FINANCIAL EVALUATION OF
PROJECTS
FINANCIAL EVALUATION OF PROJECT
• Financial Evaluation estimates the worth of
investment in a project.
• It estimates the financial feasibility of the
project taking into account the income from
the project(i.e. Toll from a highway) or the
cost saved due to implementation of the
project( i.e. Value of Time saved from
construction of a flyover)
FINANCIAL EVALUATION OF PROJECT
Financial evaluations can be done using any of
the following methods
• Non-Discounted Cash Flow Methods
– Payback Period Method
– Accounting Rate of Return(ARR)
• Time Adjusted/ Discounted Cash Flow Methods
– Net Present Value Method(NPV)
– Internal Rate of Return Method(IRR)
– Profitability Index
PAYBACK PERIOD METHOD
• How long it take the project to “Pay Back” its
Initial Investment
• Payback Period= Number of years to recover
Initial Costs
• Payback Period should be Less than the life
cycle of the project.
• If Payback period is less than acceptable
payback period then project is accepted
PAYBACK PERIOD METHOD
• Example
Considering three projects A,B & C with same Initial
Investment of Rs. 10 Lakh each. The expected net cash flow
are as following
Net Cash Inflow in Lakhs (Rs.)
Year Project A Project B Project C
1 4 1 2
2 4 2 2
3 3 3 2
4 2 4 2
5 2 4 2
6 1 4 2
Total 16 18 12
PAYBACK PERIOD METHOD
Year Project A Project B Project C
Net Cash Sum of Net Cash Sum of Net Cash Sum of
Inflow Net Cash Inflow Net Cash Inflow Net Cash
(Rs. In Inflow (Rs. In Inflow (Rs. In Inflow
Lakh) (Rs. In Lakh) (Rs. In Lakh) (Rs. In
Lakhs) Lakhs) Lakhs)
1 4 4 1 1 2 2
2 4 8 2 3 2 4
3 3 11 3 6 2 6
4 2 13 4 10 2 8
5 2 15 4 14 2 10
6 1 16 4 18 2 12
Total 16 16 18 18 12 12
PAYBACK PERIOD METHOD
• For Project A
In 2 Years it recover Rs.8 lakhs(4+) & for remaining Rs.
2lakhs it will take 8 months considering Rs. 3 lakh
annually means Rs. 25 Thousand/Month and thus it
took 8 months to recover balance amount. Hence its
Payback Period is 2 Year 8 Month
• For Project B
Payback Period is 4 Year
• For Project C
Payback Period is 5 Year
Hence, Project A is most viable in these method
PAYBACK PERIOD METHOD
• Advantages
- Easy to Calculate & Understand
-Focus is on quick return of funds
• Disadvantages
-Ignores the time value of money
-Ignores cash flows after the payback period
-Biased against long-term projects
-Requires an arbitrary acceptance criteria
-A project accepted based on the payback
criteria may not have a positive NPV
ACCOUNTING RATE OF
RETURN(ARR) METHOD
• Also called Average Return on Investment
Method
• Based on relationship between Return &
Investment
Net Average Annual Income 100
ARR
Investment
Where,
Net Income
Net Average Annual Income
Life Period of Project
ACCOUNTING RATE OF
RETURN(ARR) METHOD
• Example
Net income of a company from three projects of Life
Span 6 years
Total Net Total
Investment Net Average
Cash Inflow Income
Project (Rs. In Annual ARR
(Rs. In (Rs. In
Lakhs) Income(Rs.)
Lakhs) Lakhs)
(1,00,000×100)/10,00,000
A 10 16 6 1,00,000
=10%
(1,33,333×100)/10,00,000
B 10 18 8 1,33,333
=13.3%
(33,333×100)/10,00,000
C 10 12 2 33,333
=3.3%
Hence, Project B is most viable in this method
ACCOUNTING RATE OF
RETURN(ARR) METHOD
• Advantages
– Very easy to calculate
– Recognize Profitability Factor of Investment
– Covers the entire life period of the project
• Disadvantages
-Ignores the time value of money
- Uses accounting income rather than cash flow
information, so not suitable for projects having
high maintenance costs
NET PRESENT VALUE(NPV) METHOD
• Also Called Net Present Worth(NPW) Method
• Difference between Initial Investment with the
Sum of Discounted cash flow generated over
the life cycle of the project
I= Initial Investment
R= Discount Rate
Ai = Cash Inflow Generated
over different time period
i is 1,2….n
NET PRESENT VALUE(NPV) METHOD
• If NPV is positive it implies the project is
financially viable
• NPV is highly dependent on discount rate r, if r
is less then chance of NPV is higher
• If the net cash flow is uneven then present
value of cash flow for every year is calculated
separately.
• Can be used for Cost-Benefit Analysis
NET PRESENT VALUE(NPV) METHOD
• Example
Considering three projects A,B & C with same Initial
Investment of Rs. 10 Lakh each and Discount Rate r is 10%.
The expected net cash flow are as following
Net Cash Inflow in Lakhs (Rs.)
Year Project A Project B Project C
1 4 1 2
2 4 2 2
3 3 3 2
4 2 4 2
5 2 4 2
6 1 4 2
Total 16 18 12
NET PRESENT VALUE(NPV) METHOD
• For Project A,
NPV=-10,00,000+4,00,000/(1+0.1)1+4,00,000/(1+0.1)2+
3,00,000/(1+0.1)3+2,00,000/(1+0.1)4+
2,00,000/(1+0.1)5+1,00,000/(1+0.1)6
=Rs. 2,36,844
• For Project B, NPV =Rs. 2,28,956
• For Project C, NPV = Rs. -1,28,948
Hence, Project A is most viable in these method at 10%
discount rate
NET PRESENT VALUE(NPV) METHOD
• If Discount Rate is 8%
• For Project A,
NPV=-10,00,000+4,00,000/(1+0.08)1+4,00,000/(1+0.08)2+
3,00,000/(1+0.08)3+2,00,000/(1+0.08)4+
2,00,000/(1+0.08)5+1,00,000/(1+0.08)6
=Rs. 2,97,595
• For Project B, NPV =Rs. 3,20,523
• For Project C, NPV = Rs. -75,424
Hence, Project B is most viable in these method at 8%
discount rate
NET PRESENT VALUE(NPV) METHOD
• Advantages
– Consider the Time Value of Money
– Uses ALL cash flows of the project
– Discounts ALL cash flows properly
– Easy to choose the priority project
• Disadvantage
– Discount rate (r) must be calculated properly
SUMMARY
Project A, B & C has the same amount of Investment
required with different amount of Net Cash Inflow but
when these are compared in different methods the results
are
• Project A is more viable than other projects in Payback
Period Method and in Net Present Value Method for
Discount Rate 10% though Project B is most viable in
Accounting Rate of return Method and in Net Present Value
Method for Discount Rate 8%
• Project C has the 5 year Payback Period for recovering the
initial investment in Payback Period method but it become
unviable in Net Present Value Method if Discount Rate is
more than 5%.
