Chapter 5

Project Appraisal
(Project Evaluation
Techniques)
Contents
Non-discounting methods
⚫ Ranking by inspection
⚫ The payback period
⚫ Proceeds per unit of outlay
Discounting methods of project selection
⚫ The Net present Value (NPV)
⚫ The internal rate of return of a project (IRR)
⚫ Discounted payback period (DPP)
Introduction
⚫There are two types of measures of project appraisal
techniques: undiscounted and discounted.
The basic underlying difference between these two lies in
the consideration of time value of money in the project
investment.

⚫Undiscounted measures do not take into account the

time value of money, while discounted measures do.

3
Introduction
⚫ Many economic decisions
(for example: fish production involves benefits and costs
that are expected to occur at future time period).
The construction of ponds, and fish tank, for example, requires
immediate cash outlay, and the production and sale of fish, will
result in future cash inflows or returns

⚫ In order to determine whether the future cash inflows

justify present Initial investment, we must compare
money spent today with the money received in the
future.
 Introduction
The time value of money influences many production decisions. Everyone prefers
money today to money in the future.

The preference for the Birr now instead of a Birr in the future arises from three basic
reasons:

Uncertainty - Influences preferences because one is never sure what will take place
tomorrow.

Reinvestment-The sooner you get the birr back, the sooner you can reinvest it and
earn a positive return;

Inflation - affects the purchasing power of the money.

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A. Inspection by ranking
B. Payback period
C. Proceeds per unit of outlay

6
 A. Ranking by inspection
⚫ By this, the assessor will be interested in the
Investment cost of the project and its cash flow patterns. For
example cash flows of hypothetical investments
Net cash proceeds per year (Birr)
Investment Initial cost (Birr)
Year 1 Year 2

A 10,000 10,000 -

B 10,000 10,000 1,100

C 10,000 3,762 7,762
D 10,000 5,762 5,762
Ranking by inspection
1. Two investments have identical cash flows
⚫ investment B is better than investment A, because all
factors are equal except that B continues to earn
proceeds after A has been retired.
2. Two investments have the same initial outlay and the
same earning life and earn the same total proceeds.
⚫ Thus, investment D is more desirable than investment C

The deficiency of this method:

⚫ It does not take into account the timing of the proceeds

8
B. Payback period (PBP)
⚫ the length of time required to recover the initial
investment
using project cash flows, PBP answers the question
‘how long will it take the project to pay back its cost
(initial investment)?'

⚫ Among alternative projects, the one with the shortest

payback period is more desirable .

Decision Rules:
If payback < acceptable time limit, accept
project
If payback > acceptable time limit, reject project
9
For a project with equal annual receipts

Years 0 1 2 3 4 5

Project A 1,000,000 250,000 250,000 250,000 250,000 250,000

For a project with equal annual receipts (cash inflows):

Payback period= Initial investment/Annual cash flow
PBP= 1,000,000/250,000= 4 years.

10
For non-uniform cash flows, the payback period is computed as
follows/

Years 0 1 2 3 4
Project B 10,000 5,000 2,500 4,000 1,000

PBP = year before full recovery + Unrecovered cost

Annual flow during the next year

• Payback period lies between year 2 and year 3.

• At the end of year 2, the remaining amount to be collected= 2,500.
• This means (2500/4000) = 0.625 or 62.5 % of the time is required to gain a
financial return equal to the original investments.

= 2.625 years or 2 years and (.625 * 12 months)= 2 years and 7

months 11
Example: Computing Payback

Capital Budgeting Project

Ye a r CF Cum. CFs
0 $ (165,000) $ (165,000)
1 $ 63,120 $ (101,880)
2 $ 70,800 $ (31,080)
3 $ 91,080 $ 60,000

Payback = year 2 +
+ (31080/91080)

Payback = 2.34 years

Do we accept or reject the project?

8-12
Advantages of Payback

⚫ It is simple to calculate.

⚫ It is helpful in weeding out risky projects

⚫ The pay back period is sometimes used

by investors who are short of cash and
need to reinvest all cash flows that occur
in early stages of the projects.

13
Disadvantages of Payback

⚫ It ignores the time value of money.

⚫ It may divert attention from profitability

⚫ It lacks objective measure that constitutes

an acceptable payback period.

