BNFN 521

INVESTMENT APPRAISAL

Lecture Notes
Lecture Three

DISCOUNTING
AND
ALTERNATIVE INVESTMENT
CRITERIA

Project Cash Flow Profile

Benefits Less Costs

(+)

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Year of Project Life

(-)
Initial Investment
Period

Operating Stage
Project Life

Liquidation

Discounting and Alternative Investment Criteria

Basic Concepts:
A.

Discounting

Recognizes time value of money

a. Funds when invested yield a return
b. Future consumption worth less than present consumption
o

PVB = (B /(1+r) +(B 1/(1+r) 1+..+(Bn /(1+r) n

r

PVC = (C /(1+r) +(C 1/(1+r) 1+..+(Cn /(1+r)

r

NPV = (B o-C o)/(1+r) o+(B 1-C 1)/(1+r) 1+..+(B n-C n)/(1+r) n

r

Discounting and Alternative Investment Criteria

(Contd)
B. Cumulative Values
The calendar year to which all projects are discounted to is important
All mutually exclusive projects need to be compared as of same
calendar year
1

If NPV r= (B o-Co)(1+r) 1+(B 1-C 1) +..+..+(B n-C n)/(1+r) n-1 and

NPV 3r= (B o-Co)(1+r) 3+(B 1-C 1)(1+r) 2+(B 2-C 2)(1+r)+(B 3-C 3)+...(B n-C n)/(1+r) n-3
3

Then NPV r = (1+r) 2 NPV r

Example of Discounting (10% Discount Rate)

Year
Net Cash Flow
PV00.1 1000
PV01.1

0
-1000

1
200

2
300

3
350

4
1440

200
300
350
1440

676.25
2
3
4
1.1 (1.1)
(1.1)
(1.1)

300
350
1440
1000(1.1) 200

743.88
2
3
1.1 (1.1)
(1.1)

PV02.1 1000(1.1) 2 200(1.1) 300

350
1

(1.1)

1440
(1.1)

818.26

Note: All of the transactions are done at the beginning of the year.

C. Variable Discount Rates

Adjustment of Cost of Funds Through Time

r0
r1
r2
r3
r4
r5

If funds currently are

abnormally scarce
Normal or historical
average cost of funds

r *4
r *3
r *2
r *1
r *0

If funds currently are

abnormally abundant

Years from
present period

For variable discount rates r1, r2, & r3 in years 1, 2, and 3, the discount factors
are, respectively, as follows:

1/(1+r1), 1/[(1+r1)(1+r2)] & 1/[(1+r1)(1+r2)(1+r3)]

Example of Discounting (multiple rates)

Year
Net Cash Flow
r
NPV 0 1000

0
-1000
18%

1
200
16%

2
300
14%

3
350
12%

4
1440
10%

200
300
350
1440

436.91
1.18 (1.18)(1.16) (1.18)(1.16)(1.14) (1.18)(1.16)(1.14)(1.12)

300
350
1440
NPV 1000(1.18) 200

515.55
1.16 (1.16)(1.14) (1.16)(1.14)(1.12)
1

350
1440
NPV 1000(1.18)(1.16) 200(1.16) 300

598.04
(1.14) (1.14)(1.12)
2

Note: All of the transactions are done at the beginning of the year.

ALTERNATIVE INVESTMENT
CRITERIA
1.
2.
3.
4.

Net Present Value (NPV)

Benefit-Cost Ratio (BCR)
Pay-out or Pay-back Period
Internal Rate of Return (IRR)

Net Present Value (NPV)

1. The NPV is the algebraic sum of the discounted values of the
incremental expected positive and negative net cashflows over a
projects anticipated lifetime.
2. What does net present value mean?
Measures the change in wealth created by the project.
If this sum is equal to zero, then investors can expect to recover
their incremental investment and to earn a rate of return on their
capital equal to the private cost of funds used to compute the
present values.
Investors would be no further ahead with a zero-NPV project than
they would have been if they had left the funds in the capital
market.
In this case there is no change in wealth.

