Project Analysis Under Certainty pptx

NPV is given in NPV -- relates directly to the firm’s goal of wealth maximization -- employs the time value of money -- can be used in all types of investments -- can be adjusted to

Ch 6 Project Analysis Under

Certainty Methods of evaluating projects when the future is assumed to be certain.

The ideal investment decision making

technique is Net Present Value.

N P V measures the equivalent present

wealth contributed by the investment

NPV is given in

NPV relates directly to the firm’s goal of

wealth maximization employs the time value of money can be used in all types of

investments can be adjusted to incorporate risk.

Other Project Evaluation Techniques: Slide I

Discounted Cash Flow Techniques

Internal Rate of Return – calculates

the discount rate that gives the project an NPV of $0 If the IRR is greater than the required rate, the project is accepted IRR is given as

% pa.

IO IRR

CF IRR

CF

+

+ +

) 1

( )

1 (

) (

0

1 1

Other Project Evaluation Techniques: Slide II

Modified Internal Rate of Return – calculates

the discount rate that gives the project an NPV

of $0, when future cash flows can be re-invested

at the Re-Investment Rate, a rate different from the IRR If the MIRR is greater that the

required rate, the project is accepted MIRR is given as % pa.

IO IRR

RIR

CF IRR

RIR

CF NPV

n

n

− +

+

× +

+

+

×

) 1

(

) 1

( )

1 (

) 1

( )

( 0

) 1

( 2

1 1

Other Project Evaluation Techniques:

Slide III

Non-Discounted Cash Flow Techniques

Accounting Rate of Return- measures the ratio

of annual average accounting income to an

asset base value ARR is given as % pa.

= % pa.

Payback Period – measures the length of time

required to retrieve the initial cash outlay

PB is given as number of years.

Selection of Techniques: Slide I

NPV is the technique of choice; it satisfies the

requirements of: the firm’s goal, the time value

of money, and the absolute measure of

investment.

IRR is useful in a single asset case, where the cash

flow pattern is an outflow followed by all positive

inflows In other situations the IRR may not rank

mutually exclusive assets properly, or may have

zero or many solutions.

Selection of Techniques: Slide

II

•MIRR is useful in the same situations as the IRR, but requires the extra

prediction of a re-investment rate.

•ARR allows many valuations of the asset base, does not account for the time

value of money, and does not relate to the firm’s goal It is not a recommended method.

•PB does not allow for the time value of

money, and does not relate to the firm’s

The Notion of Certainty

• Certainty allows demonstration and

evaluation of the capital budgeting

techniques, whilst avoiding the complexities involved with risk.

• Certainty requires forecasting, but forecasts

which are certain.

• Certainty is useful for calculation practice

• Risk is added as an adaption of an evaluation

model developed under certainty.

Investment Cash Flow Timing End Of Year cash flow timing is

assumed.

Capital Flows

0 1 2 3 4

5

Initial Later Terminal

Outlay Outlay Flow

Operating Flows

0 1 2 3 4

5

The NPV Process: Slide I

• Net annual cash flows are forecast

for each year of the project.

EOY 0

-900

EOY 1 300

EOY 2 380

EOY 3

600

• The discount rate is then applied.

-900

1

) 06 1 (

300

380

+ ( 1 06 ) 3

600

+

The NPV Process: Slide II

• The NPV is calculated.

$503.77

$338.19

$283.01 -$900

NPV = $ 224.97 Positive: the project is acceptable.

Other NPV Applications:

Slide I

Asset

Retirement:

Asset

Replacement:

Other NPV Applications:

Slide II

• Optimum cycle length within a replacement chain.

At EOY:

3 6 9 12 15

OR ?

4 8 12 16

Other NPV Applications:

Slide III Correct ranking of mutually exclusive projects.

Where projects have different outlays.

Where projects have different lives.

Net Present Value

THE model to use in all investment evaluations.

Other criteria, such as IRR, MIRR, ARR, and Payback may be used as complementary

measures.

The End