Table of Contents1. INTRODUCTION12. FINANICAL ANALYSIS12.1 Cost
of project22.2 Means of financing52.3 Estimates of sales and
production62.4 Cost of production72.5 Working capital requirement
and its financing72.6 Profitability projections92.7 Projected cash
flow statements122.8 Projected balance sheet133. PROJECT INVESTMENT
CRITERIA ANALYSIS153.1 Payback period analysis153.2 Net present
value173.3 Internal rate of return193.4 Accounting rate of
return213.5 Profitability index (PI)223.6 Benefit cost ratio224.
SENSITIVITY ANALYSIS244.1 Scenario analysis265. CONCLUSION276.
REFERENCE28
1. INTRODUCTION A project analysis is performed by a company
when they want to know whether a project is possible given certain
circumstances. Feasibility studies are undertaken under many
circumstances - to find out whether a company has enough money for
a project, to find out whether the product being created will sell,
or to see if there are enough human resources for the project. A
good project analysis study will show the strengths and deficits
before the project is planned or budgeted for. By doing the
research beforehand, companies can save money and resources in the
long run by avoiding projects that are not feasible.Rather than
just diving into a project and hoping for the best, a feasibility
study allows project managers to investigate the possible negative
and positive outcomes of a project before investing too much time
and money. project analysis is a multi-step exercise. As the
analysis progresses, the developer or sponsor will gradually
acquire more information that will help determine whether or not to
proceed further.27 The following four activities may be performed
sequentially, although more often than not, they are done
simultaneously:1. market analysis;2. Environmental analysis;3.
Economic analysis4. Financial feasibility analysis.5. Ecological
analysis In this paper we will address project financial and
investment criteria analysis part. 2. FINANICAL ANALYSIS Financial
analysis seeks to ascertain whether the proposed project will be
financially viable in the sense of being able to meet the burden of
serving debt and whether the proposed project will satisfy the
return expectation of those who provide the capital. The aspects of
which have to be looked into while conducting financial analysis
are: Cost of a project Means of financing Estimates of sales and
production Cost of production Working capital requirement and its
financing Profitability projections Projected cash flow statements
Projected balance sheets 2.1 Cost of project
The first logical step in the financial analysis is the
estimation of how large the total investment cost will be. The
investment outlays can be planned for several initial years and
some non-routine maintenance or replacement costs in more distant
years. Thus we need to define a time horizon.
By time horizon, we mean the maximum number of years for which
forecasts are provided. Forecasts regarding the future of the
project should be formulated for a period appropriate to its
economically useful life and long enough to encompass its likely
mid-to-long term impact.
Although the investment horizon is often indefinite, in project
analysis it is convenient to assume reaching a point in the future
when all the assets and all the liabilities are virtually
liquidated simultaneously.Conceptually, it is at that point that
one can cost up the accounts and verify whether the investment was
a success. This procedure entails choosing a particular time
horizon.For the majority of infrastructures the time horizon is at
least 20 years; for productive investments, and again indicatively,
it is about 10 years. Nevertheless, the time horizon should not be
so long as to exceed the economically useful life of the
project.
In practice, it is helpful to refer to a standard benchmark,
differentiated by sector and based on some internationally accepted
practices. An example is shown in Table 1. Each project proposer,
however, can justify the adoption of a specific time horizon based
on project-specific features.
Table 1 reference time horizon (years) recommended for a
period
Conceptually, the cost of project represents the total of all
items of outlay associated with a project which is supported by
long-term funds. It is the sum of the outlays on the following.
