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There are several criteria that have been suggested by economists, accountants and others to
judge the worthwhile ness of capital project. There have been more than thirty criteria proposed
in the intensive literature on this subject. Some are general and applicable to wide range of
investment; others are specialized and suitable for certain types of investments and industries.
1
Normal year is a representative year in which capacity utilization is at technically
maximum feasible level and debt repayment is still underway.
o The return on total capital is computed by deducting/excluding interest from the net
profit and including loan capital in total capital invested. The simple rate of return can be
expressed by the following formula:
F Y F
o R or Re ----------------------------------------------------------------------(5.1)
I Q
Where,
R = Simple rate of return on total investment;
Re= Simple rate of return on equity capital;
F =Net profit (in normal year) after depreciation and taxes;
Y =Annual interest charges;
I = Total investment comprising of equity and debt; and;
Q = Equity capital invested.
Decision rule:
If R or Re is higher than the rate of interest (r) prevailing in the capital market, the
project can be considered as good and should be accepted. If R or Re < r, Reject the
project.
In the case of choosing among several alternative projects, other things being equal,
the one with the highest rate of return either on total or equity investment should be
selected for implementation.
Example: If investment projects with a life of ten years are considered to reach full capacity in
the forth year of operation and the integrated financial analysis table of the projects display the
data (in ‘000 Birr) represent as follows:
Question:
(1) Calculate the simple rate of return for both projects.
(2) Based on your answer in (1) are the projects good or not if
they were to be evaluated alone?
2
(3) Which of the two projects should be selected for
implementation if they were alternative projects? Why?
Answer:
(1) The simple rate of return will be:
105 85
RA x100 21% or ReA x100 34%
500 250
144 120
RB x100 18% or ReB x100 24%
800 500
(2) If the projects are submitted at
different time and evaluated alone both are good because their R and Re are greater than
the prevailing rate of interest (Y=8%) in the capital market and hence should be
accepted. The rate of interest is obtained by the following formula
3
(II) It is only relevant for commercial (profit
making) projects and does not take into account (or ignores) the time value of
resources overtime.
(III) It is based upon the accounting profit,
not cash flow. The project may fail because of lack of liquidity fund.
o Definition: The payback period is the length of time (years) required by a project to
recover its initial cash outlay (investment).
o For example, if a project involves a cash outlay of Birr 600,000 and generates cash inflow
of Birr 100,000, Birr 150,000, Birr 150,000, and Birr 200,000, in the first, second, third,
and forth years, respectively, its payback period is 4 because the sum of cash flows during
the 4 years is equal to the initial outlay.
o When the annual cash inflow is a constant sum then the payback period of the project is
simply the initial outlay divided by the annual cash inflow.
o Symbolically, the PBP is expressed as:
I
PBP --------------------------------------------------(5.2)
c
Where, I Initial investment outlay and c annual cash inflow.
For example, a project with an initial cash outlay of Birr 900,000 and a constant annual cash
inflow of Birr 300,000 has a payback period of 3 years.
o For instance, the PBP of the project mentioned above to having uniform cash inflow is
obtained using equation (5.2) as:
o According to PBP criterion, the shorter the PBP, the more desirable the project. Firms
using this criterion generally specify the maximum acceptable PBP. If this is n years,
projects with a PBP of n years or less are deemed worthwhile and projects with a PBP
exceeding n years are considered as unworthy.
Decision Rule:
Accept the project if the PBP is equal to or less than the predetermined cut-off PBP set by set
by the investor.
4
For competing projects, choose the one with quicker PBP.
The payback criterion prefers project A, which has a PBP of 3 years in comparison to project B
with PBP of 4 years, even though B has a substantial cash inflows in the 5th and 6th years.
3. It is a measure of the project’s capital recovery, not profitability.
5
4. Though it measures project’s liquidity, it does not indicate the liquidity position of the
firm, which is more important.
5. It discriminates against projects with long gestation period.
Self Exercise:
1. Distinguish between SRR (ARR) and PBP. Mention at least three similarities and 6
differences.
2. Based on the information given in the table below and with interest rate of 10%, answer
the questions that follow.
Year Initial Deprecati Income before Tax Interest Income before Income after dep, Cash flow
investment on amount interest & tax tax interest, & tax before interest
0 100,000 0 0 0
1 80,000 20,000 30,000 10,000
2 60,000 20,000 35,000 13,125
3 40,000 20,000 40,000 15,000
4 20,000 20,000 40,000 15,000
5 0 20,000 35,000 13,125
(iii) Given the information for two projects below answer questions that follow
Project X Project Y
Year Initial Deprecati Income Cash flow Book Deprecation Profit Cash flow
investment (book on amount (profit) after value amount after tax
value) tax
0 1,000,000 0 0 (1,000,000) 1,000,000 0 0 (1,000,000)
1 75,000 25,000 40,000 65,000 75,000 25,000 10,000 35,000
2 50,000 25,000 30,000 55,000 50,000 25,000 20,000 45,000
3 25,000 25,000 20,000 45,000 25,000 25,000 30,000 55,000
4 0 25,000 10,000 35,000 0 25,000 40,000 65,000
6
(E) Calculate the PBP for the two projects and determine which one to be chosen. Support
your answer with argument.
