Assessing the Project Worth

Samantha Manawadu
 Financial and Economic Analysis
Financial Analysis
Definition
Financial Analysis evaluates the commercial viability / Profitability of a project
from the point of the owner/enterprise perspective.

Objectives
Objective is to assess the degree to which a project will generate revenue
sufficient to meet its financial obligation. i.e. meet the O&M and recover the
capital cost.

Aspects
 Financial Performance/Profitability - Owners perspective
 Ability to generate sufficient revenue
 Cost Recovery (including the O&M)
 Cost effectiveness
 Financial Sustainability
 Capability to survive event after the termination of the external assistance.
How to conduct financial analysis
Estimated Financial Costs
- Investment cost
- O&M Cost

 Estimated Financial benefit

 Cash flow Analysis
 Project Life
 Match the Financial benefit to Financial cost
 Time value of money – Discounting
 Compute NPV, FIRR, B/C ratio, pay back period
 Sensitivity Analysis – risk/uncertainty
 Economic Analysis
Definition
Evaluates the Economic Viability of the project from the
country perspective

Objectives
Assessment of the impact of the project to the National
economy from a country perspective

Aspects
Contribution to the aggregate output
Contribution to the Macro Economic Objectives and
Sectoral Objectives
Socio Economic Impact
 How to conduct economic analysis
 Estimated Economic Costs
- Investment Cost
- O&M Cost
(Financial Prices to Economic Prices / Shadow pricing)
 Estimated Economic Benefits
 “With” and “Without” Project scenario
- Incremental Cost/Benefits
 Cost/Benefits at Constant cash flow profile
 Project Life
 Compare / Match the Economic benefit stream to
Economic cost stream
 Economic Criteria

 Net Present Value (NPV)

 Benefit Cost Ratio (B/C Ratio)

 Economic Internal Rate of Return

Opportunity Cost of Capital – 10%

 Sensitivity Analysis
 A Comparison of Financial and
Economic Analysis

Financial Economic
Commercial Viability / Impact on National
Objective Profitability – Enterprise Economy Country
Perspective Perspective
Composition of (Financial) Enterprise (Economic) – National
Costs/ Benefits Perspective Perspective

Prices Financial Prices Economic Prices

Weighted Opportunity Economic cost of public

Discount
Cost of Capital funds
 Financial and Economic Point of View
Economic
+ -

Financial
+ a b
- c d

a. Generate benefits to the owner and country

b. Cultivation with extensive pesticides, Hotel projects, Environmentally

threatening projects

c. Profitability to the Country/Society. But unprofitable to owner.

E.g. Rural Electrification. Bio Diversity, Watershed protection

d. Net loss to both owner and country

Assessing the Project Worth
 Intrinsic worth of a project could be
investigated by comparing its estimated
benefits and costs overtime.

 Selection of single project is based on the

following measures
- Payback
- Accounting Rate of Return (ARR)
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Benefit Cost Ratio (BCR)
Project Analysis Techniques
Non discounting techniques
(a) Payback Period
(b) Accounting Rate of Return (ARR)

Discounting techniques
(a) Net Present Value (NPV)
(b) Internal Rate of Return (IRR)
(c) Benefit / Cost Ratio (B/C Ratio)
 Cash Flow Statement of Project
Year Y0 Y1 Y2 Y3 Y4 Y5

Investment
(1,000,000)
cash – outflow

O&M (600,000) (600,000) (700,000) (900,000) (1,100,000)

Revenue 900,000 900,000 1000,000 1200,000 1,400,000

Net cash flow (1,000,000) 300,000 300,000 300,000 300,000 300,000

1. Pay-back :
Number of years it will take for a project to recover its investment
Payback period 1000000 = 3.33 years or 3 years and 4 months
300000
Shorter the period is preferred

Rules for decision :

a. Accept or Reject decision rule
If the payback is lower than the “target payback” accept the project otherwise reject.
b. Ranking rule :
Provided that the paybacks are lower than the target paybacks, the lower the payback
the better the project.
Advantages
- It is easy to calculate
- “Liquidity” aspect is considered
- It considers safe guard against risk
- Could be used as an initial screening device

Limitations
- Fails to take account of “timing” of receipts and payments
- Importance of the flows received after payback are not considered in decision making
- Time value of money is ignored
- Defining the target period may be a problem
- Variations in the timing of Cash flows within the payback period are ignored
 Exercise - Payback
Using the following data, select the projects using payback
(target payback – 4 yrs)

