Session12 13

PROJECT MANAGEMENT &
ECONOMICS
SESSIONS 12 & 13
DR ASSEM AL-HAJJ, Univation, RGU
Project Management and Economics. SITP-SPDC, NIGERIA
PAYBACK PERIOD
The pay back period of a project is the time needed
for the company to recover its initial investment as
calculated from the cash inflows.
PB Example: PROJECT A
Project A will last for five years. The cash flow
streams of the project are shown below. When will
be the payback period?

Initial
investment
Year 1 Year 2 Year 3 Year 4 Year 5
-10000 1000 2000 2000 5000 2000
Payback Period
-10000
-9000
-8000
-7000
-6000
-5000
-4000
-3000
-2000
-1000
0
1000
2000
3000
4000
5000
6000
7000
8000
9000
10000
I
n
i
t
i
a
l
i
n
v
e
s
t
m
e
n
t
Y
e
a
r

1
Y
e
a
r

2
Y
e
a
r

3
Y
e
a
r

4
Y
e
a
r

5
Time
C
U
M
U
L
A
T
I
V
E

C
a
s
h

F
l
o
w
PAYBACK METHOD
SHORTCOMINGS
The least precise of all capital budgeting
methods.
It gives equal weight to all cash flows
before the payback date.
It gives no weight at all to subsequent
flows.
It does not adjust for the time value of
money.
Make up your mind
What would you prefer to do if you are
made the following offer?
Take $100 now or take it after One year
Take $100 now or take it $102 after One
year
Take $100 now or take it $110 after One
year
Time Value Of Money
FUTURE PRESENT
=
INVESTMENT
+
Money today has different value
from money tomorrow
TIME VALUE OF MONEY: EXAMPLE
NOW
after ONE
year
+
=
INVESTMENT
100
10 %
110
after TWO year
+
=
INVESTMENT
10 % 121
12 % 123.2
Future Value Equation
Common elements used in the formulae:
P = Present value or value at base year
i = interest or cost of capital
expressed as a decimal
n = number of time periods
F = Future amount
It should be noted that i must be quoted in the same
units as n, i.e. if i = 0.12 per annum (12% per
annum) then n must be quoted in years. Similarly if
i = 0.05 per month (5% per month) then n must be
quoted in months.
At beginning of first time period F = P
At end of first time period F1 = P + P(i)
F1 = P(1 + i)
At end of second time period F2 = F1 + F1 * i
= F1(1+i)
= P(1+i)(1+i)
= P(1+i)2
F3 = F2 + F2 * i
= P(1+i)2 + P(1+i)2 * i
= P(1+i)2 (1+i)
= P(1+i)3
-
Similarly at end of 'n' the period Fn = P(1 + i)n
n
n
i P F ) 1 ( + =
FUTURE VALUE
0
100000
200000
300000
400000
500000
600000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
TIME (Years)
V
A
L
U
E
PRESENT VALUE/WORTH
The Present Value represents the amount needed
to be invested today to pay for capital cost plus
future operating costs.
X
r = discount rate
YEAR (n)

NOW

DISCOUNT
FACTOR
=
1
( 1 r )
n
+
Example
If an investment yields $1000 a year from now,
then how much is it worth today if the discount
rate is 10%?

PV= 909
THE OPPORTUNITY COST
For a project to be acceptable:
1. It must earn a minimum return equal to that
required by investors on their money.
2. It must earn at least as great a return as could be
earned on any project which it displaces because
finance is limited.
The Internal Opportunity Cost is the return
which could be earned on the best project
displaced by the one accepted.
DISCOUNT RATE
A vital factor in choice between alternative
projects.
The selection of the appropriate discount rate for
an investment is of great importance.
Wrong choice can lead to wrong conclusions
Inflation
The general increase in price level of the same
goods and services over time reflecting a decline in
the purchasing power of money
i.e. increase in cost without corresponding
increase in value.

Inflation (contd.)
In the real world inflation cannot be ignored.
Two approaches to the problem of inflation:
to Ignore it because it is often impossible to
forecast.
to take it into account.
The effect of inflation can be considered in the
following way:

NET OF INFLATION
DISCOUNT RATE
If:
i = interest rate
d = inflation rate
r = net of inflation discount rate

1
) 1 (
) 1 (
r
(
+
+
=
d
i
Actual and Present Value Cash Flow
0
1000
2000
3000
4000
5000
6000
1 2 3 4 5 6 7 8 9 10
Time (Years)
V
a
l
u
e
Cash Flow
Discounted
CF
Actual and Present Value Cash Flow
0
1000
2000
3000
4000
5000
6000
1 2 3 4 5 6 7 8 9 10
Time (Years)
V
a
l
u
e
Cash Flow
5%
10%
20%
30%
PV Example: PROJECT A
Calculate the Present Value of inflow from Project A
using a discount rate of 10%.

