Chapter Six

Investment Evaluation

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 OVER VIEW

Total Investment Costs

Project Financing
Finance Evaluation: Time value of money,
Cash Flow Diagram, Payback
Period,Return on Investment (ROI), Net
present Value (NPV) , Internal rate of return
(IRR)

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 1. COST OF PROJECTS

• Conceptually, the cost of project represents

the total of all items of outlay associated
with a project which are supported by long-
term funds.
It is the sum of the outlays on the following:
• Land and site development
• Buildings and civil works
• Plant and machinery
• Technical know-how and engineering fees 3
 Cont.

• Expenses on foreign technicians and

training of local technicians abroad
• Miscellaneous fixed assets
• Pre-operative expenses
• Provision for contingencies
• Margin money for working capital
• Initial cash losses…….

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 2. MEANS OF FINANCE
To meet the cost of project the following
means of finance are available:
• Share capital
• Term loans
• Deferred credit
• Incentive sources
• Miscellaneous sources..

5
Finance Evaluation
Time Value of Money (TVM)
• Description: TVM explains the change in the
amount of money over time for funds owed by or
owned by a corporation (or individual)
• The time value of money is the most important
concept in engineering economy

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Basic Concepts and Definitions
Money has the capacity to generate more money.
– If a given sum of money is deposited in a
savings account; it earns interest.
– If it is used to start a business, it earns profit
– If it is used to purchase a share in a business,
it earns dividends.
– If it is used to purchase an office building or
apartment house, it earns rent.
• Thus, the original sum of money expands as
time elapses through the accretion of these
periodic earnings. 7
• Interest – the expression of the time value of money
• The money earned by the original sum of money
• Fee that one pays to use someone else’s money
• Difference between an ending amount of money
and a beginning amount of money
 Interest = amount owed now – principal

• Interest rate: the time rate at which a sum of money

earns interest (it is usually expressed in percentage
form).
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• Investment: the productive use of money to
earn interest.
• Capital: the money that earns interest.

“”The interest earned by the original capital can

itself be invested to earn interest, and this
process can be continued indefinitely. “”
• This capacity of money to enlarge itself with the
passage of time is referred to as the time value
of money. 9
Cash Flow and Cash-Flow Diagrams
• Cash flow is nothing but the set of payments
associated with an investment; and cash flow
diagram is a diagram that shows these payments.
• In the cash flow diagram:
– Time is plotted on a horizontal axis
– The payments are represented by vertical bars
– The amount of each payment is recorded directly
above or below the bar representing it.
– The bars are generally not drawn to scale

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 Categories of Cash Flows

• The expenses and receipts due to engineering projects

usually fall into one of the following categories:
– First cost: expense to build or to buy and install
– Operations and maintenance (O&M): annual expense,
such as electricity, labor, and minor repairs
– Salvage value: receipt at project termination for sale or
transfer of the equipment (can be a salvage cost)
– Revenues: annual receipts due to sale of products or services

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 Cash Flow diagrams (CFD)

• The costs and benefits of engineering projects over

time are summarized on a cash flow diagram (CFD).
• A CFD is created by first drawing a segmented time-
based horizontal line, divided into appropriate time
unit. Each time when there is a cash flow, a vertical
arrow is added  pointing down for costs and up for
revenues or benefits.

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 Cash Flows: Terms
• Cash Inflows – Revenues (R), receipts,
incomes, savings generated by projects and
activities that flow in. Plus sign used
• Cash Outflows – Disbursements (D), costs,
expenses, taxes caused by projects and
activities that flow out. Minus sign used
• Net Cash Flow (NCF) for each time period:
NCF = cash inflows – cash outflows = R – D
• End-of-period assumption:
Funds flow at the end of a given interest period

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E.g. assume that a project has the following cash flow:
1) a disbursement of $ 50,000 now
2) a receipt of $ 10,000 after three years
3) a receipt of $ 15,000 after five years and
4) a receipt of $ 20,000 eight years hence
Taking the unit of time one year, the cash flow diagram
is represented as in fig

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Basic Relationship between Money & Time
• The sum of money that is earning interest at a given
instant is known as the principal in the account.
• The interest that has been earned up to date is converted
to principal there by causing it to earn interest.
• This process of converting interest to principal is referred
to as the compounding of interest; it represents an
investment of the interest in the same investment.