P Q R
Project Year
NCF (Rs. ‘000) NCF (Rs. ‘000) NCF (Rs. ‘000)
0 (50,000) (45,000) (40,000)
1 10,000 16,000 20,000
2 12,000 18,000 22,000
3 15,000 10,000 8,000
4 16,000 9,000 4,000
5 10,000 5,000 2,000
6 6,000 2,000 1,000

What would be the decision about the project P,Q and R

 Project P Project Q Project R
Year
Cum. NCF Cum. NCF Cum. NCF
NCF (Rs. Mn) NCF (Rs. Mn) NCF (Rs. Mn)
(Rs. Mn) (Rs. Mn) (Rs. Mn)

0 (50) (50) (45) (45) (40) (40)

1 10 (40) 16 (29) 20 (20)
2 12 (28) 18 (11) 22 2
3 15 (13) 10 (1) 8 10
4 16 3 9 8 4 14
5 10 13 5 13 2 16
6 6 16 2 15 1 17
Pay 3+13/16 3+1/9 1+20/22
back
= 3.81 yrs = 3.11 yrs = 1.91 yrs

As above, the payback periods of all 3 projects are lower

than the target payback period of 4 years. All 3 projects can
be selected for implementation.
2. Accounting Rate of Returns (ARR)

ARR = Estimated average Profit X 100

Estimated Initial Investment

It is the return on investment (ROI)

Accounting Rate of Return : is a measure of Profitability

Total Profit after depreciation = 1,500,000 – 1,000,000
= 500,000
Average Profit = 500,000/5 = 100,000
Average Accounting Rate of Return = 100,000 x 100
1,000,000
= 10%
Rules for decision :
a. Accept or reject decision rule
If the ARR greater than the “cost of Capital” accept the
project, otherwise reject
b. Ranking decision rule
Provided that the ARRs are greater than the cost of
capital, the higher the ARR the better the project.
Advantages :
- It is simple to calculate
- It is considered profits over the life of the project and
therefore shareholders are more impressed
Limitations
- Fails to take account of “timing” of receipts and
payments
- Importance of “liquidity” (quick cash return) is not
reflected “Time value of money” is ignored
- The method of defining both capital employed and
profits must be clearly stated
- The different size of projects is not explicitly
considered
Discounting
Benefits and costs at different point of time are not comparable. Discounting is a mechanism
used to bring the cost and benefits of different point of time into a comparable form.

Discounting factor = 1 r = cost of capital

(1+r)n

Present Value = Future Value

(1+r)n
Discount Table

Year Y0 Y1 Y2 Y3 Y4 Y5

10% Disc. rate 1.00 0.91 0.83 0.75 0.68 0.62

18% Disc. rate 1.00 0.85 0.72 0.61 0.52 0.44

3. Net Present Value (NPV)
NPV = Discounted Cash inflows-Discounted Cash outflows
OR
= Present value of benefits – Present value of costs

 NPV gives the absolute worth of the project – absolute surplus (size
of the cake)
 Cost of capital is used as a discounting rate
 NPV is the summation of the discounted net benefits

Rules for decision :

a. Accept or Reject decision rule
Using the cost of capital as discounting rate if NPV is positive accept
the project, otherwise reject.
b. Ranking decision rule
Using the cost of capital as discounting rate, provided that the NPVs
are positive, the grater the NPV the better the project.
 Net Present Value
 NPV is the summation of the discounted net benefits

Where Bt = Project benefit in period “t”

Ct = Project cost in period “t”
r = Appropriate discount rate
n = Number of years
If NPV > 0, accept the project; if NPV < 0,reject; if NPV
is zero, no effect whether accepted or rejected
 Advantages
- Cash flow method
- The concept of “ time value of money” is taken into account
- It gives a measure of the absolute surplus derived from an investment.
- Correct reinvestment assumptions (NPV methods assumes that cash flows
are reinvested at cost of capital, which is correct in practice).
- Stakeholder’s wealth is maximized (therefore the authority to make
decisions could be delegated to agents)
- By applying “sensitivity analysis” and “simulation” risk can be taken into
account.
Limitations
- A constant cost of capital is assumed over the life of the project
- Difficulties in determining the interest rate
- Cannot be directly used for mutually exclusive projects with unequal lives.
- Cannot be directly used for ranking projects under capital rationing.
- In order to assess the whether a larger NPV indicates a more efficient use
of capital the NPV has to be supplemented by the calculation of the IRR.
- Fails to indicate which project uses capital more efficiently.
 Discounted Cash Flow Statement at 10%
Year Y0 Y1 Y2 Y3 Y4 Y5
Net cash flow (1,000,000) 300,000 300,000 300,000 300,000 300,000
Disc. Rate 10% 1.00 0.91 0.83 0.75 0.68 0.62

