We can evaluate a project or select a project from different alternatives by the following methods:

 the equivalent present value (worth) method

 the equivalent future value (worth) method
 the equivalent annual value (worth) method.
Apart from the above, we can evaluate a project on the basis of Internal Rate of Return (IRR) and the payback
period.
The above is called capital budgeting technique or project evaluation technique.

Payback period
 The payback period is the number of years required to recover the investment made in a project.
 Example:
 Initial Investment = Rs 300,000
 Annual Net benefits = Rs 75,000
 Payback period = Initial investment/ Unif. Annual benefit =4 years

Discounted Payback Period

To modify the payback period method and accound time value of money, we may consider the cost of fund
(interest) used to support the project. This modified method is called discounted payback period.

Present Value Analysis

Until 1950s, the payback period method was widely used as a means of making investment decisions. As
there are flaws in this method, businessmen began to search methods for improving the project evaluations.
This led to the development of discounted cash flow (DCF) techniques, which take account of time value of
money. One of the DCF methods is Net Present Value (NPV) method.
Under NPV method, PV of all cash inflows are compared with PV of all cash outflows. The difference
between these PV's is called Net Present Value (NPV).
NPV Criterion
 The basic procedure for applying this criterion:
 Determine the required rate of interest the firm wants. This interest rate is called
required rate of return (ROR) or minimum attractive rate of return (MARR).
 Estimate the service life of the project
 Estimate the cash inflow for each period of the service life
 Estimate the cash outflow for each period of service life
 Determine the net cash flows
 Find the present value of each net cash flow discounted at the MARR.
 Add up the PV's including the initial investment. Their sum is defined as the NPV of the
project
 NPV = A0/(1+i)0 + A1/(1+i)1 + A2/(1+i) 2 + ….. +An/(1+i)n

 If NPV > 0, accept the investment

 If NPV = 0, remain indifferent
 If NPV< 0, reject the investment.
 For service projects, we use the NPV of costs and choose the project which has the least
negative NPV.
 For revenue projects, we use NPV of revenues and choose the project which has the
highest NPV.
 Capitalized Equivalent Method
Another method of PV criterion is useful when the life of project is perpetual
or planning horizon is very long.
Perpetual Service life
PV = A/i
 The process of calculating PV cost for infinite period is called capitalization of project
cost. The cost is known as the Capitalized cost i.e. the amount of money to be invested
now to get a certain return 'A' at the end of each and every year forever.

Annual Equivalent Analysis

The annual equivalent value (AE) criterion is a basis for measuring investment
value by determining equal payments on an annual basis.

First, we have to find the NPV of the project and then convert it to equal
annual payments.
AE(i) =PV(i)(A/P,i,n)
If AE>0, accept the project
If AE =0, remain indifferent
If AE <0, reject the project
Benefit of AE analysis than others
 1. Consistency of report format. Financial and engineering managers may prefer to
work on yearly costs rather than overall costs.
 2. Need for unit costs. In many situations, project must be broken down into unit
costs for comparison and ease.
 3. Unequal project lives. Comparing projects with unequal service lives is complicated
in calculations, but using AE analysis, this problem can be easily solved.

Life Cycle cost

 If a project investment cost is ‘P’ with the service life of ‘n’ period.
 The annual operating cost is ‘Ai’.
 The life cycle cost (LCC) is
 LCC = Capital cost + operating cost
𝑷
LCC=P+∑ 𝑨𝒊(𝑨 , 𝒊, 𝒏)

Internal Rate of Return

 IRR is the interest rate earned on the unrecovered project balance of
investment such that, when the project terminates, the unrecovered project
balance will be zero.

NPV = A0/(1+i*)0 + A1/(1+i*)1 + A2/(1+i*)2 …….+ An/(1+i*)n =0

Methods of project Evaluation by IRR
 If IRR>MARR, accept the project
 If IRR = MARR, remain indifferent
 If IRR < MARR, reject the project

 Under NPV and AEV analysis, the mutually exclusive project with the highest value is
selected and this method is known as “Total Investment Approach”. NPV, NFV, and AEV
methods of project evaluation are absolute measures, whereas the IRR method is a
relative (percentage) measure, and it ignores the scale of investment. But for
comparison of mutually exclusive projects by IRR method, we have to do Incremental
Investment Analysis.
 ROI Return of investment expresses the annual return from project as % of capital cost.
This is a broad indicator of the annual return expected from initial capital investment,
expressed as a percentage

 Annual Net Cash Flow

 ROI = --------------------------------- x 100
 Capital Cost
It does not take into account the time value of money
It does not account for the variable nature of annual net cash flow inflows
Benefit Cost Analysis
 The objective of private investment is to increase the net worth of the company
 In the public sector, government spend a lot of money on projects such as education,
health, infrastructure – road construction, airport construction, water pipeline,
irrigation systems, and hydropower plants etc.
 Benefit –cost Analysis is a decision-making tool for systematically developing useful
information about desirable or undesirable effects of a public project.
 Benefit-cost Analysis tries to determine whether the social benefits are greater than
social costs.
 Benefit Cost Ratio
 We need to consider social benefits and costs of primary effects and secondary effects

 B – C should be positive
 If B and C are the present values of benefits and costs, then
 B =Σ Bn (1+i)-n
 C = Σ Cn (1+i)-n
 The sponsors’ costs consist of the equivalent capital (I) and equivalent annual operating
costs (C’), then
 I =Σ cn (1+i)-n
 C’ =Σ Cn (1+I)-n
 Here, C =I+C’
 BC(i) = B/C= B/(1+C’)>1
 An alternative measure,
 net B/C =(B –C’)/I>1, where I>0