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E.g. At the beginning of a particular year, the sum of $10,000 was
deposited in a savings account that earned interest of 10% per
annum. The growth of this sum during a three-year period is
explained as follows:
• During the first year, the principal is $10,000, and the interest
earned by the end of that year is 10,000(0.10) = $1,000
• At that time, the interest is compounded, there by increasing the
principal to 10,000 + 1,000 = $11,000.
• The interest earned by the end of the second year is 11,000(0.10) =
$1,100
• At that time, this interest is compounded, there by increasing the
principal to 11,000 + 1,100 = $12,100
• The interest earned by the end of the third year is 12,100(0.10) =
$1,210
• At that time, this interest is compounded, there by increasing the
principal to 12,100 + 1,210 = $13,310
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In general, let
P = sum deposited in savings account at the beginning of an interest
period
F = Principal in account at expiation of n interest periods
i = interest rate
The principal at the end of the first period is P + Pi = P (1+i)
The principal at the end of the second period is P (1+i) + P (1+i) i
= P (1+i) (1+i) = P (1+i)2
The principal at the end of the 3rd period is
= P (1+i) (1+i ) + P (1+i) (1+i) i
= P (1+i) (1+i) (1+i) = P(1+i)3
From this we conclude that the principal is multiplied by the factor
(1+i) during each period. Therefore, the principal at the end of the
nth period is
– F = P (1+i) n 17
• Example 1: If $ 5,000 is invested at an interest rate of
10% per annum, what will be the value of this sum of
money at the end of 2 years?
Soln.
Given: P = $5,000, n = 2, i = 0.10
F = P = 5,000 (F/P, 2, 10%)
= 5,000 (1.1)2
= $6,050

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Example 2: Smith loaned Jones the sum of $ 2000 at the beginning
of year 1, $3000 at the beginning of year 2 and $ 4000 at the
beginning of year 4. The loans are to be discharged by a single
payment made at the end of year 6. If the interest rate of the loans
is 6% per annum, what sum must Jones pay?
Soln:
• Refer to figure below. To maintain consistency and there by
simplify the calculation of time intervals, convert the date of
payment to the beginning of year 7.

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Soln: Applying eqn 4.1b and using Table A.B
F = 2000 (F/P, 6, 6%) + 3000 (F/P, 5,6%) + 4,000 (F/P, 3, 6%)
= 2000 (1.41852) + 3000 (1.33823) + 4000 (1.19102)
= $ 11,616

Example 3: If $5000 is deposited in an account earning interest at 8% per

year compound quarterly, what will be the principal at the end of 6 years?
Soln
p = $ 5000 n = 6 x 4 = 24
True interest rate = nominal rate
the no of interest periods contained 1 year
=8%/4= 2%
F = 5000 (F/P, 24, 2%)
= 5000 (1.60844) = $ 8,042

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Example 4: An individual possesses two promissory notes. The first
note has a maturity value of $1000 and is due 2 years hence. The
second note has a maturity value of $1500 and is due 3 years hence.
As this individual requires cash for his immediate needs, he wishes
to discount these notes (i.e. to assign them to another individual or
organization). If an investor wishes to earn 7%, at what price
should she offer to purchase the notes?
Soln:
• The maturity value of a note is the amount of money that the holder
of the note is entitled to receive at the specified date. The proposed
purchase price is
P = 1000 (P/F, 2, 7%) + 1500 (P/F, 3, 7%)
= 1000 (0.87344) + 1500 (0.81630)
= $ 2098
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 Calculation of Present Worth and Future Worth
(for uniform serious payment)
• Let equal amounts of money, A, be deposited in a savings
account (or placed in some other interest-bearing investment) at
the end of each year, as indicated in Fig.

• If the money earns interest at a rate i, compounded annually,

how much money will have accumulated after n years?