Disc. Cash flow (1,000,000) 273,000 249,000 225,000 204,000 186,000

Net Present Value (NPV) = 137,000 at 10%

Discounted Cash Flow Statement at 18%

Year Y0 Y1 Y2 Y3 Y4 Y5

Net cash flow (1,000,000) 300,000 300,000 300,000 300,000 300,000

Disc. Rate 18% 1.00 0.85 0.72 0.61 0.52 0.44

Disc. Cash flow (1,000,000) 255,000 216,000 183,000 156,000 132,000

Net Present Value (NPV) = (58000) at 18%

 Exercise – Increased Discounting Rate
Discounting rate is 10%
Project P Project Q Project R
Present
Year Factor PV
NCF NCF PV NCF PV
@ 10% Rs. ‘000
Rs. ‘000 Rs. ‘000 Rs. ‘000 Rs. ‘000 Rs. ‘000

0 1 (50,000) (50,000) (45,000) (45,000) (40,000) (40,000)

1 0.909 10,000 9,090 16,000 14,544 20,000 18,180
2 0.826 12,000 9,912 18,000 14,868 22,000 18,172
3 0.751 15,000 11,265 10,000 7,510 8,000 6,008
4 0.683 16,000 10,928 9,000 6,147 4,000 2,732
5 0.621 10,000 6,210 5,000 3,105 2,000 1,242
6 0.564 6,000 3,284 2,000 1,128 1,000 564
NPV 789 NPV 2,302 NPV 6,898

As above, since NPVs of all 3 projects are positive, the projects can be
selected for implementation
 Exercise – Increased Discounting Rate
Discounting rate is 15%
Project P Project Q Project R
Present
Year Factor PV
NCF NCF PV NCF PV
@ 15% Rs. ‘000
Rs. ‘000 Rs. ‘000 Rs. ‘000 Rs. ‘000 Rs. ‘000

0 1 (50,000) (50,000) (45,000) (45,000) (40,000) (40,000)

1 0.870 10,000 8,700 16,000 13,920 20,000 17,400
2 0.756 12,000 9,072 18,000 13,608 22,000 16,632
3 0.658 15,000 9,870 10,000 6,580 8,000 5,264
4 0.572 16,000 9,152 9,000 5,148 4,000 2,288
5 0.497 10,000 4,970 5,000 2,485 2,000 994
6 0.432 6,000 2,592 2,000 864 1,000 432
NPV (5,644) NPV (2,395) NPV 3,010

As above, since NPV of project R is positive, only project R can be selected for
implementation
 4. Internal Rate of return (IRR)
 For a project cash flow, when the discounting rate is changed
the NPV would change. For one particular discounting rate NPV
could become zero. This particular discounting rate is termed as
the Internal Rate of Return the project
 IRR is the Rate of Return of the project

+
NPV

0
Discount Rate %
IRR

-
Internal Rate of Return (IRR)
IRR is the discount rate at which the project’s NPV is Zero.

If IRR > opportunity cost of capital (OCC), accept the

project; if IRR < OCC ,reject; if IRR =OCC, no effect
whether accepted or rejected
Rules for decision :
a. Accept or Reject decision rule
If IRR is greater than cost of capital accept
the project, otherwise reject

b. Ranking decision rule

Provided that the IRRs are greater than
cost of capital, the greater the IRR the
better the project.
5. Internal Rate of Return

A + P X (B-A)
P+N A = Lower discount rate
B = Higher discount rate
P = Positive NPV
N = Negative NPV
= 10 + 137,000 x (18-10)
137,000+58,000

= 10 + 137,000 x 8
195,000

= 10 + 5.6

= 15.6%

Advantages

- The concept of “time value of money” is taken into account.

