Unit - 5

SUBJECT NAME: PROJECT MANAGEMENT AND FINANCE CREDITS: 3
SUBJECT CODE: 1150MG101 HOURS: 3
UNIT – V: PROJECT EVALUATION UNDER CERTINITY
Objectives, essential of a project methodology – Market appraisal – Technical appraisal –

Financial appraisal – Capital budgeting – Capital budgeting process – Techniques of project
appraisal and their applications – NPV – IRR – Pay Back period – Make or buy decisions –
Lease or buy decisions – Socio-economic appraisal – Management appraisal
PROJECT EVALUATION:
The steps described demonstrate how you would go about developing your evaluation plan.
1. Determine what information you will need to collect:
 To see how your project is doing day to day (on-going monitoring)

 To see if you are on track to achieve your intended results, if you are on time and
if you are using resources as planned mid-way through your project (mid-term
evaluation), so that you may make adjustments as needed
 To see if the overall changes you were trying to achieve actually happened by the
end of the project (final evaluation) and identify what you learned.
2. Determine your information sources/data collection methods. Sources of information may

include project staff, other agencies, participants and their families, members of the
public and the media. Information may be collected via a variety of methods, including:
 Project records such as project activity log/daily journal: A book where you write
down what happens each day. It is a useful source to document many of your
indicators and will be helpful to you when writing the final project report.
 Number and type of documents produced during the project (tools, flyers,
advertisements, media coverage of your event/project, curriculum, etc)
 Information collected about your participants related to the project (number
attending sessions, information about who they are - age, gender, education,
background, culture, etc)
 Data from official sources (e.g. school records, census data, health data)
 Questionnaires or surveys
 Interviews or focus groups
 Observation of project activities or locations in the community (e.g. track graffiti,
condition of playground, activity in public spaces, etc)
3. Determine the frequency of the data collection and who will collect the information.
4. Finally, determine how you will analyse your data and report your findings to funders,
your community and your project partners and stakeholders.
- Sample evaluation plan: Objectives
Indicators Sources/methods
Outcomes How will you know What proposed source/method will be used to gather
that the project is the information?
What will happen as achieving its
a result of your objectives and Source of Frequency
project? outcomes? Information Tool/instrument used of collection
Phase 1 Number of Project Minutes taken at Monthly

Increased stakeholders who records meetings
involvement of attend planning Ongoing
community meetings Time sheets record-
stakeholders in maintained by keeping
collaborative efforts Number of stakeholders
to reduce dating volunteer/in-kind hrs
violence spent on collaborative
efforts
Enhanced Number of Letters of Comparison of project End of

commitment of key stakeholders who have commitment plan to best practices project
stakeholders to a "signed on" to the identified in the
comprehensive, project Project Plan literature
evidence-based plan
for addressing dating Extent to which plan Literature
violence in the reflects knowledge of
community "what works" to
prevent dating
violence among youth
Phase 2 Extent to which Project Plan Comparison of project End of

Increased availability curriculum reflects plan to best practices project
of prevention what is known about Literature identified in the
resources that "what works" literature Key End of
conform to best Stakeholders informant interviews project
practices in the Extent to which with stakeholders and
literature and respond curriculum is Project mentors Ongoing
to community needs appropriate to the local records record-
context keeping
Extent to which
curriculum is made
available to the wider
community
Phase 3 Increased Level of knowledge Participants Test of participant Before

participant awareness about factors leading awareness of the project
about factors that to dating violence factors leading to sessions start
contribute to teen among youth dating violence and again
dating violence when they are
finished
Improved Level of Participants Analysis of video- Start and end

communication skills communication skills taped role play of project
among youth in project exercises
Increased participant Level of conflict Participants Video-taped role play Start and end
use of non-violent resolution skills exercises of project
conflict resolution among youth in project
Percentage of Attendees at One-page survey of a End of the

information night information random sample of event
attendees who report night people attending the
they are more aware of public awareness night
the root causes of
dating violence after
the evening than they
were before
Percentage of Attendees at One-page survey of a End of the

information night information random sample of event
attendees who report night people attending the
they are have more public awareness night
positive perceptions of
the benefits of
prevention activities
after the evening than
before
PROJECT APPRAISAL:
Project Appraisal is a consistent process of reviewing a given project and evaluating its content
to approve or reject this project, through analyzing the problem or need to be addressed by the
project, generating solution options (alternatives) for solving the problem, selecting the most
feasible option,conducting a feasibility analysis of that option, creating the solution
statement,and identifying all people and organizations concerned with or affected by the project
and its expected outcomes. It is an attempt to justify the project through analysis, which is a
way to determine project feasibility and cost-effectiveness
METHODS OF APPRAISAL:
Different types of appraisal include technical, economic, organizational and managerial,

