1 Project Appraisal

Project Appraisal (A Preliminary Analysis)
Project Appraisal can be divided into two broad categories.

1. Undiscounted Measures
2. Discounted Measures
1. Undiscounted Measures:
Undiscounted measures can be further divided into the
following measure.
I. Payback Period
II. Accounting Rate of Return (AROR)
III. Book Rate of Return (somewhat similar to AROR)
IV. Decision Making Under Uncertainty
(case of perfect certainty, uncertainty)
(single parameter criteria vs two parameter criteria)
(simple two parameter criteria, refined two parameter criteria,
1
utility based decisions and their pros and cons, stochastic
dominance etc.)
Project Appraisal (A Preliminary Analysis) Cont.
2. Discounted Measures:
I. Discounted Payback Period
II. Net Present Value(NPV)
III. Internal Rate of Return(IRR)
IV. Benefit Cost Ratio/ Profitability Index
V. Project Appraisal for interactive projects
(ME, Independent, different time horizon etc.)
1. Undiscounted Measures:
Whenever we want to start a new project we have to check
either it is worthwhile to undertake the project or not. That’s
why we want to discuss the following Undiscounted measures.
These measures ignores the discounted value of the future cash
flows. 2
I. Payback Period:
“The period of time required to recover the initial investment”.
• One of the simplest and oldest investment appraisal
techniques is the payback period.
• The payback technique states how long does it take for the
project to generate sufficient cash flow to cover the initial cost
of the project.
For Example, in case of uneven cash flows we have the
following information:
XYZ Org. is considering two projects costing $100,000.
There are two options Project A and Project B.
Project A will generate revenue of $ 50,000, $ 50,000 & $ 20,000
in year 1, year 2 & year 3 respectively.
Project B will generate revenue of $ 30,000, $ 40,000 & $ 60,000
in year 1, year 2 & year 3 respectively.
3
Payback period is 2 years & 2.5 years for Project A & Project B
respectively.
Formula for Payback Period (for uneven cash flows):
P= # of years prior to the full recovery + ((Leftover amount or unrecovered
cost at the start of the final
recovery year) /
proceeds during the final recovery
year)
Example 2
An investment of $200,000 is expected to generate the following cash
inflows in six years:
Year 1: $70,000
Year 2: $60,000
Year 3: $55,000
Year 4: $40,000
Year 5: $30,000
Year 6: $25,000 4
Required: Compute payback period of the investment. Should the
investment be made if management wants to recover the initial
Payback period = 3 + (15,000*/40,000)

= 3 + 0.375
= 3.375 Years
*Unrecovered investment at start of 4th year:
= Initial cost – Cumulative cash inflow at the end of 3rd year
= $200,000 – $185,000
= $15,000 5
The payback period for this project is 3.375 years which is longer than the
maximum desired payback period of the management (3 years). The
Payback Period Formula for Even Cash Flows
*The denominator of the formula becomes incremental cash flow if