- IRR methods gives a rate of return of project (based on cash flows)
IRR - Limitations
- Certain projects have no rate of return
- Certain projects have multiple rate of return
- Not appropriate for mutually exclusive projects
- Lending or borrowing – When we lend money, we want a high rate
of return, when we borrow money, we want a low rate of return.
- IRR can lead to ambiguous results where negative benefits arise in
the middle of the project life, with more than one solution to
stream of net benefit.
- IRR does not strictly give a measure of the re-investible surplus
generated by a project
Benefit / Cost Ratio

B/C Ratio = Present value of Benefits

Present value of Costs

PV of Gross Benefits = PV of Benefits

PV of Gross Costs PV of Capital costs + PV of Operating
costs

B/C Ratio at 10% = 1,137,000 = 1.137

1,000,000
Benefit-Cost Ratio (BCR)
 BCR is the ratio of present value of benefits to
the value of costs.

 If BCR > 1, accept the project; if BCR < 1,reject;

if BCR = 1, no effect whether accepted or
rejected
 Rules for Decisions
Criterion Accept Reject
Non–discounting
methods

Payback period (PBP) PBP < target period PBP > target period

Accounting Rate of ARR > target rate ARR < target rate
Return
(ARR)

Discounting methods
Net Present Value (NPV) NPV > 0 NPV < 0

Internal Rate of Return IRR > cost of capital IRR < cost of capital
(IRR)

Benefit Cost Ratio (BCR) BCR > 1 BCR < 1

Methodology for
Mutually Exclusive Project Alternatives
 Mutually Exclusive alternative can be defined as a
project that can only be implemented at the
expense of an alternative project or by forgoing the
substitute project. If the selection and
implementation of one project is likely to make
another project unnecessary or unfeasible either
technically or commercially, then the two projects
are said to be mutually exclusive

 Frances Perkins (1994, p68) states, “By choosing one

mutually exclusive project, the opportunity to do
other will be lost”.
Projects can be Mutually Exclusive due to
 Choice of location: A road project with different
alternative alignments.
 Size : A large dam project as an alternative to a small dam
project
 Choice of technology : Project using capital-intensive
technology to labour intensive technology
 Site: Projects competing for the use of same site
 Choice of Project Life : A 10 year project against a
similar 50 year project
 Alternative versions: A project with a high maintenance
cost and low investment cost for a substitute project with
a lower maintenance cost and high investment cost.
 Alternative Design: In water supply project, pipeline
with 6 or 10 inch- diameter
Mutually Exclusive Projects
 For mutually exclusive, as it is a unique opportunity lost
forever and the chance to undertake the project will not
be repeated, the criteria should be to maximize the
magnitude of the absolute net benefit. Select the project
that gives the highest NPV at the appropriate discount
rate.

 IRR not suitable for mutually exclusive, as it reflects the

efficiency of the use of capital and not the absolute net
benefit. IRR or BCR is likely to be misleading, as selection
of a project with higher IRR (or BCR) may lead to smaller
project with lower absolute net surplus (NPV) thus
depriving the net gain to the economy.
(Price Gitinger, 1982, p373)
 In mutually exclusive, maximize the absolute surplus and
not the percentage return.
Mutually Exclusive Projects
Projects Investment cost NPV IRR
US$ ‘000 US$’000
Project A 375 181 (Rank 2) 20% (Rank 2)
Project B 170 112 (Rank 3) 26% (Rank 1)
Project C 825 232 (Rank 1) 16% (Rank 3)

 Assuming a COC of 8%, all 3 projects are viable as they have NPV > 0 and
IRR>COC. Under mutually exclusive, only one project can be selected.

 If we are to use IRR as criteria, the project B with highest IRR of 26% would
be selected and this has a lowest magnitude of absolute net benefit. By
selecting Project B the community will lose the benefit of Project C (NPV $
232) forever, which is economically undesirable. i.e, the lost opportunity of $
120 (i.e. S 232 – $112 = $ 120).

 Under mutually exclusive projects, as it is a unique opportunity and the

chance to undertake the project will not be repeated, one should select the
project that provides higher magnitude of absolute surplus – in this case the
Project C with highest NPV.
Discount Rate and NPV

Project B

Project A

NPV (+ive)

0
NPV (- ive) r r© r2 r3
IRR (A)

IRR (B)
 If the appropriate discount rate is r, then Project B has a
higher NPV than Project A, hence Project B would be
selected
 However, if the appropriate rate is greater than the cross-
over discount rate of r©, then Project A has higher NPV
than that of Project B, and as such Project A should be
selected.
 However,, in between the discount rate of r2 and r3, Project
B has negative NPV, whereas Project A has positive NPV
hence, Project A should be selected.
 If the discount rate is over r3, both projects have negative
NPV hence both should be rejected.
 But under the IRR criteria Project A looks better since it has
a greater IRR (r3>r2)
 Under mutually exclusive alternatives, the rule of thumb is
“Choose to maximize NPV, among alternatives as long as
NPV > 0 at a given discount rate (Steve Curry, et al. 2000,
p55)
Choosing Projects under Capital Rationing Scenario
 Capital rationing refers to allocation of scare capital
resources among competing economically desirable
projects, not all of which can be carried out due to
capital constraints (Haim Levy et al, 1982, p 513)