Land and Site Development: The costs of land site development are-
- Cost of leveling and development - Cost of compound wall and
gates - Cost of tube wells Buildings and Civil Works: Building and
civil works covers the following- - Buildings for the main plants
and equipments - Warehouse and open yard facilities - Garage -
Sewers, drainage Plant and Machinery: The plant and machinery
consists the following costs- i) Cost of Imported Machinery: This
is the sum of a) FOB Value (Free on board) b) Imported duty c)
Clearing, loading and unloading charges. ii) Cost of Indigenous
Machinery: This consists of a) FOR (Free On Rail) cost b) Sales tax
and other taxes iii) Cost of Stores and Spares: Provision of
Escalation = (Latest rate of annual inflation to the plant and
machinery X (Length of the delivery period) Technical know-how and
Engineering Fees: The technical know-how and engineering fees for
setting up the project is a component of the project cost which is
taken into account as cost of capital. Expenses on Foreign
Technicians and Training of Technicians Abroad: Expenses on foreign
technicians like traveling, boarding and lodging are considered as
a cost of project. Miscellaneous Fixed Assets: Fixed assets and
machinery which are not part of the direct manufacturing process
may be referred to as miscellaneous fixed assets. Like furniture,
office machinery and equipment. Preliminary and Capital Issue
Expenses: Preliminary expenses are- - Identifying the project -
Market survey - Articles of association Capital Issue Expenses are-
- Underwriting commission - Brokerage - Stamp duty Pre-operative
Expenses: These types of expenses are the following- i)
Establishment expenses ii) Traveling expenses iii) Insurance
charges iv) Mortgage expenses v) Miscellaneous expenses Provision
for Contingencies: There are 2 procedures that are followed for
provision for contingencies. These are- i) Divide the cost items
into 2 categories - Firm cost items - Non-firm cost items ii) Set
the provision for contingencies at 5% to 10%. Margin Money for
Working Capital: Margin money for working capital is an important
element of the project cost which is provided by commercial banks
and trade creditors. Initial cash Losses: Most of the projects
incur cash losses in the initial years. Failure to make a provision
for such cash losses in the project cost affects the liquidity
position and impairs the operations.2.2 Means of financingTo meet
the cost of the project, the following means of finance are
available- Share Capital: Two types of share capitals are- i)
Equity capital represents the contribution made by the owners of
the business and equity shareholders. ii) Preference capital
represents the contribution made by preference shareholders. Term
Loans: Term loans provided by financial institutions and commercial
banks, term loans represent secured borrowings which are a very
important source (and sometimes the major source) for financing new
projects. There are 2 types of term loans. - Native Term Loans -
Foreign Currency Term Loans Debenture Capital: Akin to promissory
notes, debentures are instruments for rising debt capital. There
are 2 types of debenture capital. This are- i) Non- convertible
debentures: are straight debt instruments which have maturity
period of 5 to 9 years. ii) Convertible debentures: are debentures
which are convertible wholly or partly into equity shares. Deferred
Credit: Many times the suppliers of the plant and machinery offer a
deferred credit facility under which payment for the purchase of
the plant of the plant and machinery can be made over a period of
time. Incentive Source: Government provides different types of
incentives for financing. These includes- - Tax exemption - Capital
subsidy Miscellaneous Sources: Miscellaneous sources are- -
Unsecured loans: are typically provided by the promoters to bridge
the gap between the promoters contribution and (as required by the
financial institutions) and the equity capital the promoters can
subscribe to. - Public deposits: represents unsecure borrowing from
the public at large. - Leasing and hire purchase finance:
represents a form of borrowing different from the conventional term
loans and debenture capitals. We have described the various means
of finance that can be tapped for a project. The guidelines and
considerations that should be borne in mind for planning the means
of finance as follows:i) Norms of regulatory bodies and financial
institutionsIn some countries, the proposed means of finance for a
project must either be approved by a regulatory agency or conform
to certain norms laid down by the government or financial
institutions in this regard. The primary purpose of such regulation
is to impart prudence to project financing decisions and provide a
measure of protection to investors. In addition, the norms of
financial institutions, which often provides substantial assistance
to projects significantly shape and circumscribe project financing
decisions. ii) Key business considerations: Key business
considerations which are relevant for project financing decision
are: - Risk (Business risk and financial risk) - Cost (Lower than
cost of equity) - Control - Flexibility2.3 Estimates of sales and
productionIn estimating sales revenues, the following
considerations should be kept in mind:1. It is not advisable to
assume a high capacity utilization level in the first year of
operation. It is sensible to assume that capacity utilization would
be somewhat low in the first year and rise there after gradually to
reach the maximum level in the third or fourth year of operation.2.