an old asset (e.g., machine or equipment) is replaced by a new one.
For Example:
• If our project require the purchase of a machine of $ 25,000
• Life of machine is 10 Years
• Expected annual benefits are $10,000
Required: Compute payback period of machine and conclude
whether or not the machine would be purchased if the maximum
desired payback period of our company is 3 years.
Payback period = $25,000/$10,000
= 2.5 years 6
According to payback period analysis, the purchase of machine X is
desirable because its payback period is 2.5 years which is shorter than
Example 2: Due to increased demand, the management of IIUI is
considering to construct new blocks to increase the enrolment and
revenues. The useful life of the buildings is 50 years and the
institution’s maximum desired payback period is 10 years. The inflow
and outflow of cash associated with the new buildings is given below:
Initial cost of Buildings = Rs. 3.75 Billion
Annual cash inflows from fee collection = Rs. 800 Million
Annual cash Outflows:
Cost of wages and salaries: = Rs. 300 Million
Expense for utilities = Rs. 100 Million
Maintenance expenses = Rs. 15 Million
Non cash expenses:
Depreciation expense: = Rs. 75 Million
Required: Should IIUI construct the new Buildings? Use payback 7
method for your answer.
Solution:
Step 1: In order to compute the payback period of the block, we need to
workout the net annual cash inflow by deducting the total of cash
outflow from the total of cash inflow associated with the building`.
• Computation of net annual cash inflow:
Rs. 800 Million – (Rs. 300 Million+ Rs. 100 Million + Rs. 15 Million)
= Rs. 385 Million
Step 2: Now, the amount of investment required to construct the
buildings would be divided by the amount of net annual cash inflow
(computed in step 1) to find the payback period of the buildings.
= Rs. 3,750 Million / Rs. 385 Million
= 9.74 years
Note that the depreciation is a non-cash expense and has therefore
been ignored while calculating the payback period of the project.
Ans: According to payback method, the buildings should be purchased 8
because the payback period of the equipment is 9.74 years which is
shorter than the maximum desired payback period of 10 years by the
Comparison of two or more alternatives – choosing from several
alternative projects:
• If funds are limited and several alternative projects are being
considered, the project with the shortest payback period is preferred.
It is explained with the help of the following example:
Example 3:
• The management of IIUI wants to reduce its labor cost by installing a
new machine. Two types of machines are available in the market –
machine X and machine Y. Machine X would cost $18,000 where as
machine Y would cost $15,000. Both the machines can reduce annual
labor cost by $3,000.
• Required: Which is the best machine to purchase according to payback
method?
Solution:
• Payback period of machine X: $18,000/$3,000 = 6 years 9
• Payback period of machine Y: $15,000/$3,000 = 5 years
Ans: According to payback method, machine Y is more desirable than
Advantage of Payback Period:
1. Easy to understand and implement/calculate/compute.
2. Even a layman can understand it.
3. An investment project with a short payback period promises the quick inflow
of cash. It is therefore, a useful capital budgeting method for cash poor firms.
4. A project with short payback period can improve the liquidity position of the
business quickly. The payback period is important for the firms for which
liquidity is very important.
5. An investment with short payback period makes the funds available soon to
invest in another project.
6. A short payback period reduces the risk of loss caused by changing economic
conditions and other unavoidable reasons.
Disadvantages of Payback Period:
7. Ignores the Time Value of Money
8. Ignores the cash flows after the payback point.
II. Accounting Rate of Return (AROR):
10
A calculation of the anticipated net profit from an investment in an asset or
project, expressed as a percentage of the money invested.
AROR= Average Annual Profit / Average Annual Investment
II. Accounting Rate of Return (AROR) Cont.:
A calculation of the anticipated net profit from an investment in
a project, expressed as a percentage of the money invested.
• It is the net accounting profit from the investment in a project
expressed as a percentage of the average capital investment.
For Example,
• XYZ Org. is looking to invest in machinery to replace its current
machinery.
• The new machine, which costs $ 420,000, would increase annual
