PROJECT EVALUATION

Basic Concepts of Economic Evaluation

A systematic approach for economic evaluation of facilities consists of the following

major steps:

1. Generate a set of projects or purchases for investment consideration.

2. Establish the planning horizon for economic analysis.
3. Estimate the cash flow profile for each project.
4. Specify the minimum attractive rate of return (MARR).
5. Establish the criterion for accepting or rejecting a proposal, or for selecting the
best among a group of mutually exclusive proposals, on the basis of the objective
of the investment.
6. Perform sensitivity or uncertainty analysis.
7. Accept or reject a proposal on the basis of the established criterion.

It is important to emphasize that many assumptions and policies, some implicit and some
explicit, are introduced in economic evaluation by the decision maker. The decision
making process will be influenced by the subjective judgment of the management as
much as by the result of systematic analysis.

The period of time to which the management of a firm or agency wishes to look ahead is
referred to as the planning horizon. Since the future is uncertain, the period of time
selected is limited by the ability to forecast with some degree of accuracy. For capital
investment, the selection of the planning horizon is often influenced by the useful life of
facilities, since the disposal of usable assets, once acquired, generally involves suffering
financial losses.

In economic evaluations, project alternatives are represented by their cash flow profiles
over the n years or periods in the planning horizon. Thus, the interest periods are
normally assumed to be in years t = 0,1,2, ...,n with t = 0 representing the present time.
Let Bt,x be the annual benefit at the end of year t for a investment project x where x = 1, 2,
... refer to projects No. 1, No. 2, etc., respectively. Let Ct,x be the annual cost at the end of
year t for the same investment project x. The net annual cash flow is defined as the
annual benefit in excess of the annual cost, and is denoted by At,x at the end of year t for
an investment project x. Then, for t = 0,1, . . . ,n:

where At,x is positive, negative or zero depends on the values of Bt,x and Ct,x, both of
which are defined as positive quantities.

Once the management has committed funds to a specific project, it must forego other
investment opportunities which might have been undertaken by using the same funds.
The opportunity cost reflects the return that can be earned from the best alternative
investment opportunity foregone. The foregone opportunities may include not only
capital projects but also financial investments or other socially desirable programs.
Management should invest in a proposed project only if it will yield a return at least equal
to the minimum attractive rate of return (MARR) from foregone opportunities as
envisioned by the organization.

In general, the MARR specified by the top management in a private firm reflects the
opportunity cost of capital of the firm, the market interest rates for lending and
borrowing, and the risks associated with investment opportunities. For public projects,
the MARR is specified by a government agency, such as the Office of Management and
Budget or the Congress of the United States. The public MARR thus specified reflects
social and economic welfare considerations, and is referred to as the social rate of
discount.

Regardless of how the MARR is determined by an organization, the MARR specified for
the economic evaluation of investment proposals is critically important in determining
whether any investment proposal is worthwhile from the standpoint of the organization.
Since the MARR of an organization often cannot be determined accurately, it is advisable
to use several values of the MARR to assess the sensitivity of the potential of the project
to variations of the MARR value.

Selective methods of economic evaluation

Many methods can be seen to evaluate any project or to make comparison between many
alternatives. The result of this shall a decision of which one of these alternatives or is it
feasible to go on in this project.

Payback Period method

The payback period (PBP) refers to the length of time within which the benefits received
from an investment can repay the costs incurred during the time in question while
ignoring the remaining time periods in the planning horizon. Even the discounted
payback period indicating the "capital recovery period" does not reflect the magnitude or
direction of the cash flows in the remaining periods. However, if a project is found to be
profitable by other measures, the payback period can be used as a secondary measure of
the financing requirements for a project.

