DISCOUNTED MEASURES OF PROJECT WORTH CONTINUED

Lecture 5

Net Present Value (NPV)

The cashflows estimated for the project are in the future; they are not yet realised The future is not here yet, but decisions would have to be taken in the present time

Net Present Value (NPV)

The question then is, what is the value of these future estimated cashflows in the present or current period, or better still today? future estimated cashflows would have to be brought to the current or present period

Net Present Value (NPV)

Bt -Ct NPV = t (1+r) t=1

Net Present Value (NPV)

Bt Ct NPV = t t (1+r) (1+r) t=1 t=1

Net Present Value (NPV)

Where : Bt Ct is periodic benefit is periodic cos t is the summation sign

Net Present Value (NPV)

Decision Rule:
NPV > 0; project is viable, accept. NPV < 0; project is not viable, reject. NPV = 0; project is neither viable nor not viable

Net Present Value (NPV)

The value of NPV suggests how much a project is adding in value terms to an existing entity or how much value the project is creating. A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.

Net Present Value (NPV)

Since the goal of projects is to add value or increase owners wealth, NPV is a direct measure of how well this project will meet the goal. NPV has units of currency such as cedis () or US dollars (US$).

Net Present Value (NPV)

Year 0 1 2 3 4 5 6 7

-100

30

30

40

20

10

-100

30

30

30

30

30

10

10

Net Present Value (NPV)

Cashflow Analysis for Project A and B Cashflow Year 0 1 2 3 A -100 30 30 40 B -100 30 30 30 Discount Factor (1+0.30)^-t 1.0000 0.7692 0.5917 0.4552 Discounted Cashflow A -100.00 23.08 17.75 18.21 B -100.00 23.08 17.75 13.65

4
5 6 7

20
10 0 0

30
30 10 10

0.3501
0.2693 0.2072 0.1594 Net Present Value

7.00
2.69 0.00 0.00 -31.2691

10.50
8.08 2.07 1.59 -23.2675

Net Present Value (NPV)

Advantages Takes opportunity cost of money into account. A single measure, which takes the amount and timing of cashflows into account. With NPV one can consider different scenarios.

Net Present Value (NPV)

Results are expressed in value terms units of currency. So one is able to know the impact the value that the project would create. It is based on cashflows, which are less subjective than profits.

Net Present Value (NPV)

Disadvantages Complex to calculate and communicate. Meaning of the result is often misunderstood. Only comparable between projects if the initial investment is the same.

Net Present Value (NPV)

It can be difficult to identify an appropriate discount rate. Cashflows are usually assumed to occur at the end of a year, but in practice this is over simplistic.

Net Benefit Investment Ratio

Investments are required for project benefits to be realised. These investments in the project cashflow can be identified as negatives.

Net Benefit Investment Ratio

The procedure:
discount all the positive cashflows separately discount all the negative cashflows separately. Sum each of them The sum of positive discounted cashflows is divided by sum of negative discounted cashflows.

Net Benefit Investment Ratio

B
t 1

t t

NBIR

(1 i)

K
t 1

t t

(1 i) where K is sum of negative net benefit or investment

Net Benefit Investment Ratio

The decision rule:
NBIR > 1 accept; NBIR < 1 reject.

Net Benefit Investment Ratio

Cashflow Analysis for Project A and B Cashflow Year 0 1 2 3 A -100 30 30 40 B -100 30 30 30 Discount Factor (1+0.30)^-t 1.0000 0.7692 0.5917 0.4552 Discounted Cashflow A -100.00 23.08 17.75 18.21 B -100.00 23.08 17.75 13.65

4
5 6 7

20
10 0 0

30
30 10 10

0.3501
0.2693 0.2072 0.1594 Sum of +ves Sum of -ves

7.00
2.69 0.00 0.00 68.7309 100.00

10.50
8.08 2.07 1.59 76.7325 100.00

NBIR

0.687309

0.767325

Net Benefit Investment Ratio

NBIR is also referred to as Profitability Index by the accounting profession. It is often used for ranking projects especially if rationing is in place.

Benefit Cost Ratio (BCR)

A variant of the formula for NPV uses the subtraction of discounted cash outflow from discounted cash inflow. In the case of BCR, the discounted cash inflow is expressed in terms of the discounted cash outflow.

Benefit Cost Ratio (BCR)

Bt t (1 r ) t BCR T Ct t (1 r ) t

Benefit Cost Ratio (BCR)

This can be viewed as:
how many times the discounted cash inflow covers the discounted cash outflow over the project horizon.

Benefit Cost Ratio (BCR)

Decision criteria
For a single project, a B/C ratio which is greater than 1 indicates acceptability For multiple (competing) projects, the project(s) with the highest B/C ratios (greater than 1) should receive highest priority

Benefit Cost Ratio (BCR)

NPV measures totals, indicates the amount by which benefits exceed (or do not exceed) costs. B/C measures the ratio (or rate) by which benefits do or do not exceed costs. They are clearly similar, but not identical. With multiple projects, some may do better under NPV analysis, others under B/C.

Internal Rate of Return (IRR)

IRR is the rate of return or discount rate that makes the NPV = 0. Decision Rule:
Accept the project if the IRR is greater than the required return

Internal Rate of Return (IRR)

This is the most important alternative to NPV. It is often used in practice and is intuitively appealing. It is based entirely on the estimated cashflows and is independent of interest rates found elsewhere. Without a financial calculator, this becomes a trial and error process.