revenue by $ 200,000 and annual expense by $ 50,000. The
machine is estimated to have a useful life of 12 years.
• Depreciation expense per year = $ 420,000/ 12 = $ 35,000
• Increase in average annual profit = $ 200,000 – ( $ 50,000 + $
11
35,000) = $ 115,000
• Initial investment = $ 420,000
III. Book rate of Return (somewhat similar to AROR):
In order to calculate the shareholders’ return we have to use
BROR.
BROR= (Book Income/ Book Assets)
IV. Decision Making Under Uncertainty:
(case of perfect certainty, uncertainty)
(single parameter criteria vs two parameter criteria)
(simple two parameter criteria, refined two parameter criteria,
utility based decisions and their pros and cons, stochastic
dominance etc.)
12
Project Appraisal (A Preliminary Analysis)
In order to evaluate a project we may face two different scenarios
i) Perfect Certainty
ii) Uncertainty
• In case of perfect certainty single parameter criteria is used (based
on maximization of return).
• In case of uncertainty usual single parameter criteria does not work.
• Under uncertainty we use simple two parameter criteria and refined
two parameter criteria.
• In simple two parameter criteria in addition to Monitory reward we
have to consider uncertainty associated with such a reward.
13
Simple two Parameter Criteria
Expected Value of X = Expected Value of Y E(X) = E(Y) &
Standard Deviation of X < Standard Deviation of Y <
Then X is preferred over Y
Expected Value of X > Expected Value of Y E(X) > E(Y) &
Standard Deviation of X = Standard Deviation of Y =
Standard Deviation of X > Standard Deviation of Y >
14
Simple two parameter criteria failed
Simple two Parameter Criteria
Then Y is preferred over X
Expected Value of X < Expected Value of Y E(X) < E(Y) &
Standard Deviation of X = Standard Deviation of Y =
Simple two parameter criteria failed 15
Refined two Parameter Criteria
Coefficient of Variation of X > Coefficient of Variation of Y >
Coefficient of Variation of X = Coefficient of Variation of Y =
Coefficient of Variation of X < Coefficient of Variation of Y <
Even refined two parameter criteria failed
16
Refined two Parameter Criteria
Coefficient of Variation of X = Coefficient of Variation of Y =
Even Refined two parameter criteria failed 17
Projects
Situations Prob. Cement Co. A Pharma B Cosmetics C Covid Vex. D Tourist E
Covid 0.5 - (5,000,000.00) 10,000,000.00 50,000,000.00 10,000,000.00
Recovery 0.5 10,000,000.00 15,000,000.00 30,000,000.00 - 50,000,000.00
Expected Return 5000000 5000000 20000000 25000000 30000000
Variance 25000000000000 100000000000000 100000000000000 625000000000000 400000000000000
Standard Deviation 5000000 10000000 10000000 25000000 20000000
CV 1.000 2.000 0.500 1.000 0.667
18
Comparison of Five Different Projects
1. Cement Co. A VS Pharma B STPC Cement Co. A is
preferred
2. Cement Co. A VS Cosmetics C STPC We can’t decide!
3. Cement Co. A VS Covid Vex D STPC We can’t decide!
4. Cement Co. A VS Tourist E STPC We can’t decide!
In such a case we have to use refined two parameter criteria.
2. Cement Co. A VS Cosmetics C RTPC Cosmetics C is
preferred
3. Cement Co. A VS Covid Vex D RTPC Covid Vex D is
preferred
4. Cement Co. A VS Tourist E RTPC Tourist E is preferred
More Interesting Comparisons:
5. Cosmetics C VS Covid Vex D Both STPC and RTPC failed
6. Cosmetics C VS Tourist E Both STPC and RTPC failed 19
(in such a case even a layman can decide). Therefore we have to
discuss some other undiscounted measures
Utility Based Appraisal
In case if we are not in a position to decide on the
basis of single parameter criteria or simple two
parameter criteria or even refined two parameter
criteria then what should we do?
• In such a case we have a number of alternatives
the most simplest one is based on the utility.
• Therefore, now we will discuss Utility based
approach.
• A Sure/guaranteed return/reward/money will
worth more than an uncertain/risky
return/reward/money.
20
• What is a utility function?
Cosmetics C Tourist E
Utility 3,162.28 3,162.28
Utility 5,477.23 7,071.07
E(U) 4,319.75 5,116.67
Cosmetics C Covid. Vex. D
Utility 3,162.28 7,071.07
Utility 5,477.23 0
E(U) 4,319.75 3,535.53
21
Criticism of Utility Based Approach
Project A Project B
Prob. Project B
NPV = 1,000,000 0.01 -
0.89 1,000,000
0.10 5,000,000
22
Criticism of Utility Based Approach Cont.
Project A Project B
Prob. Project A Prob. Project B
0.89 - 0.9 -
0.11 1,000,000 0.1 5,000,000
23
Project A Project B
0.01 - 0.02 -
0.89 1,000,000 0.78 1,000,000
0.10 5,000,000 0.20 5,000,000