C
number of years for payback=
R−(O∧M +T )

Where
C= Initial cost
R= Annual revenues
O&M= annual operation and maintenance cost
T= Annual taxes
Internal Rate of Return Method

The internal rate of return (IRR) is defined as the discount rate which sets the net present
value of a series of cash flows over the planning horizon equal to zero. It is used as a
profit measure since it has been identified as the "marginal efficiency of capital" or the
"rate of return over cost". The IRR gives the return of an investment when the capital is
in use as if the investment consists of a single outlay at the beginning and generates a
stream of net benefits afterwards. However, the IRR does not take into consideration the
reinvestment opportunities related to the timing and intensity of the outlays and returns at
the intermediate points over the planning horizon. For cash flows with two or more sign
reversals of the cash flows in any period, there may exist multiple values of IRR; in such
cases, the multiple values are subject to various interpretations.

The term internal rate of return method has been used by different analysts to mean
somewhat different procedures for economic evaluation. The method is often
misunderstood and misused, and its popularity among analysts in the private sector is
undeserved even when the method is defined and interpreted in the most favorable light.
The method is usually applied by comparing the MARR to the internal rate of return
value(s) for a project or a set of projects.

A major difficulty in applying the internal rate of return method to economic evaluation
is the possible existence of multiple values of IRR when there are two or more changes of
sign in the cash flow profile At,x (for t=0,1,2,...,n). When that happens, the method is
generally not applicable either in determining the acceptance of independent projects or
for selection of the best among a group of mutually exclusive proposals unless a set of
well defined decision rules are introduced for incremental analysis. In any case, no
advantage is gained by using this method since the procedure is cumbersome even if the
method is correctly applied. This method is not recommended for use either in accepting
independent projects or in selecting the best among mutually exclusive proposals.

If the lives of the alternatives are mot equal, there is a need to unify these lives

pv (i2 −i1 )
IRR=i1 +
pv+ nv

Where

IRR = internal rate of return

pv = positive value of NPV at the lower discount rate i 1

nv = negative value of NPV at the higher discount rate i 2in absolute terms .
Ex: make your decision to choose one of the following investments using IRR
method:

Investment A Investment B
Initial cost 250 000 400 000
Revenues 3000 2000
O&M annual cost 750
Annual tax 240 160

Ex: select one of the following machines using IRR

Machine 1 Machine 2 Machine 3 Machine 4

Initial cost 50000 40000 30000 25000
Annual O&M 500 400 300 250
cost
Revenues 14000 13000 12000 11500
Rehabilitation 2000 2000 2000 2000
cost at the end
of the5th and
10th year
Useful life 12 12 12 12
Return on Investment (Rate of return method)

When an accountant reports income in each year of a multi-year project, the stream of
cash flows must be broken up into annual rates of return for those years. The return on
investment (ROI) as used by accountants usually means the accountant's rate of return for
each year of the project duration based on the ratio of the income (revenue less
depreciation) for each year and the undepreciated asset value (investment) for that same
year. Hence, the ROI is different from year to year, with a very low value at the early
years and a high value in the later years of the project.

R− ( O∧M + D )
Rate of return=
C

Where

C= Initial cost
R= Annual revenues
O&M= annual operation and maintenance cost
D= Depreciation

Depreciation is the decrease in value of an asset resulting from deterioration, wear and
tear; obsolescence … etc. Depreciation can be calculated using one of the following
methods

1- Straight line method

C−C L
D=
n
Where C L= salvage value

2- Declining balance method

3- Sum of the integers years methods

D=1− n
√ C
CL

[
2(n−m+ 1)
D=( C−C L )
n(n+1) ]
Where m = year number of which depreciation is required

4- Sinking fund method

The amount of depreciation written off in any one year is the uniform payment plus the
interest charge, for that year on the amount already accumulated in the sinking fund.

D=( C−C L ) ¿A/p, i % , n ¿

Ex2: make your decision which investment is the best, using interest rate method. Use
straight line method for depreciation calculation.

Investment I Investment II Investment III

Initial cost 60 000 75000 70000
Revenues 3000 2000 4000
O&M annual cost 750 1500
Salvage value - 15000 10000
Useful life 8 12 10

Ex3: Solve ex2 if 10000 OR to be added to the revenues of each investment.