10

Alternative Investment Criteria

First Criterion: Net Present Value (NPV)

Use as a decision criterion to answer
following:
a. When to reject projects?
b. Select project(s) under a budget constraint?
c. Compare mutually exclusive projects?
d. How to choose between highly profitable
mutually exclusive projects with different
lengths of life?
11

Net Present Value Criterion

a. When to Reject Projects?
Rule: Do not accept any project unless it generates a positive net
present value when discounted by the opportunity cost of funds
Examples:
Project A: Present Value Costs $1 million, NPV + $70,000
Project B: Present Value Costs $5 million, NPV - $50,000
Project C: Present Value Costs $2 million, NPV + $100,000
Project D: Present Value Costs $3 million, NPV - $25,000
Result:
Only projects A and C are acceptable. The country is made worse
off if projects B and D are undertaken.
12

Net Present Value Criterion (Contd)

b. When You Have a Budget Constraint?
Rule: Within the limit of a fixed budget, choose that subset of the
available projects which maximizes the net present value
Example:
If budget constraint is $4 million and 4 projects with positive NPV:
Project E:
Costs $1 million, NPV + $60,000
Project F:
Costs $3 million, NPV + $400,000
Project G:
Costs $2 million, NPV + $150,000
Project H:
Costs $2 million, NPV + $225,000
Result:
Combinations FG and FH are impossible, as they cost too much. EG
and EH are within the budget, but are dominated by the combination
EF, which has a total NPV of $460,000. GH is also possible, but its
NPV of $375,000 is not as high as EF.

13

Net Present Value Criterion (Contd)

c. When You Need to Compare Mutually Exclusive Projects?
Rule: In a situation where there is no budget constraint but a project
must be chosen from mutually exclusive alternatives, we should always
choose the alternative that generates the largest net present value
Example:
Assume that we must make a choice between the following three
mutually exclusive projects:
Project I: PV costs $1.0 million, NPV $300,000
Project J: PV costs $4.0 million, NPV $700,000
Projects K: PV costs $1.5 million, NPV $600,000
Result:
Projects J should be chosen because it has the largest NPV.

14

Alternative Investment Criteria

Benefit-Cost Ratio (R)

As its name indicates, the benefit-cost ratio (R), or what is
sometimes referred to as the profitability index, is the ratio of
the PV of the net cash inflows (or economic benefits) to the
PV of the net cash outflows (or economic costs):

PV of Cash Inflows (or Economic Benefits )

PV of Cash Outflows (or Economic Costs )

15

Benefit-Cost Ratio (Contd)

Basic rule:
If benefit-cost ratio (R) >1, then the project should be undertaken.
Problems?
Sometimes it is not possible to rank projects with the Benefit-Cost Ratio
Mutually exclusive projects of different sizes
Mutually exclusive projects and recurrent costs subtracted out of
benefits or benefits reported gross of operating costs
Not necessarily true that RA>RB

that project A is better

16

Benefit-Cost Ratio (Contd)

First Problem:The Benefit-Cost Ratio Does Not Adjust for Mutually Exclusive Projects
of Different Sizes. For example:
Project A:
PV0of Costs = $5.0 M,
PV0 of Benefits = $7.0 M
NPV0A = $2.0 M
RA = 7/5 = 1.4
Project B:
PV0 of Costs = $20.0 M,
PV0 of Benefits = $24.0 M
NPV0B = $4.0 M
RB = 24/20 = 1.2
According to the Benefit-Cost Ratio criterion, project A should be chosen over project B
because RA>RB, but the NPV of project B is greater than the NPV of project A. So,
project B should be chosen

Second Problem: The Benefit-Cost Ratio Does Not Adjust for Mutually Exclusive
Projects and Recurrent Costs Subtracted Out of Benefits or Benefits Reported As Gross of
Operating Costs. For example:
Project A: PV0 Total Costs = $5.0 M
PV0 Recurrent Costs = $1.0 M
(i.e. Fixed Costs = $4.0 M)
PV0 of Gross Benefits= $7.0 M
RA = (7-1)/(5-1) = 6/4 = 1.5
Project B: Total Costs
= $20.0 M
Recurrent Costs
= $18.0 M
(i.e. Fixed Costs = $2.0 M)
PV0 of Gross Benefits= $24.0 M
RB = (24-18)/(20-18) = 6/2 =3
Hence, project B should be chosen over project A under Benefit-Cost Criterion.

Conclusion: The Benefit-Cost Ratio should not be used to rank projects

17

Alternative Investment Criteria

Pay-out or Pay-back period

The pay-out period measures the number of years it will
take for the undiscounted net benefits (positive net
cashflows) to repay the investment.
A more sophisticated version of this rule compares the
discounted benefits over a given number of years from the
beginning of the project with the discounted investment
costs.
An arbitrary limit is set on the maximum number of years
allowed and only those investments having enough
benefits to offset all investment costs within this period
will be acceptable.
18

 Project with shortest payback period is preferred by this criteria

Comparison of Two Projects With Differing Lives Using Pay-Out Period

Bt - Ct

Ba
Bb

ta

tb
C =C
a

Payout period for

project a

Time

Payout period for

project b

19

Pay-Out or Pay-Back Period

Assumes all benefits that are produced by in longer
life project have an expected value of zero after the
pay-out period.
The criteria may be useful when the project is
subject to high level of political risk.