24
Project A Project B
0.71 - 0.72 -
0.19 1,000,000 0.08 1,000,000
0.10 5,000,000 0.20 5,000,000
25
Stochastic Dominance
• There are many types of the utility functions and the utility
functions are subjective (depend upon something i.e. utility
functions are non standardize).
• Expected utility takes into account discrete probability
distribution whereas, stochastic dominance consider whole
probability distribution.
• FDSD More is preferred over less U1 du/dx>0
• SDSD Individuals are risk averse U2 du/dx>0 &
d(du/dx)/dx<0
• TDSD Is based on positive skewness U3 du/dx>0
d(du/dx)/dx<0 & d{d(du/dx)/dx}/dx>0
• Although the concept of stochastic dominance is based on the
derivative of the utility function but we will not calculate utility
here. 26
• In such a case we can also use the concept of expected utility

but it has problems that is weaknesses or criticism.
Stochastic Dominance Cont.
FDSD: Consider the following projects
Project A Project B Prob.
0 10,000 0.5
10,000 30,000 0.5
E(Return) 5,000 20,000
SD σ 5,000 10,000
X F(A) F(B) F(A)-F(B)

0 0.5 0.0 0.5
10,000 1.0 0.5 0.5
30,000 1.0 1.0 0
Decision Rule:
If all the values of F(A)-F(B) are positive/non-negative then B A
If all the values of F(A)-F(B) are negative/non-positive then A B
27
Ans: As all the values of F(A)-F(B) are positive therefore, B A
SDSD: Consider the following projects
Project A Project B Prob.
0 -5,000 0.5
10,000 15,000 0.5
E(Return) 5,000 5,000
SD σ 5,000 10,000
X F(A) F(B) F(A)-F(B) ∫[F(A)-F(B)}

-5,000 0.0 0.5 -0.5 -0.5
0 0.5 0.5 0 -0.5
10,000 1.0 0.5 0.5 0
15,000 1.0 1.0 0 0
Decision Rule:
If all the values of ∫[F(A)-F(B)] are positive/non-negative then B A
If all the values of ∫[F(A)-F(B)] are negative/non-positive then A B
Ans: As all the values of ∫[(A)-F(B)] are non-positive therefore, A 28
B
TDSD: Consider the following projects
Project
A Prob. Project B Prob.
0 0.25 100,000 0.75
200,000 0.75 300,000 0.25
E(Return) 150,000 150,000
X F(A) F(B) F(A)-F(B) ∫[F(A)-F(B)} ∫∫[F(A)-F(B)}
0 0.25 0.0 0.25 0.25 0.25
100,000 0.25 0.75 -0.50 -0.25 0
200,000 1.0 0.75 0.25 0 0
300,000 1.0 1.0 0 0 0
Decision Rule:
If all the values of ∫∫[F(A)-F(B)] are positive/non-negative and E(B) ≥
E(A) then B A
If all the values of ∫∫[F(A)-F(B)] are negative/non-positive and E(A) ≥
E(B) then A B 29
Ans: As all the values of ∫∫[(A)-F(B)] are non-negative and E(B) ≥
E(A) therefore, B A
Project A Prob. Project B Prob.
0 0.25 100,000 0.75
200,000 0.50 300,000 0.25
400,000 0.25
E(Return) 200,000 150,000
X F(A) F(B) F(A)-F(B) ∫[F(A)-F(B)} ∫∫[F(A)-F(B)}
0 0.25 0.0 0.25 0.25 0.25
100,000 0.25 0.75 -0.50 -0.25 0
200,000 0.75 0.75 0 -0.25 -0.25
300,000 0.75 1.0 -0.25 -0.5 -0.75
400,000 1.0 1.0 0 -0.5 -1.25
Decision Rule:
If all the values of ∫∫[F(A)-F(B)] are positive/non-negative and E(B) ≥
E(A) then B A
If all the values of ∫∫[F(A)-F(B)] are negative/non-positive and E(A) ≥ 30
E(B) then A B
Ans: The values of ∫∫[(A)-F(B)] are both positive and negative therefore, we
Are the Undiscounted Measures Enough for Project Appraisal?
Project A Prob. Project B Prob.
0 0.25 100,000 0.75
200,000 0.50 300,000 0.25
400,000 0.25
E(Return) 200,000 150,000
SD σ 141421.356 86602.54
31
CV 0.70710678 0.57735
Benefit Cost Ratio / Profitability Index
Formula:
BCR= (future cash inflows /Initial investment).
• The Profitability Index/Benefit Cost Ratio defines how much project
will earn per dollar of investment.
• The value of an anticipated future cash flows divided by initial
outflow gives the profitability index (PI) or BCR of the project. It is
also one of the easy investment appraisal techniques.
• Suppose, the value of anticipated future cash flow is $120,000 &
the initial outflow is $100,000. Then the profitability index/BCR is
1.2. i.e. $120,000 / $100,000.
• This means each invested dollar is generating a revenue of 1.2
dollars.
• If the profitability index is more than 1, the project should be
accepted & if it is less than 1 it should be rejected.
32
2. Discounted Measures
I. Discounted Payback Period:
“The period of time required to recover the discounted initial investment on
the basis of discounted future cash flows”.
• It only differs from the payback period in the sense that rather than
nominal future cash flows we use discounted values of future cash flows.
For Example,
XYZ Org. is considering buying a machine costing $100,000.
There are two options Project A and Project B.
Project A will generate revenue of $ 50,000, $ 50,000 & $ 20,000 in year 1,
year 2 & year 3 respectively.
Project B will generate revenue of $ 30,000, $ 40,000 & $ 60,000 in year 1,
year 2 & year 3 respectively.
Rate of Interest is 10%
Payback period is 2.88 years & 2.88 years for Project A & Project B
respectively.
DPBP says Both the projects are equally good but layman can decide even 33
in this case.
Discounted Payback Period Cont.
Project A’s DPBP = 2.88 years Project B’s DPBP = 2.88 years
Cash flows 50,000 50,000 20,000 Cash flows 30,000 40,000 60,000
Discounted
CF 45454.55 41322.31 15026.3 Discounted CF 27272.73 33057.85 45078.89
86776.86 13223.14 0.88 60330.58 39669.42 0.880
34
II. Net Present Value (NPV)
NPV is based on the Concept of PV.
Formula:
NPV= PV of future cash inflows – Initial investment or
NPV ={ + + …….. } – Initial Investment
• It is the most common method of investment appraisal.
• Net present value is the sum of discounted future cash
inflow & outflow related to the project.
• Generally, the weighted average cost of capital (WACC) is the
discount factor for future cash-flows in the net present value
method.
• For simplicity we will use interest rate as a discount factor.
• NPV sums up the discounted net cash inflows from the
investment & deducts the initial investment to give the ‘net 35
present value’.
• The Project may be accepted if the NPV is positive.
Net Present Value(NPV) Cont.
For Example,
• XYZ Org. is starting the project at a cost of $100,000.
• The project will generate cash-flow of $40,000, $50,000
& $50,000 in year 1, year 2 & year 3 respectively. The
company’s WACC/i is 10%. Find out NPV.
• Formula of NPV = [ $40,000/( 1+0.1)1] +
[ $50,000 / (1+0.1)2 ] +[ $50,000/ (1+0.1)3 ] – 100,000
• Net present value = $36,363.63 + $41,322.31 +
$37,565.74 – $100,000
• = $115,251.68 – $100,000
• The net present value of the project is $ 15,251.68
• The NPV is positive therefore project may be accepted. 36
III. Internal Rate of Return(IRR)
“The rate of discount/cost of capital at which NPV of future
cash flows becomes zero”. Or
“An internal rate of return is the discounting rate, which
brings discounted future cash flow at par with the
discounted initial investment”.
• It is such a discount rate at which the project will neither
make a loss nor make a profit.
• It is obtained by the trial & error/ hit and trial method.
• We can also state that IRR is the rate at which the NPV of
the project will be zero. i.e. Present value of cash inflow
– Present value of cash outflow = zero
NPV = 0 = PV of future cash flows – Initial investment 37
or
NPV = 0 = { + + …….. } – Initial Investment
Internal Rate of Return(IRR) Cont.
Steps
1. Choose a Particular i for discounting.
2. Choose a Higher i if the NPV on the basis of previous step is
positive and vice versa.
3. Round the answer in downward direction
NPV +ve NPV -ve
Choose higher i Choose lower i
Formula = L + (Positive NPV at low i/ Positive NPV at low i - negative

