1. 5-1 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Chapter 5 Project Evaluation: Principles and Methods

2. 5-2 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Learning Objectives Understand different steps of the capital-expenditure process. Different methods of project evaluation and decision rules. Outline the advantages and disadvantages of the main project evaluation methods. Explain why the NPV method is preferred to all other methods. Understand the link between economic value added (EVA) and net present value (NPV). Know the relationship between options, managerial flexibility and firm value analysis during project evaluation.

3. 5-3 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Capital Expenditure Process The capital expenditure process involves: –Generation of investment proposals. –Evaluation and selection of those proposals. –Approval and control of capital expenditures. –Post-completion audit of investment projects.

4. 5-4 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Generation of Investment Proposals Investment ideas can range from simple upgrades of equipment, replacing existing inefficient equipment, through to plant expansions, new product development or corporate takeovers. Generation of good ideas for capital expenditure is better facilitated if a systematic means of searching for and developing them exists. This may be assisted by financial incentives and bonuses for those who propose successful projects.

5. 5-5 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Evaluation and Selection of Investment Proposals In order to evaluate a proposal, the following data should be considered: –Brief description of the proposal. –Statement as to why it is desirable or necessary. –Estimate of the amount and timing of the cash outlays. –Estimate of the amount and timing of the cash inflows. –Estimate of when the proposal will come into operation. –Estimate of the proposal’s economic life.

6. 5-6 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Approval and Control of Capital Expenditures Capital-expenditure budget (CEB) maps out the estimated future capital expenditure on new and continuing projects. CEB has the important role of setting administrative procedures to implement the project (project timetable, procedures for controlling costs). Timing is important because project delays and cost over-runs will lower the NPV of a project, costing shareholder wealth.

7. 5-7 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Post-completion Audit of Investment Projects Highlights any cash flows that have deviated significantly from the budget and provides explanations where possible. Benefits of conducting an audit: –May improve quality of investment decisions. –Provides information that will enable implementation of improvements in the project’s operating performance. –May result in the re-evaluation and possible abandonment of an unsuccessful project.

8. 5-8 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Methods of Project Evaluation Different methods of project evaluation include: –Net present value (NPV). –Internal rate of return (IRR). –Benefit-cost ratio (profitability index). –Payback period (PP). –Accounting rate of return (ARR).

9. 5-9 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Project Evaluation Methods Used by the Entities Surveyed (a) The aggregate percentage exceeds 100% because most respondents used more than one method of project evaluation. Source: Graham, J.R. & C.R. Harvey (2001) Table 5.1: Selected project evaluation methods used by the CFOs surveyed (a) MethodPercentage Accounting Rate of Return20.29 Profitability Index11.87 Internal Rate of Return75.61 Net Present Value74.93 Payback Period56.74

10. 5-10 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Discounted Cash Flow Methods Discounted cash flow (DCF) methods involve the process of discounting a series of future net cash flows to their present values. DCF methods include: –The net present value method (NPV). –The internal rate of return method (IRR).

11. 5-11 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Net Present Value (NPV) Difference between the PV of the net cash flows (NCF) from an investment, discounted at the required rate of return, and the initial investment outlay. Measuring a project’s net cash flows: –Forecast expected net profit from project. –Estimate net cash flows directly. The standard NPV formula is given by:

12. 5-12 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Net Cash Flow Cash inflows: –Receipts from sale of goods and services. –Receipts from sale of physical assets. Cash outflows: –Expenditure on materials, labour and indirect expenses for manufacturing. –Selling and administrative. –Inventory and taxes.

13. 5-13 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Evaluation of NPV NPV method is consistent with the company’s objective of maximising shareholders’ wealth. –A project with a positive NPV will leave the company better off than before the project and, other things being equal, the market value of the company’s shares should increase. Decision rule for NPV method: –Accept a project if its NPV is positive when the project’s NCFs are discounted at the required rate of return.

14. 5-14 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University NPV Example Example 5.1: – Investment of $9000. – Net cash flows of $5090, $4500 and $4000 at the end of years 1, 2 and 3 respectively. – Assume required rate of return is 10% p.a. – What is the NPV of the project?

15. 5-15 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University NPV Example (cont.) Solution: Apply the NPV formula given by Equation 5.5. Thus, using a discount rate of 10%, the project’s NPV = +$2351 > 0, and is therefore acceptable.

16. 5-16 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Internal Rate of Return (IRR) The internal rate of return (IRR) is the discount rate that equates the PV of a project’s net cash flows with its initial cash outlay. –IRR is the discount rate (or rate of return) at which the net present value is zero. The IRR is compared to the required rate of return (k). If IRR > k, the project should be accepted.

17. 5-17 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Calculation of Internal Rate of Return By setting the NPV formula to zero and treating the rate of return as the unknown, the IRR is given by:

18. 5-18 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Calculation of Internal Rate of Return (cont.) Using the cash flows of Example 5.1, the IRR is:

19. 5-19 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Multiple and Indeterminate Internal Rates of Return Conventional projects have a unique rate of return. Multiple or no internal rates of return can occur for non-conventional projects with more than one sign change in the project’s series of cash flows. Thus, care must be taken when using the IRR evaluation technique. Under IRR: Accept the project if it has a unique IRR > the required rate of return.

