Unit 6: Project Evaluation

57
UNIT 6
Project Evaluation
When cost and benefit cash flows have been estimated and combined, a
project proposal is ready for evaluation. This unit shows how to calculate
the most widely used measures of project profitability, and discusses their
use in evaluating and ranking projects.
Learning Objectives When you have completed this unit you should:
A. Know how to calculate payback, return on investment, net present
value, and internal rate of return for a project.
B. Understand the advantages and disadvantages of each method.
C. Know how to use each method to evaluate and rank proposed
projects.
6-1. Is It Worth Doing?
Many more projects are proposed than are approved. How can the pro-
posals that are most profitable to the organization be selected? Each pro-
posal must be evaluated and, if resources are limited, compared against
other proposals. Evaluation decides whether the project qualifies as profit-
able, measured against a specified organization guideline (e.g., three-year
payback, or positive net present value at 10% discount rate). If the organi-
zation has unlimited resources, a favorable evaluation is sufficient for
project approval. Otherwise, the proposal must compete against other
qualified proposals for limited resources.
To evaluate proposed investments, one must first express them on a com-
mon basis and then apply some sort of economic criterion, or profitability
index. The usual common basis is estimated cash flow. No one economic
criterion dominates the field. There are several, and each has its particular
strengths, weaknesses, and impassioned champions and detractors. The
criteria discussed in this unit are the four most widely used. They include
payback, return on investment, net present value, and internal rate of
return.
6-2. Project Cash Flow Table
A control improvement project starts as an idea. The idea takes on differ-
ent representations as it is developed. Representations may be as concrete
Friedmann05.book Page 57 Tuesday, June 13, 2006 11:31 AM
58 UNIT 6: Project Evaluation
as a pilot plant demonstration of a proposed control scheme or as abstract
as a mathematical proof. The financial representation of a project is a
string of numbers, the expected yearly cash flows. These cash flows are the
algebraic sums of the benefit cash flows discussed in Unit 4 and the cost
cash flows covered in Unit 5. The combined cash flow table for a conven-
tional project starts with negative numbers, then switches to positive.
Example 6-1: The first costs of a four-unit control consolidation are
described in Example 5-2. The cash flows for the first costs of this project
are listed in the second column of Table 6-1. If benefits from the consolida-
tion are $40,000 per unit per year, the benefit cash flows will be $80,000 for
the second year, during which only two units will be run from the consoli-
dated control room, and $160,000/year thereafter for the life of the project.
Benefit cash flows are listed in the third column of Table 6-1. Combined
cash flows, the year-by-year algebraic sums of cost and benefit cash flows,
are listed in column four.
6-3. Nondiscounted Evaluation Methods
The earliest widely used evaluation methods are payback and return on
investment. The payback period (PP) is the time required to recover the
original capital investment from cash flow. The original capital investment
is the project first cost, and for payback calculation purposes, the cash
flows are benefits minus operating costs. PP thus can be defined as the
value that satisfies Eq. (6-1).
(6-1)
Cash Flows, $
Year Costs Benefits Combined
0 -200,000 0 -200,000
1 -190,000 0 -190,000
2 -140,000 80,000 -60,000
3 0 160,000 160,000
4 0 160,000 160,000
5 0 160,000 160,000
6 0 160,000 160,000
7 0 160,000 160,000
8 0 160,000 160,000
Table 6-1. Cash Flows for Control Consolidation
FC CF t d
0
PP
=
UNIT 6: Project Evaluation 59
where:
FC = project first cost
CF = operating cash flow, not including first costs
Time is usually measured from the start of operations rather than from the
first expenditure.
Return on investment (ROI) uses the same first cost and cash flow defini-
tions. It is expressed as a percentage and measured by the ratio of average
yearly operating cash flow to first cost, as shown in Eq. (6-2).
(6-2)
where:
CF
i
= cash flow for ith year
n = project operating lifetime, in years
Example 6-2: A straightforward project has an estimated first cost,
invested at the start of the project, of $100,000. The project will take one
year before operation starts, so operating cash flows start in year 2. They
are estimated to be $40,000 per year for eight years. The overall cash flow
diagram is shown as Fig. 6-1. Payout period is 2.5 years, the time after
start-up at which operating cash flow equals first cost. ROI = 100 x
$40,000/100,000 = 40%.
