One of the main objectives of any project promoter is ensuring that the project is able to earn sufficient return on their investment. The very idea of promoting a project by an entrepreneur is to earn attractive return on investment on the project. On the other hand, project sponsored by government take into account social cost benefits of the project and in such cases financial return may not be high on the agenda. To ensure that there would be maximum benefits; investors normally carry out financial analysis to determine the type of return anticipated.
Let us look at some financial benefits which can be categorised into two categories; Non-discount cash flow techniques and Discounted cash flow techniques
Non-discounted
Cash flow Techniques
- Payback Period (PB) Method
- Accounting Rate of Return (ARR) Method
Discounted
Cash Flow Techniques
- Net Present Value (NPV) Method
- Profitability Index (PI) Method
- Internal Rate of Return (IRR) Method
- Benefit Cost Ratio (BCR) Method
Payback
Period Method
One of the most widely used and recognised simple
method is the Payback Period Method of evaluating investment proposals. This
method is defined as the length of time required to recover the original
investment on the project through the cash flow earned. Thus cash the cash
inflow would include operating profits less income tax payable plus
depreciation.
Let us look at an Illustration:
Project A
investment is K14, 000, 000.00 and it is expected to take two years for
implementation of the project. The project is expected to earn profits from the
third year onwards. The estimated profits; tax; depreciation are as follows;
Details
|
3rd
Year
|
4th
Year
|
5th
Year
|
6th
Year
|
7th
Year
|
Opening
Profit
|
1, 500, 000
|
1, 750, 000
|
2, 000, 000
|
2,250, 000
|
2, 000, 000
|
Tax
|
500, 000
|
600, 000
|
680, 000
|
750, 000
|
680, 000
|
Depreciation
|
3, 300, 000
|
2, 210, 000
|
1, 480, 000
|
990, 000
|
670, 000
|
SOLUTION
|
|||||
Profit
– Tax + Depreciation
|
4, 300, 000
|
3, 360, 000
|
2, 800, 000
|
2, 490, 000
|
1, 990, 000
|
Cumulative
Cash flow
|
4, 300, 000
|
7, 660, 000
|
10, 460, 000
|
12, 950, 000
|
14, 940, 000
|
From the initial investment of K14, 000, 000.00, a
return on investment would likely be received in the seventh year according to
the above illustration that is four years after the project implementation
period. Let us do a simple calculation of the Cumulative Profit after 4 years
of implementation is K12, 950, 000.00. Cumulative profit after 5 years of
implementation is K14, 940, 000.00. The difference is K1, 990, 000.00
Payback Period = 4 years + [12 x (14, 000, 000 – 12,
950, 000)] divided by 1, 990, 000.00
= 4 years + [12 x 1, 050, 000) divided by 1, 990,
000 months
= 4 years + 6.33 months
Say = 4 years and 6 months
Limitation
of Pay Back Period Method ignores the time value of money.
Let us look at an example on the drawback;
CASH
INFLOW
Details
|
1st Year
|
2nd
Year
|
3rd
Year
|
4th
Year
|
5th Year
|
Project
A
|
20, 000, 000
|
25, 000, 000
|
25, 000, 000
|
30, 000, 000
|
10, 000, 000
|
Project
B
|
40, 000, 000
|
30, 000, 000
|
20, 000, 000 |
10, 000, 000
|
10, 000, 000
|
The two projects require investments of K1, 000, 000
million each and the payback period for both projects is exactly 4 years. The
pay back method rates these two projects equally; however, Project B would be
better proposition than Project A since the cash inflow out of Project B is
more in the initial years. The payback period however fails to recognize the
time value for money and rates both the above projects equally. The payback
period methods also ignore the cash flow beyond the payback period.
Illustration
of the Drawback
Project
A
Investment
K1, 000, 000
|
Project
B
Investment
K1, 000, 000
|
|||
Years
|
Annual
Cash Inflow
| |||
1
2
3
4
5
6
7
8
|
20,
000, 000
25,
000, 000
25,
000, 000
30,
000, 000
30,
000, 000
20,
000, 000
20,
000, 000
10,
000, 000
|
20,
000, 000
45,
000, 000
70,
000, 000
100,
000, 000
130,
000, 000
150,
000, 000
170,
000, 000
180,
000, 000
|
40,
000, 000
30,
000, 000
20,
000, 000
10,
000, 000
10,
000, 000
-
-
-
|
40,
000, 000
70,
000, 000
90,
000, 000
100,
000, 000
110,
000, 000
-
-
-
|
Although simple in nature, one of the drawback of the Payback period simply is the lack of in-depth analysis which may lead to inaccurate results. This method may come handy for situations where projects to be compared relates to industries and where the rate of technological obsolescence is very fast, requiring investment on projects to be covered in the shortest possible time.