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• To answer this question, we note that after n years, the first year's
deposit will have increased in value to
Fl = A(1+ i)n-1
• Similarly, the second year's deposit will have increased in value to
F2 = A(1+ i)n-2
• and so on. The total amount accumulated will thus be the sum of a
geometric progression:
F=F1+F2 +F3+…………… + Fn
= A (1+ i)n-1 + A(1+ i)n-2 +……… + A
=A[(1+ i)n-1 + (1+ i)n-2 +……… +1 ]
= A [(1+ i)n-1 ]
i

is called the uniform-series, compound-amount factor

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P=F(1+i)-n
=A [((1+ i)n-1)/ i ] *(1+i)-n
=A[((1+ i)n* (1+i)-n )-(1+i)-n ]/i
=A[1-(1+i)-n ]/i

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• Example: You have just graduated from college & plan to begin
a retirement fund. It is your desire to withdraw money every
year for 30 years starting 25 years from now. The fund earns 7%
interest. What uniform annual amount will you be able to
withdraw when you retire in 25 years if you deposit $1,000 per
year for the 1st 20 years starting one year hence?

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Project selection
 The selection of the right project for future
investment is a crucial decision for the long-term
survival of your company.
 The selection of the wrong project may well
precipitate project failure leading to company
liquidation.
 Project selection is making a commitment for the
future. The execution of a project will tie up
company resources, and as an opportunity cost the
selection of one project may preclude your
company from pursuing another project. 26
 We live in a world of finite resources and
therefore cannot carry out all the projects we may
want or need.
 Therefore a process is required to select and rank
projects on the basis of beneficial change to your
company.
Project Selection Models
 A numeric model is usually financially focused and
quantifies the project in terms of either time to
repay the investment (payback) or return on
investment. While non­numeric models look at a
much wider view of the project considering items
from market share to environmental issues. 27
 The main purpose of these models is to aid
decision-making leading to project selection.
 When choosing a selection model the points
to consider are: realism, capability, ease of
use, flexibility and low cost. Most importantly
the model must evaluate projects by how well
they meet a company's strategic goals and
corporate mission.
 The following sub-headings indicate the type
of questions to ask:

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• Will the project maximize profits?
• Will the project maintain market share, increase
market share or consolidate market position?
• Will the project enable the company to enter new
markets?
• Will the project maximize the utilization of plant
and equipment?
• Will the project improve the company's image?
• Will the project satisfy the needs of the
stakeholders and political aspirations?

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Numeric Models
 The numeric selection models may be sub-
divided into financial models and scoring
models. The financial models are:
– payback period
– return on investment (ROI)
– net present value (NPV)
– internal rate of return (IRR)

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Payback Period
 The payback period is the time taken to gain a
financial return equal to the original
investment, neglecting the time value of
money. The time period is usually expressed in
years and months.
 To calculate the payback period, simply work
out how long it will take to recover the initial
outlay. It is given by as follow

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Example: Determine the payback period for a proposed
investment as follows:
End of Year 0 1 2 3 4 5
Cash Flow, $1000 -50 10 12 15 18 20

The sum of the first three yearly cash inflows, $37 000, is
less than the initial investment, $50 000; but the sum of
the first four yearly cash inflows, $55 000, exceeds the
initial investment. Hence the payback period will be
somewhere between 3 and 4 years. Linear interpolation
yields
PBP= 3 + {(50,000 – 37,000)/(55,000 – 37,000)}*(4 – 3) = 3.72 years
Because it ignores the time value of money

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 Advantages of the payback method are:
 It is simple and easy to use.
 It uses readily available accounting data to
determine cash-flows.
 It reduces the project's exposure to risk and
uncertainty by selecting the project that has the
shortest payback period.
 The uncertainty of future cash-flow is reduced.

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 It is an appropriate technique to evaluate high
technology projects where the technology is
changing quickly and the project could run the
risk of being left holding out of date stock.
 It is an appropriate technique for fashion projects
where the market demand tends to change
seasonally.
 Faster payback has a favorable short-term effect
on earnings per share.
 The payback period quantifies the selection
criteria in terms the decision-makers are familiar
with.

