Project Economics

Dr. D. Hendra Amijaya

Graduate Program
Department of Geological Engineering
Gadjah Mada University
 Profitability Indicators of a Project
Net Present Value (NPV)
Internal Rate of Return (IRR)
Benefit/Cost Ratio (BCR)
Pay Out Time (POT)
 Net Present Value
Some times also called Net Present Worth
Defined as the sum of the present values (PVs)
of the individual cash flows of the same entity.
It is the difference amount between the
sums of discounted: cash inflows and cash
outflows.
It compares the present value of money today
to the present value of money in future, taking
inflation and returns into account.
 Each cash inflow/outflow is discounted back
to its present value (PV). Then they are
summed. Therefore NPV is the sum of all
terms,
where

t - the time of the cash flow

i - the discount rate(the rate or return that could be earned on
an investment in the financial markets with similar risk.) = the
opportunity cost of capital
R t - the net cash flow (the amount of cash, inflow minus
outflow) at time t. For educational purposes, Ro is commonly
placed to the left of the sum to emphasize its role as (minus) the
investment.
 Given the (period, cash flow) pairs (t, Rt)
where N is the total number of periods, the
net present value is given by:

Notes
The discount rate:
- an interest rate a central bank charges depository institutions that
borrow reserves from it, for example for the use of the Federal
Reserve's discount window.
- the same as interest rate
 NPV in Decision Making
If... It means... Then...
the investment would add
NPV > 0 the project may be accepted
value to the firm

the investment would

NPV < 0 the project should be rejected
subtract value from the firm

We should be indifferent in the decision

whether to accept or reject the project. This
the investment would
project adds no monetary value. Decision
NPV = 0 neither gain nor lose value
should be based on other criteria, e.g.,
for the firm
strategic positioning or other factors not
explicitly included in the calculation.
Example NPV Calculation

Corporation must decide whether to introduce a new product

line. The new product will have startup costs, operational
costs, and incoming cash flows over 12 months.
This project will have an immediate (t=0) cash outflow of
100,000 (which might include machinery, and employee
training costs). The monthly net income is depicted in the
income statement sheet each for months 112. All values are
after-tax, and the required rate of return is 10%.
The present value (PV) can be calculated for each month:
Month Cash flow Present value

T=0 -100,000

T=1 -49701.81

T=2 -32364.46

T=3 2294.51

T=4 4868.51

T=5 16098.62
 T=6 16278.29

T=7 23650.43

T=8 35956.52

T=9 19816.38

T=10 29629.77

T=11 46381.55

T=12 52907.69

NPV = 65,816.04

Since the NPV is greater than zero, it would be better to

invest in the project than to do nothing, and the
corporation should invest in this project if there is no
alternative with a higher NPV.
 Internal Rate of Return
IRR is the discount rate often used in capital budgeting that
makes the net present value of all cash flows from a particular
project equal to zero.
IRR is the rate of return that makes the sum of present value
of future cash flows and the final market value of a project (or
an investment) equal its current market value.

IRR is sometimes referred to as "economic rate of return

(ERR).
 Given the (period, cash flow) pairs (n, Cn) where n is a positive
integer, N is the total number of periods , and NPV is the net
present value , the internal rate of return is given by r in:
Note: r sometime also written as i
 IRR in Decision Making
IRR is the flip side of NPV, where NPV is the discounted
value of a stream of cash flows, generated from an
investment.
IRR thus computes the break-even rate of return
showing the discount rate, below which an investment
results in a positive NPV.
A simple decision-making criteria can be stated to accept
a project if its IRR exceeds the cost of capital and rejected
if this IRR is less than the cost of capital.
The higher a project's internal rate of return, the more
desirable it is to undertake the project.
Assuming all other factors are equal among the various
projects, the project with the highest IRR would probably
be considered the best and undertaken first.
 Example IRR Calculation

If an investment may be given by the sequence of cash flows

Year (n) Cash flow (Cn)

0 -4000
1 1200
2 1410
3 1875
4 1050

Then the IRR is given by

In this case, the answer is 14.3%.

Easiest way to calculate Trial & Error Methods

 Calculation by numerical method

where rn is considered the nth approximation of the IRR.

use iteration
 Calculation by graphic method

Year (n) Cash flow (Cn)

0 -100 NPV = 10.16
1 20 IRR = ? %
2 30
15%
3 20
NPV = 0
4 40 10%
5 40 NPV = -4.02

Calculate the NPV

If r = 10% then NPV = 10.16 IRR = 10% + {(15%-10%)* (10.16/(10.16+4.02))}
If r = 15% then NPV = -4.02 = 13.58 %
NPV should be zero
It means:
10% < r < 15%
 Benefit Cost Ratio (BCR)
A BCR is the ratio of the benefits of a project or
proposal relative to its costs. All benefits and costs
should be expressed in discounted present values.
BCR takes into account the amount of monetary gain
realized by performing a project versus the amount it
costs to execute the project.
The higher the BCR the better the investment.
General rule of thumb is that if the benefit is higher
than the cost the project is a good investment.
 BCR = NPV (+Investment) /Investment
If BCR > 1, the project is good

Profit to Investment Ratio (PIR) = NPV/Investment

If PIR > 0, the project is good
 Pay Out Time (POT)
A measurement of profitability or liquidity of an investment,
being the time required to recover the original investment

Np = P / NCF

P = investment
NCF = net cash flows (either considering time value of money or not)
 Minimum Acceptable Rate of Return

The minimum acceptable rate of return (MARR), or

hurdle rate is the minimum rate of return on a
project a manager or company is willing to accept
before starting a project, given its risk and the
opportunity cost of forgoing other projects.
A synonym is minimum attractive rate of return.
Usually a project should have IRR > MARR
 Exercise
Cash flow (Cn)
Year Cash flow (Cn)
Project B
(n) Project A

0 -100 -100
1 30 40
2 30 40
3 30 30
4 30 20
5 30 20

Calculate NPV (with r = 10%), IRR, BCR & POT for each project.
Which project is better?