It is not necessary to make adjustments for stocks of finished
goods. For practical purposes, it may be assumed that production
would be equal to sales. 3. The selling price considered should be
the price realizable by the company net of excise duty.4. The
selling price used may b the present selling price- it is generally
assumed that changes in selling price will be matched by
proportionate changes in cost of production. If a portion of
production is salable at a controlled price, take the controlled
price for that portion. 2.4 Cost of production After production is
estimated the cost of production may be worked out.The major
components of cost of production are: Material cost Utilities cost
Labor cost Factory overhead costMaterials: The most important
element of cost, the material cost comprises of the cost of raw
materials, chemicals, components and consumable stores required for
production. It is a function of the quantities in which these
materials are required and the prices payable for them. Utilities:
Utilities consist of power, water, and fuel. The requirements of
power, water, and fuel may be determined on the basis of norms
specified by the collaborators, consultants, etc or the consumption
standards in the industry, whichever is higher.Labor: Labor cost is
the cost of all manpower employed in the factory. Labor cost
naturally is a function of the number of employees and the rate of
remuneration.Factory Overhead: The expenses on repairs and
maintenance, rent, taxes, insurance on factory assets, and so on
are collectively referred as factory overhead. 2.5 Working capital
requirement and its financing The capital used for performing day
to day activities i.e. purchases of Raw material, making payment of
direct and indirect expenses, carrying out of production of goods
and services, investment in stocks, stores, etc is called as
working capital. All assets consisting of working capital revolve
around cash. Firstly, cash is used to purchase of raw materials,
which when certain expenses are in carried on it gets itself
converted into semi finished goods and finally into inventory of
finished products. Inventory (finished goods), after adding certain
profit margin to it, is sold to the customers, which may take the
form of cash or receivables or debtors. Receivables or debtors when
realized again take the form of cash and the cycle goes on. The
revolving nature of current assets consisting of working capital
has been cleared with the help of following chart:
ReceivablesSales
Finished goodsCash
Work in progressRaw materials
Because of this revolving nature of the assets consisting
working capital, later is also known as 'fluctuating' or 'floating'
or ' circulating' capital.In estimating the working capital
requirement and planning for its financing, the following pints
have to be kept in mind: The working capital requirement consists
of the following: raw materials stocks of goods in process stocks
of finished goods debtors operating expenses consumable stores The
principal sources of working capital finance are: working capital
advances trade credit accruals and provisions long term sources of
financing. The margin requirement varies with the type of current
assets as follows: Current Assets Margin Raw materials 10-25
percent Work-in-process 20-40 percent Finished Goods 30-50 percent
Debtors 30-50 percent2.6 Profitability projections The
profitability projections or estimates of working results (as they
are referred to by term-lending financial institutions) are
prepared along the following lines:A. Cost of production B. Total
administrative expensesC. Total sales expensesD. Royalty and
know-how payableE. Total cost production ( A+B+C+D)F. Expected
salesG. Gross profit before interestH. Total financial expenses I.
DepreciationJ. Operating profit ( G-H-I)K. Other incomeL.
Preliminary expenses written offM. Profit/loss before taxation (
J+K-L)N. Provision for taxes O. Profit after tax (M-N) Less,
dividend on: - Preference capital - Equity capital P. Rental profit
Q. Net cash accrual (P+I+L)Cost of Production:Represent the cost of
materials, labor, utilities and factory overheads as calculated
earlier.Total Administrative Expenses:Consist of Administrative
salaries, remuneration to directors, professionals fees, light,
postage, telegrams and telephones and office supplies (stationary,
printing etc)
Total Sales Expense:Consist of commission payable to dealers,
packing and forwarding charges, salary of sales staff, sales
promotion and advertising expense and other miscellaneous
expenses.Royalty and Know-how Payable:Rate is usually 2-5 % of
sales and generally payable for a limited numbers f years i.e. 5 to
10 years Total cost of productionThis is simply the sum of cost of
Production, royalty and Know-how Payable, total Sales Expense and
total Administrative Expenses.Cost of Production + Royalty and
Know-how Payable + Total Sales Expense + Total Administrative
Expenses = Total cost of production Expected salesThe figures of
expected sales are drawn from the estimates of sales and production
prepared earlier. Gross profit before interest This represents the
difference between expected sales and total cost of production.