2. Discounting measures of project worth or investment assessment criteria
Introduction:
o For a variety of social and economic reasons a unit of benefits now is considered more
valuable than an equivalent unit of benefit in future. Social reasons include uncertainty
about the future and the expectation that both society and individuals will be better off in
the future than they are now (Perkins, 1994:53). From a financial perspective, income
received now can be invested so that it accrues interest.
o A project’s net benefits have to be measured against the benefits that could have been
gained by investing the equivalent sum for alternative uses. This is termed as the
opportunity cost of capital.
o This is achieved by using Discounted Cash Flow (DCF) measures of project worth.
According to Snell (1997), Discounting is the arithmetical process of converting value
statements referring to one moment in time to their equivalent value statements
referring to another moment in time. In investment project analysis discounting is
normally used to work out the Present Value (PV) of a set of several Future Values
(FVs). The relationship between the present and future values can be expressed as:
1
PV FV --------------------------------------------------------------- (6.1)
(1 r )
t
Where, r is the discounted rate expressed as a fraction or percentage and
t is year
The value in the bracket is called discounted factor (DF) for each year.
o The discount rate is a rate that reflects the opportunity cost of capital. It is the rate at
which streams of expected costs and benefits are discounted in estimating NPV and IRR.
It is a national parameter that should be determined by central authority of a government
by considering several conditions such as international borrowing, returns to past
projects, Commercial bank interest rates, and macro economic analysis. The recently
published National Economic Parameters and Conversion Factors for Ethiopia indicate
that the discount rate is 10%.
7
Discounting measures of project worth or investment assessment criteria
There are four distinct but inter-related measures of project worth based on discounted cost and
benefit streams. These are:
o The Net Present Value (NPV) and
o Internal rate of Return
o Cost- benefit ratio
o
A.Net Present Value (NPV)
o The NPV is defined as the difference between the present values of the future benefits
and costs.
o It is the simplest of all the four methods and is essentially a measure of the present value
of aggregate surplus generated by the project over its expected operating life.
o It is calculated by subtracting the present values of costs (PVC)1 from the present values
of benefits (PVB).
o This implies that NPV represents the net benefit over and above the compensation for
time and risk. This involves two steps of calculations as expressed by the formula.
n n
NPV PVB PVC ---------------------------------------------------------- (6.2a)
t 1 t 1
Or
n
Bt n
Ct
NPV t --------------------------------------------------- (6.2b)
t 1 (1 r ) t 1 (1 r )
t
1
Total cost is the sum of investment costs, incremental working capital (incremental stocks plus net incremental
receivables, account receivable less account payable), and operating cost. Note also that incremental stocks and
net incremental receivable figure are the difference in values between the total stocks and net receivables in
certain year minus total stocks and net receivables in the preceding year.
8
Table 6.1: Cost and benefit streams discounted at 10% separately (Method 1)
(all figures in million)
Year 1.Total 2.Discount 3.Present value 4.Total 5.Discount 6.Present value of
cost factor at 10% of costs (1*2) Revenues/Benefits factor at 10% Benefits (4*5)
1 140 0.9091 127.3 0.0 0.9091 0.0
2 65 0.8264 53.7 100 0.8264 82.6
3 95 0.7513 71.4 150 0.7513 112.7
4 95 0.6830 64.9 200 0.6830 136.6
5 75 0.6209 46.6 150 0.6209 93.1
6 55 0.5645 31.1 100 0.5645 56.5
PVC=395 PVB=481.5
The alternative method (method 2) of calculating NPV is that the difference between benefits
(revenues of cash inflows) and costs (cash outflows) may be taken separately and then the single
stream of net cash flows could be discounted to arrive at the NPV. For it reduces the number of
discounting calculations, the second method is usually adopted. The formula is expressed as:
n
NPV PV ( B C ) ------------------------------------------------------------ (6.3a)
t 1
Or
n
( B Ct )
NPV t t ----------------------------------------------------------- (6.3b)
t 1 (1 r )
2
Note that there may be slight difference in NPV computed using the two methods due to rounding all the numbers
to one decimal place. In our example for instance the second method is greater than the NPV of first method by
Birr 100. Such a difference is insignificant and is well within the margin of error of the cost and benefit estimates.
9
If the information given is only cash flow like under PBP instead of costs and benefits then the
formula for the NPV will be
n
CFt
NPV initial investment --------------------------------------------- (6.4)
t 1 (1 r )
t
Other things being equal, the project’s NPV increases with larger benefits and number of years
but decreases with a higher discount rate and higher costs.