⚫ It overlooks cash flows beyond the payback

period.

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 C. Proceeds per unit of outlay
⚫ This is the ratio of the net value of production (proceeds) to the total
volume of the capital invested.
Ranking by proceeds per unit (a Birr) of outlay
Investment Investment Proceeds per
project Total proceeds outlay Birr of outlay Ranking

A 10,000 10,000 1.0 4

B 11,100 10,000 1.11 3
C 11,524 10,000 1.15 2
D 11,800 10,000 1.18 1

⚫ The deficiency of this method:

It does not take into account the timing of the proceeds
i. NPV
ii. DPP
iii. IRR

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Discounting
⚫ Discounting: The process of converting future
benefits and costs/cash fl ows into today’s birr.
The recognition that a future payoff amount is
worth something less than that amount today.

• Discount rate: the interest rate used in the

discounting process, reflecting the time value
of money.
It is set by Central Authority (for instance, MOFED in
Ethiopia)

It has been estimated to be in the range of 9.96 -

10.49 percent with an average percentage figure of
10.23.

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Time value of money
⚫ The Discounted Cash Flow (DCF) methods take time value of
money into account
the value of money will change over time.
⚫ All other things being constant, a birr received soon is worth
more than a birr we will receive in the distant future
⚫ This is true for three different, yet related reasons
• Risk/uncertainty
• Reinvestment-the sooner you get the birr back, the sooner you can
reinvest it for a profit
• Inflation, the birr we receive in the distant future
will have
proportionately less buying power than it does today.
⚫ In project management, the time value of money
is a foundational element for financial analysis
i. Net present value (NPV)
⚫ NPV is the sum of the present values of all the positive cash flows
minus the sum of the present values of all the negative cash flows.
⚫ Interpretation
NPV measures the net contribution of the project to investors
wealth
CF2

CF1

CF4

t=0 t=3
t=0 t=3
t=1 t=4 t=4
t=1 t=
t=2
2
r = req’d return
–CF3
NPV0 = ?
Initial Outlay0
NPV
⚫ All future cash flows should be discounted into present
values. The discounting factor is:

⚫ Assume that a given project has a life of five years & a

discount rate (r) of 8% is used.
⚫ For example, the discounting factor for year 3 (i.e. t=3) is
calculated as follows:
NPV calculations - example, r = 8%
Question: Compute the NPV for project A and Project B
Cash flows Cash flows
Year Project A Project B
0 (120,000) (75,000)
1 40,000 5,000
2 25,000 70,000
3 70,000 45,000
4 130,000 30,000
5 80,000 5,000
 Solution
Year Project A Discount Factor Discounted Cash Flow

-120,000
= -120,000
0

1 40,000 37,037
2 25,000 21,433
3 70,000 55,568
4 130,000 95,554
5 80,000 54,447
Add them up NPV= 144,039
Project B

0 -75,000 = -75,000
1 -5,000 -4,630
2 70,000 60,014
3 45,000 35,723
4 30,000 22,051
5 5,000 3,403
Add them up NPV= 41,561
Exercise 1- for NPV
Consider the following projects (A and B)
$75,000
$45,000
$40,000
$20,000

Project A with the following cash flows:

t=0
What is its NPV? t=1 t=2 t=3 t=4

Decision? r = 10%

–$100,000

Project B with the following cash flows: $55,000

$45,000

What is its NPV? $35,000

$25,000

Decision? t=0

t=1 t=2
t=3 t=4

r = 10%
NPV
$75,000
$45,000
$40,000

Project A: $20,000

The NPV for this project is Birr 29,872.52 t=0

Decision  Accept the project. t=1 t=2 t=3 t=4

r = 10%
–$100,000

$55,000

Project B:
$45,000
$35,000
$25,000
The NPV for this project is Birr 27,783.12
t=0
Decision  Accept the project. t=1 t=2 t=3 t=4

r = 10%
–$100,000
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NPV
⚫ Where regular cash flows are expected [these are termed
as annuities], the above expression can be reduced to:

⚫ Exercise 2 for NPV: Compute the NPV for the

following three project alternatives at 3%, 5% and 8%
discount rates.
Projects X Y Z
Costs -Initial investment 10,380 10,380 10,380
Project life span (years) 5 15 25
Annual Benefits 2,397 1,000 736
NPV
⚫ Net present value is expressed in terms of money, and it
represents the wealth that any single project is expected to
return to the company.
This wealth typically comes in the form of either making or
saving money.
⚫ In other words, a project with +ve NPV has the ability to
accomplish three things:
o covers its own operating and financing costs
o provides an additional return to shareholders, and
o accumulates wealth for the investors.
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Rationale for the NPV Method
NPV = PV cash inflows – PV cash outflows
⚫NPV = net gain in shareholder wealth
⚫If NPV = 0 → Project’s inflows are “exactly sufficient to
repay the invested capital and provide the required
rate of return”
Decision rules:
 If the NPV is +ve, accept the project
 If the NPV is -ve, reject the project.
 If the NPV is zero, indifferent to decide

27
Calculating NPVs with Excel
NPV function: =NPV(rate,CF01:CFnn) … syntax
⚫ First parameter = required return entered as a decimal (12% = 0.12)
⚫ Second parameter = range of cash flows beginning with Year 1

After computing NPV, subtract the initial investment (CF0)

A B C D
2 Required Return = 12%
3 Year CF F o rmu la Disc C F s
4 0 (165,000.00) =(-165000)/(1.12)^0 = (165,000.00)
5 1 63,120.00 =(63120)/(1.12)^1 = 56,357.14
6 2 70,800.00 =(70800)/(1.12)^2 = 56,441.33
7 3 91,080.00 =(91080)/(1.12)^3 = 64,828.94
8 12,627.41
9
10 EXCEL =NPV(D2,B5:B7) 177,627.41
11 NPV + CF0 12,627.41
Advantages of NPV
• Time value of money
• The cash flows
• It focuses on the profitability of the project.
• Useful for the comparison and selection from
among mutually exclusive projects or when capital
rationing is used.
• It discounts cash flows by the cost of capital
• the managers can understand it more easily

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Disadvantages of NPV
If the investments are different, deciding the desirability of the project
based on the NPV will be misleading.
⚫ We have learnt that NPV tells us ‘how much birr is the net result of the
project’ but it does not tell us if this amount is the outcome of a big
effort or a small one.
Example:
⚫ For Project A:
NPV= 10; {B-C=110-100=10]

Big differences in investment amount

⚫ For Project B:
NPV=15; [10,015-10,000=15]
The cost of capital is assumed to remain constant throughout the life of the
project.
ii. Discounted Payback Period
⚫ This improves upon the payback period by
taking into account the time value of money.

⚫ A project’s DPP is the number of years it takes

for the net cash flows’ present values to pay
back the net investment.

⚫ Again, shorter paybacks are better than longer

paybacks.
Example of Discounted Payback Period
⚫ We need a required rate of return for the computation.
Let’s use 10%.
Year CF (Birr)
0 -200,000
1 70,000
2 70,000
3 70,000
4 70,000
5 70,000
Discounted Payback Period
Year CF (Birr) PV of CF (Birr) Cumulative (Birr)
0 -200,000 -200,000 -200,000

1 70,000 63,636 -136,364

2 70,000 57,851 -78,513

3 70,000 52,592 -25,921

4 70,000 47,811

5 70,000 43,463

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Discounted Payback Period
⚫ The DPP will be 3 years plus whatever proportion of
year 4 is needed to pay back the final Birr 25,921.

25,92
DPP  3 1 47,811 
3.54
⚫ The discounted payback is 3.54 years.
⚫ This project recovers its net investment in 3.54 years
when considering the time value of money.
Discounted Payback Period
The DPP is an improvement upon the payback period
in 2 ways:
⚫ The DPP takes into account the time value of
money.
⚫ There is an objective criterion for an acceptable
DPP if a project has normal cash flows.
⚫ Under these circumstances a project is acceptable
if the DPP is less than the economic life of the
project.
Discounted Payback Period-Exercise

What is the DPP period given the discount rate of 10%

Project Year Cash flow (in Birr)

0 -10000
1 5000
2 6000
3 8000
4 7000
5 6000

46
Discounted Payback Period-
Exercise
What is the discounted Payback period?
PV of Birr Cumulative cash
Project Year Cash flow 1 at 10% PV of cash flow savings
0 -10000 1.000 -10000 -10000
1 5000 0.909 4545 -5455
2 6000 0.826 4956 -499
3 8000 0.751 6008 5509
4 7000 0.683 4781 10290
5 6000 0.621 3726 14016