Internal Rate of Return (IRR)

A critical thing to note is that there should be at least one change of sign in order to realise IRR. there should be a negative net cashflow among positive net cashflows or a positive cashflow among negative cashflows. The change in sign is crucial.

Internal Rate of Return (IRR)

Using a spreadsheet; Start with the cashflows. You first enter your range of cashflows, beginning with the initial cash outlay (negative).

Internal Rate of Return (IRR)

Call the IRR function
Choose insert on the menu bar Select function Choose IRR from among the list Select the range of cashflows Enter a guess rate, but it is not necessary; Excel will start at 10% as a default The default format is a whole percent you will normally want to increase the decimal places to at least two to get the most accurate output.

Internal Rate of Return (IRR)

NPV and IRR will generally give us the same decision. There are however some exceptions.
Non-conventional cashflows
cashflow signs change more than once

Mutually exclusive projects

Initial investments are substantially different Timing of cashflows is substantially different

Internal Rate of Return (IRR)

When the cashflows change sign more than once, there is more than one IRR. When we solve for IRR it would be noticed that we are solving for the root of an equation and when we cross the x-axis more than once, there will be more than one return that solves the equation. Therefore, IRR may be unreliable if we have any negative cashflows after our original investment.

Internal Rate of Return (IRR)

Suppose an investment will cost 90,000 initially and will generate the following cashflows:
Year 1: 132,000 Year 2: 100,000 Year 3: -150,000

The required return is 15%. Should we accept or reject the project?

Internal Rate of Return (IRR)

Year 0 -90,000

Year 1
Year 2 Year 3

132,000
100,000 -150,000

IRR

10.11%

reject

NPV fx 15% Less inv. NPV at 15%

91,770 -90,000 1,770 accept

IRR says to reject, but NPV says to accept. Go with NPV.

Internal Rate of Return (IRR)

Mutually exclusive projects
If you choose one, you cant choose the other Example: You can choose to attend graduate school next year at either Legon or Central, but not both

Internal Rate of Return (IRR)

Intuitively you would use the following decision rules:
NPV choose the project with the higher NPV IRR choose the project with the higher IRR

Internal Rate of Return (IRR)

Period Project A Project B

0
1 2 IRR

-500
325 325 19.43%

-400
325 200 22.17%

NPV

64.05

60.74

Internal Rate of Return (IRR)

The required return for both projects is 10%. Which project should you accept and why? (Accept Project A because of NPV)

Internal Rate of Return (IRR)

Conflicts between NPV and IRR
NPV directly measures the increase in value to the firm. Whenever there is a conflict between NPV and another decision rule, you should always use NPV. IRR is unreliable in the following situations Non-conventional cashflows Mutually exclusive projects

Internal Rate of Return (IRR)

Advantages of IRR It takes into account the time value of money, which is a good basis for decisionmaking. Results are expressed as a simple percentage, and are more easily understood than some other methods. It indicates how sensitive decisions are to a change in interest rates.

Internal Rate of Return (IRR)

Advantages of IRR It is a simple way to communicate the value of a project to someone who doesnt know all the estimation details. If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task.

Internal Rate of Return (IRR)

Advantages of IRR It is a simple way to communicate the value of a project to someone who doesnt know all the estimation details. If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task.

Internal Rate of Return (IRR)

Disadvantages For mutually exclusive projects: timing and scale differences. This may lead to incorrect decisions in comparisons of mutually exclusive investments. Assumes funds are re-invested at a rate equivalent to the IRR itself, which may be unrealistically high.

Internal Rate of Return (IRR)

IRR will produce more than one mathematically correct rate for each year in which inflows are followed by outflows and vice versa. This is common with projects with unconventional cashflows. This can create some confusion to the user.

Choice of Discount Rate

Cost of capital - weighted average and marginal (financing rate) Opportunity cost of capital - what could they earn if that money was elsewhere Current capital position and expected capital position over next few years The rates of return for alternative investments. Market sentiments.

Sources of discount rate

Banks Long term government papers Ministry of Finance Sponsors

Suggestions
For industrial projects use market rate or cost of borrowing funds. For public sector projects use social time preference rate. For public projects to be funded from international loans use the cost of borrowing.

Suggestions
Generally, in financial analysis, the market rate is used, whilst the social time preference rate is used for public sector projects. When funding comes from various sources or from the same source but at different rates, then, compute and use the weighted average.

Choosing Year 0 or Year 1

World Bank
World Bank believes that since investment is made and some returns may accrue from the first year, then discounting should start from 0 to first year. In this case, the initial year is Year 1.

Choosing Year 0 or Year 1

Others
Other international originations use Year 0. Their argument is that investment must take place before benefits accrue. Thus, discounting should start from the second year.

Choose any convention but be consistent.

Deciding on a Project
We should consider several investment criteria when making decisions. NPV and IRR are the most commonly used primary investment criteria. Payback is a commonly used secondary investment criteria, but only because of its ease of use.

Deciding on a Project
For a single project, a positive NPV indicates acceptability. For multiple (competing) projects, the project(s) with the highest NPVs should receive highest priority.