CHAPTER FIVE

PROJECT SELECTION
(Financial Evaluation)

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 Introduction

• While discussing the evaluation of a project, it is important

to understand some terms that are often used. Some of these terms
may include;
 Cost of capital: the weighted average cost of various sources of
finance used by it
-It is measured as the weighted arithmetic average of the cost of
various sources of finance obtained by the firm.
 Incremental cash flow: the difference in cash flows of a
firm with and without a project. The change in the future
cash flows of a firm as a result of undertaking a project
Net present value: the value of a future stream of payments or
receipts from a project when discounted at a given rate to
the present time.
 Projects are said to be mutually exclusive when the
acceptance of one will necessarily mean the rejection of others.
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 Internal rate of return :the rate of discount at which
the net present value of an investment is zero.
 Benefit cost ratio: measures the present value of returns
per Birr of investment.
Social cost benefit analysis :aids in evaluating individual
projects with in the planning frame work.
The evaluation of social impact aims at
ensuring that the Consequences of a project (in
terms of employment, output, savings and so on) are
beneficial to the public.

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 Financial Evaluation of a Project
• The financial evaluation of a commercial
project mainly involves estimating
– the return on investment and
– the profitability of the project.
• However, the financial evaluation of non-
commercial projects involve
– the identification of the most efficient way of delivering
the desired project outputs and
– ensuring that the project outputs result in significant
benefits to the community.
• The financial evaluation is conducted using the project
cash flows.

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 Financial Analysis Basic
The most important, but also the most difficult step in capital
budgeting. Estimating cash flows process involves many people and
numerous variables.
 A project which involves cash outflows followed by cash inflows
comprises of three basic components. They are,
 Initial investment: Initial investment is the after-tax cash outlay on
capital expenditure and net working capital when the project is set
up.
 Operating cash inflows: The operating cash inflows are the after-
tax cash inflows resulting from the operations of the project during
its economic life.
 Terminal cash inflow: The terminal cash inflow is the after-tax
cash flow resulting from the liquidation of the project at the end of
its economic life
By Beyene Y 5
 Cash Flows from Total Funds Point of View

• When cash flows are computed from the total funds point of view,
the funds contributed by all the suppliers of funds towards the
project are considered for the calculation of the initial investment.
• The operating cash flows are calculated by adding profit after
taxes, depreciation, non-cash charges, interest on long term
borrowing (1-T) and interest on short term borrowing (1-T). The
terminal flow will be equal to the net salvage value of fixed assets
and net recovery of WC margin.

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 Choice of Discount Rate
• The determination of an appropriate discount rate is necessary
for establishing the financial feasibility of a project.
• Most of the appraisal criteria used these days are time adjusted or
discounted criteria, like net present Value (NPV), benefit cost
ratio (BCR) and internal rate of return (IRR).
• All these require the use of a risk-adjusted discount rate to
determine the actual returns from the project .
• The most commonly used method for determining the discount
rate makes use of theoretical models like the capital asset Pricing
model (CAPM) and the weighted-average cost of capital
(WACC) model. 7
• The CAPM is used to ascertain the relevant cost of equity
for a given level of risk.
• This is then combined with the cost of debt funds in proportion
to their respective Weights in the total funds used to finance
the project.
• This combined approach is known as the WACC.

Where:
Re = Cost of Equity
Rd = Cost of Debt
E = Market value of the firm's equity
D = Market value of the firm's debt
V= E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
T = the corporate tax rate 8
 Project Appraisal Criteria
• After determining the cash flows of a project, we must assess
its viability.
• This can be achieved through the use of either the
– discounted criteria or
– non-discounted criteria.
• Discounted criteria's include:
 Net Present value (NPV)
 The modified net Present value (MNPVM)
 Benefit-Cost Ratio or profitability index,(BCR or PI)
 Internal Rate of Return (IRR)
 Discounted payback period.
 Modified Internal Rate of Return (MIRR)
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• Traditional or Non-discounted criteria's include;
Accounting Rate of Return (ARR)
Payback Period (PBP)
 Based on each of the criteria, the investment decision
will be either to accept or to reject the project.

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Discounted/Time Adjusted Techniques

• These methods require cash flows to be discounted at a

certain rate known as the cost of capital.
• This technique recognizes the fact that cash flows
occurring at different time periods and in different
amounts can be compared only when they are
expressed in terms of a common denominator i.e. The
cost of capital (discount rate).
• Thus, in this method, all the cash inflows are discounted at
an appropriate discount rate and the present value so
determined is compared with the present value of cash
outflows.

