Project Analysis and Methods of project evaluation
- 1. 1 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 CashFlows: 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
- 2. 2 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
- 3. 3 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 EvaluationMethodologies 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 presentvalue 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.
- 4. 4 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 – cashinflow 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:
- 5. 5 *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
- 6. 6 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.
- 7. 7 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. DisadvantagesOfProfitability 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%.
- 8. 8 (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
- 9. 9 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 FlowYear 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.
- 10. 10 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 ofpayback 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.