Project Appraisal & Finance

Unit III Part B

Investment Criteria
Investment Criteria
 Methods
 Discounted

 NPV, NPV*
 IRR, MIRR

 Profitability Index

 Non-discounted
 Payback Period Method

 Accounting Rate of Return (ARR)

 Independent vs.
Mutually Exclusive Projects

 Projects are:
 independent, if the cash flows of one are
unaffected by the acceptance of the other.
 mutually exclusive, if the cash flows of one
can be adversely impacted by the
acceptance of the other.
NPV: Sum of the PVs of all
cash flows.
n CFt
NPV = ∑
(1 + r)t
t=0

Cost often is CF0 and is negative.

n CFt
NPV = ∑ - CF0
(1 + r)t
t=1
 Cash Flows for project L and
project S

0 1 2 3
L’s CFs: 10%

-100 10 60 80

0 1 2 3
S’s CFs: 10%

-100 70 50 20
 What’s project L’s NPV?

0 1 2 3
L’s CFs: 10%

-100 10 60 80

= NPVL
 What’s project L’s NPV?

0 1 2 3
L’s CFs: 10%

-100 10 60 80

9.09
49.59
60.11
18.79 = NPVL NPVS = $19.98.
Which project should be chosen?

• What if mutually exclusive? L or S?

• What if independent projects? L or
S?
 Using NPV method, which project(s)
should be accepted?

 If project S and L are mutually

exclusive, accept S because
NPVs > NPVL .
 If S & L are independent, accept both;
NPV > 0.
 Properties of NPV Rule

 Net Present Values are Additive.

 Intermediate cash flows are invested at cost

of capital.

 NPV Calculation permits time varying discount

rates.

 NPV of a simple project decreases as the

discount rate increases.
 Rationale for the NPV Method
 NPV = PV inflows – Cost

 This is net gain in wealth, so accept

project if NPV > 0.

 Choose between mutually exclusive

projects on basis of higher NPV. Adds
most value.
NPV with variable discount
rate
 A 5 year project with following cash
flows and discounting rates is given:
Cash Discounting
Flows Rate
(12000)
4000 14%
5000 15%
7000 16%
6000 18%
5000 20%
 NPV with variable discount
rate
 PV of C1 = 4000/1.14 = 3509
 PV of C2 = 5000/(1.14 x 1.15) = 3814
 PV of C3 = 7000/(1.14 x 1.15 x 1.16) = 4603
 PV of C4 = 6000/(1.14 x 1.15 x 1.16 x 1.18) = 3344
 PV of C5 = 5000/(1.14 x 1.15 x 1.16 x 1.18 x 1.20) = 2322

 NPV of Project = 3509 + 3814 + 4603 + 3344 + 2322 – 12000 =

Rs.5592
Problem 2
 A company is evaluating an investment
opportunity in project P and Q. Cash
flows are given below:
Year Project P Project Q
0 -110 -100
1 -70 -40
2 20 12
3 60 70
4 80 70
5 70 80
6 110 110

The rate of discounting is 10%.

NPV of P = 48.17 and NPV of Q = 85.72
 Modified NPV
 The standard NPV method is based on the
assumption that the intermediate cash
flows are re-invested at a rate of return
equal to the cost of capital.
 But actual re-investment rates are taken
into account for calculating modified NPV.
Steps to calculate MNPV
 Step 1: Calculate terminal value.
n
TV = ∑ CFt (1 + r’)n-t
t=1
Steps to calculate MNPV
 Step 2: Determine modified NPV from
TV.
TV
NPV* = - CF o
(1 + r)n
 Problem 1
 Calculate Modified NPV from following data:
Initial 110,000
Investment
Cash Inflow
Year 1 31,000
Year 2 40,000
Year 3 50,000
Year 4 70,000

The rate of discounting is 10% and re-

investment rate is 14%.
Ans: NPV* = Rs. 43,614
 Merits and Demerits of NPV
 Merits:
 It takes into account time value of money.
 Easy to calculate.

 Demerits:
 NPV is expressed in absolute terms rather in
relative terms and hence does not factor in the
scale of investment.
 NPV rule does not consider the life of a project.
 Internal Rate of Return:
IRR

0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forces

PV inflows = cost. This is the same
as forcing NPV = 0.
 NPV: Enter r, solve for NPV.
n CFt
= NPV .
∑ (1 + r)t
t=0
IRR: Enter NPV = 0, solve for IRR.
n CFt
= 0.
∑ (1 + IRR)t
t=0
Decision Rule for IRR:
Accept: If the IRR is greater than the cost of capital
Reject: If the IRR is less than the cost of capital
 What’s project L’s IRR?
0 1 2 3
IRR = ?

-100 10 60 80
PV1
PV2
PV3
0 = NPV Enter Cash Flows in CF, then
press IRR:
 What’s project L’s IRR?
0 1 2 3
IRR = ?

