Project Analysis and Methods of project evaluation

Project Analysis
Methods of project evaluation

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Project Analysis
Methods of project evaluation

The examination of all the costs or problems of a project before work on it is started.
Project analysis used to evaluate the potential merits of an investment or to objectively assess
the value of a business or asset. Valuation analysis is one of the core duties of a fundamental
investor, as valuations (along with cash flows) are typically the most important drivers of
asset prices over the long term. Valuation analysis should answer the simple yet vital
question: what is something worth? The analysis is then based on either current data or
projections of the future.

In this section, we'll consider how companies can value any projects they're considering to
determine whether they are worth undertaking.

For the purposes of this lesson, projects can be divided into two categories:

1. Expansion projects are projects companies invest in to expand the business's earnings.

2. Replacement projects are projects companies invest in to replace old assets and maintain
efficiencies.

Determining a Project's Cash Flows:
when beginning capital-budgeting analysis, it is important to determine the cash flows of a
project. These cash flows can be segmented as follows:

1. Initial Investment Outlay
These are the costs that are needed to start the project, such as new equipment, installation,
etc.
2. Operating Cash Flow over a Project's Life
This is the additional cash flow a new project generates.
3. Terminal-Year Cash Flow
This is the final cash flow, both the inflows and outflows at the end of the project's life, such
as potential salvage value at the end of a machine's life.
Analysis Techniques for Projects:

Projects are time-limited efforts aimed at accomplishing specific goals. Project managers
have the task of completing the project on time, on budget and with the required
functionality. Before the project work starts, and at regular intervals, the project team can

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analyse the project to determine progress. This analysis relies on techniques aimed at
verifying what costs the project has incurred, what activities are finished and whether project
team members have experienced problems with equipment or functions. If the analysis
reveals discrepancies, the team can take corrective action.
 Financial
A financial analysis verifies that the project's disbursements correspond to the amount of
progress toward completion. A technique for analyzing costs lists all the purchase orders the
project team has issued and compares the amounts to the costs in the budget. It then adds
labor costs and compares the total to the amounts allocated for this work in the budget. If the
analysis detects discrepancies, it looks for reasons such as a change in project scope or
unexpected difficulties. If necessary, the project team has to adjust the project plans to reflect
the new situation.
 PERT
The Project Evaluation and Review Technique, or PERT, is a powerful tool for analyzing
projects. Using PERT charts, project managers can track progress and percent completion of
the project or of individual tasks. PERT uses software to track scheduled activities and
identify critical ones. A delay in a critical activity results in a delay of the whole project. The
series of critical activities make up the project's critical path. PERT identifies and tracks the
critical path to allow project managers to analyze any delays.
 Risk
Risk analysis lets project managers determine appropriate contingency plans for the
company. If a project is at a high risk of failure, meaning it will not be available to execute
the planned functions on time or at the expected cost, companies want to be aware of the
consequences of such failure. Risk analysis techniques look at what would happen to the
project if single variables, such as a currency exchange rate, for example, would undergo a
large and unexpected change. It then tries to determine the likelihood of such a change.
Companies develop contingencies for factors that have a combination of high likelihood and
serious consequences.
 Requirements
A project plan tries to execute the project so it fulfills specified requirements. As the project
progresses, the project team may become aware of aspects of the requirements that the
specification does not cover adequately. Techniques for evaluating requirements look at
whether the requirement is optional or mandatory. They rank the requirements in order of

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importance and assign values. The project team has to prioritize mandatory requirements with
a high value, while it can drop optional, low-value requirements if it helps the overall project.
Types of Project Evaluation Methodologies

Project appraisal methodologies are methods used to access a proposed project's potential
success and viability. These methods check the appropriateness of a project considering
things such as available funds and the economic climate. A good project will service debt and
maximize shareholders' wealth.
1. Net Present Value
2. Payback Method.
3. Internal Rate of Return
4. Profitability Index
Net present value method :
(Also known as discounted cash flow method) is a popular capital budgeting technique that
takes into account the time value of money. It uses net present value of the investment
project as the base to accept or reject a proposed investment in projects like purchase of new
equipment, purchase of inventory, expansion or addition of existing plant assets and the
installation of new plants etc.
A project's net present value is determined by summing the net annual cash flow, discounted
at the project's cost of capital and deducting the initial outlay. Decision criteria is to accept a
project with a positive net present value. Advantages of this method are that it reflects the
time value of money and maximizes shareholder's wealth. Its weakness is that its rankings
depend on the cost of capital; present value will decline as the discount rate increases.
Net present value is the difference between the present value of cash inflows and the present
value of cash outflows that occur as a result of undertaking an investment project. It may be
positive, zero or negative. These three possibilities of net present value are briefly explained
below:
Positive NPV:
If present value of cash inflows is greater than the present value of the cash outflows, the net
present value is said to be positive and the investment proposal is considered to be
acceptable.
Zero NPV:
If present value of cash inflow is equal to present value of cash outflow, the net present value
is said to be zero and the investment proposal is considered to be acceptable.