38
NPV at high i) * (H-L)
IV. Benefit Cost Ratio / Profitability Index
Formula:
BCR= (PV of future cash flows or NPV/PV of Initial investment).
• The Profitability Index/Benefit Cost Ratio defines how much project
will earn per dollar of investment on the basis of PV.
• The present value of an anticipated future cash flow divided by
initial outflow gives the profitability index (PI) or BCR of the
project. It is also one of the easy investment appraisal techniques.
• Suppose, the present value of anticipated future cash flow is
$120,000 & the initial outflow is $100,000. Then the profitability
index/BCR is 1.2. i.e. $120,000 / $100,000.
• This means each invested dollar is generating a revenue of 1.2
dollars on the basis of PV.
• If the profitability index is more than 1, the project should be
accepted & if it is less than 1 it should be rejected.
• If we reduce complications, it is nothing but a different
39
presentation of NPV.
V. Project Appraisal for Interactive Projects
1. Difference in Time Horizon of the Projects:
Year 0 Year 1 Year 2
Projects Cost Return Return
A -100,000 120,000 0
B -100,000 0 144,000
40
Difference in Time Horizon of the Projects Cont.
• On the basis of IRR both the projects gives the same return.
• IRR=20%
• Are you sure both the projects are equally good?
• If yes then Why?
• If No the why not?
PBP says project A is better.
DPBP gives contradictory results at interest rate of less than 20% (A
is better), 20% (A is better) and more than 20% (none is
preferable).
NPV also gives contradictory results at interest rate of less than
20%, 20% and more than 20%.
If i=0 NPV of Project A is 20K & NPV of Project B is 44K.
In order to compare such projects where the time horizon is
different we have to calculate either NPV or IRR.
41
If i=10 Project A is worse and Project B is better.
If i=20 we have already discussed that both are equally good.
Problems Associated with main
Discounted Measures.
1. IRR assumes reinvestment at IRR which sometime
may not be a feasible idea.
• Suppose over the years there is change in interest
rate so how we can use a single i/discount rate over
the years.
• In such a situation we can use NPV because NPV
does not assume a single discount rate.
Conclusion:
Do not use IRR criteria if there is a change in
discount rate.
42
Problems Associated with main Discounted
Measures Cont.
2. Sometimes / occasionally Internal rate of Return gives
Multiple IRRs commonly known as MIRR.
-++++ (1 IRR)
- + - - + + (2 IRRs)
IRR depends on number of sign change.
3. Both IRR and NPV can’t distinguish between lending and
borrowing.
Year 0 Year 1
Projects Cost Return
A -100,000 120,000
B 100,000 -120,000 43
Measures Cont.
4. Consider the case of different time horizon.
Year 0 Year 1 Year 2 Year 3

