Time Preference: undiscounted measures fail to take into account adequately the timing of
benefits and costs( Time preference). It is an accepted principle in economics that inter-
temporal variations of costs and benefits influence their values and a time adjustment is
necessary before aggregation.
 Before the selection of projects it is necessary to address the problem of the differences in the
timing of a project’s costs and benefits. Because
 The costs and benefits of a project occur over a number of years, they will not be directly
comparable.

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 Why people, enterprises and governments prefer receive income sooner rather than later (Time
preference)? Some of the main reasons people will prefer to have income now rather than in the
future include the following:
1. There is an expectation that society and individuals will be better off in the future than they are
now.
2. One may expect inflation to reduce the real value of money in a year’s time.
3. If there is no inflationary effect it would still be preferable to take the money today and invest it
at some rate of interest.
4. Uncertainty about the future: people cannot be sure that they will be alive in years of time to
collect their money. They may also be uncertain about whether they really will be paid the
money after years of time, as many factors may change over such a period. 9/13/21
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 The marginal rate of time preference (MRTP): MRTP find out how much more income will
individuals need to receive in the future to make them indifferent to receiving this amount later
rather than a given amount of income in the present.
 If a person is indifferent to receiving 10$ now rather than 11$ in 12 months time, then MRTP
one year from now equal 0.1 per annum. This is calculated from (11$ – 10$)/10$.
 MRTP in one years from now is: 11 *(1+0.1) Equal 12.1
 MRTP is said to be r, an can be calculated using he following formula: 1 *(1+r) n

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 Discounting Process: Discounting is

o A technique or a process by which one can reduce future benefits and costs to their present
worth or present value.
o Is method used to revalue future cost and benefit flows from project into present day values so
that they are comparable and can be added together.
 The factor used to discount future costs and benefits is called the discount rate, and is usually
determined by the central authorities (national Bank).
 Discounting rate or discount factor tells us how much money at a future date is worth today at
a certain discount rate.
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 Present value formula:

 Also PV formula can be written as follows:

 Discount factor formula:

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 The following example demonstrates the undiscounted and discounted cost and benefits,
discount factor and net present value.

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 How to set the discounting rate, r ? Discount rate is determined by the central bank, also
discount rate can be determined by capital markets.

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Discounted Project Assessment Criteria

 Net Present Value (NPV): The NPV is defined as the difference between the present value of
benefits and the present values of costs.
 Net Present Value Formula:

Where:
 Bt stands for the project benefits in period t
 Ct stands for the project costs in period t
 r, stands for the appropriate financial or economic discount rate
 n, stands for the number of years for which the project will operate. 9/13/21
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 NPV – Decision Rule: The decision is to accept all the project that NPV ≥ 0.
 Example 1: Consider the following Discounted Cash Flows for a Fertilizer Project:

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 Since discounting the cash flow at 10 percent produces a positive NPV of 4.57, we conclude
that the project should be undertaken.
 Suppose now that the cost of capital were to be raised to 20 percent, the project produces a
negative NPV of 3.21 .
 In this event the project would have to be rejected. This shows that the NPV is critically
dependent upon the level of the discounting rate, r.

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 Example 2: What would be the present value of 1000 $ received five years in the future
assuming a 9 percent discount rate?
 We consider the discount factor for the 5th period under the 9 percent table. The discount
factor is 0.6499. Then we multiply the amount due by the discount factor.
1000 * 0.6499 = 649.90$
 Example 3: What would be present value of a stream of income of 5000$ received each year
for nine years assuming a discount rate of say 10 percent?
5000 * 5.759 = 28795
 NPV Using Excel Function= initial investment + NPV (interest rata, cash flow)
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 Practical application for the present value method: The following assumptions are required
for practical application for the NPV:
1. Outlays and receipts from each investment are known for the entire life of the project.
2. The project life span is known.
3. There is a rate of discount, which can be applied to every proposal and for every tie period.
o However, the information required (the assumptions) made above is not always available for
every project. That means the NPV criterion may be applicable only to a limited number of
project

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 Advantages of NPV Approach: The major advantage of the NPV are

1. it is simple to use and does not rely on complex conventions about where costs and benefits
are netted out, as do some ratio measures.
2. it is the only selection criteria that can correctly be used to choose between mutually exclusive
projects
 Limitations of the Net Present Value Test:
1. Some projects could be deferred from implementation although they show positive NPVs, due
to scarcity of funds. Thus passing the NPV test may be a necessary condition but not a
sufficient condition.
2. The selection of an appropriate discount rate is another limitation. 9/13/21
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3. NPV does not show the exact profitability rate of the project.
4. For some projects the required information/data/ for computing the NPV may not be
available, or cheaply accessible.
5. It assume the same class (type and degree) of risk for both the costs and revenue sides of the
cash flow of a project.
6. When it is used to select among projects, it implicitly assumes that all projects share common
type and degree of risk.

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 The Internal Rate of Return of a Project (IRR): is the rate of discount, which makes the
present value of the benefits exactly equal to the present value of the costs.
 Internal Rate of Return formula:

 IRR -Decision Rule:

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 Calculation of IRR: Estimation the IRR for the following project,

Year 0 1 2 3 4
Cash flow 100 30 30 40 45

o The IRR is the value of r which satisfy the following equation:

30 30 40 45
100    
1  r  1  r  1  r  1  r  4
1 2 3

o r can be found through trial & error method. We try different values of r till we find that the right
hand side of the above equation is equal to 100. lets us , to begin with r= 15%. This makes the
right hand side equal to: 100.802.
o This value is slightly higher than our target value. 9/13/21
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o If we increase the value of r from 15 to 16%. The right hand side became 98.641.
o This value is slightly lower than our target value.
o What is the r that equates the right hand side to the left hand?
o NPV/15%= 802 and the NPV/16%= 1359
o 802+1359=2161
o 802/2161=0.37
o The percentage that equates the right hand side to the left hand side is 15.37%
 IRR Using Excel Function= IRR(initial _ cash flow, interest)
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 Advantages of the IRR:

1. The IRR is used in many projects
2. IRR can be calculated without predetermined discount rate.
3. It is a measure that could be understood easily by non-economists since it is closely related to
the concept of the return on investment.
4. It is a pure number and hence allows projects of different size to be directly compared.
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 Problems with the IRR:

1. The IRR is inappropriate to use for mutually exclusive projects and independent projects
when there is a single period budget constraint.
2. A project must have at least one negative cash flow period before it is possible to calculate its
internal rate of return.
3. Another problem with the IRR is that in some cases it my be possible to compute more than
one IRR for a project.
4. It is relatively complex to compute the IRR-the iterative nature of its computation.
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 Other Investment Criteria:

 The Net Benefit Investment Ratio (NBIR): It is the ratio of the present value of the projects
benefits, net of operating costs, to the present value of its investment costs. This is given by,

 NBIR- Decision Rule is to accept project when the ratio is greater than 1. NBIR>1
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 The Benefit Cost Ratio (BCR): Is ratio of the sum of the project’s discounted benefits to the
sum of its discounted investment and operating costs. This is given as,

 The Decision rule for BCR is to accept all projects that their BCR>1.
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THE END
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