Decision Rule:
a. Accept the project if the NPV is positive, which implies that the net benefits
will be created after allowing for the required rate of return fixed principally to cover the cost
of capital in financing or opportunity cost of a sacrificed investment.
b. If the NPV is zero, is a marginal case and hence the decision may need to be
informed by other criteria particularly for public sector projects. NPV equal to zero means
the project will return the capital utilized, but it will not generate any surplus.
c. Reject the project if the NPV is less than zero or negative because the project
will not recover its cost at the specified rate of discount.
10
NPV and Decision Rule for Independent Projects
o Independent projects are projects that are not in any way substitutes for each other. In such
cases the decision rule is to accept the project if the NPV is greater than or equal to 0(approve any
project for which NPV>=0).
o If two projects have positive NPV and there is no budget constraint both should be accepted and
you do not need to choose the one with higher NPV.
o For example, if two independent projects road and fisheries development projects in different
locations are being considered and both have a positive NPV, then both should be undertaken.
Both will increase community’s welfare if they were undertaken and hence both should be
undertaken.
Decision Rule for Mutually Exclusive Projects
o A mutually exclusive project is defined as a project that can only be implemented at the expense
of an alternative project as they are in some sense substitutes for each other.
o Example of the mutually exclusive projects includes two versions of the same project, say with
different technology, scale or time. The decision rule for such projects is to accept the project
with the highest NPV.
Example: Consider two dams which may be proposed for one prime site in a locality in a fast flowing
river (in million Birr).
A. Years
Dam A 1 2 3 4 5 6 7 8 9 10
Costs 3
Benefits 0 1 1 1 1 1 0.5 1
Net benefits -3 1 1 1 1 1 0.5
B. NPV $1m
2 PV (benefits/costs)1.37
Dam B
Costs 500
Benefits 0 100 100 100 100 100 100 100 100 100
Net benefits -500 100 100 100 100 100 100 100 100 50
3 NPV $33m
4 PV (benefits/costs)1.07
o Dam A is small but has a high ratio of discounted benefits to costs (1.37). However, the total
benefits it produces and hence its NPV are quite small only 1 million Birr.
11
o The alternative dam B is much larger and has much larger benefits as well as higher costs.
Although NPV is large 33 million Birr its ratio of discounted benefits to costs is much lower than
project A’s only 1.07.
o If the two propjets were independent and the country could therefore construct both, then it
should do so as they both have positive NPVs.
o However, since the projects are mutually exclusive the dam with the higher NPV should be
selected, that is dam B. If dam A were constructed a gain of only 1 million Birr would be realized,
and the community would be prevented for ever from gaining the much greater net benefits of 33
million Birr, which dam B is expected to produce.
o The opportunity of gaining the other 32 million Birr of benefits from this unique dam site would
be lost forever. Consequently in choosing between mutually exclusive projects the one with the
highest NPV should always be selected.
o It is also possible to discount costs and benefits separately (individually) and now the decision
rule becomes that the discounted benefits should exceed the discounted costs, i.e.,
B > C and NPV = B - C >0.
The practical application of the present value criterion as a means of evaluating investment proposals for
project planning implies the following assumptions.
(i) Annual outlays and receipts from each investment are known for the entire life of the project.
(ii) That the project life span is known.
(iii) That there is a rate of discount, which can be applied to every proposal and for every tie
period.
However, the information required (the assumptions) made above is not always available for every
project. That means the NPV criterion may be applicable only to a limited number of project proposals on
which relevant data as indicated above could be computed or imputed. In some projects investment
outlays are difficult to estimate.
12
o It is misleading to think that inflation can be ignored in discounting net flows since inflation
affects both costs and benefits and that the effects cancel out each other.
o This is not true as the following example shows. Suppose benefits and costs of next year are
discounted at the rate r.
o Suppose further, in another scenario, price has increased at rate p. If the above assertion is right
the discounted net benefit of the two scenarios should yield identical value of NB.
NB=[B/(1+r)]-[C/(1+r)]= [B-C]/(1+r)
NB’=[B(1+p)/(1+r)]-[C(1+p)/(1+r)]={(1+p)[B-C]}/(1+r)
o As the above computation shows the NB computed in the two scenarios are different. Note,
however, that discounting NB’ by a discount rate which incorporates the inflation rate.
o This rate is usually called the real discount rate and can be given as r*, the nominal rate r,
1+r = (1+r*)(1+p)
r*= (1+r)/(1+p)]-1
1 r
r* 1
1 p
o In general one must either estimate the rate of inflation (assuming it is identical for cost
and revenue) or add it to the appropriate discount rate, or one must express all flows in
constant prices before discounting. In most of the cases it is preferable to do the latter
since it is non usually the case that costs and revenues will be affected identically by
inflation.
Properties of NPV
o NPV are additive : one add the present value of costs and benefits together
o NPV permits time varying discount rate.
o NPV of simple project decrease as discount rate increase.
13
Rationale for NPV
Evaluation of NPV:
The NPV as one of the discounting criteria of measuring project worth has the following
advantages.