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 Disadvantages of the payback period are:-
 It does not consider the time value of money. It is
indifferent to the timing of the cash-flow. The
project with a high, early income (cash­ inflow)
would be ranked equally with a project which had
late income if their payback periods were the
same.
 It does not look at the total project. What happens
to the cash-flow after the payback period is not
considered. A project that built up slowly to give
excellent returns would be rejected in favor of
project with low early returns if the payback
period was shorter.
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 Cont.

 It is not a suitable technique to evaluate long

term projects where the effects of differential
inflation and interest rates could significantly
change the results.
 The figures are based on project cash-flow only.
All other financial data are ignored.
 Although payback period would reduce the
duration of risk, it does not quantify the risk
exposure.
 The payback period is the most widely used
project selection calculation, even if this is an
initial filter. Its main strength is that it is simple
and quick…… 36
Return on Investment (ROI)
 This method first calculates the average annual
profit, which is simply the project outlay
deducted from the total gains, divided by the
number of years the investment will run. The
profit is then converted into a percentage of the
total outlay using the following equations
 Average Annual Profit = (Total Gains) – (Total outlay)
Number of years

 Return on Investment = Average Annual Profit X 100

Original Investment
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Advantage:
– a simple technique like back period,
– it considers the cash-flow over the whole project.
– The total outcome of the investment is expressed as a
profit and percentage return on investment, both
parameters readily understood by management.
The main criticism of return on investment is that it
averages out the profit over successive years. An
investment with high initial profits would be ranked
equally with a project with high profits later if the
average profit was the same. Clearly the project with
high initial profits should take preference……..

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Discounted Cash-Flow (DCF)
 To address the short-coming of both return on
investment and payback period, the time value of
money must be considered using a discounted
cash-flow technique. This is particularly desirable
where interest rates and inflation are high.
 The discounted cash-flow (DCF) technique takes
into consideration the time value of money. There
are two basic DCF techniques which can model
this effect, net present value (NPV) and internal
rate of return (lRR).

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 These discounting techniques enable the project
manager to compare two projects with different
investment and cash-flow profiles.
 There is, however, one major problem with DCF,
besides being dependent on the accurate
forecast of the cash-flows; it also requires an
accurate prediction of the interest rates.

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Net Present Value (NPV)
 Where the cash-flow timing is expressed in years from
the start date of the project, the inflation effect is
assumed to act at the end of the first year or beginning
of the second year, therefore all cash-flows in the first
year are at present value.
 Project cash-flow = income - expenditure
 Present value = discount factor x cash-flow
 The discount factor is derived from the reciprocal of the
compound interest formula.
 Discount factor = 1 / (1 + i) n
Where i = the forecast interest rate
n = the number of years from start date
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• The NPV of an investment proposal can be defined as
follows:

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43
Example:- Saber Electronics provides specialty
manufacturing services to defense contractors. The
initial outlay is $3 million and, management
estimates that the firm might generate cash flows
for years one through five equal to $500,000;
$750,000; $1,500,000; $2,000,000; and $2,000,000.
Saber uses a 20% discount rate for projects of this
type. Is this a good investment opportunity?
Soln: We need to analyze if this is a good
investment opportunity. We can do that by
computing the Net Present Value (NPV), which
requires computing the present value of all cash
flows. 44
• NPV = -$3m + $.5m/(1.2) + $.75m/(1.2)2 +
$1.5m/(1.2)3 + $2m/(1.2)4 + $2m/(1.2)4
• NPV = -$3,000,000 + $416,666.67 + $520,833.30
+ $868,055.60 + $964,506 + $803,755.10
• NPV = $573,817
• The project requires an initial investment of
$3,000,000 and generates futures cash flows that
have a present value of $3,573,817.
Consequently, the project cash flows are
$573,817 more than the required investment.
• Since the NPV is positive, the project is an
acceptable project. 45
 The NPV is a measure of the value or worth
added to the company by carrying out the
project. If the NPV is positive the project merits
further consideration. When ranking projects,
preference should be given to the project with
the highest NPV.
The steps are as follows:
• insert the cash-flow
• transfer the discounting factors from the table
• calculate present value : multiplying cash-flow by
discount factor
• aggregate the present values to give the NPV
46
The advantages of using NPV are:
• It introduces the time value of money.
• It expresses all future cash-flows in today's
values, which enables direct comparisons.
• It allows for inflation and escalation.
• It looks at the whole project from start to finish.
• It can simulate project what-if analysis using
different values.
• It gives a more accurate profit and loss forecast
than non DCF calculations.