PV= 8721.523
Initial
investment
-10000 1000 2000 2000 5000 2000
Another example
1.You have a choice between two investments. Investment A
will generate 100,000 two years from now and
investment B will generate 110,000 three years from now.
If the cost of capital is 15%, which investment is better?

Answers:
PVA= 75,614;
PVB= 72,327
This implies that a return of 100,000 in two years is worth
more to the firm than a 110,000 return three years from
now.
THE ANNUAL EQUITY
FACTOR

Example:
If the annual cleaning costs over the 25-year life of a
building are 400. What is the present value, assuming a
9% discount rate?
The present value is:
PV= 9.8226 x 400 = 3929
(
(
+
+
=
n
r r
n
r
) 1 (
1 ) 1 (
Factor Equity Annual
=
+
+ =
n
t
t
t
r
F C NPV
1
0
) 1 (
1

NET PRESENT VALUE
(NPV)
C0 = Initial cash investment (An outflow, it is negative)
r = Discount rate
Ft = Net cash flow in period t

Project is acceptable if NPV is positive.
NPV Example: PROJECT A
Calculate the Present Value of inflow from Project A
using a discount rate of 10%.

PV= 8721.523
NPV= 8721.523 - 10000 = -1278.477
Project is not acceptable.
Initial
investment
-10000 1000 2000 2000 5000 2000
Another example
A 110,000 investment with a net cash inflow of 25,000
per year for a period of eight years. Interest rate applied is
18% with an inflation rate of 3% per year.
Is the project acceptable?
NPV?
5 . 2182
) 15 . 0 1 (
1
000 , 25 000 , 110
8
1
=
+
+ =

=
NPV
NPV
t
t
INTERNAL RATE OF
RETURN
Perhaps the most sophisticated capital budgeting technique
and more difficult to calculate than NPV.
The internal rate of return is the discount rate where the
present value of the cash inflows exactly equals the initial
investment i.e. when NPV=0

The solution to problems involving IRR is basically a trial-
and-error solution.
0
) 1 (
1
0
1
=
+
=
C
IRR
F
n
t
t
t
IRR Example: PROJECT A

IRR ANALYSIS
5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
-3000
-2000
-1000
0
1000
2000
3000
1 2 3 4 5 6 7 8 9 10 11 12
IRR
V
A
L
U
E
NPV
Rates
Another Example
A company has $300,000 committed for projects and must
select from the list of projects identified below. Assume
that the cost of capital is 10%.
Project Investment IRR
Discounted
cash flow at
10%
A 50000 20% 116000
B 120000 18% 183000
F 180000 11% 206000
D 130000 15% 171000
E 90000 12% 103000
G 80000 8% 66000
C 110000 16% 147000
ANNUAL EQUIVALENT
(AE)
Cash flows throughout the life of the project are converted
into an equivalent uniform annual cost.
This is done by multiplying the total present value by the
reciprocal of the PV of 1 per annum factor. This factor is
known as the Uniform Series that 1 will buy and is given
by the following formula.

Gives same ranking as PV method but presented in form of
annual receipts.
(
(
+
+
=
1 ) 1 (
) 1 (
Factor Equivalent Annual
n
r
n
r r
AE Example: PROJECT A
Total Present Value = 8721.5
Annual Equivalent Factor = 0.2638
Annual Equivalence = 2301
RISK ANALYSIS
Almost entirely based upon how well we
can predict cash inflows which are in turn
based on sales, taxes, cost of materials,
labour rates and economic conditions.

Methods:
Sensitivity analysis
Monte-Carlo simulation
Example:
An organisation is considering an investment project which requires
the outlay of $100,000 and is expected to earn receipts of $40000 at
the end of year 1, $50000 at the end of year 2, and $ 40000 at the end
of year 3. The external cost of capital is taken as 10% p.a. being the
rate to be earned to satisfy the shareholders.

Calculate the NPV, then advise on the acceptability of the investment.

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