Session 2: Project Evaluation and Selection Analysis TechniquesLearning Outcome
Identify various project evaluation and analysis techniques namely Payback Method, Accounting rate of return, Internal rate of return, Net present Value, and Profitability Index Important learning Terms - Cash flow
- Discounted cash flow
- Discount rate
- Present value
- Net present value
- Profitability index
Introduction
Telecommunication regulator needs to be informed on the two aspects: - Whether the projects under the telecommunication commission are worth to be invested i.e. are financially, socially and economically viable.
- Whether the projects invested by the telecommunication companies are financially and socially desirable. While the company may insist on profitability (financial viability) a regulator may insist on its socially or economically viability. Examples are investments in rural areas may be financially not viable but socially as a means to bridge the rural and urban divide they become necessary
Methods of Ranking Investment Proposals
Therefore project appraisal and evaluation requires the following: - Detailed statement giving the expected cash inflows and outflows to be assigned to the investment those relevant cash flows.
- Assessment of the impact of taxation
- Discount rate to account for the time value of money
- Add level rate to account for the risk associated with the investment that the risk of use of project cash flows.
A. Non Discounted Cash Flow Methods 1. Payback method (or Payback Period)
The payback period is the number of years required to return the original investment from the net cash flows (net operating income after taxes plus depreciation). Example
Assume the firm is considering two projects; project A and project B, each requires an investment of $100 millions. The cost of capital is 10%. Below is the summary of expected net cash flows in millions. 
The payback from the two projects is Project A: 2 and1/3 years
Project B: 4 years If the firm has the policy of employing three years payback period, project A will be accepted but project B will be rejected. Decision Rule
• If payback ? acceptable time limit, accept project
• If payback < acceptable time limit, reject project Advantages of PB method.
• It is very easy to calculate, but it can lead to wrong decision
• Put more emphasis to quick return of the invested fund so that they may be put to use in other places or in meeting other needs.
• Easy to apply (Simple to understand Problems with the Payback Method
• Does not consider post-payback cash flows
• Does not consider time value of money
• Does not explicitly consider risk
• The "acceptable" time period is arbitrary Illustration
In case two projects need initial outflow of $30m and has the following expected net cash inflows 
ARR is also known as accrual accounting rate of return unadjusted rate of return model and the book value model. Its compilations is related with
- Conventional accounting models of calculating income and required investment
- Shows the effect of an investment on project’s financial statement. 
Advantages of using ARR
• It is simple to calculate using accounting data
• Earning of each year is included in the calculating the profitability of the project Disadvantages of using ARR
• It is inconsistency with wealth maximization as the objective of the firm
• Since it uses the accounting data it includes the amount of accruals in calculating the earnings “net profit”.
• It is based on the familiar accrual accounting.
• It ignores the time value of money i.e. expected future dollars are erroneously regarded as equal to present dollars. B: Discounted Cash Flow Methods 1. Net Present Value Method (NPV)
It is the method of evaluating project that recognizes that the dollar received immediately is preferable to a dollar received at some future date. It discounts the cash flow to take into the account the time value of money. This approach find the present value of expected net cash flows of an investment, discounted at cost of capital and subtract from it the initial cash outlay of the project.
In case the present value is positive, the project will be accepted; if negative, it should be rejected. If the projects under consideration are mutually exclusive the one with the highest net present value should be chosen. 
Problems with NPV
• Difficult to explain to non-finance people
• Solution is in dollars, not percentage rates of return 
Some value of R will cause the sum of the discounted receipts to the equal the initial cost of the project, making the equation equal to zero, and that value R will be the project’s internal rate of return. 
From the above calculation, when rate is 15% the PV of investment A is zero, which indicates that its internal rate of return is 15%. The IRR for project B is approximately to 20%. IRR Decision Rules
Independent Projects: Accept all as long as the IR ? hurdle rate
Mutually Exclusive Projects: Compute (IRR - hurdle rate) for each project, rank from highest to lowest and accept the highest ranking project [assuming the computation (IRR - hurdle rate) > 0] IRR--Advantages/Disadvantages
1) Advantages
• Considers all cash flows
• Considers time value of money
• Comparable with hurdle rate
2) Disadvantages
• Does not show dollar improvement in value of firm if project is accepted
• IRR can be affected by the scale (size) of the project, i.e., Io
• Possible existence of multiple IRRs Relationship Between IRR and the NPV Profile 1) When the IRR = the firm's hurdle rate, NPV = 0
2) When the IRR < the firm's hurdle rate, NPV < 0
3) When the IRR > the firm's hurdle rate, NPV > 0 NPV and IRR Methods: Possible Decision Conflicts
An accept/reject "conflict" occurs when NPV says "accept" and IRR says "reject" or NPV says "reject" and IRR says "accept" Note: When projects are independent, no accept/reject conflict will arise
A ranking conflict occurs when one project has a higher NPV than another while the lower NPV project has a higher IRR.
Note: Ranking conflicts are unusual but can occur. These conflicts are relevant only when there are multiple acceptable mutually exclusive projects Ranking conflicts arise because of:
1) Timing differences in incremental cash flows
2) Magnitude differences in incremental cash flows
When a conflict arises among mutually exclusive projects, pick the one with the highest NPV
3. Profitability index
It is sometimes called Benefit Cost Ratio or present value index. It is calculated by taking the present value of cash inflows divided by the present value of cash outflows. The decision criteria is to accept project with a Profitability Index (PI) greater than one.
This ratio gives the return in the present terms per unit invested. Using this criterion, projects will be ranked from the one with highest PI down to one with the lowest, and then project would be selected in the order of ranking up to the point where the budget is exhausted. This criterion is simple but suffers from two basic limitations.
It cannot be used to except in cases where there is only a single constraint. In case where the capital is rationed in more that one period or where the capital is not the only constraint, the criteria will not provide the best solution. It looks projects individually and does not take into account the overall portfolio where correlation of projects’ returns is important
Review Questions - What do you understand by non-discounted and discounted project evaluation techniques?
- What is the payback period? What advantages and disadvantages do the Payback method of project analysis have?
- What is the difference between a project evaluated using accounting rate of Return (ARR) and the one using Internal rate of return (IRR). What are the advantages and disadvantages of each of the methods
- Ms Mary Temba is a financial analyst for the East Coast Consulting (T) Ltd. responsible for the consulting work awarded recently from the Tanzania Telecommunications Commission in the evaluating the two projects in the telecommunication industry. The projects costs $500mil each and the required rate of return for each of the project is 12%. The projects expected net cash flows are as follows:
a) Calculate each of the project's payback, net present value (NPV) and internal rate of return.
b) Which project or projects should be accepted if they are independent?
c) Which project should be accepted if they are mutually exclusive?
d) How might a change in the required rate of return produce a conflict between NPV and IRR rankings of the two projects? Would this conflict exist if k is 5%? [HINT: Plot the NPV profiles]
e) Why does the conflict exist?
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