Projects Cost Return Return Return
A -100,000 120,000 0 0
B -100,000 0 0 150,000
44
Measures Cont.
5. Case of different initial Investment.

Projects Cost Return Return
A -100,000 120,000 0
B -500,000 0 605,000
45
Discounted Measures Cont.
Case of Mutually Exclusive Projects:
Example of ME projects:
• A construction company may have to face two ME projects A
technically advanced apartment or an office block.
• A organization may face two mutually exclusive energy options
oil vs natural gas or petrol vs diesel that is newly designed
production process may operate on oil or natural gas.
• Similarly, management have to decide energy or environment
efficient cars are designed to use either petrol or diesel.
• Undertaking a project right now or to wait for favorable
situation (after few years).
• A cheaper short term project or an expensive long term
project.
• Expensive project for higher profits or a cheaper project for 46
relatively low profits.

Case of Mutually Exclusive Projects:
• In case of mutually exclusive projects rule of thumb is to use
NPV criteria but why?
• The reason is IRR can’t rank Mutually exclusive projects.
• The project with higher IRR may have a lower NPV.
• Suppose Project A is construction of a Single story building
and Project B is the construction of a plaza.
Projects Cost Return IRR
A -100,000 110,000 10%
B -200,000 216,000 8%
• If i=5% then
47
• NPV of A = 4761.9 < NPV of B = 5714.3
Case of Independent Projects:

Independe PI based IRR based
nt Projects Cost/Inv. Return Return PV at 10% NPV PI=NPV/I PI=PV/I Ranking IRR Ranking
A -3,000,000 2,200,000 2,420,000 4000000 1,000,000 0.333333 1.33333 2 33.70% 2
B -5,000,000 2,200,000 4,840,000 6000000 1,000,000 0.2 1.2 5 22.80% 5
C -7,000,000 6,600,000 4,840,000 10000000 3,000,000 0.428571 1.42857 1 42.73% 1
D -6,000,000 3,300,000 6,050,000 8000000 2,000,000 0.333333 1.33333 2 31.61% 3
E -4,000,000 1,100,000 4,840,000 5000000 1,000,000 0.25 1.25 4 24.60% 4
• In case of independent projects and absence of funds constraint

PI/BCR is useful.
48
• In case of independent projects and funds constraint IRR is useful.
Determination of optimal life of a project:
Determination of an optimal life of a
project/building/machine/equipment is always an
important task.
• Suppose Covid Vex. is creating a severe problem
of blood clotting
• A pharmaceutical company on the basis of
evaluation techniques determines that they have
to undertake a new project for the development
of a new formula to cure blood clotting.
• The expected cost and benefits are as follows: 49
Research and development expenditures = Cost = 10 Million
Expected Life till the development of better medicine by the
competitors = 5 Years
Annual profits = 5 Million
Sale of the production rights (copyrights) to another organization =
Salvage value after 1 year = 8 Million
Salvage value after 2 years = 7 Million
Salvage value after 5 years = 0
Interest rate = 10%
50
Year 1 Year 2 Year 3 Year 4 Year 5
NPV at
Cost/Inv. SV Return Return Return Return Return 10%
-10,000,000 8,000,000 5,000,000 1818182
-10,000,000 7,000,000 5,000,000 5,000,000 4462810
-10,000,000 6,000,000 5,000,000 5,000,000 5,000,000 6942149
-10,000,000 2,000,000 5,000,000 5,000,000 5,000,000 5,000,000 7215354
-10,000,000 0 5,000,000 5,000,000 5,000,000 5,000,000 5,000,000 8953934