Payback and ROI have similar advantages and disadvantages. Both are
easy to understand and easy to compute. Neither explicitly takes into
account the time value of money, since future cash flows are not dis-
counted as a function of time. As a result, these methods are biased in the
values placed on some cash flows compared to the discount methods cov-
ered in 6.4. Payback places no value on cash flows beyond those required
to cover first cost. ROI places equal value on immediate and remote cash
flows. These biases are not important if all the projects being compared
have similar lifetimes and cash flow trajectories. They can produce bad
decisions when comparing dissimilar projects. Payback and ROI have
been largely superseded by the discounted evaluation methods discussed
in the next section.
ROI 100 CF
i
( ) n
i 1 =
n
FC ( ) =
6-4. Discounted Evaluation Methods
The evaluation methods recommended by most economists are net present
value (NPV) and internal rate of return (IRR). Both of these methods take
into account the time value of money by discounting future cash flows as a
function of time. The time value of money is simply the effect of interest.
The future value (FV) of a present value (PV) after n years is determined
by Eq. (6-3), the compound interest formula.
FV
n
= PV (1 + k)
n
(6-3)
where k is the yearly fractional interest rate.
Table 6-2 shows a few future values of one dollar as a function of interest
rate and time. Discount factors for future values are calculated by rear-
ranging Eq. (6-3) into Eq. (6-4) to solve for PV.
PV = FV
n
/(l + k)
n
(6-4)
Fig. 6-1. Cash Flow Diagram for Example 6-2
Interest Rate
Year 5% 10% 20%
1 1.050 1.100 1.200
5 1.276 1.611 2.488
10 1.629 2.594 6.192
Table 6-2. Compounded Future Value of $1
The present value of one dollar of future value is the discount factor that
must be applied when evaluating future cash flow. Some discount factors
are plotted in Fig. 6-2 and listed in Table 6-3. Note that the entries in this
table are simply the inverse of the entries in Table 6-2.
Fig. 6-2. Discount Factor for Future Values
Interest Rate
Year 5% 10% 20%
1 0.952 0.909 0.833
5 0.784 0.621 0.402
10 0.614 0.386 0.161
Table 6-3. Discount Factors
If interest rate k is set at the cost of capital, the net present value of a string
of cash flows (CF
i
) over n years can be calculated by repeated application
of Eq. (6-4), as follows:
(6-5)
The project represented by the string of cash flows should be approved if
NPV is positive, since a positive value of NPV indicates that investment in
the project will earn at a rate greater than k. For instance, if capital can be
obtained by borrowing at 10%, a project with an NPV of $20,000 at k = 0.10
will yield $20,000 over and above interest costs.
The calculation procedure for internal rate of return uses the NPV calcula-
tion as a means to a different end. An unknown rate of return (r) is substi-
tuted for cost of capital (k) in Eq. (6-5), producing Eq. (6-6).
(6-6)
The internal rate of return (IRR) is that value of r which will result in a
zero value of NPV. Eq. (6-6) cannot be solved explicitly for r, so finding
IRR is a trial-and-error procedure. Those projects with an IRR greater than
a specified target rate should be approved.
Example 6-3: The cash flows for Example 6-2, shown in Fig. 6-1, can also
be used to calculate NPV and IRR. If a pretax cost of capital of 15% is
assumed, NPV can be calculated from Eq. (6-5) as follows:
NPV = -100,000 + 0 + 40,000/(1.15)
2
...40,000/(1.15)
9
= $56,081
IRR must be greater than 15%, since NPV is positive at that rate of return.
A rate of 30% produces a negative NPV of -10,009, so IRR must be less
than 30%, but closer to 30% than 15%. Two interpolations yield an IRR of
26.8%. Fig. 6-3 shows the effect of rate of return on NPV.
NPV of a nonconventional project may equal zero at more than one dis-
count rate, producing multiple internal rates of return. A necessary but
not sufficient condition is at least two changes of sign for cash flow. See
Exercise 6-10 for an example. Methods have been proposed (Ref. 1) to deal
NPV CF
0
CF
1
1 k + ( ) CF
2
1 k + ( )
2
CF
n
1 k + ( )
n
+ + +
CF
0
CF
i
1 k + ( )
i
( )
i 1 =
n
+
=
=
NPV CF
0
CF
i
1 r + ( )
i
( )
i 1 =
n
+ =
with these cases by identifying a single relevant rate of return for use in
determining project acceptability.
