Knowledge and application of project evaluation techniques is very necessary before taking investment decisions for capital projects. We have learnt fundamentals about project and project management in our previous post. Let us understand various project evaluation techniques for taking investment decisions for capital projects. The investment criteria are broadly divided into two categories:
Discounting Cash Flow (DCF) Criteria
Non- Discounting Cash Flow Criteria
These criteria are further divided into sub- categories as below:
Let us discuss each investment method in detail:
Net Present Value (NPV)
Net present value is the sum of present values of all the cash flows expected to occur over the life of the project. The cash flows may be negative or positive and accordingly the net present values of cash flows will be.
NPV= ∑ Ct /(1+r)t – Initial Investment, ∑ runs from 1 to n.
Where Ct is the cash flow at the end of year t, n is the life of the project and r is the discount rate.
Decision rule for net present value:
Benefit Cost Ratio
The benefit cost ratio is defined in two ways:
Where PVB is the present value of benefits, and I is the initial investment.
The following decision rule is followed w.r.t. the benefit cost ratio:
Internal Rate of Return
The internal rate of return (IRR) of a project is the discount rate which makes its NPV equal to zero. In other words, it is the discount rate which equates the present value of future cash flows with the initial investment.
Investment= ∑ Ct/ (1+r)t, t runs from 1 to n,
Where Ct is the cash flow at the end of year t, r is the internal rate of return (IRR), and n is the life of the project.
In NPV calculation, we assume that the discount rate (cost of capital) is known and we calculate the value of NPV. In the IRR calculation, the NPV is kept equal to zero and the discount rate is calculated to satisfy the equation.
The decision rule for IRR is as follows:
The payback period is the time required to recover the initial investment made on the project. For e.g. if a project involves an initial investment of USD 5,50,000 and the paybacks are in the form of cash flows of USD 1,00,000, USD 1,50,000, USD 2,00,000 and USD 1,00,000, in the first, second, third and fourth years respectively, then it’s payback period is 4 years because the initial investment is being recovered in four years. When the annual inflow is the constant amount, the payback period is calculated by simply dividing the initial investment by the annual cash flow. For e.g., if the project has an initial outlay of USD 2,50,000 and a constant annual cash flow is USD 50,000 then the project will be a payback period of 5 years which is derived from dividing USD 2,50,000 by USD 50,000.
According to this criteria, the shorter the payback period, the more desirable is the project. This criterion is used by the firms to specify the maximum acceptable payback period. Projects with the payback period less than the acceptable payback period are accepted while the projects having payback period equal to or more then the desirable payback period are rejected.
Accounting Rate of Return
The accounting rate of return, also known as the average rate of return on investment, is a measure of profitability which relates income to investment, both measured in accounting terms.
The measures generally used in practice are as follows:
The higher the accounting rate of return, the better the project. In general, projects which have and accounting rate of return equal to or greater than a pre- specified cut off rate of return which is usually between 15% and 30%.
Applicability of various methods
The most commonly methods for evaluating small sized projects are payback method and accounting rate of return method. For larger projects, IRR appears to be the most commonly used method. The selection of project evaluation technique depends on the type and size of the project.
(a) The methods of project evaluation are broadly categorized into two parts, discounting methods and non-discounting methods of project evaluation.
(b) The important discounting methods are net present value, benefit cost ratio and internal rate of return methods.
(c) The main non- discounting methods of project evaluation are payback period and accounting rate of return methods.
(d) The net present value is the sum of all positive and negative cash flows expected to occur during the lifetime of the project.
(e) The decision rule regarding NPV method is: accept the project if the NPV is positive and reject the project if NPV is negative.
(f) The benefit cost ratio is determined by dividing the present value of benefits (cash inflows) to the present value of costs (cash outflows)
(g) A project is considered worthwhile if the benefit cost ratio is more than one and not worthwhile if the benefit cost ratio is less than one.
(h) The internal rate of return is the discount rate (cost of capital) which makes its NPV equal to zero.
(i) The decision rule in IRR is: accept the project if tis IRR is greater than the cost of capital; reject the project if its IRR is less than the cost of capital.
(j) The payback period is the length of time required the initial cost outlay of the project.
(k) The shorter the payback period, the more desirable will be the project.
(l) The accounting rate of return is also called the average rate of return.