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CRITERIA
CHAPTER 8 TEXTBOOK T2
FINANCIAL FEASIBILITY OF
PROJECTS
ESTIMATE THE COSTS AND BENEFITS OF THE
PROJECT
ASSESS THE RISKINESS OF THE PROJECT
CALCULATE THE COST OF CAPITAL
COMPUTE THE CRITERIA OF MERIT
JUDGE THE PROJECT IS GOOD OR BAD
COST OF CAPITAL
IT IS THE WEIGHTED AVERAGE COST OF VARIOUS
SELECTION CRITERIA
FINANCIAL MODELS: PREFERRED METHOD TO
EVALUATE PROJECTS
PAY
IMAGE,
MULTI-CRITERIA SELECTION
MODELS
CHECKLIST MODEL:
LIST OF QUESTIONS TO REVIEW POTENTIAL PROJECTS
DETERMINE ACCEPTANCE OR REJECTION
FLEXIBILITY
WEIGHT
SCORES ARE ASSIGNED TO EACH CRITERION
FOR THE PROJECT BASED ON ITS IMPORTANCE
WEIGHTS AND SCORES ARE MULTIPLIED TO
GET TOTAL WEIGHTED SCORE FOR THE
PROJECT
PROJECTS
WITH HIGHER SCORES ARE
CONSIDERED BETTER
EXAMPLE
CRITERION
WEIGHTAGE
A. STAY WITH CORE COMPETENCIES
2.0
B. STRATEGIC FIT
3.0
C. URGENCY
2.0
D. 25% OF SALES FROM NEW PRODUCTS 2.5
E. REDUCE DEFECTS TO LESS THAN 1%
1.0
F. IMPROVE CUSTOMER LOYALTY
1.0
G. ROI OF 18% +
3.0
B
1
3
3
1
C
D
8
2
3
2
0 10
10
5
E
6
0
0
10
F
0
0
0
0
G
WT. TOTAL
6 5
66
5 1
27
6 0
32
8 9
102
APPLYING A SELECTION
MODEL
PROJECT
CATEGORIES OF INVESTMENT
CRITERIA
DISCOUNTING CRITERIA
NET PRESENT VALUE (NPV)
BENEFIT COST RATIO (BCR)
INTERNAL RATE OF RETURN (IRR)
NON-DISCOUNTING CRITERIA
PAYBACK PERIOD
ACCOUNTING RATE OF RETURN
PROPERTIES
VALUE OF FIRM =
PRESENT VALUE OF
PROJECTS + NET PRESENT VALUE OF
PROSPECTIVE PROJECTS
WHEN A FIRM TERMINATES AN EXISTING
PROJECT WHICH HAS NEGATIVE NPV BASED
ON ITS EXPECTED FUTURE CASH FLOWS, THE
VALUE OF FIRM INCREASES BY THAT AMOUNT
THE VALUE OF FIRM MAY DROP IF NPV IS NOT IN LINE WITH THE
HIGH EXPECTATION OF INVESTORS
WHEN A FIRM MAKES AN ACQUISITION AND PAYS A PRICE IN
EXAMPLE 1
YEAR
0
1
2
3
4
5
COST
CASH FLOW
(1,000,000)
200,000
200,000
300,000
300,000
350,000
OF CAPITAL = r = 10%
(1.10)0
(1.1)1
(1.1)2
EXAMPLE 2
YEAR
0
1
2
3
4
5
CASH FLOW
(12000)
4000
5000
7000
6000
5000
DISCOUNT RATE
14%
15%
16%
18%
20%
SOLUTION
NPV = -12000 + 4000 +
5000______ +
(1.14)
(1.14)(1.15)
7000___________ + 6000________________ +
(1.14)(1.15)(1.16)
(1.14)(1.15)(1.16)(1.18)
5000________________ = 5592
(1.14)(1.15)(1.16)(1.18)(1.20)
PROJECTS
CASH
INFLOWS
USING
REINVESTMENT
RATE
THAT
REFLECTS
PROFITABILITY OF INVESTMENT
TV = CFi (1 + r)n-t
Where
Project X
Project Y
Investment Outlay
110,000
110,000
Year 1
31,000
71,000
Year 2
40,000
40,000
Year 3
50,000
40,000
Year 4
70,000
20,000
Re-investment rate = 14% and 20%
Project X
(TV) 14% = 224,911
(TV) 20% = 241,168
NPV = 43,614
NPV = 54,717
Project Y
(TV) 14% = 222, 774
(TV) 20% = 248, 288
NPV = 42,158
NPV = 59,584
EXAMPLE 3
INITIAL INVESTMENT (I) : 100,000
YEAR 1
25000
YEAR 2
40000
YEAR 3
40000
YEAR 4
50000
BCR = PVB / I
r = 12%
BCR = 1.145
NBCR = 0.145
for t = 1 to t = n
COST OF CAPITAL
REJECT : IF THE IRR IS LESS THAN THE COST
OF CAPITAL
EXAMPLE 4
YEAR
0
1
2
3
4
CASH FLOW
(100,000)
30,000
30,000
40,000
45,000
project
EXAMPLE 5
YEAR
0
1
2
3
4
5
6
Cost of Capital = 15%
CASH FLOW
- 120
- 80
20
60
80
100
120
Solution
PVC = 120 + 80/(1.15) = 189.6
TV = 20(1.5)4 + 60 (1.15)3+ 80 (1.15)2 + 100
PAYBACK PERIOD
LENGTH OF TIME REQUIRED TO RECOVER THE
ADVANTAGES
IT
LIMITATIONS
IT FAILS TO CONSIDER THE TIME VALUE OF
MONEY
IT IGNORES CASH FLOWS BEYOND THE
PAYBACK PERIOD
IT IS A MEASURE OF PROJECTS CAPITAL
RECOVERY, NOT PROFITABILITY
IT MEASURES A PROJECTS LIQUIDITY BUT
DOES NOT INDICATE LIQUIDITY POSITION OF
THE FIRM AS A WHOLE
DISCOUNTED PAYBACK
PERIOD
IT TAKES INTO ACCOUNT TIME VALUE OF
MONEY
CASH FLOWS ARE CONVERTED TO THEIR
PRESENT VALUES BY APPLYING DISCOUNTING
FACTORS
FIND THE CUMULATIVE NET CASH FLOW
AFTER DISCOUNTING TILL WE GET POSITIVE
VALUE
THE CORRESPONDING PERIOD SHOWS THE
DISCOUNTED PAYBACK PERIOD
EXAMPLE 6
YEAR
ACCOUNTING RATE OF
RETURN
IT IS THE AVERAGE RATE OF RETURN ON
CASH FLOW
0 - 1000,000
1
100,000
2
200,000
3
300,000
4
600,000
5
300,000
Part A : Taking r = 14%
Part B : Taking r=12% and then 1% increase every
year
PART A
NPV = -1000000 + 100000/(1.14) + 200000/
YEARS
300000 = 60000/(1+r) + 60000/(1+r) 2 +
60000/(1+r)3 + 60000/(1+r)4 + 60000/(1+r)5
+ 60000/(1+r)6
+ 60000/(1+r)7
r=9
304165
4165
Sum of absolute values = 12060
Ratio = 4165/12060 = 0.345
IRR = 9 + 0.345 = 9.345