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1. Net Present Value (NPV)
• The net present value of a project is the sum of the present
values of all cash flows that are expected to occur over the
life of the project. The general formula for NPV is:

• The decision rule associated with NPV criteria is to accept all

proposals with a NPV greater than zero.
• Where two or more projects are mutually exclusive, then
the project with the highest NPV should be chosen.

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Example:
• The cash flow stream of a certain project is estimated as
follows. If the cost of capital, K for this company is 14%,
– what is the NPV of this project?
– What should be the decision?
YEAR CASH FLOW
0 -155,000
1 38,000
2 44,000
3 49,000
4 54,500
5 60,000

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  155,000 38,000 44,000 49,000 54,500 60,000
NPV  0
 1
 2
 3
 4

(1  0.14) (1.14) (1.14) (1.14) (1.14) (1.14) 5

The net present value of the above project at the cost of capital of 14% would
be,
= -155,000 + 33,333.33 + 33,856.57 + 33,073.60 + 32,268.38 + 31,162.12
= 8,694
Decision: Since the NPV of the project is greater than zero it can be
accepted.

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2. Modified Net present value (MNPV)
• One of the basic assumptions of NPV is that all the intermediate cash
flows are re-invested at a rate equal to the cost of capital.
• However, if this assumption is invalid, the net present value has
to be modified taking into account the re-investment rate.
 The steps involved in the calculation of the Modified Net Present Value
are given below;
(i) Calculate the terminal value of intermediate cash flows using the re-
investment rate as follows:

TV = Terminal Value of the project’s cash inflows

CFt = Cash inflow at year end
r'= re-investment rate applicable to the cash inflows of the project 15
TV-the present value of all your business's cash flows at a future
point, assuming a stable rate of growth in perpetuity.
(ii) Calculate the Modified Net Present Value in the following
manner:

Example
Consider the same example illustrated previously . The
net present value of that project at the cost of
capital of 14% was Br 8,694. Assuming re-investment
rates of 18% and 12%, determine the modified net present
value of the project?

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A) Re-investment Rate of 18%
TV18% = 38,000 (1.18)4 + 44,000 (1.18)3 + 49,000 (1.18)2 +
54,500 (1.18) + 60,000
= 338,492
MNPV = 338,492 - 155,000 = 20,802.14
(1.14)5
B) Re-investment Rate of 12%
TV12% = 38,000 (1.12)4 + 44,000 (1.12)3 + 49,000 (1.12)2 +
54,500 (1.12) + 60,000
= 304,118
MNPV = 304,118 - 155,000 = 2,949.36
(1.14)5
• Hence, the modified net present value is greater than the net
present value if the re-investment rate is greater than the
discount rate, and vice versa . 17
3. Benefit-Cost Ratio (BCR)
• There are two ways of defining the relationship between
benefits and costs. These are the BCR and NBCR.
• The BCR, also Known as the profitability index, measures
the present value of returns per Birr of investment. BCR is
defined as the ratio of the present value of benefits to the
initial investment. It is represented as follows:

Where, BCR = Benefit-cost ratio

PVB = Present value of benefits
I = Initial investment

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• The decision rule of BCR criteria is to accept all proposal with
a BCR greater than one. If the BCR is equal to one, the firm is
indifferent to the project.
• If two or more projects are mutually exclusive, then the
project with the higher BCR should be chosen.
• The other measure linked to BCR is NBCR. NBCR is the ratio
between PVB and initial investment, and is represented as;

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Example: Consider two mutually exclusive projects of X and Y
with the following cash flow streams. The cost of capital for
both projects is 14%. Determine BCR and NBCR for both
projects and decide the project that needs to be accepted?
year Project X Project Y
0 -155, 000 -48,000
1 38,000 13,500
2 44,000 14,700
3 49,000 17,300
4 54,500 18,800
5 60,000 20,500

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 Year Project X Project Y
Cash PV/br present Cash PV/br present
flow @ 14% value flow @ 14% value
0 -155, 000 -48,000
1 38,000 0.877 33,326 13,500 0.877 11,839.5
2 44,000 0.769 33,836 14,700 0.769 11,304.
3 49,000 0.675 33,075 17,300 0.675 11,677.5
4 54,500 0.592 32,264 18,800 0.592 11,129.6
5 60,000 0.519 31,140 20,500 0.519 10,639.5
Total 163,641 56,590.4

• The BCR of both the projects is calculated as follows:

BCR , Project X = Present Value / Initial Investment
= 163641/155000 = 1.05575
BCR , Project Y = Present Value / Initial Investment
= 56590.4/48000 = 1.17896
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• NBCR, project X = 1.05575 – 1 = 0.05575
NBCR, project Y = 1.17896 – 1 = 0.17896
 Though the BCR and NBCR of both projects is more than 1
and zero respectively, Project Y should be accepted since it has
a higher BCR and NBCR than Project X.
 Generally, the following decision rules are associated with
BCR and NBCR;
When BCR when NBCR Rule is
>1 >0 Accept
=1 =0 Indifferent
<1 <0 Reject

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4. Internal Rate of Return Method
• refers to the rate of return on the unrecovered investment
balance. It equates the PV of cash inflows with the initial
investment, i.e. it is the discount rate at which the NPV of a
project is zero. The IRR is represented by the following formula;

Where Io = Initial investment

CFt = Cash inflows & outflow at different time periods
r = internal rate of return
n = Life of the project
• If the IRR of a project is greater than the cost of capital (k), the
project should be accepted, and if IRR is less then k it is rejected.
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Example Firm XYZ Ltd. is planning to invest Br 65,000 in its new
project. This project is expected to last for 5 years. Its
estimated cash flows are Br12,500, Br15,300, Br16,700, Br
13,400 and Br 14,300 for the years one up to five
respectively. What is the IRR of this project?
 The IRR of this project is the value of r which satisfies the
following equation:

• The calculation of r involves a process of trial and error. We

try different values of r till we find that the right hand side of
the above equation is equal to 65,000. Let us first substitute
“r” with 4%; then the right hand side of the equation changes
to:

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• By using 4%, the value derived after solving the equation is
slightly less than Br 65,000. Hence, we decrease ‘r’ to 3%, and
the right hand side becomes;

• By using 3%, the value derived after solving the equation is

more than Br. 65,000. It is therefore clear that the actual IRR
lies somewhere between 3% and 4%. Using interpolation, we
can find out a single value of IRR. The actual IRR calculated
using interpolation is then 3.58%.

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 Four steps
1. Determine the NPV of two closest rates of return
(NPV/4 percent) = 64,219 – 65,000 = (781)
(NPV/3 percent) = 66,081 -65,000 = 1,081
2. Find the sum of the absolute values of NPV obtained in step 1
781 + 1081 = 1,862
3. Calculate the ratio of the NPV of the smaller discount rate, identified in
step 1, to the sum obtained in step 2;
1081/1862 = 0.58 percent
4. Add the number obtained in step 3 to the smaller discount rate;
3 + 0.58 = 3.58 percent
So, 3.58 % is a rate which equates the PV of cash inflows with the initial
investment.
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5. Modified Internal Rate of Return (MIRR)
• A percentage measure that overcomes the short comings of
regular IRR is known as modified internal rate of return
(MIRR).
The procedure for calculating MIRR is given below:
• Step 1 Calculate the present value of the costs (PVC)
associated with the project, Using the cost of capital (r) as the
discount rate:

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• Step 2: Calculate the terminal value (TV) of the cash inflows
expected from the project:

• Step 3: Obtain MIRR by solving the following equation:

Hence, MIRR can be presented as follows:

Example; DEMBEL Limited is evaluating a project that has the

following cash flows. Using cost of capital 15%, determine MIRR
Year 0 1 2 3 4 5 6
Cash flow -120 -80 20 60 80 100 120
(Br. In Millions)
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• The present value of costs is:
120 + 80/(1+0.15) = 189.6
• The terminal value of cash inflows is:
20(1.15)4 + 60(1.15)3 + 80(1.15)2 + 100(1.15)1+ 120
= 34.98 + 91.26 + 105.76 + 115 + 120 = 467
• The MIRR is obtained as follows:
𝟒𝟔𝟕 𝟏
𝑴𝑰𝑹𝑹= ( )𝟔 −𝟏
𝟏𝟖𝟗.𝟔
MIRR = 0.162 = 16.2%
 The evaluation criteria under the MIRR method is accept a
project if the MIRR is greater than the cost of capital (k), and
reject if MIRR is less than K.