Expected sales + Total cost of production = Gross profit before
interest Total Financial ExpenseConsist of interest on term loans,
interest on bank borrowings, commitment charge on term loans and
commission for bank guarantee. In estimating the interest on term
loans, two points should be borne in mind: Interest on term loans
is based on the present rate of interest charged by the term
lending financial institutions and commercial banks. Interest
amount would decrease according to repayment schedule of the term
loan. The interest on working capital borrowings from banks may be
estimated as follows:i. Determine the total requirement of the
working capitalii. Find out the quantum of bank borrowing that
would be available against the total working capital requirement
iii. Calculate the interest charge on the basis of the prevailing
interest rates
DepreciationDepreciation is an important item, particularly for
capital-incentive projects. In figuring out the depreciation
charge, the following points should be borne in mind:1. Contingency
margin and pre-operative expenses provided in estimating the cost
of project should be added to the fixed assets proportionately to
ascertain the value of fixed assets for determining the
depreciation charge.2. Preliminary expenses in excess of 5.0% of
the project cost is included under pre-operative expenses which is
subsequently allocated to fixed assets for determining the
depreciation charge.3. The income tax specifies that the written
down value method should be used for tax purpose. If further
specifies the rate of depreciation applicable to different kinds of
assets. 4. For company law (Financial reporting) purpose, the
method of depreciation may be either written down value (WDV) or
straight line (SL) method. Other IncomeIncome arising from
transactions is not part of the normal operations of the firm. i.e.
sale of machinery, disposal of scrap etc.Write off Preliminary
Expenses5% of the cost of project or capital employed, whichever is
higher, can be amortized in five equal annual installments.Profit
or Loss before TaxationThis is equal to: operating Profit + other
income write off preliminary expense. Provision of TaxationTo
figure out the tax burden, a second understanding of the income tax
acta complicated legislationand relevant case laws is required.
While calculating the taxable income, a variety of incentives and
concessions have to be taken in to account. Once the taxable
income, as per the income tax act, is calculated, the tax burden
can be figured our fairly easily by applying the appropriate tax
rates. Profit after TaxationThis is simply profit/loss before
taxation minus provision for taxation. A part of profit after tax
usually paid out as dividend- dividend on preference capital and
dividend on equity capital.Retained ProfitThe difference between
profit after tax and dividend payment is referred to as retained
profit. It is also called ploughed back earnings.Net Cash
AccrualThe net cash accruals form operations are equal to: retained
profit + depreciation + Write-off preliminary expenses + other
non-cash charges. 2.7 Projected cash flow statements The cash flow
statement shows the movement of cash into and out of the firm and
its net impact on the cash balance within the firm. A format for
preparing the cash flow statement, which is really a cash flow
budget.Cash Flow StatementSources of fund1. Share issue2. Profit
before taxation with interest added back3. Depreciation provision
for the year4. Development rebate reserve5. Increase in secured
medium and long-term borrowings for the project6. Other
medium/longterm loans7. Increase in unsecured loans and deposits8.
Increase in bank borrowings for working capital9. Increase in
liabilities for deferred payment to machinery suppliers10. Sale of
fixed assets11. Sale of investments12. Other income (indicate
details)Total (A) Disposition of Funds1. Capital expenditure for
the project2. Other normal capital expenditure3. Increase in
working capital4. Decrease in secured medium and long-term
borrowings All Bangladesh institutions SFCs- Banks5. Decrease in
unsecured loans and deposits6. Decrease in bank borrowings for
working capital7 . Decrease in liabilities for deferred payments to
machinery suppliers8. Increase in investments in other companies9.