A. It takes into account the value of resources overtime.
B. It considers the net benefit stream in its entirety.
C. For commercial projects it corresponds with the financial objective of maximization of
the wealth of shareholders.
D. The NPV of various projects, measured as they are in today’s Birr can be added. The
additive property of NPV ensures that a poor project (one which has a negative NPV)
will not be accepted, just because it is combined with a good project, which has positive
NPV.
E. The concept is clear and the solution is always determined. it is simple to use and does
not rely on complex conventions about where costs and benefits are netted out, as do
some ratio measures.
F. it is the only selection criteria that can correctly be used to choose between mutually
exclusive projects, without further manipulation.
Despite the above advantages, the NPV has its opponents towards some limitations.
A. The application and dimension of NPV, seems to be constrained in ranking projects, is
influenced by the discount rate.
B. The NPV is expressed by in absolute terms rather than relative terms and hence does not
factor in the scale of investment. For example, project A may have a NPV of 5000 while
project B has a NPV of 2500, but project A requires an investment of Birr 50,000 whereas
project B may require an investment of 10,000. Advocators of NPV argue that what
matters is the surplus value (rate of returns) irrespective of what is invested. However,
opponents argue that for the NPV is an absolute measure of value it does not show the
14
efficiency of a project in using capital. Out of the two projects B is efficient that A for its
investment capital generates a 25% return than as compared to 10% of A.
C. The NPV rule does not consider the life of the project. Hence, when mutually exclusive
projects are with different lives are considered the NPV is rule is biased in favour of the
longer-term projects.
D. Although it is simple to use, its meaning may not be intuitively obvious for non economists and
politicians.
E. Furthermore, although it can be used when there is budget constraint, it is not the
simplest method for this situation, especially for a large and complex investment budget.
If the budget constraint is long term, it will be necessary to raise the discount rate being
used or the size of the budget, so that only projects with a positive NPV will be selected,
in which again the NPV will be the most useful criterion for deciding whether to accept
or reject projects.
F. Some projects could be deferred from implementation although they show positive
NPVs, due to scarcity of funds. Thus passing the NPV test may be a necessary condition
but not a sufficient condition.
G. If some projects are mutually exclusive then the implementation of one would naturally exclude
the execution of the other. This will lead both the central authorities and the sponsoring agency
into a dilemma which project should be implemented. If funds are unlimited then both could be
implemented, but this is not always the case.
15
B. Internal Rate of Return (IRR):
t
Pt t
( Bt C t )
NPV P0 0
t 0 1 R t t 0 1 R t
16
For financial analysis it would be the maximum interest rate that the project could afford to pay on its
funds and still recover all its investment and operating costs.
o While calculating the NPV we have used a pre determined discount rate and a table. But the
calculation of the IRR amounts to searching for the discount rate that gives a zero NPV. This is
achieved through trial and error using the standard discounting table.
If the IRR is computed for financial appraisal in which all values are measured in market prices, it is
called the financial internal rate of return (FIRR). When economic prices are used instead, it will
be termed as economic internal rate of return (EIRR)
o Thus the rate is derived by trial and error or interpolation. The interpolation is could be
done arithmetically using two discount rates, one which gives a positive NPV and the
other which gives a negative NPV. IRR is expressed by the following formula.
NPV1
IRR r1 (r2 r1 ) * ----------------------------------------------------- (6.5)
NPV1 NPV2
Where, r1 is the lower discount rate
R2 is the higher discount rate
NPV1 is NPV at the lower discount rate and
NPV2 is NPV at the higher discount rate. The IRR calculated in this manner is ver close
to the true IRR.
Using the same example in table 6.2, it was found that NPV at 10% discount rate is 86.6 (second
method). Adopting a second trial discount rate of 32% the NPV is found to be negative at Birr
0.3.
Year 1.Total 2.Total 3.Net benefit 4. Discount 5.Present value of
cost Revenues/Benefits (2 – 1) factor at 10% Benefits (3*4)
1 140 0.0 -140 0.7576 -106.1
2 65 100 35 0.5739 20.1
3 95 150 55 0.4348 23.9
4 95 200 105 0.3294 34.6
5 75 150 75 0.2495 18.7
6 55 100 45 0.1890 8.5
NPV= -0.3
The IRR therefore lies between 10% and 32%. Using the formula in 6.5 the calculation of IRR
proceeds as:
IRR = 10% +[(32% - 10%)*(86.6/(86.6 – (-0.3)))]
= 10% + [22% *(86.6/86.9)]
= 10% + [22% *0.9965]
17
= 10% + 21.9%
= 31.9%
Decision rule:
Accept the project if the IRR is greater than the discount rate. For competing projects
choose the one with the higher IRR.
If IRR is equal to the discount rate, it indicates the project has no net return but will
recover the cost to be incurred. In other word the project is marginal.
Reject the project with IRR less than the discount rate because it will not recover its
cost after allowing for the cost of capital.