Average Rate of Return Method or (Accounting Rate of Return Method)
Formula:- Average Rate of Return = (Profit after Tax)/ (Book Value of Investment)
Profit after tax is the average annual post tax benefit over the life of the project. Unlike pay back period method, under ARR method the entire life of the project is taken into account.
Example & Illustration
Three projects A, B & C. We will compare these
three projects by ARR method and choose the one that is most attractive among
the three.
|
Profit
After Tax (Kina)
|
|||
|
Life of Project
|
Project A (4
Years)
|
Project B (5
Years)
|
Project C (6
Years)
|
|
1st
Year
2nd
Year
3rd
Year
4th
Year
5th
Year
6th
Year
|
K4, 000, 000.00
K4, 500, 000.00
K5, 000, 000.00
K4, 500, 000.00
-
-
|
K3, 000, 000.00
K4, 500, 000.00
K5, 000, 000.00
K5, 500, 000.00
K5, 000, 000.00
-
|
K2, 500, 000.00
K3, 000, 000.00
K4, 000, 000.00
K5, 000, 000.00
K3, 000, 000.00
K2, 500, 000.00
|
|
|
K18, 000, 000.00
|
K23, 000, 000.00
|
K20, 000, 000.00
|
|
Book
Value of Investment
|
Project A
|
Project B
|
Project C
|
|
1st
Year
2nd
Year
3rd
Year
4th
Year
5th
Year
6th
Year
|
K15, 000, 000.00
K13, 500, 000.00
K12, 150, 000.00
K10, 930, 500.00
-
|
K12, 000, 000.00
K10, 800, 000.00
K9, 720, 000.00
K8, 740, 800.00
K7, 870, 320.00
|
K10, 000, 000.00
K9, 000, 000.00
K8, 100, 000.00
K7, 290, 000.00
K6, 560, 100.00
K5, 900, 490.00
|
|
|
K51, 580, 500.00
|
K57, 851, 120.00
|
K46, 850, 590.00
|
|
|
|||
|
|
Project A (4
Years)
|
Project B (5
Years)
|
Project C (6
Years)
|
|
Total Profit over
the life Period of the project
Average annual
Profit
Average
Investment
Return on average
Investment
|
K18, 000, 000.00/-
K18, 500,
000.00/-
4
= K4, 500, 000.00
51, 580, 500.00/4
K12, 896, 250.00
K4, 500, 000/12,
896, 250 x 100
|
K23, 000, 000.00/-
K23, 000,
000.00/-
5
= K4, 600, 000
57, 851, 120/5
K9, 828, 240
4, 600, 000/9,
828, 240 x 100
|
K20, 000, 000.00/-
K20, 000,
000.00/-
6
= K3, 333, 333
46, 850, 590/6
K7, 800, 932
3, 333, 333/7,
800, 932 x 100
|
|
Returns
|
= 34.89%
|
= 46.80%
|
= 42.68%
|
As per ARR method Project B gives a higher return on
investment than Project A & C
Limitations of ARR Method
This method also does not take into account the time
value of money.
This method is based on accounting profit and not
cash inflow.
Net Present Value (NPV) Method.
This method recognises the time value of money and
it is one of the discounted cash flow techniques.
Net
Present Value (NPV) of Cash Flow = [Present Value of all future Cash inflows
over the life of the project] – [Present Value of Cash Outflow].
The present value of future cash inflows is arrived
at by discounting the future cash inflows at an interest rate equal to the cost
of capital..
NPV Formula is expressed:
NPV = CF1 + CF2 + CF3 + …………………..CFn
(1 +r)1 + (1 + r)2 + (1 + r)3 3 + (1 + r)n
CF1. CF2……….Future
cash inflows occurring at the end of first year, second year, …….etc
n = life of the project in years
r = discount rate (cost of capital)
CF0 = Present Cash
Outflow
IF NPV = 0, it indicates that the present cash
outflow and the present value of future cash inflows are equal.