Interest on term loans10. Interest on bank borrowings for working
capital11. Taxation12. Dividends - Equity - Preference13. Other
expenditure Total (B) Opening balance of cash in hand and at bank
Net surplus/deficit (A-B) Closing balance of cash in hand and at
bank2.8 Projected balance sheet The balance sheet, showing the
balances in various asset and liability accounts, reflects the
financial condition of the firm at a given point of time. The
horizontal format of balance sheet as prescribed by the Companies
Act is given below
Liabilities side of the balance sheet represents the following:
Share capital consists of paid-up equity and preferences capital.
Reserves and surplus represent mainly the accumulated retained
earnings like debenture redemption reserve, dividend equalization
reserve, and the general reserve. Secured loans represent the
borrowings of the firm against which security has been provided.
The important components are debentures, term loans from financial
institutions, and loans from commercial banks. Unsecured loans
represent borrowings against which no specific security has been
provided. Examples; fixed deposits from public and unsecured loans
from promoters. Current liabilities are obligations which mature in
the near future, usually within a year. Payables from acquiring
materials and supplies used in production, provision for provident
fund, provision for pension and gratuity, and provision for
proposed dividends. The assets side of the balance sheet shows how
funds have been used in the business. The major asset components
may be described briefly. Fixed assets are tangible long-lived
resources ordinarily used for producing goods and services. They
are shown at original cost less accumulated depreciation.
Investments represent financial securities owned by the firm.
Current assets, loans, and advances consist of cash, debtors,
inventories of different kinds, and loans and advances made by the
firm. Miscellaneous expenditures and losses represent outlays not
covered by the previously described asset accounts and accumulated
losses, if any.
For preparing the projected balance sheet at the end of year
n+1, we need information about following: the balance sheet at the
end of year n; the projected income statement and the distribution
of earnings for year n+1; the sources of external financing
proposed to be tapped in year n+1; the proposed repayment of debt
capital (long-term, intermediate term, and short-term) during year
n+1; the outlays and the disposal of fixed assets during year n+1;
the changes in the level of current assets during year n+1; the
changes in other assets and certain outlays like preoperative and
preliminary expenses (which are capitalized) during year n+1; the
cash balance at the end of year n+1; 3. PROJECT INVESTMENT CRITERIA
ANALYSISAt the simplest level of analysis, you'll want to make sure
that the total costs of any major project you undertake are less
than the total benefits resulting from the project. You could
simply add up the costs, and then add up your expected revenue
increases and cost savings over the next few years, and compare the
two.However, if we did that, we'd be ignoring the fact that many of
the costs will be incurred at the beginning of the project, while
many of the revenues or cost savings will occur later, over a
period of months or, more likely, years.We've reviewed a number of
more formal ways to evaluate the costs or benefits that a major
project will bring to your company. The most commonly used include:
Payback period analysis Net present value Internal rate of return
Accounting rate of return profitability index Benefit cost ratio
Each of these methods has its advantages and drawbacks, so
generally more than one is used for any given project. And no
financial formula, or combination of formulas, should be used to
the exclusion of common sense.3.1 Payback period analysisThe
payback method is the simplest way of looking at one or more major
project ideas. It tells you how long it will take to earn back the
money you'll spend on the project. The formula is:Cost of
Project
Annual Cash Inflow= Payback Period
Thus, if a project cost $50,000 and was expected to return
$12,000 annually, the payback period would be $50,000 $12,000, or
4.16 years.If the return from the project is expected to vary from
year to year, you can simply add up the expected returns for each
succeeding year, until you arrive at the total cost of the
project.For example, in our previous cash flow example, the project
costs $100,000 and the expected returns were as follows:Year
1$18,059
Year 2$25,513
Year 3$27,951
Year 4$32,021
Year 5$40,072
The project would be completely paid for about 10 1/2 months
into the fourth year, because $100,000 (cost of project) is equal
to all of the first three years' revenues, plus $28,477. $28,477 is
equal to about 10.7/12 of the fourth year's revenues.Under the
payback method of analysis, projects or purchases with shorter
payback periods rank higher than those with longer paybacks. The
theory is that projects with shorter paybacks are more liquid and
thus less riskythey allow you to recoup your investment sooner, so
you can reinvest the money elsewhere. With any project, the
variables grow increasingly fuzzy as you look out into the future.