commercial.
Type 1. Technical Appraisal:
The status of the technical know-how and design as envisaged in the project should be fully
assessed.
The cautions in general in this area are:
(i) Project committing with technology and design only in the preliminary stage should be
avoided.
(ii) The details of the designs involved should be attended to minimise the technical risk.
Innovative design should be distinguished and recognised as tougher than mere uncertainty. It
may appear innocuous and less costly but later on may escalate up to an awkward situation when
it is too late.
(iii) In technically complex and sensitive designs all design proposals should be fully
investigated.
(iv) The appraisal should ensure that the project has minimum of technical uncertainty and
resolve uncertainty, if any, on a priority basis.
(v) Design should not have unnecessarily burdensome specifications.
The technology and design should be one already tested and established.
We are to recognise that project without the latest technology ultimately leads to obsolescence,
higher cost and, as such, extreme difficulty in withstanding competition. The latest technology
may be, on the other hand, a Costly proposition in the initial stage but economic in the long run.
In carrying out the technical appraisal of the project, we should guard recalling the old adage ‘all
that glitters is not gold’ technology from a multinational does not necessarily mean the most
appropriate.
Experiences suggest that many MNCs get rid of their obsolete technology/designs and
machineries by giving the same to others at a very high cost. This situation can best be tested
where the technical collaborator is to buy-back a substantial part of the products.
The appraisal should ensure that the ‘project schedule’ does not incorporate ‘concurrency’ to
hasten the project. “Concurrency” known as the practice of initiating production activities prior
to the completion of full scale development should be avoided.
While carrying out the technical appraisal, it is necessary to appraise the terms for the know-how
as agreed with the collaborator as such terms have a direct bearing on the cost and financial
impact on the operation of the project. The financial institution providing the term loan for the
project also appraises the terms before agreeing to finance the project.
Let us cite an example. A large private sector organization has considered a project (in 1995) for
the manufacture of ‘wheel rims’ and has roped in the largest manufacturer of the wheel rims for
heavy and light commercial vehicles in Europe. While such terms are not ideal, they are
considered reasonably acceptable.
The major clauses are:
(i) ensure necessary training of personnel by the technical collaborator, the trainees being the
key personnel in the plant;
(ii) to have a buy-back arrangement with the technical collaborator ensuring collaborator’s
commitment towards the know-how process and the quality of the output;
(iii) such buy-back arrangement also releases the pressure on the need for valuable foreign
exchange;
(iv) payment of know-how fee should be by stages, not in one go.
Type 2. Economic Appraisal:
The economic appraisal of the project covers the following areas:
To ensure:
(i) The project’s compatibility with the macroeconomic environment in the relevant industry and
fitting in with the government’s concerned policy.
(ii) That the current situation in the industry involved permits such a project, mainly emphasizing
the appraisal in respect of the following points:
a. Existence of a growing market with increasing gap between the demand and the supply
of such product/service as envisaged in the project;
b. When the product is ‘intermediate.’ in nature and the customer is in particular