The calculation procedure begins with the preparation of a cash flow table. Estimated discount rate is then
used to discount the net cash flow to the present value. If the NPV is positive a higher rate is applied. If it
is negative at this higher rate the IRR must be between those two rates.
18
By iterations it is possible to determine the discount rate that just makes the project’s NPV equal to zero.
This rate is the IRR of the project. Fortunately spreadsheet programs such as Lotus 123 and excel can
calculate the IRR of project’s net benefit flow once starting value for the iteration is provided.
If the positive and negative NPVs are close to zero, a precise and less time consuming way to arrive at the
IRR uses the following interpolation formula.
PV ( I 2 I1 )
IRR I1
PV NV
Where: I1 = the lower discount rate
I2= the upper discount rate
PV = NPV (positive) at the low discount rate of I1
NV = NPV (negative) at the high discount rate of I2
Note: I and I should not differ by more than one or two percent.
PV ( I 2 I1 )
I1
PV NV
241.9(12 10)
10 .....we..ignore..the..sign
241.9 12.0
241.9( 2)
10
253.9
10 1.905
11.90
Another approximate solution to the IRR is to plot the NPVs corresponding to several discount rates to
give what we call the NPV curve. The present values are plotted on the y-axis and the discount rates on
the X-axis. A curve is then drawn to connect the various points on the graph. The point at which the curve
cuts the X-axis represents the rate at which the present value of the investment is equal to 0.
Example: By experimenting with discount rates between 10 and 20 in our fertilizer project example, the
IRR for the project is fractionally above 15%. The simplest way of getting this is by plotting the NPV (y-
axis) against different level of discount rates (x-axis); three points are usually sufficient. The point at
which this curve (called the NPV curve) crosses the x-axis provides the IRR value.
19
Diagram : The NPV Curve for The Fertilizer Project
5
4 (4.57)
3
2
1 IRR
NPV in million Birr
0 Discount rate
2 4 6 8 10 12 14 16 18 20 22
-1
-2
-3
(-3.21)
According to the IRR version of economic criterion we implement all projects that show an IRR greater
than the predetermined discount rate (opportunity cost of capital), i.e., accept all independent projects
having an IRR >= the opportunity cost of capital (cut off rate). The reference discount rate which is also
called the target rate is predetermined by the Central Bank.
Once the IRR is identified, the decision rule is ‘accept the project if the IRR is greater that the cost of
capital, say r. Note also that:
Note also the other point that, in the case of our example, if the discount rate is 10% both the NPV and
IRR will suggest to accept the project if the cost of capital is 10% and both suggest to reject the project
20
when the discount rate and the cost of capital is 20%. As will be demonstrated below, however, the two
methods may not give identical signals.
All projects with an internal rate of return greater than some target rate of return, r*, should be accepted.
The target rate is usually the same rate used as the financial or social discount rate employed in the
computation of the projects net present value. Note that the use of IRR does not avoid the need for
discount rate, as sometimes claimed, but merely delays the need to use it until the IRR has been
computed.
o While the IRR cannot be directly used to choose between mutually exclusive projects it can be
employed for further manipulation.
o This manipulation entails the subtracting the cash flow of the smaller project from the cash flow
of the larger one and calculating the internal rate of return for the residual cash flow.
o If the residual cash flow’s internal rate of return exceeds the target discount rate, which could
only occur if the larger project has a higher NPV, then the larger project should be undertaken. If
the analyst encountered with mutually exclusive projects with IRR greater than the target interest
rate, it cannot merely choose the project with the highest IRR. We can examine this at large using
the example of two dams.
Years 1 2 3 4 5 6 7 8 9 10
Dam A
Net Benefits -3 1 1 1 1 1 0.5
NPV $1m
IRR 22.2%
Dam B
Net Benefits -500 100 100 100 100 100 100 100 100 100
NPV $33m
IRR 13.7%
Dam A has higher IRR (22%) than does Dam B (13%). However, since dam B offers higher discounted
benefits it should be chosen. This case is illustrated in the following diagram.
21
Diagram: Project selection for mutually exclusive projects
NPV
NPVB B
NPVA A
0 Discount rate
Rt Rt Rt
IRRB IRRA
In the above diagram the discount rate and the target IRR is assumed 10%. Given this, the IRR of the two
projects is given as IRRA and IRRB. We have assumed the appropriate discount rate to be R 11 If the
discount rate is R’ project A will be the one that should be selected as the NPV of B will be negative.
22
Comparison of the NPV and IRR
o From the foregoing discussions it is clear that both the NPV and the IRR methods can and do
rank investment projects in more rational manner than the other methods previously considered.
o Thus it is advisable to calculate these measures so that easily understandable information is
provided to the authorities. In general it can be said that the NPV method is simpler, easier, and
more direct and more reliable.
o Do the IRR and NPV rules leads to identical decisions? Yes . provided that two conditions are
satisfied:
I. The cash flow of the project must be convectional implying the first flow is
negatives( initial investments) and subsequent cash flow are positive
II. Project must be independent
o In some situations both the NPV and the IRR criteria give the same accept -reject decision.