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• The MIRR method is superior to the IRR method.
MIRR assumes that the project cash flows are
reinvested at the cost of capital whereas the
regular IRR assumes that the project cash flows
are reinvested at the project's own IRR.
• Since reinvestment at the cost of capital (or some
other explicit rate) is more realistic than
reinvestment at IRR, MIRR reflects the true
profitability of a project.
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6. Discounted Payback Period Method
• Unlike the payback method, this criterion takes
into account the discounted cash flows of a
project at the cost of capital.
• In this modified method, cash flows are first
converted into their present values and then
added to ascertain the period of time required to
recover the initial outlay on the project.
The decision rule for this criterion is to accept a
project with less payback period than the
required PBP.
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Example: Consider the two mutually exclusive projects of X and Y
with the following cash flow streams. The cost of capital for both
projects is 10%. Then, the discounted payback period can be
determined as follows;

Year Project X Project Y

CF Discounte Accumula CF Discounte Accumulat
d CF (DCF) ted DCF d CF (DCF) ed DCF
0 -155,000 - -48,000 -
1 38,000 34,545 34,545 13,500 12,273 12,273
2 44,000 36,364 70,909 14,700 12,149 24,422
3 49,000 36,814 107,723 17,300 12,998 37,420
4 54,500 37,227 144,950 18,800 12,842 50,262
5 60,000 37,267 182,217 20,500 12,733 62,995

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• Hence, the DPBP is 4.27 years and 3.82 years for project X and Y

respectively.

The evaluation criteria for this method are:

• The project is accepted when the actual DPBP is less than the

required payback period, and rejected in the reverse case.

 When there are mutually exclusive projects, the one with the

lowest DPBP, but less than cut off payback period must be

selected.

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 Traditional or Non-Discounted Criteria
1. Accounting Rate of Return (ARR)
• also known as the average rate of return.
• It is a measure of profitability which relates income to
investment. ARR is represented as follows:
ARR = average annual income /average investment
Example; Two projects, p and q have an initial cost of Br 70,000 and
an estimated life of 5 years. The estimated income of the
projects over a period of 5 years is given in the table below.
Required: What are the average rate of return of the projects
given the following additional information?

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Year Annual estimated Annual estimated
income of project P income of project Q
1 Br.2,140 Br. 3,420
2 Br. 3,235 Br. 4,525
3 Br. 5,420 Br. 5,632
4 Br. 4,810 Br. 5,065
5 Br. 5,175 Br. 2,560
Total Br. 20,780 Br. 21,202
Av. Income Br. 4,156 Br. 4,240
Av. Inv’t Br. 14,000 Br. 14,000
ARR 29.6% 30.2%

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 The evaluation criteria used by this method:

• The project is accepted when the actual ARR is greater than

the required ARR, and rejected when the actual ARR is less

than the required ARR.

• When there are mutually exclusive projects, the one with the

highest ARR but more than the cut off ARR must be selected.

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2. Payback Period Method
• This is the most commonly and widely used method of project
appraisal.
• Payback period is the length of time required to recover the
initial cash outlay on the project. This criterion evaluates a
project on the basis of the speed within which it recovers its
initial investment.
• It can be computed in two ways:
(i) When the cash inflows are the same every year and
(ii) When cash inflows are constantly changing from year to
year.
 When the cash inflows are the same every year the following
formula is used:

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 Io= the initial investment
CF = cash inflow
Example: Consider two mutually exclusive projects X and Y.
Project X is expected to collect Br 8,750 every year for 6 years.
Its initial investment is Br. 35,000. Project Y is expected to
generate Br 11,000 every year for 6 years. Project Y's Initial
investment is Br. 38,500. Calculate the PB period for both
projects.
PBP-project X = 4 yrs
PBP-project Y = 3.5 yrs
 When cash inflows are constantly changing from year to year,
the method for calculating PBP is as follows:

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Year Project X Project Y
CF Cumulative CF CF Cumulative CF
0 -155,000 - -48,000 -
1 38,000 38,000 13,500 13,500
2 44,000 82,000 14,700 28,200
3 49,000 131,000 17,300 45,500
4 54,500 185,500 18,800 64,300
5 60,000 245,500 20,500 84,800
R-PBP 4 yrs 3.5yrs
• Project X will recover Br 131,000 of its initial investment in the
first 3 years. In the fourth year, it will recover the balance, i.e.,
(155,000 – 131,000 = 24,000). The payback period in the
fourth year is computed as follows 24,000/54,500 = 0.44.
Therefore, the investment in project X can be recovered in
3.44years. Similarly, the initial investment in project Y can be
recovered in 3.133 years. 39
The evaluation criteria for this method:
• The project is accepted when the actual payback
period is less than the required or predetermined
payback period, and rejected in the reverse case.
When there are mutually exclusive projects, the
one with the lowest payback period but less than
cut off payback period must be selected.

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THE END

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