Ex4: What will happen if the useful lives of the investments of example 3 are
doubled?

Ex5: if the minimum rate of return is 8%, which investment of example 3 is

accepted or rejected?
Net Present Value Method

The net present value (NPV) of the estimated cash flows over the planning horizon
is the discounted value of the NFV to the present. A positive NPV for a project indicates
the present value of the net gain corresponding to the project cash flows.
Let BPVx be the present value of benefits of a project x and CPV x be the present value of
costs of the project x. Then, for MARR = i over a planning horizon of n years.

Where the symbol (P|F,i,t) is a discount factor equal to (1+i) -t and reads as follows:
"To find the present value P, given the future value F=1, discounted at an annual discount
rate i over a period of t years." When the benefit or cost in year t is multiplied by this
factor, the present value is obtained. Then, the net present value of the project x is
calculated as:

or

If there is no budget constraint, then all independent projects having net present values
greater than or equal to zero are acceptable. That is, project x is acceptable as long as

For mutually exclusive proposals (x = 1,2,...,m), a proposal j should be selected if it has

the maximum nonnegative net present value among all m proposals, i.e. provided that
NPVj 0.
In case of different useful lives of the investments the investment should be repeated
for one or more than one of these investments till the lives will be equal.

Example 6:

Evaluate of four independent projects. The cash flow profiles of four independent
projects are shown in Table 6-1. Using a MARR of 20%, determine the acceptability of
each of the projects on the basis of the net present value criterion for accepting
independent projects.
 Cash Flow Profiles of Four Independent Projects (in $ million)
t At,1 At,2 At,3 At,4
0 -77.0 -75.3 -39.9 18.0
1 0 28.0 28.0 10.0
2 0 28.0 28.0 -40.0
3 0 28.0 28.0 -60.0
4 0 28.0 28.0 30.0
5 235.0 28.0 -80.0 50.0

Using i = 20%, we can compute NPV for x = 1, 2, 3, and 4 from Eq. (6.5). Then, the
acceptability of each project can be determined from Eq. (6.6). Thus,

[NPV1]20% = -77 + (235)(P|F, 20%, 5) = -77 + 94.4 = 17.4

[NPV2]20% = -75.3 + (28)(P|U, 20%, 5) = -75.3 + 83.7 = 8.4
[NPV3]20% = -39.9 + (28)(P|U, 20%, 4) - (80)(P|F, 20%, 5)
= -39.9 + 72.5 - 32.2 = 0.4
[NPV4]20% = 18 + (10)(P|F, 20%, 1) - (40)(P|F, 20%, 2)
- (60)(P|F, 20%, 3) + (30)(P|F, 20%, 4) + (50)(P|F, 20%, 5)
= 18 + 8.3 - 27.8 - 34.7 + 14.5 + 20.1 = -1.6

Ex7: using net present value method, make your decision which of the investments in the
table below, use MARR of 10%.

Investment I Investment II Investment III

Initial cost 60 000 75000 70000
Revenues 12000 11000 13000
O&M annual cost 750 1500
Salvage value - 15000 10000
Useful life 12 12 12

Ex8: make your decision of choosing one of the following investments use MARR of
10%.

Investment I Investment II
Initial cost 60 000 75000
Revenues 12000 11000
O&M annual cost 750
Salvage value - 15000
Useful life 3 4
Equivalent Uniform Annual Net Value. The equivalent uniform annual net value
(NUV) is a constant stream of benefits less costs at equally spaced time periods over the
intended planning horizon of a project. This value can be calculated as the net present
value multiplied by an appropriate "capital recovery factor." It is a measure of the net
return of a project on an annualized or amortized basis. The equivalent uniform annual
cost (EUAC) can be obtained by multiplying the present value of costs by an appropriate
capital recovery factor. The use of EUAC alone presupposes that the discounted benefits
of all potential projects over the planning horizon are identical and therefore only the
discounted costs of various projects need be considered. Therefore, the EUAC is an
indicator of the negative attribute of a project which should be minimized