However, there is a probable reason why all acceptable projects cannot be undertaken.
o The invest able funds (capital funds) may be limited. This will have implication on the discount
rate. It may mean that the discount rate has not been set correctly.
o When the capital requirements of all acceptable projects exceed the available funds, the central
authorities (national bank) should raise the discount rate up to that level where the projects
passing the test are just enough to exhaust the available funds.
o But if too few projects are acceptable then the discount rate should be reduced. Hence as long as
capital funds are ‘unlimited’ it is argued that NPV should be the relevant criterion. But the
function of the discount rate is to ration capital in such a manner, as eventually to pass just
sufficient projects as will use up available investment resources.
o Hence the argument is not whether NPV or IRR should be preferred as a criterion, but whether
planners have set the discount rate correctly.
o As is noted in the pervious section, the IRR and NPV might suggest different projects for similar
level of discount rate. The example below demonstrates this
23
Example: Cash Flows for Fertilizer Project
Cash Flows
As it can be observed ranking the three projects by their NPVs (at 10% discount rate) results in
project B heading the list, while ranking them according to their IRRs would lead the planners to
prefer C. 25.8% is better because a project with 25 % economic rate of return is likely to be a
better investment than with a project with 15% economic rate of return. That is, it contributes
more to the national income relative to the resources used.
If all of the projects are to be undertaken (i.e. there is enough budget/resource) both NPV and IRR
give the same accept-reject decision. However, ranking the projects using the two methods will
lead to the choice of different projects: Project B on NPV basis and project C on IRR basis.
The above projects may not be undertaken because there may not be enough capital funds. In this
case it means the discount rate is not set correctly to reflect this scarcity (i.e. despite the scarcity
capital is cheap, being only obtainable at 10%). So, 10% is not an appropriate discount rate
because it passes all the three projects more than can be accommodate by the given capital (i.e.
the scarcity of capital is not reflected in higher value of discount rate - the discount rate failed to
ration). For instance, raising it to 20% would leave us with surplus funds since A and B will have
negative NPV. If the rate is set fractionally below 15.1% will the right number of projects be
accepted as shown below?
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Project A B C
NPV 15% 0.08 -1.84 2.76
NPV 10% 4.57 6.08 4.36
NPV 20% -3.23 -7.75 1.39
The point contained in the above Table is depicted in the following diagram
Project C
2
Discount rate
0
2 4 6 8 10 12 14 16 18 20 24
Project A
Project B
o Now if total investment budget is 80 million Birr and that the above projects constitute an
exhaustive list of all feasible projects in the economy. In this case planners could do all three
projects.
o However, if the budget were only 40 million Birr implying that either B could be undertaken, or
alternatively A and C. Since A and C together yield a total NPV of 8.93 million Birr planners
would choose A and C rather than B which yields only 6.08 million Birr at 10 percent discount
rate. But it should be understood that 10 percent is not appropriate rate since it effectively passes
all three projects, more than can accommodated given the capital constraint.
o Now if we raise the discount rate to 20 percent we could have rejected A and B, and there could
be simpler investment funds. Thus, if the rate is set at 15 percent then the right number of projects
could be accepted.
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NPV 20% -3.23 -7.75 1.39
In some cases it could be possible to find more than one IRR. This happens where a project’s cash flow
changes signs more than once, which could happen when there is a major replacement investment.
Example
Year Cash flow Discount rate NPV
1-4 100 20 30
5 -1500 30% -11
6-10 200 40% -4
10-20 150 45% 6
The resulting NPV curve is perverse. This implies that one should take (undertake) the project if the
opportunity cost of capital is either below 25 percent or above 42 percent. Hence the NPV is still
preferred on this ground.
IRR
Discount rate
20 24 28 32 36 40 44 48
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Evaluation of IRR:
The use of IRR as a measure of project worth has the following advantages.
a. It is more familiar concept and better understood by most people
b. It takes into account the value of resources overtime.
c. It considers the net benefit stream in its entirety.
d. It provides a measure of efficiency of the project in using capital.
e. The IRR is used in many projects
f. It is the only measure of project worth that takes account of the time profile of a project
but can be calculated without reference to a predetermined discount rate. (Useful for
international institutions like the WB since they cannot do with different discount rate for
different countries.
g. It is a measure that could be understood easily by non-economists since it is closely
related to the concept of the return on investment.
h. It is a pure number and hence allows projects of different size to be directly compared.