= 1818182
= 4462810
= 6942149
= 7215354
= 8953934
51
Which of the five alternatives is most suitable for the Pharma. co.
Can we compare all the NPVs?
We can’t compare all the five alternatives because time horizon is
different.
So what should we do?
= 1818182
= 4462810
= 6942149
= 7215354
= 8953934
= + /1.1 (for comparison of )
= + (/1.1) + {/(1.1)^2} (for comparison of )
= + /(1.1)^3 (for comparison of )
= + {(/(1.1)^2}+ {/(1.1)^4} (for comparison of )
To compare all five options we must have a common time horizon of 60
years or to repeat the project for an infinite time. 52
Here we have to use the concept of UAS.
UAS for 1 year = / PV of
UAS for 1 Year = / [1-1/(1+i)^j]/i or
UAS = ( * i) / [1-1/(1+i)^j]
UAS for infinite time = / [1-1/(1+i)^j] or
= () / [1-1/(1+i)^j]
= 2,000,000 = 20,000,000
= 2,570,743 = 25,707,430
= 2,791,374 = 27,913,747
= 2,327,534 = 23,275,336
= 2,361,892 = 23,618,923
The Pharma. Co. may sell the production rights after 3 years.
53
Any Question?

1 Project Appraisal

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1 Project Appraisal

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Project Appraisal (A Preliminary Analysis)

Project Appraisal can be divided into two broad categories.

Payback period = 3 + (15,000*/40,000)

*The denominator of the formula becomes incremental cash flow if

NPV = 1,000,000 0.01 -

Prob. Project A Prob. Project B

0.11 1,000,000 0.1 5,000,000

Prob. Project A Prob. Project B

0.89 1,000,000 0.78 1,000,000

0.10 5,000,000 0.20 5,000,000

Prob. Project A Prob. Project B

0.19 1,000,000 0.08 1,000,000

0.10 5,000,000 0.20 5,000,000

• In such a case we can also use the concept of expected utility

X F(A) F(B) F(A)-F(B)

X F(A) F(B) F(A)-F(B) ∫[F(A)-F(B)}

Project A Prob. Project B Prob.

0 0.25 100,000 0.75

200,000 0.50 300,000 0.25

E(Return) 200,000 150,000

86776.86 13223.14 0.88 60330.58 39669.42 0.880

NPV +ve NPV -ve

Choose higher i Choose lower i

Formula = L + (Positive NPV at low i/ Positive NPV at low i - negative

Year 0 Year 1 Year 2

Projects Cost Return Return

Year 0 Year 1 Year 2 Year 3

Year 0 Year 1 Year 2

relatively low profits.

Year 0 Year 1 Year 2

A -3,000,000 2,200,000 2,420,000 4000000 1,000,000 0.333333 1.33333 2 33.70% 2

B -5,000,000 2,200,000 4,840,000 6000000 1,000,000 0.2 1.2 5 22.80% 5

C -7,000,000 6,600,000 4,840,000 10000000 3,000,000 0.428571 1.42857 1 42.73% 1

D -6,000,000 3,300,000 6,050,000 8000000 2,000,000 0.333333 1.33333 2 31.61% 3

E -4,000,000 1,100,000 4,840,000 5000000 1,000,000 0.25 1.25 4 24.60% 4

• In case of independent projects and absence of funds constraint

-10,000,000 8,000,000 5,000,000 1818182

-10,000,000 7,000,000 5,000,000 5,000,000 4462810

-10,000,000 6,000,000 5,000,000 5,000,000 5,000,000 6942149

-10,000,000 2,000,000 5,000,000 5,000,000 5,000,000 5,000,000 7215354

-10,000,000 0 5,000,000 5,000,000 5,000,000 5,000,000 5,000,000 8953934

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