20. 5-20 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Choosing Between the Discounted Cash Flow Methods Independent investments: –Projects that can be considered and evaluated in isolation from other projects. –This means that the decision on one project will not affect the outcomes of another project. Mutually exclusive investments: –Alternative investment projects, only one of which can be accepted. –For example, a piece of land is used to build a factory, which rules out an alternative project of building a warehouse on the same land.

21. 5-21 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Choosing Between the Discounted Cash Flow Methods (cont.) Independent investments: – For independent investments, both the IRR and NPV methods lead to the same accept/reject decision, except for those investments where the cash flow patterns result in either multiple or no internal rate(s) of return. – In such cases, it doesn’t matter whether we use NPV or IRR.

22. 5-22 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Choosing Between the Discounted Cash Flow Methods (cont.) Evaluating mutually exclusive projects: –NPV and IRR methods can provide a different ranking order. –The NPV method is the superior method for mutually exclusive projects. –Ranking should be based on the magnitude of NPV.

23. 5-23 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Benefit-Cost Ratio (Profitability Index) The profitability index is calculated by dividing the present value of the future net cash flows by the initial cash outlay: Decision rule: –Accept if benefit–cost ratio > 1 –Reject if benefit–cost ratio < 1

24. 5-24 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Other Methods of Project Evaluation Two major non-discounted cash flow methods that are used: –Accounting rate of return method (ARR) –Payback period method (PP) These methods are usually employed in conjunction with the discounted cash flow methods of project evaluation.

25. 5-25 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Accounting Rate of Return Earnings (after depreciation and tax) from a project expressed as a percentage of the investment outlay. The calculation involves: –Estimating the average annual earnings to be generated by the project. –Investment outlay (initial or average).

26. 5-26 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Accounting Rate of Return (cont.) Fundamental problems of ARR in project valuation: –Arbitrary measure — based on accounting profit as opposed to cash flows, depends on some accounting decisions such as treatment of inventory and depreciation. –Ignores timing of the earnings stream — no time value of money concepts are applied, as equal weight is given to accounting profits in each year of the project’s life.

27. 5-27 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Payback Period The time it takes for the initial cash outlay on a project to be recovered from the project’s after-tax net cash flows. Using Example 5.1, assume cash flow occurs throughout year and find the payback period of the project: Project cost: –9000 Year 1: +5090 3910 Year 2: 3910/4500 = 0.87, so it takes 1.87 years for the project to recover its initial cost. Decision: –Compare payback to some maximum acceptable payback period. –What length of time represents the ‘correct’ payback period as a standard against which to measure the acceptability of a particular project?

28. 5-28 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Payback Period (cont.) Strengths: –It is a simple method to apply. –It identifies how long funds are committed to a project. Weaknesses: –Inferior to discounted cash flow techniques because it fails to account for the magnitude and timing of all the project’s cash flows. –Does not consider how profitable a project will be, just how quickly outlay will be recovered.

29. 5-29 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Summary of Evaluation Methods Discounted cash flow methods are superior investment appraisal methods as they account for timing of cash flows and the time value of money. DCF methods will always give the same accept/reject decision for a conventional project. In practice, the above-mentioned alternative project evaluation methods (most likely payback period) may be used in conjunction with DCF methods: see Table 5.1.

30. 5-30 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Economic Value Added (EVA) Alternative to discounted cash flow methods, accounting rate of return and payback period. Key factor is the required rate of return. EVA is the difference between the project’s accounting profit and the required return on the capital invested in the project. EVA can be improved by increasing accounting profit or by reducing capital employed.

31. 5-31 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Economic Value Added (cont.) EVA is given by: Discounted sum of EVAs equals NPV of project.

32. 5-32 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Real Option Analysis In practice, company management will often have time flexibility in their investment decision choices and ways to manage project if firm decides to proceed. Management choices are often known as real options. Option gives a successful tender for a project the right but not the obligation to initiate operation on a project. Depending on changes in circumstances successful bidder may or may not take up option immediately. Hence, option gives bidder the right to exploit any advantageous changes in circumstances. It is significant to consider value associated with management’s flexibility. (pp.127–8)

33. 5-33 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Summary NPV method is recommended for project evaluation. The method is consistent with shareholder wealth maximisation. NPV is also simple to use and gives rise to fewer problems than the IRR method, such as non-uniqueness. Independent projects — accept if NPV > 0, reject if NPV < 0.

34. 5-34 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Summary (cont.) Mutually exclusive projects — accept project with the highest NPV. In practice, other valuation methods such as accounting rate of return, payback period and economic value added are used in conjunction with NPV, despite a preference for DCF methods. This may be to measure some other effect, such as the effect of the project on liquidity — payback period. Real option analysis considers managerial flexibility is valuable unlike project evaluation methods, where the idea of management ability to intervene in an ongoing project is ignored.