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A. The Benefit Cost (B/C) Ratio:
The benefit-cost ratio is defined as the ratio of the discounted values of benefits to the discounted
value of costs. A ratio of least one is required for acceptability and a B/c ratio of one indicates that
the NPV of zero at a particular discount rate. The formula for B/C ratio is expressed as:
PVB
B / C Ratio ------------------------------------------------------------------- (6.6)
PVC
For the example illustrated in table 6.2 the B/C ratio is:
481.5
B / C Ratio 1.22
395
o The benefit cost ratio is the earliest discounted project assessment criterion to be employed. The BCR
is defined as the ratio of the sum of the project’s discounted benefits to the sum of its discounted
investment and operating costs. This is given as,
n
Bt
(1 r ) t
t 0
BCR n
Ct
(1 r ) t
t 0
o A project should be accepted if its BCR is greater than or equal to 1 (i.e. if its discounted benefits
exceed its discounted costs). But if BCR is less than 1 , the project should be rejected. The BCR will
be less than, equal to, and greater than one when the discount rate used is greater, equal to, and less
than the IRR.
o One possible advantage o the BCR, on top of being easy to show to non-economists is that it is easy
to show the impact of a percentage change in cost or benefits on the projects viability.
o Its major disadvantage is the need to specify and adhere to conventions regarding the designation of
expenditures as costs and benefits.
o Example cost of transporting finished goods (say Br. 25) may be figured as cost in one project (other
costs are Br. 25 + transport cost Br. 25 = Br. 50; if sales price is Br. 100 the BCR will be 2) but price
may be given net of transport cost (Br.100- Br.25=Br.75; compare to cost Br. 25 will given a BCR of
3) in the other and the two projects, thus, are incomparable. Clear convention on such issues will be
necessary for comparison purposes.
Decision rule:
Accept the project if the B/C ratio is greater than one, which implies that NPV is
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positive.
B/C ratio equal to 1 implies that NPV is equal to zero, which is marginal.
Reject the project with B/C ratio less than one, implying the NPV is negative..
The proponents also argue that since it measures net present value per Birr outlay, it can
discriminate better between large and small investments and hence preferable to the NPV.
Nevertheless, it also suffers from a consistent definition of capital.
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These criteria related to welfare optimization. They are broadly classified in two: Pareto optimality
(improvement criterion) and Hicks-Kaldor compensation criterion.
Advantage:
o When using this criterion it is unnecessary to make any comparison between the utility (welfare)
enjoyed by different people as a result of any change in their income, since everyone must either
be unaffected or made better off by the change for it to be considered a Pareto welfare
improvement.
Disadvantage:
o This situation may be difficult to achieve in reality. However, if projects could only be
implemented when they were expected to result in an actual Pareto welfare improvement, it is
obvious that very few, if any, would be approved. Because there will always be someone who is
made worse off by the improvement of project.
o To overcome the restrictive nature of Pareto unanimity rule, the concept of a potential Pareto
improvement or the compensation principle, was developed by Hicks (1939) and Kaldor (1939).
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better off themselves. The Hicks-Kaldor compensation principle is central to the theoretical
justification for cost benefit analysis in welfare economics.
Advantage:
o This criterion provides the rationale for choosing projects whose benefits outweigh their costs,
even if the people who gain from a project are not the same as those who pays for it. The excess
of benefits over costs is called the project’s net benefit.
o A crucial element of this criterion is that it is not necessary for the gainers from a project to
actually compensate the losers, only for them to be able to do so if they wished and still remain
better off than if the project had not been implemented. Hence a project that meets the Hicks -
Kaldor hypothetical compensation criterion will not necessarily result in an actual Pareto
welfare improvement, only a potential improvement.
Disadvantages:
o The Hicks - Kaldor criterion can be criticized because of its failure to address the distributional
impacts of projects. Total welfare will not necessarily be increased even if a project meets the
Hicks-Kaldor criterion, unless those who gain receive the same increase in their utility from an
extra unit of income as those who lose from the project.
o In economic analysis it is implicitly assumed that everyone has the same marginal utility of
income. However, it is a basic tenet of welfare economics that the poor can be expected to receive
a greater increase in their utility or welfare from 1 extra unit of income than the rich. That is, the
poor are expected to have higher marginal utility of income than the rich.
o Put simply a project that costs the poor 1 unit of income and increases the income of the rich by
1.5 units will pass the hicks-Kaldor criterion and be selected, but will not increase total
community welfare if the poor value their unit of lost income twice as highly as the rich value
each additional unit of income they gain.
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allocation of these scarce resources will be ensured by giving priority to public and
private sector projects that are deemed contemporary in terms achieving the national
development objectives and executing company/institutional mission by addressing
urgent/timely needs or problems.
o However, this criterion is in contrast to fairness, one of the basic principles of project
appraisal3. The basic question is thus should the scarce resources be allocated in favor of
replacement, modernization, expansion, diversification, R&D, or mandatory projects4?
o The problem with this criterion is how can the degree of urgency be objectively
determined and justified?
o In certain situations, of course, it may not be difficult to identify really urgent investment.