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Negative NPV:
If present value of cash inflow is less than present value of cash outflow, the net present value
is said to be negative and the investment proposal is rejected.
The summary of the concept explained so far is given below:

The following example illustrates the use of net present value method in analyzing an
investment proposal.
Example 1 – cash inflow project:
The management of Fine Electronics Company is considering to purchase an equipment to be
attached with the main manufacturing machine. The equipment will cost $6,000 and will
increase annual cash inflow by $2,200. The useful life of the equipment is 6 years. After 6
years it will have no salvage value. The management wants a 20% return on all investments.
Required:
1. Compute net present value (NPV) of this investment project.
2. Should the equipment be purchased according to NPV analysis?
Solution:
(1) Computation of net present value:

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*Value from “present value of an annuity of $1 in arrears table“.
(2) Purchase decision:
Yes, the equipment should be purchased because the net present value is positive ($1,317).
Having a positive net present value means the project promises a rate of return that is higher
than the minimum rate of return required by management (20% in the above example).
Assumptions:
The net present value method is based on two assumptions. These are:
1. The cash generated by a project is immediately reinvested to generate a return at a
rate that is equal to the discount rate used in present value analysis.
2. The inflow and outflow of cash other than initial investment occur at the end of each
period.
Advantages and Disadvantages:
The basic advantage of net present value method is that it considers the time value of money.
The disadvantage is that it is more complex than other methods that do not consider present
value of cash flows. Furthermore, it assumes immediate reinvestment of the cash generated
by investment projects. This assumption may not always be reasonable due to changing
economic conditions.
This is the ratio of the present value of project cash inflow to the present value of initial cost.
Projects with a Profitability Index of greater than 1.0 are acceptable. The major disadvantage
in this method is that it requires cost of capital to calculate and it cannot be used when there
are unequal cash flows. The advantage of this method is that it considers all cash flows of the
project.
Sometime a company may have limited funds but several alternative proposals. In such
circumstances, if each alternative requires the same amount of investment, the one with the

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highest net present value is preferred. But if each proposal requires a different amount of
investment, then proposals are ranked using an index called present value index
(or profitability index). The proposal with the highest present value index is considered the
best. Present value index is computed using the following formula:
Formula of present value or profitability index:

Example:
Choose the most desirable investment proposal from the following alternatives using
profitability index method:

Solution:
Because each investment proposal requires a different amount of investment, the most
desirable investment can be found using present value index. Present value index of all three
proposals is computed below:
Proposal X: 212,000/200,000 = 1.06
Proposal Y: 171,800/160,000 = 1.07
Proposal Z: 185,200/180,000 = 1.03
Proposal X has the highest net present value but is not the most desirable investment. The
present value indexes show proposal Y as the most desirable investment because it promises
to generate 1.07 present value for each dollar invested, which is the highest among three
alternatives.
Advantages Of Profitability Index (PI):

1. PI considers the time value of money.

2. PI considers analysis all cash flows of entire life.

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3. PI makes the right in the case of different amount of cash outlay of different project.

4. PI ascertains the exact rate of return of the project.

Disadvantages Of Profitability Index (PI):

1. It is difficult to understand interest rate or discount rate.

2. It is difficult to calculate profitability index if two projects having different useful life.
Internal rate of return method:
Internal rate of return (IRR) is a metric used in capital budgeting measuring the profitability
of potential investments. Internal rate of return is a discount rate that makes the net present
value (NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on
the same formula as NPV does.
This method equates the net present value of the project to zero. The project is evaluated by
comparing the calculated Internal rate of return to the predetermined required rate of return.
Projects with Internal rate of return that exceed the predetermined rate are accepted. The
major weakness is that when evaluating mutually exclusive projects, use of Internal rate of
return may lead to selecting a project that does not maximize the shareholders' wealth.
Example:
A machine can reduce annual cost by $40,000. The cost of the machine is 223,000 and the
useful life is 15 years with zero residual value.
Required:
1. Compute internal rate of return of the machine.
2. Is it an acceptable investment if cost of capital is 16%?
Solution:
(1) Internal rate of return (IRR) computation:
Internal rate of return factor = Net annual cash inflow/Investment required
= $223,000/$40,000
= 5.575
Now see internal rate of return factor (5.575) in 15 year line of the present value of an
annuity if $1 table. After finding this factor, see the corresponding interest rate written at the
top of the column. It is 16%. Internal rate of return is, therefore, 16%.