 A temporary budget constraint may compel the planners

to choose some projects out of the list of viable projects.
Under such situation, NPV criteria may not be useful
since selecting the project with highest NPV will not
generate greatest net receipt (net operating benefit) per
unit of investment.

 When investments funds are constraint, the greatest

benefit could only be obtained by selecting projects that
will yield highest net-benefit per unit of investment cost.
Choosing Projects under Capital Rationing Scenario
 The adjusted Benefit Cost Ratio – Known as Net
Benefit Investment Ratio (NBIR) or PV/K is used for
ranking projects under budget constraint. NBIR or PV/K
is the ratio of discounted net benefits (Benefits minus
operating cost) to the discounted capital investment
cost. If NBIR or PV/K > 1, the project is viable.

Where B1 = Project benefit in period “t”

OC1 = operating Cost in period “t”
K1 = Investment cost
r = Appropriate discount rate
n = Number of years
Choosing Projects under Capital Rationing Scenario
 Under the budget constraint scenario, the planners should select the
project that gives greatest net benefit (or net inflow) per unit of
investment cost until they exhaust the allocated budget.

 As the scarcity is only in respect of investment funds and not

operating cost, the basis of selection will to be maximized the net
benefit per unit of investment cost rather than the total cost.

 The ranking of projects using NBIR or PV/K criteria tallies with the
IRR based ranking. This implies that the project could be ranked on
the basis of IRR until the budget allocation is exhausted.

 Multilateral donor agencies such as World Bank and ADB operate

under fund constraint situation due to heavy demand for financing of
investments use IRR as criteria for selection.
Conclusion
 If inadequate investment budget is a permanent
phenomenon and if there are large numbers of
viable projects, when compared to the fund
availability, then it implies that the discount rate
does not reflect the true opportunity cost of
capital.

 Hence, the discount rate should be increased,

so that some of the projects that were earlier
viable would become unviable with the
increased discount rate, thus reducing the
number of projects to meet the limited budget.
Annuity Factors
 Where the same amount is received or paid per
period for several years, it is possible to use an
Annuity Factor.

 Suppose we wish to find the present value of

100 received annually for 5 years, with the first
payment received 1 year from now, using a
discount factor of 10%. The annual discount
factors somewhat laborious.
Year F x Discount = Present
Factor Value
1 100 x 0.9091 = 90.91
2 100 x 0.8264 = 82.64
3 100 x 0.7513 = 75.13
4 100 x 0.6830 = 68.30
5 100 x 0.6209 = 62.09
Total 379.07
Annuity Factors
 A shorter and easier method is to multiply the future
annual sum arising by the appropriate annuity factor, for
the term of years and rate of interest, in order to obtain
the present value. In this case:
F = 100 x Annuity Factor 3.7908 = Present value 379.08

 Annuity Factor is simply the sum of the discount factors

for the relevant years, e.g. the annuity factor for 5 years
at 10% per annum is 3.7908, while the discount factors
for years 1-5 at 10% sum to 3.7907 (the difference is
due to rounding of four figure tables):
0.9091 + 0.8264 + 0.7513 + 0.6830 + 0.6209 = 3.7907
 Annuity Factors
 Annuity factors may still be used, even when the sums
payable or receivable are constant for only part of the
project life. If 2000 is received annually for 6 years from
year 4 to year 9 inclusive, we can adopt the following
procedure, assuming a 9 % discount.
1. Take the present value of an annuity factor for 9 years at 9% =
5.9952
2. Subtract the annuity factor for 3 years at 9% = 2.5313
3. Equals annuity factor for years 4 – 9% = 3.4639
i.e, 2000 x 3.4639 = 6928
 We have subtracted the annuity factor for 3 years from that for 9
years to obtain the factor for years 4-9 inclusive.
Exercise
 A feeder road would cost Rs. 400,000 and last 10
years. Annual maintenance costs would be Rs.5,000
per year. If it were built there would be savings on
existing vehicle operating costs of Rs.20,000 per year.
New crops would be grown worth Rs.200,000 per
year. The cost of growing, transporting and marketing
them would be Rs.160,000 per year