For example, some minor equipment of project or production that has failed may be
replaced immediately to ensure continuity of production or service provision as non
replacement have great effects. You can take as an example for the later case what if
minor lab or hospital equipment in JU has failed? Non-replacement of such equipment
may mean considerable losses arising from stoppage in production or service delivery. It
may be futile in such a case to go into a detailed analysis and delay decision.
o In many situations, however, it is difficult to determine the relative degree of urgency
because of lack of an objective basis such as why the equipment has failed? The use of
urgency criterion may imply that the persuasiveness of those who propose projects would
become a very important factor in investment decisions. Resource allocation may
degenerate into a political battle. In view of these limitations of the urgency criterion,
scholars and expertise suggest that in general it should not be used for investment
decision-making. In exceptional cases, when genuine urgency exists, it may be used
provided that investment outlays are not large.
This ratio is often used in trade oriented projects or trade policy. In its simple form the DRCR (sometimes
referred as Bruno ratio (Bruno, 1967) is an undiscounted measure of project worth calculated for a single
typical year of project operation.
3
See the basic principles of project appraisal under section 1.2.
4
Refer to section 2.3 for their distinction.
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DRC is a measure of the economic efficiency of production of a commodity or in other words the national
comparative advantage in its production.
It is defined as the value of domestic resources (primary, non traded factors of production) in domestic
currency units required to earn or save a unit of foreign exchange, which is the cost per unit of foreign
exchange saved for imported competing goods and the cost per unit of foreign exchange earned for
exports.
The DRC coefficient is a cost benefit ratio and it is essentially a measure of the efficiency of domestic
production relative to the international market.
If the DRC for a commodity is less than the appropriate accounting price of foreign exchange (OER or
SER) a comparative cost advantage exists in producing the commodity in question and vise versa. From
this:
DRC < 1 implies that the productivity is economically profitable because its production yields more than
enough international value added to compensate for the cost of domestic factors used.
DRC = 1 implies a break-even situation, where it is only just economically worthwhile to produce the
commodity.
DRC > 1 indicates that the cost of domestic resources needed to generate one unit of foreign exchange
exceeds the value of the foreign exchange. This means the country is internally not competitive in the
production of the commodity or the country is better off to import rather than to produce the commodity.
Undiscounted measures, as we noted, are excessively crude and most invariably inaccurate. Thus, the
discounted version is the most appropriate one. It is given as,
( Ctl BCtl )
n
(1 r ) t
( Br .)
t 0
DRCR n
( C BC )
(tf1 r ) t tf ($US )
t 0
Where:
Btl are the benefits of the project obtained in local currency
Ctl are the costs of the project incurred in local currency
Btf are the benefits of the project obtained in foreign exchange
Ctf are the costs of the project incurred in foreign exchange
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The Decision rule for DRCR
o When undertaking a financial appraisal a project should be accepted if its DRCR is less than or
equal to the official exchange rate, OER.
o This means a project should proceed if it uses less domestic resources, measured in local prices,
to earn 1 unit of foreign exchange than is the norm for the whole economy (the norm here being
represented by the official exchange rate).
o In economic analysis, however, a shadow exchange rate (as oppose to OER is used). The
modified DRCR (modified because it is discounted which traditionally was not the case) is
sometimes referred as the internal exchange rate approach to emphasize the fact that the
computation of DRCR is independent of any predetermined exchange rate as that of IRR, which
do not, immediately, require a discount rate. It produces own internal exchange rat, which is
internal to the project.
Example: Estimation of the domestic resource costs ratio, special economic zone project - local cost
component (numerator) in million Birr
Years
1 2 3 4 5 6 7 30
Local costs
Investment 40 60 30 10
Production 0 50 75 90 100 100 100 100
Total local costs 40 110 105 100 100 100 100 100
Local sales 0 0 20 25 25 25 25 25
Net local costs 40 110 85 75 75 75 75 75
PV of net local costs Birr 712 million
Estimation of the DRCR, special economic zone project - Foreign exchange component (denominator)
Million US$)
Years
1 2 3 4 5 6 7 30
Foreign exchange earnings
Exported output 0 3 20 30 30 30 30 30 30
Foreign exchange costs
Imported investment goods 20 40 12 2
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Other imported items 0 5 7 8 10 10 10 10 10
Net foreign exchange earnings (export – -20 -42 1 20 20 20 20 20 20
imports)
PV of net foreign exchange earnings US$ 86.7
DRCR = PV net local costs/PV of net forex earnings = Birr 711.6/US$86.7= 8.21 Birr per US$.
o The main advantage of this approach is that non-economists can readily understand its decision
rule. More substantially in economies with serious balance of payment problem the DRCR
clearly show the potential of a project to earn foreign exchange. It also avoids the need to
compute the shadow exchange rate in advance.
o However, its disadvantages includes, like that of IRR it cannot be used to rank projects. It cannot
also be used to choose between mutually exclusive projects if both use less domestic resource to
earn a unit of foreign exchange. This is because it doesn’t show which of the two, or more,
mutually exclusive projects will generate the greatest net benefits for the country.
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