-100 10 60 80
PV1
PV2
PV3
0 = NPV Enter Cash Flows in CF, then
press IRR: IRRL = 18.13%.
IRRS = 23.56%.
 IRR by Short Cut method
0 -1,00,000
1 30,000
2 30,000
3 40,000
4 45,000

r = Lower rate + Difference in two rates x (PV of CI at LR – initial Investment)

(PV of CI at LR – PV of CI at HR)
 LR HR
-100000 15% -100000 16%
30000 26,086.96 30000 25,862.07
30000 22,684.31 30000 22,294.89
40000 26,300.65 40000 25,626.31
45000 25,728.90 45000 24,853.10
PV 100,800.81 PV 98,636.36
800.81 -1,363.64
IRR = 15.37%
Merits and Demerits of IRR
 Advantages
 closely related to NPV
 easy to understand and communicate
 Disadvantages
 may result in multiple answers
 may lead to incorrect decisions
 not always easy to calculate
 Modified Internal Rate of
Return (MIRR)
 MIRR is the discount rate which causes the
PV of a project’s terminal value (TV) equal
to the PV of costs.
 TV is found by compounding (FV) inflows at
the WACC.
 Thus, MIRR assumes cash inflows are
reinvested at the WACC.
 MIRR for project L: First, find
PV and TV (r = 10%)

0 1 2 3
10%

-100 10.0 60.0 80.0

10%
66.0
10%
12.1
-100 158.1
PV outflows TV inflows
 Second, find discount rate that
equates PV and TV

0 1 2 3

MIRR = 16.5%
-100 158.1

PV outflows TV inflows

$100 = $158.1
(1+MIRRL)3

MIRRL = 16.5%
 Problem
 The following cash flow are given below:
Year Project P
0 -120
1 -80
2 20
3 60
4 80
5 100
6 120
Calculate Modified IRR of the above project,
if the cost of capital is 15%.
 Solution
 Present value of Costs = 120 + 80/(1.15)
 = 189.60
 TV of Cash Inflows =
20(1.15)^4 + 60(1.15)^3 + 80(1.15)^2 +
100(1.15)^1 + 120 = 467

189.6 = 467 /(1+MIRR)^6

MIRR = 16.2%
 Why use MIRR versus IRR?
 MIRR correctly assumes reinvestment at
opportunity cost = WACC. MIRR also
avoids the problem of multiple IRRs.
 Managers like rate of return
comparisons, and MIRR is better for this
than IRR.
Benefit Cost Ratio or
Profitability Index
 Benefit cost ratio: BCR = PVB / I
 It helps in discriminating between large
and small projects.
 When BCR
 >1 Accept
 =1 Indifferent
 <1 Reject
Payback Period Method
 The number of years required to
recover a project’s cost,

 or how long it takes to get the

business’s money back.
What is the payback period?
0 1 2 3

-100 50 50 50
What is the payback period?
0 1 2 3

-100 40 40 40
 What are the payback periods
for projects L and S?

0 1 2 3
L’s CFs: 10%

-100 10 60 80

0 1 2 3
S’s CFs: 10%

-100 70 50 20
 Payback for project L

0 1 2 2.4 3

CFt -100 10 60 80
Cumulative -100 -90 -30 0 50

PaybackL = 2 + 30/80 = 2.375 years

 Payback for project S

0 1 1.6 2 3

CFt -100 70 50 20

Cumulative -100 -30 0 20 40

PaybackS = 1 + 30/50 = 1.6 years

Strengths and Weaknesses of
Payback
 Strengths:
 Provides an indication of a project’s risk
and liquidity.
 Easy to calculate and understand.
 Weaknesses:
 Ignores the TVM.
 Ignores CFs occurring after the payback
period.
 Accounting Rate of Return
 It is a measure of profitability which relates
income to investment, both measured in
accounting terms.
 Uniform Annual Equivalent
 For mutually exclusive projects with
unequal life, UAE approach is used.
 UAE is a function of present value of costs,
the life of the asset and the discount rate.
PV Cost
UAE =
PVIFAr,n
Where, PVIFAr,n means Present Value Interest
Factor for Annuity.
Sample Problem 1
 Suppose a firm has to choose between
two machines: Machine A and Machine
B.
 Machine A costs Rs 75,000 and lasts for
5 years. Its annual operating cost will
be Rs 12,000. Machine B, costs
Rs50,000 but last for 3 years. Its annual
operating costs would be Rs20,000.
 The discount rate is 12%.
 Sample Problem 2
 The initial outlay on an internal transportation
system would be Rs15,00,000. The operating
costs are expected to be as follows:
Year Operating Costs
1 3,00,000
2 3,60,000
3 4,00,000
4 4,50,000
5 5,00,000

 The estimated salvage value at the end of five

years is Rs3,00,000. What is the UAE if the cost
of capital is 13%.
Solution