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(2) Conclusion:
The investment is acceptable because internal rate of return promised by the machine is equal
to the cost of capital of the company.
Issues with 'Internal Rate of Return (IRR):
1. While IRR is a very popular metric in estimating a project’s profitability, it can be
misleading if used alone. Depending on the initial investment costs, a project may
have a low IRR but a high NPV, meaning that while the pace at which the company
sees returns on that project may be slow, the project may also be adding a great deal
of overall value to the company.
2. A similar issue arises when using IRR to compare projects of different lengths. For
example, a project of a short duration may have a high IRR, making it appear to be an
excellent investment, but may also have a low NPV. Conversely, a longer project may
have a low IRR, earning returns slowly and steadily, but may add a large amount of
value to the company over time.
3. Another issue with IRR is not one strictly inherent to the metric itself, but rather to a
common misuse of IRR. People may assume that, when positive cash flows are
generated during the course of a project (not at the end), the money will
be reinvested at the project’s rate of return. This can rarely be the case. Rather, when
positive cash flows are reinvested, it will be at a rate that more resembles the cost of
capital. Miscalculating using IRR in this way may lead to the belief that a project is
more profitable than it actually is in reality. This, along with the fact that long projects
with fluctuating cash flows may have multiple distinct IRR values, has prompted the
use of another metric called modified internal rate of return (MIRR).
Pay-back period:
A company chooses the expected number of years required to recover an original investment.
Projects will only be selected if initial outlay can be recovered within a predetermined period.
This method is relatively easy since the cash flow doesn't need to be discounted. Its major
weakness is that it ignores the cash inflows after the payback period, and does not consider
the timing of cash flows.
Payback period in capital budgeting refers to the periodof time required to recoup the funds
expended in an investment, or to reach the break-even point. For example, a $1000
investment made at the start of year 1 which returned $500 at the end of year 1 and year 2
respectively would have a two-year payback period.
Payback period is the time in which the initial cash outflow of an investment is expected to
be recovered from the cash inflows generated by the investment. It is one of the simplest
investment appraisal techniques.
Formula

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The formula to calculate payback period of a project depends on whether the cash flow per
period from the project is even or uneven. In case they are even, the formula to calculate
payback period is:
Payback Period =
Initial Investment
Cash Inflow per Period
When cash inflows are uneven, we need to calculate the cumulative net cash flow for each
period
Decision Rule
Accept the project only if its payback period is LESS than the target payback period.
Examples:
Example 1: Even Cash Flows

Company C is planning to undertake a project requiring initial investment of $105 million.
The project is expected to generate $25 million per year for 7 years. Calculate the payback
period of the project.

Solution:

Payback Period = Initial Investment ÷ Annual Cash Flow = $105M ÷ $25M = 4.2 years

Example 2: Uneven Cash Flows

Company C is planning to undertake another project requiring initial investment of $50
million and is expected to generate $10 million in Year 1, $13 million in Year 2, $16 million
in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the
project.
Solution
(cash flows in millions) Cumulative
Cash Flow Year Cash Flow
0 (50) (50)
1 10 (40)
2 13 (27)
3 16 (11)
4 19 8
5 22 30
Payback Period
= 3 + (|-$11M| ÷ $19M)
= 3 + ($11M ÷ $19M)
≈ 3 + 0.58
≈ 3.58 years

Advantages of payback period are:

1. Payback period is very simple to calculate.

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2. It can be a measure of risk inherent in a project. Since cash flows that occur later in a
project's life are considered more uncertain, payback period provides an indication of how
certain the project cash inflows are.
3. For companies facing liquidity problems, it provides a good ranking of projects that
would return money early.
Disadvantages of payback period are:

1. Payback period does not take into account the time value of money which is a serious
drawback since it can lead to wrong decisions. A variation of payback method that
attempts to remove this drawback is called discounted payback period method.
2. It does not take into account, the cash flows that occur after the payback period.