With a shorter payback period, there's less of a chance that market
conditions, interest rates, the economy or other factors affecting
your project will drastically change.Generally, a payback period of
three years or less is preferred. Some advisers say that if the
payback period is less than a year, the project should be
considered essential.Payback period has advantages like it measure
of risk and liquidity and it useful for evaluating small projects.
But don't forget the drawbacks of the payback period method.
Chiefly, it ignores any benefits that occur after the payback
period, so a project that returns $1 million after a six-year
payback period is ranked lower than a project that returns zero
after a five-year payback. In addition it is not consistent with
investors wealth maximization. But probably the major criticism is
that a straight payback method ignores the time value of money. To
get around this problem, you should also consider the net present
value of the project, as well as its internal rate of return.3.2
Net present valueThe net present value method (NPV) of evaluating a
major project allows you to consider the time value of money.
Essentially, it helps you find the present value in "today's
dollars" of the future net cash flow of a project. Then, you can
compare that amount with the amount of money needed to implement
the project.If the NPV is greater than the cost, the project will
be profitable for you (assuming, of course, that your estimated
cash flow is reasonably close to reality). If you have more than
one project on the table, you can compute the NPV of both, and
choose the one with the greatest difference between NPV and cost.
In order to calculate net present value the formula is:
Procedure:NPV is the present value of all cash flows generated
by a project.1) Find the PV of each cash flow (both inflows and
outflows)2) Add up all the PVs to get NPV.3) Accept the project if
NPV > 0. If two projects are mutually exclusive, pick the one
with the higher positive NPV. Bear in mind, though, that NPV
analysis is generally used to evaluate the project's cash flows,
rather than the income from the project that would be shown on an
income statement. Why? Because the income statement factors in
depreciation, but depreciation is not an out-of-pocket expense. For
instance, if revenue of $10,000 is reduced to $7,000 of income
because of a $3,000 depreciation deduction, you still have the use
of the full $10,000. So, the cash flow figure of $10,000 is the
more instructive one to look at. However, if you are very concerned
about the appearance of your income statement (for example, if you
anticipate putting the business up for sale or seeking major
financing in the future, or if you're under stockholder pressure to
show more income) you may decide that the income figure is more
appropriate to use.Net present value is Consistent with shareholder
wealth maximization, Consider both magnitude and timing of cash
flows and Indicates whether a proposed project will yield the
investors required rate of return. However many people find it
difficult to work with a dollar return rather than a percentage
return.3.3 Internal rate of returnThe internal rate of return is a
discount rate that is commonly used to determine how much of a
return an investor can expect to realize from a particular project.
Strictly defined, the internal rate of return is the discount rate
that occurs when a project is break even, or when the NPV equals 0.
Here, the decision rule is simple: choose the project where the IRR
is higher than the cost of financing. In other words, if your cost
of capital is 5%, you don't accept projects unless the IRR is
greater than 5%. The greater the difference between the financing
cost and the IRR, the more attractive the project becomes.
ExampleTo illustrate the calculation of IRR, lets consider the cash
flow belowYear 0 1 2 3 4Cash flow(100,000) 30,000 30,000 40,000
45,000The IRR is the value of r which satisfies the following
equation:r = Internal rate of return
The calculation of r involves a process of trial and error. We
try different value of r till we find the right hand side of the
above equation which is equal to 100,000. Lets begin to try r = 15
%. This makes the right hand side equal to:
This value is slightly higher than our target value, 100,000. So
we increase the value of r to 16 %. Then the right hand
becomes:
Since the value is now less than 100,000. We consider that value
of r lies between 15 percent and 16 percent. If more refined
estimate of r is needed, use we the following procedure: 1.