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The disadvantages are:-
• Its accuracy is limited by the accuracy of the
predicted future cash-flows and interest rates.
• It is biased towards short run projects.
• It excludes non financial data e.g. market
potential.
• It uses a fixed interest rate over the duration of
the project. The technique can, however,
accommodate a varying interest rate.

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Internal Rate of Return (IRR)
 The internal rate of return is also called DCF yield
or DCF return on investment.
 The IRR is the value of the discount factor when
the NPV is zero.
 The IRR is calculated by either a trial and error
method or plotting NPV against IRR. It is
assumed that the costs are committed at the
end of the year and these are the only costs
during the year.

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• The IRR analysis is a measure of the return on
investment, therefore, select the project with the
highest IRR. This allows the manager to compare
IRR with the current interest rates.
• One of the limitations with IRR is that it uses the
same interest rate throughout the project,
therefore as the project's duration extends this
limitation will become more significant. This
problem can be addressed, however, using a
modified version of the DCF method……..

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 Rate of Return Analysis
• Steps to determine rate of return for a single
stand-alone investment
– Step 1: Take the dollar amounts to the same point
in time using the compound interest formulas
– Step 2: Equate the sum of the revenues to the sum
of the costs at that point in time and solve for i

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 Rate of Return Analysis
• An initial investment of $500 is being
considered. The revenues from this
investment are $300 at the end of the first
year, $300 at the end of the second, and $200
at the end of the third. If the desired return on
investment is 15%, is the project acceptable?
• In this example we will take benefits and costs
to the present time and their present values
are then equated

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 Rate of Return Analysis
• $500 = $300(PF, i, n=1) + 300(PF, i, n=2) + $200(PF, i,
n=3)
• Now solve for i using trial and error method
• Try 10%: $500 = ? $272 + $247 + $156 = $669 (not
equal)
• Try 20%: $500 = ? $250 + $208 + $116 = $574 (not
equal)
• Try 30%: $500 = ? $231 + $178 + $91 = $500 (equal)
 i = 30%
• The desired return on investment is 15%, the project
returns 30%, so it should be implemented

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Scoring Models
• The numeric models only look at the financial
element of the project. In an attempt to broaden
the selection criteria a scoring model called the
factor model which uses multiple criteria to
evaluate the project.
• The factor model simply lists a number of
desirable factors on a project selection proforma
along with columns for Selected and Not
Selected.
• A weighted column can be added to increase the
score of important factors while reducing the
scoring of the less important. 54
• The weighted column is calculated by first
scoring each factor, and then dividing each factor
by the total score. The total of the weighted
column should always add up to one. The factors
can be weighted simply 1 to 5 to indicate; 1
"very poor", 2 "poor", 3 "fair", 4 "good" and 5
"very good". Three, seven and ten point scales
can also be used.

55
Advantages of using a scoring model include:
• Encouraging objectivity in decision making.
• Using multiple selection criteria to widen the
range of evaluation.
• Simple structure, therefore easy to use.
• Selection factors are structured by senior
management. This implies that they reflect the
company goals and objectives.
• Easy to change factors.
• Weighted scoring reflects the factor's differential
importance.

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• They are not biased towards short run projects
favored by financial models.
• Very low weightings can be removed from the list
as they have little to no influence. This will
reduce the number of questions.
• The weighted model can also be used as a flag to
improve projects by identifying the variance
between the factor score and the maximum
possible score.

57
Disadvantages of using a scoring model are:
• If the factors are not weighted they will all
assume equal importance.
• A simple model may encourage the
development of long lists which could
introduce trivial factors and therefore waste
management time…….

58
END
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