Calculate the NPV and IRR of building the feeder

road. Should the feeder road be built. Assume the
discount rate is 10%
 Answer
Year 0 1 2 3 4 5 6 7 8 9 10
Capital Cost 400
Maintenance Cost 5 5 5 5 5 5 5 5 5 5
Cost of new crops 160 160 160 160 160 160 160 160 160 160
Total Costs 400 165 165 165 165 165 165 165 165 165 165
Vehicle cost
savings
20 20 20 20 20 20 20 20 20 20
New Crops 200 200 200 200 200 200 200 200 200 200
Total Benefits - 220 220 220 220 220 220 220 220 220 220
Net Benefits (400) 55 55 55 55 55 55 55 55 55 55

NPV = - 62.05 IRR = 6%

Discount Rate 10% Guess 10%
The feeder road should not be built.
 Answer
Year 0 1 2 3 4 5 6 7 8 9 10

Net Benefits (400) 55 55 55 55 55 55 55 55 55 55

PV factor
1 0.909 0.826 0.751 0.683 0.621 0.565 0.513 0.467 0.424 0.386
@10%
PV (400) 50.00 45.43 41.31 37.57 34.16 31.08 28.21 25.69 23.32 21.23

NPV = - 62.025
Annuity factor @ 10 % 10 years = 6.1446
PV of Benefits = 55 x 6.1446 = 337.953
PV of Costs = 400
NPV = PVB – PVC = 337.953 – 400 = -62.047
 Exercise
 A Planning unit has four projects with the following costs and
receipts (expressed as present values)

PV of Costs (Mn) PV ofReceipts (Mn)

(a) 9.0 10.0
(b) 0.9 1.0
(c) 0.9 1.5
(d) 0.9 0.9

Calculate the B/C ratios and NPVs for each projects

Rank the projects by each criterion
If one of the four projects can be undertaken, which should
be selected?
Suppose there is budget constraints which project(s) would
you choose
Answer
Project B/C NPV (Mn)
(a) 1.1(=2nd) 1.0(1st)
(b) 1.1 (=2nd) 0.1(3rd)
(c) 1.7 (1st ) 0.6 (2nd)
(d) 1.0 (4th ) 0 (4th )

• C has the highest B/C ratio.

• A has the highest NPV. Project A should be selected if the projects
are mutually exclusive because it provides the greatest absolute gain.
• Under capital rationing Project C should be selected first and this
should be followed by B and A
Exercise – Multiple IRR
 The expected cash flow from an open cast mining
project is

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

-1100 1000 1000 100 -100 -1010

Calculate the NPV at the following discount rates

0%,5%,10% and 30%
What is unusual about this project
 Answer
Year 0% 5% 10% 30%
0 -1,100 -1,100 -1,100 -1,100
1 +1,000 +952 +909 +769
2 +1,000 +907 +826 +562
3 +100 +86 +75 +45
4 -100 -82 -68 -35
5 -1,010 -792 -627 -272
NPV -110 -29 +15 -1

The Project is unusual because there are apparently two internal

rates of return at approximately 8 and 30%. The NPV is negative
at low discount rates, becomes positive as the rate increases and
finally becomes negative at a rate of about 30%. (see graph)
 Multiple IRR

40
20
0
-20 0% 5% 10% 30% 50%
NPV

-40
-60
-80
-100
-120
Discount Rate
 Exercise

 A small industrialist is considering the purchase of a new

machine costing 5,000. this will replace the need to hire
sub-contractors to do the necessary work, which costs
at present 1,750 per annum. The machine will also do
additional jobs in the factory, valued at 650 per annum.
The machine costs 1,250 per annum to run, and will last
for five years only. It has a residual value of 1,000.
Assuming a discount rate of 12%, should the industrialist
purchase the machine ? Assume purchase and
installation in year 0, and full operation from year 1
 Answer

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Capital Cost (5,000)

Running Cost (1,250) (1,250) (1,250) (1,250) (1,250)
Hire Savings 1,750 1,750 1,750 1,750 1,750
Value, other jobs 650 650 650 650 650
Residual value 1,000
(Scrap)
NCF (5,000) 1,150 1,150 1,150 1,150 2,150

NPV = -5,000 + (1,150 x 3.037) + (2,150 x 0.567) = -288

It is therefore not worthwhile.