The advantage of these discount-based methods over payback and ROI is
their consistent valuation of future cash flows. Their historical disadvan-
tage, which limited their acceptance for a long time, is more difficult calcu-
lation. This objection is now irrelevant. Many calculator and personal
computer programs, especially spreadsheets, can be used for NPV and
IRR calculation.
NPV and IRR are equivalent methods for project evaluation, and the
choice between them for this purpose is a matter of taste. If the target rate
is set equal to the cost of capital and no other restrictions apply, the use of
NPV or IRR will produce identical results. They will not necessarily pro-
duce identical rankings, so care should be taken to use the appropriate
method when projects must be rank ordered. These situations are dis-
cussed in Section 6-6.
6-5. Using a Spreadsheet
Calculation of NPV using pencil and paper is slow and tedious. Calcula-
tion of IRR is even more repetitive, since it involves a trial-and-error pro-
cedure. For any problems more complex than evaluation of a single set of
Fig. 6-3. Effect of Rate of Return on NPV in Example 6-3
cash flows, the easiest way to get NPV and IRR values is through the use
of a spreadsheet program. The most popular spreadsheets, including the
widely used Excel
, have built-in NPV and IRR functions.

Operation of a computer spreadsheet is essentially an information entry
process. Calculation and display are automatically and immediately per-
formed when information is received. When an entry in one cell is
changed, all the dependent cells are altered to reflect that change. This fea-
ture allows rapid evaluation of alternatives.
Spreadsheets are particularly useful for contingency or what-if studies.
Once the original cash flows and function calls have been entered, each
change in cash flow immediately produces changes in the displayed val-
ues of NPV and IRR. Fig. 6-4 is a typical project evaluation printout from a
spreadsheet. Cash flows, discount rate, NPV, and IRR are shown. Only the
cash flow entries need to be altered to find the effects of a changed situa-
tion. The effect of a delayed start-up is shown in Fig. 6-5. The delay wipes
out cash flow for the first year, affecting NPV and IRR. Only the entry for
year one cash flow had to be changed. NPV and IRR were automatically
recalculated. All the engineering economy textbooks cited in Appendix A
have detailed descriptions of spreadsheet use for project evaluation.
6-6. Selection Among Proposals
The situation in which all projects are independent and the choice among
them is unlimited is an idealized state, more commonly encountered in
textbooks than in the real world. There are several ways to classify the
constraints that often limit project selection.
Fig. 6-4. Spreadsheet Project Evaluation Printout
Choice may be limited because multiple projects seek the same object. A
proposal to replace existing controls with a DCS cannot be evaluated inde-
pendently of a proposal to replace the same controls with multiple PLCs.
Acceptance of one proposal forecloses the opportunity for the other one.
Choice may also be limited by resource availability. The scarce resource
may be skilled labor (the process engineer who knows the plant has only
enough time to work on one control project) or productive capacity (the
only two plants making left-handed widgets cannot both be shut down for
control retrofits). In most cases the scarce resource is capital.
Capital investment literature uses a somewhat different classification
scheme. Opportunity-limited situations are lumped with those limited by
availability of resources other than capital. The conflicting projects are
mutually exclusive. The decision that must be made is no longer whether a
project qualifies for investment under organization guidelines, but which
one among qualifying proposals is most attractive. In this situation NPV
and IRR can produce different results. The literature includes many dis-
cussions (see Ref. 2 for example) of the conditions for which the two meth-
ods have ranking conflicts.
Example 6-4: Cash flows for mutually exclusive proposals A and B are
listed in Table 6-4. The required rate of return is equal to the cost of capital
at 10%, so both proposals qualify easily. NPV of proposal A at 10% cost of
capital is $6,699; IRR is 22%. NPV of proposal B is $7,136; IRR is 18.3%. If
projects are ranked by NPV, proposal B will be selected. If IRR is used,
proposal A will be selected.
NPV is considered to be the sounder methodology for ranking of mutually
exclusive proposals. It assumes that cash flows can be reinvested at the
cost of capital, while IRR assumes that cash flows can be reinvested to earn
Fig. 6-5. Spreadsheet Project Evaluation Printout after Cash Flow Change
the calculated rate of return. The NPV assumption is more conservative
and more likely.