IF NPV < 1, it indicates that the present value
of future cash inflows is less than the present cash outflow.
IF NPV>1, it indicates that the present value of
future cash inflow is more than the present cash outflow.
The following illustration explains the application
of NPV method.
Compare projects A and B using the given data. Use
NPV method of evaluation.
Project A
Investment on the Project - K10, 000,
000.00
Life of the Project - 5 years
Period of Implementation - 1 year
Cost of Capital - 15%
|
Year
|
1
|
2
|
3
|
4
|
5
|
|
Cash
Inflow
|
2,000,000
|
3,000,000
|
4,000,000
|
3,000,000
|
1,000,000
|
Project B
Investment on the Project - K10, 000,
000.00
Life of the Project - 5 years
Period of Implementation - 1 year
Cost of Capital - 13%
|
Year
|
1
|
2
|
3
|
4
|
5
|
|
Cash
Inflow
|
3,000,000
|
4,000,000
|
4,000,000
|
3,000,000
|
2,000,000
|
Project A
Present Value of future cash inflow is given by;
CF1 + CF2 + CF3 + …………………..CFn
(1 +r)1 + (1 + r)2 + (1 + r)3 3 + (1 + r)n
=
2,000,000 + 3,000,000 + 4,000,000 + 3,000,000 + 1,000,000
(1 + 0.15)1
+ (1 + 0.15)2 + (1 + 0.15)3 + (1 + 0.15)4 +
(1+ 0.15)5
= 1,739,130 +
2,268,431 + 2,630,064 + 1,715,259 + 497,176
= 8,850,063 –
10,000,000
= - 1,149,937
The present value is negative and hence the project
should not be taken up
Project B
Present Value of future cash inflow is given by;
CF1 + CF2 + CF3 + …………………..CFn
(1 +r)1 + (1 + r)2 + (1 + r)3 3 + (1 + r)n
=
3,000,000 + 4,000,000 + 4,000,000 + 3,000,000 + 2,000,000
(1 + 0.13)1
+ (1 + 0.13)2 + (1 + 0.13)3 + (1 + 0.13)4 +
(1+ 0.13)5
= 2,654,867 +
3,132,586 + 2,772,200 + 1,839,956 + 1,085,519
= 11,485,130
– 10,000,000
= 1, 485,060
Since the Net Present Value is positive, Project B
is comparatively better than Project A and hence out of the two projects,
Project B can be selected for implementation.
Students are encouraged to understand the other
methods mentioned in the lecture.
Points for Considerations
For calculation of the above factors the following information are relied upon.
Life of the project - The life of the project is assumed and the cash inflows during the life of the project are discounted at an appropriate rate of interest. How to estimate the life of a given project is a point for considerations. Remember, any project has a physical life, a technological life and a product market life. Life depends on the nature of the project.
Cash Outflow - To understand the heads which cash flow takes place for a project, consider the following components of project costs (Land, Land Development, Building, Plant and Machinery, Electricals, Contingencies, Miscellaneous Assets, Preliminary Expenses and Working Capital).
Working Capital = Current Assets - Current Liabilities other than Bank Borrowing.
Thus the total cash outflow consists of cash outflow towards creation of fixed assets, miscellaneous assets and start up expenses, as well as cash outflow towards working capital.
Cash Inflow - Cash Inflow includes the profits earned by the project out of its operations during its lifetime and the residual value of the project at the end of its life time. Thus, cash inflow for the purpose of arriving at NPV, IRR etc. of project should be taken to mean the profit before interest, lease rentals, depreciation and tax for each year during the estimated life of the project.
Cost of Capital - While arriving at the Present Value of cash inflows, the cash inflows during the life of the project are discounted at an appropriate rate of interest, normally at a rate equal to the cost of capital.
Cost of Debt Capital - Cost of borrowing is given by the interest of borrowings.
Cost of Retained Earnings - can be used either for payment of dividend to shareholders or can be invested elsewhere.
Weighted Average Cost of Capital
Any project is funded by a combination of capital from different sources and each type of capital has a cost depending upon its nature.
General Remarks
Students are encouraged to read about the different methods we have gone through in lecture. Remember, after having chosen a project based on its comparative cost advantages, further financial investigation of the chosen project is required to be done.
Sources:
Nagarajan (2008) Project Management 3rd Edition, New Age
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