20

Alternative Investment Criteria

Internal Rate of Return (IRR)
IRR is

the discount rate (K) at which the

present value of benefits are just equal to the
present value of costs for the particular project
t

B
t - Ct

=0
i=0
(1 + K)t

Note: the IRR is a mathematical concept, not an

economic or financial criterion
21

Common uses of IRR:

(a)

If the IRR is larger than the cost of funds then the

project should be undertaken

(b)

Often the IRR is used to rank mutually exclusive

projects. The highest IRR project should be chosen

An advantage of the IRR is that it only uses

information from the project

22

Difficulties With the Internal Rate of Return Criterion

First Difficulty: Multiple rates of return for project
Bt - C t
+300

Time
-100
-200

Solution 1:

K = 100%; NPV= -100 + 300/(1+1) + -200/(1+1) 2 = 0

Solution 2:

K = 0%;

NPV= -100+300/(1+0)+-200/(1+0) 2 = 0

23

Difficulties With The Internal Rate of Return Criterion (Contd)

Second difficulty: Projects of different sizes and also mutually exclusive
Year

...

...

+600
+4,000

+600
+4,000

+600
+4,000

+600
+4,000

+600
+4,000

+600
+4,000

Project A -2,000
Project B -20,000

NPV and IRR provide different Conclusions:

Opportunity cost of funds = 10%
0
NPV A : 600/0.10 - 2,000 = 6,000 - 2,000 = 4,000
NPV 0B : 4,000/0.10 - 20,000 = 40,000 - 20,000 = 20,000
Hence, NPV 0B> NPV

0
A

IRR A : 600/K A - 2,000 = 0 or K A = 0.30

IRR B : 4,000/K B - 20,000 = 0 or K B = 0.20
Hence, K A>K B

24

Difficulties With The Internal Rate of Return Criterion (Contd)

Third difficulty: Projects of different lengths of life and mutually exclusive
Opportunity cost of funds = 8%
Project A: Investment costs = 1,000 in year 0
Benefits = 3,200 in year 5
Project B: Investment costs = 1,000 in year 0
Benefits = 5,200 in year 10
NPV A0 : -1,000 + 3,200/(1.08) 5 = 1,177.86
NPV B0 : -1,000 + 5,200/(1.08)10= 1,408.60
0

Hence, NPVB > NPVA0

IRRA : -1,000 + 3,200/(1+KA)5 = 0 which implies that KA = 0.262
IRRB : -1,000 + 5,200/(1+KB)10 = 0 which implies that KB = 0.179
Hence, KA>KB

25

Difficulties With The Internal Rate of Return Criterion (Contd)

Fourth difficulty: Same project but started at different times
Project A: Investment costs = 1,000 in year 0
Benefits = 1,500 in year 1
Project B: Investment costs = 1,000 in year 5
Benefits = 1,600 in year 6
NPV 0A : -1,000 + 1,500/(1.08) = 388.88

NPV 0B : -1,000/(1.08) 5 + 1,600/(1.08) 6 = 327.68

0

Hence, NPV A> NPV

0
B

IRR A : -1,000 + 1,500/(1+K A) = 0 which implies that K A = 0.5

IRR B : -1,000/(1+K B) 5+ 1,600/(1+K B) 6= 0 which implies that K B = 0.6
Hence, K B >KA

26

IRR FOR IRREGULAR CASHFLOWS

For Example: Look at a Private BOT Project from the perspective of the
Government
Year
Project A
IRR A

1000

1200

800

3600

-8000

3600

-6400

10%
Compares Project A and Project B ?

Project B
IRR B

1000

1200

800

-2%
Project B is obviously better than A, yet IRR A > IRR B

Project C
IRR C

1000

1200

800

3600

-4800

-16%
Project C is obviously better than B, yet IRR B > IRR C

Project D
IRR D

-1000

1200

800

3600

-4800

4%
Project D is worse than C, yet IRR D > IRR C

Project E
IRR E

-1325

1200

800

3600

-4800

20%
Project E is worse than D, yet IRR E > IRR D

27