Cash Flow Profiles of Four Independent Projects (in $ million)

t At,1 At,2 At,3 At,4
0 -77.0 -75.3 -39.9 18.0
1 0 28.0 28.0 10.0
2 0 28.0 28.0 -40.0
3 0 28.0 28.0 -60.0
4 0 28.0 28.0 30.0
5 235.0 28.0 -80.0 50.0

Using i = 20%, we can compute NPV for x = 1, 2, 3, and 4 from Eq. (6.5). Then, the
acceptability of each project can be determined from Eq. (6.6). Thus,

Ex: using net present value method, make your decision which of the investments in the
table below, use MARR of 10%.

Investment I Investment II Investment III

Initial cost 60 000 75000 70000
Revenues 12000 11000 13000
O&M annual cost 750 1500
Salvage value - 15000 10000
Useful life 12 12 12

Ex: make your decision of choosing one of the following investments use MARR of
10%.

Investment I Investment II
Initial cost 60 000 75000
Revenues 12000 11000
O&M annual cost 750
Salvage value - 15000
Useful life 3 4
Net Equivalent Uniform Annual Value Method

The net equivalent uniform annual value (NUVx) refers to a uniform series over a
planning horizon of n years whose net present value is that of a series of cash flow At,x
(for t= 1,2,...,n) representing project x. That is,

(6.9)

where the symbol (U|P,i,n) is referred to as the capital recovery factor and reads as
follows: "To find the equivalent annual uniform amount U, given the present value P=1,
discounted at an annual discount rate i over a period of t years." Hence, if NPVx 0, it
follows that NUVx 0, and vice versa.

Internal Rate of Return.

The internal rate of return (IRR) is defined as the discount rate which sets the net
present value of a series of cash flows over the planning horizon equal to zero. It is used
as a profit measure since it has been identified as the "marginal efficiency of capital" or
the "rate of return over cost". The IRR gives the return of an investment when the capital
is in use as if the investment consists of a single outlay at the beginning and generates a
stream of net benefits afterwards. However, the IRR does not take into consideration the
reinvestment opportunities related to the timing and intensity of the outlays and returns at
the intermediate points over the planning horizon. For cash flows with two or more sign
reversals of the cash flows in any period, there may exist multiple values of IRR; in such
cases, the multiple values are subject to various interpretations.

The term internal rate of return method has been used by different analysts to mean
somewhat different procedures for economic evaluation. The method is often
misunderstood and misused, and its popularity among analysts in the private sector is
undeserved even when the method is defined and interpreted in the most favorable light.
The method is usually applied by comparing the MARR to the internal rate of return
value(s) for a project or a set of projects.

A major difficulty in applying the internal rate of return method to economic

evaluation is the possible existence of multiple values of IRR when there are two or more
changes of sign in the cash flow profile At,x (for t=0,1,2,...,n). When that happens, the
method is generally not applicable either in determining the acceptance of independent
projects or for selection of the best among a group of mutually exclusive proposals unless
a set of well defined decision rules are introduced for incremental analysis. In any case,
no advantage is gained by using this method since the procedure is cumbersome even if
the method is correctly applied. This method is not recommended for use either in
accepting independent projects or in selecting the best among mutually exclusive
proposals.

pv (i2 +i 1)
IRR=i1 +
pv +nv

Where IRR= internal rate of return for an investment

pv = positive value of NPV at the lower discount rate i1

nv = negative value of NPV at the higher discount rate i2 in absolute term

Ex: using IRR method, make your decision which of the investments in the table below,

Investment I Investment II Investment III

Initial cost 60 000 75000 70000
Revenues 12000 11000 13000
O&M annual cost 750 1500
Salvage value - 15000 10000
Useful life 12 12 12