The other restricted situation treated in the capital investment literature is
limited availability of capital, known as capital rationing. Theoretically,
capital should be available for any worthwhile project (i.e., one that will
earn a higher rate than the cost of capital). Actually, capital may be limited
for any number of reasons. Firms may limit capital expenditures because
of credit limits or fear of the market effects of increased borrowing. Divi-
sions and individual plants, where most decisions on control improve-
ment projects are made, are almost always subject to limits on the amount
of capital that can be committed without approval of higher authority.
There are usually more qualifying proposals than can be funded with
available capital, so some means must be found to discriminate among
them and select the most profitable.
Net present value is not very useful as a tool for this selection process. The
project with the largest NPV is expected to make the most money, but it
may not be the most efficient use of capital. The discount rate for NPV
might be raised until total capital outlay for qualified proposals is equal to
or less than the capital limit, but this is equivalent to reinventing internal
rate of return. It is simpler to use IRR directly. Projects are selected by
starting with the highest IRR and proceeding down the list until the capi-
tal limit is reached. Another possible method for ranking projects uses the
ratio of the net present value of net cash inflows to the initial investment.
This ratio is called the profitability index (Ref. 3). Profitability rankings
should be similar to those obtained using IRR.
Cash Flows, $
Year Project A Project B
0 -25,000 -25,000
1 10,000 0
2 10,000 5,000
3 10,000 10,000
4 10,000 30,000
Table 6-4. Mutually Exclusive Proposals
References
1. Hartman, J.C. and Schafrick, I.C., 2004. The Relevant Internal
Rate of Return. Engineering Economist 49, 3, pp. 139-155.
2. Barney, L.D. and Danielson, M.G., 2004. Ranking Mutually
Exclusive Projects: the Role of Duration. Engineering Economist
49, 1, pp. 43-61.
3. Peterson. S. and Pugh, D., 2005. How to Make a Good Capital
Decision. InTech 52. 3, p. 50.
4. Park C. S., 2002. Contemporary Engineering Economics (3d ed.), p.
809. Prentice-Hall.
Exercises
6-1. Payback is sometimes known as the fish-bait method of project
evaluation. Why?
6-2. Calculate payback, ROI, NP and IRR for the project for which cash flows
are listed in Table 6-2. Use a 10% discount rate.
6-3. The discount factor for earnings 5 years hence is known to be 0.497. What
is the percentage discount rate?
6-4. A firm evaluates proposals using a discount rate of 20%. This rate is
considerably higher than the cost of capital, which is available at 10%. List
some possible reasons for this behavior.
6-5. Payback, ROI, NP and IRR for the cash flows shown in Fig. 6-1 were
calculated in Examples 6-2 and 6-3. Which of these profitability measures
would be affected if the project started earning immediately instead of one
year after initial expenditures?
6-6. Two projects, A and B, are proposed for the same unit. Each project consists
of installation of a PLC to control a different part of the unit. Expected cash
flows for the projects are listed in Table 6-5. The criterion for project
approval is positive net present value at a discount rate of 15%. Which
projects should be approved?
6-7. If the PLCs for the projects in Exercise 6-6 lose power, failure may be
catastrophic. The PLCs should, therefore, be powered by an uninterruptible
power supply (UPS). An already installed UPS has the capacity to handle
one but not both PLCs. A new UPS to handle one PLC would cost $5000.
In this situation, which projects should be approved?
6-8. Under what circumstances can capital rationing make projects mutually
exclusive? Give an example.
6-9. In the example given in the solution to Exercise 6-8, what will happen if the
capital limit is less than $800,000? greater than $1,500,000?
6-10. Since you have demonstrated your mastery of the subject by reaching this
exercise, you have been asked to write a sequel to this unit. You are offered
an immediate $1000 cash payment, and royalty payments after completion
of the book are estimated to be $2000/year for 3 years. The book will take one
year to complete, and during that year you must forgo a consulting project
that would have earned you $5000. Is this an attractive proposal? What
range of discount rates would result in positive NPV?
Cash Flows, $
Year Project A Project B
0 -10,000 -10,000
1 3,000 -5,000
2 3,000 5,000
3 3,000 5,000
4 3,000 5,000
5 3,000 5,000
6 3,000 5,000
7 3,000 5,000
Table 6-5. Cash Flows for Exercise 6-6

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, have built-in NPV and IRR functions.

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