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 Quick Quiz Q1

Assume that a minimum of 10 percent return is required and select

the best project alternative using:
A. Payback period
B. NPV
C. IRR
Expected financial Return (in Birr)
year Project A Project B Project C
0-Investment (1,000) (1,000) (1,000)
1 300 1,500 525
2 300 250 525
3 300 250 525
4 300 250 525
5 1,500 250 525
Total 1,700 1,500 1,625
Solution
⚫ Net Present Value, Internal Rate of Return, and Payback Methods

Ranking method Project A Project B Project C

Pay back 3 years &4 months 8 months 1year & 11 months

NPV 882.34 1,084.06 990.16

IRR 32% 79% 44%

⚫ Project B would appear to be the most financially favorable project.

⚫ Project A now becomes the least favorable project, with the lowest
net present value at Birr 882.34 and lowest internal rate of return
at 20 percent.
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iii. IRR: Definition and decision rules
Definition:
⚫ IRR = discount rate that makes the NPV = 0

Decision Rules:
• If IRR > cost of capital, accept the project
• If IRR < cost of capital, reject the project
• If IRR = cost of capital, be indifferent.

8-31
NPV vs. IRR
NPV: Enter r, solve for NPV
n
CFt

t 0 (1 r)
t
 NPV

IRR: Enter NPV = 0, solve for IRR.

n
CFt

t 0 (1 IRR)
t
0
Internal Rate of Return: Calculation

Then solve for r = IRR

The value of r in the equation where the cash inflows and the
investment outlay is zero is known as the IRR.

Example 1: Compute IRR

Period 0 1 2 3
CF -2000 2400 0 0

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IRR – Using the NPV curve
One of the most sophisticated project appraisal
techniques and also more difficult to calculate.
⚫ Trial and error

The NPV curve

⚫ A number of NPVs are calculated using
different discount rates.
⚫ These NPVs are plotted on a graph to
calculate
IRR. The IRR on the graph the X
intercept. 34
The NPV Curve
⚫ a chart that shows how the project's NPV varies with changes in
the discount rate.
⚫ consider the following net cash flow stream (where all cash flows
are in units of birr) for seven points in time, with year 0 being
'now'.
Option-I Year 0 1 2 3 4 5 6
Net CF -1000 200 200 200 200 200 200

⚫ At a discount rate of 5%, the NPV of this stream of cash flows

would be Birr 15.10.
⚫ Now vary the discount rate (r) in small steps over the interval
from 0 to 0.1 (0% to 10%), obtain the NPV at each of these
intervals, and then plot NPV (on the Y axis) against r on the (X-
axis).
⚫ It should resemble the following chart.
The NPV Curve The project IRR = 0.0547

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Calculating IRR with Excel
⚫ Calculating Internal Rate of Return (IRR) can be
tedious if you have multiple cash flows periods to
work with.
⚫ Fortunately, Microsoft Excel make the process
amazingly simple.
⚫ Start with the cash flows as you did to solve
for NPV
⚫ Use the IRR function:
Enter the range of cash flows, beginning with the
initial cash flow (Cash flow 0)
Calculating IRR with Excel
A B C
1 IRR
2 Year CF
3 0 (165,000.00)
4 1 63,120.00
5 2 70,800.00
6 3 91,080.00
7
8 EXCEL =IRR(B3:B6) 16.13%

8-38
Comparison of IRR & NPV
⚫ IRR is easier to understand by a wider community,
since it states yield in terms of %.
⚫ NPV directly measures the increase in value to
the firm
NPV approach requires a discount rate, which may not
always be possible.
⚫ While NPV is a absolute measure, IRR is a relative
measure.
Whenever there is a conflict b/n NPV and IRR always
use NPV.
Advantages of IRR
• the time value of money
• the total cash flows during the project life provide
direct message about the yield on the project.

Disadvantages of IRR
• it involves tedious work interpolation
• the IRR does not reflect the scale, or Birr/dollar size
• all proceeds are reinvested at the particular IRR,
• if there are non-conventional cash flows, it can
produce multiple rates.
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