Determin the net percent value of two closest rate of return.(NPV
when IRR is at 15 percent) = 802(NPV when IRR is at 16 percent) =
1,3592. Find the sum of absolute value of net present values obtain
in step 1. 802 + 1,359 = 2,1613. Calculate the ratio of the net
present value of the smaller discount rate identified in step 1 to
the sum obtained in step 2.
4. Add the number obtained in step three to the smaller discount
rate. 15 + 0.37 = 15.37 percentThe IRR decision rule is
straightforward when it comes to independent projects; however, the
IRR rule in mutually-exclusive projects can be tricky. It's
possible that two mutually exclusive projects can have conflicting
IRRs and NPVs, meaning that one project has lower IRR but higher
NPV than another project. These issues can arise when initial
investments between two projects are not equal. Despite the issues
with IRR, it is still a very useful metric utilized by businesses.
Businesses often tend to value percentages more than numbers (i.e.,
an IRR of 30% versus an NPV of $1,000,000 intuitively sounds much
more meaningful and effective), as percentages are more impactful
in measuring investment success. Advantages of IRR are People feel
more comfortable with IRR and consider both the magnitude and the
timing of cash flows. However it has disadvantages such as multiple
internal rates of return with unconventional cash flows that is any
change in sign (+,-) in period cash flows produces as many IRRs as
there are changes in the cash flow directions of the investment and
IRR does not consider cost of capital; it should not be used to
compare projects of different duration.3.4 Accounting rate of
returnA fairly simple way of gauging your return on an investment
in a major project or purchase is the accounting rate of return
(ARR). The formula is:Accounting Rate of Return =Annual Cash
Inflows - Depreciation
Initial Investment
For purposes of this formula, depreciation is calculated very
simply, using the straight-line method:Depreciation =Cost - Salvage
Value
Useful Life
As an example of how ARR works, let's say you're looking at
equipment costing $7,500 that is expected to return roughly $2,000
per year for five years. After five years you'll sell the equipment
for $500. The depreciation would be ($7,500 - $500) 5, or
$1,400.ARR =$2,000 - $1,400
$7,500= 8%
Using ARR can give you a quick estimate of the project's net
profits, and can provide a basis for comparing several different
projects. Under this method of analysis, returns for the project's
entire useful life are considered (unlike the payback period
method, which considers only the period it takes to recoup the
original investment). However, the ARR method uses income data
rather than cash flow and it completely ignores the time value of
money. To get around this problem, you should also consider the net
present value of the project, as well as its internal rate of
return.3.5 Profitability index (PI) The profitability index or
present value index (PVI) indicates how the project offers to
return for each Birr or Dollar invested. The profitability index is
the ratio of the sum of present values of the project divided by
the initial cost of the investment. It is a relative measure of the
value (present value) of a project compared to its cost. The higher
profitability index projects have higher PVs relative to the scarce
capital invested.PI = NPV /InvestmentProfitability Index Decision
RuleMutually exclusive investments with capital rationingChoose the
project with the highest PI.Capital rationing exists if there is a
limit on the amount of funds available for investment. There are
two forms of capital rationing: soft rationing and hard
rationing.Only use PI if there is capital rationing.3.6 Benefit
cost ratioThere are two ways of defining the relationship between
benefits and costs. Benefit cost ratio: BCR=PVB/INet benefit cost
ratio: NBCR=PVB-I/1 = BCR-1Where PBV=Present value of benefits
I=Initial investment (cost) To illustrate the calculation of these
measures, let us consider a project which is being evaluated that
has a cost of capital of 12 %.
Initial investment $100,000Benefits Year 1 25,000 Year 2 40,000
Year 3 40,000 Year 4 50,000
The benefit cost ratio measures for this project are: BCR=
25,000/ (1.12) + 40,000/ (1.12)2 + 40,000/ (1.12)3 +50,000/
(1.12)4100,000 BCR = 1.145 NBCR = BCR-1= 0.145
The two benefit cost measure, because the difference between
them is simply unity, give the same signals. The following
decisions rules are associated with them: When BCR or NBCR Rule
>1 > 0 Accept =1 = 0 indifferent