industry/organization, which is a stable one;
c. There is reasonable amount of market research/study on the product and the project is
having a back-up with reliable support study and report;
d. The possible market share that can be arrested with the implementation of the project as
revealed by the market report.
(iii) An overall appraisal of the competitors fielding in the area with their strength and
weaknesses.
(iv)Availability of the resources required for the project. The alternatives for employment of
such resources cannot compete with the estimated project profitability. In this regard, the various
techniques for financial appraisal of the project, discussed later, are helpful.
(v) Facilities to the extent available, including monetary assistance for such project, such as
a. Value based advance licensing (VABAL) for imports required for the project; (Value based
advance licenses were scrapped in the 1997-2002 Exim Policy, because of its widespread misuse
by exporters. The new policy came into effect from April 1, 1997, known as Duty Entitlement
Pass Book (DEPB) scheme.
b. Various duty exemption scheme applicable to the project;
c. Government subsidy; helps for procurement of land/space at suitable location;
d. Benefits for the export oriented units (EOU)/and for being located at export promotion zones;
e. Tax holidays.
Type 3. Organizational and Managerial Appraisal:
A project report contains an organization structure drawn along with the suggested number of
employees and their levels and grades. These organizations recommended in the reports are,
however, impersonal and primarily deal with the functional relationship within the project team,
taking care of the work-load involved in the respective areas.
The organizational and managerial appraisal is carried out recognising that:
(i) The complexities in project management require a well-knit project organization structure,
which again depend upon the volume and nature of the project as well as the culture and motive
of the project owner. For example, in case of a owner-managed small project, the structure is
simple and the appraisal is limited to the assurance that the owner is assisted whole-time/part-
time by other functionaries.
In case of a medium sized project the owner still holds the rein for the project management but
prefers to carry out the implementation with the help of a project manager. The situation is
different for complex and large projects.
(ii) Experience suggests that the project organization should have an overall in-charge as project
manager with the quality of strong leadership and effective communicating ability besides
the required theoretical and technical skill.
(iii) The organization structure should be interlaced so that the project work is carried out in a
unified way.
(iv) The managerial personnel heading the different functions should be duly skilled in their
respective functions to carry out the project implementation and operation. The appraisal is to
ensure that the key managerial personnel have been fixed before the start of the work; it is also
desirable to appraise the backgrounds of such personnel.
As a matter of practice, the financial institutions in the process of project appraisal also look out
for the background of the key managerial personnel in the relevant project management.
(v) Organization takes care of the technical training required for the production process.
(vi) The strength of the organization takes care of the project volume with the number of
employees.
(vii) Considering the projected organization, estimated as sufficient to match the project, the
payroll is evaluated in terms of money considering the grades, rates and numbers. These are
incorporated in the project’s operation cost. The organizational and managerial appraisal should
extend to this area as well to ensure the acceptability of the financial aspect of the organization.
The additional personnel cost which can be about 30% of the salary (representing P.F., medical
benefit, leave with pay, uniform, canteen subsidy, bonus etc.) should also be considered while
taking into account the personnel cost in the project.
(viii) The organization should institute a well-balanced standard personnel policy before large
scale recruitments. This necessitates the requirement of a skilled Personnel Manager in the
organization who should be well-conversant with the factory environments as well as the
statutory rules and regulations.
(ix) Other key personnel requiring early recruitments for manning the organization include Plant
Manager, Maintenance Engineer, Security Manager, etc.
Type 4. Commercial Appraisal:
Appraisal is made about the marketability of the product including the volume considered in the
project. The project should be supported by market research/statistics from competent and
reliable organization or professional consultants like India Market Research Bureau.
The points for consideration are:
(i) The size of the market and its growth; the gap between the demand and supply;
(ii) Information about major competitors, their capacities installed, their market share, their
strength and weaknesses, if any;
(iii) The international market and the possibility of export;
a. International standard quality;
b. International prices.
(iv) Whether the product is an import substitute having the prospect of saving valuable foreign
exchange.
CAPITAL BUDGETING:
Capital budgeting (or investment appraisal) is the process of determining the viability to long-
term investments on purchase or replacement of property plant and equipment, new product line
or other projects.
Capital budgeting consists of various techniques used by managers such as:
1. Payback Period
2. Net Present Value
3. Accounting Rate of Return
4. Internal Rate of Return
5. Profitability Index
All of the above techniques are based on the comparison of cash inflows and outflow of a project
however they are substantially different in their approach.
A brief introduction to the above methods is given below:
 Payback Period measures the time in which the initial cash flow is returned by the project. Cash
flows are not discounted. Lower payback period is preferred.
 Net Present Value (NPV) is equal to initial cash outflow less sum of discounted cash inflows.
Higher NPV is preferred and an investment is only viable if its NPV is positive.
 Accounting Rate of Return (ARR) is the profitability of the project calculated as projected total
net income divided by initial or average investment. Net income is not discounted.
 Internal Rate of Return (IRR) is the discount rate at which net present value of the project
becomes zero. Higher IRR should be preferred.
 Profitability Index (PI) is the ratio of present value of future cash flows of a project to initial
investment required for the project.
FACTORS AFFECTING CAPITAL BUDGETING:

Availability of Funds Working Capital
Structure of Capital Capital Return
Management decisions Need of the project
Accounting methods Government policy
Taxation policy Earnings
PROCESS OF CAPITAL BUDGETING:
Lending terms of financial Economic value of the
institutions project The capital budgeting process has the
following four steps:
 Generation of Ideas: The generation of good quality project ideas is the most important capital
budgeting step. Ideas can be generated from a number of sources like senior management,
employees and functional divisions or even from outside the company.
 Analysis of Proposals: The basis of accepting or rejecting a capital project is the projects
expected cash flows in the future. Hence, all the project proposals are analyzed by forecasting
their cash flows to determine expected the profitability of each project.
 Creating the Corporate Capital Budget: Once the profitable projects are shortlisted, they are
prioritized according to the available company resources, a timing of the cash flows of the
project and the overall strategic plan of the company. Some projects may be attractive on their
own, but may not be a fit to the overall strategy.
 Monitoring and Post-Audit: A follow up on all decisions is equally important in the capital
budgeting process. The analysts compare the actual results of the projects to the projected ones
and the project managers are responsible if the projections match or do not match the actual
results. A post-audit to recognize systematic errors in the cash flow forecasting process is also
essential as the capital budgeting process is as good as the inputs’ estimates into the forecasting
model.
TECHNIQUES OF PROJECT APPRAISAL AND THEIR APPLICATIONS:
NET PRESENT VALUE (NPV)
Net present value is the difference between the present value of cash inflows and the
present value of cash outflows that occur as a result of undertaking an investment project. It may
be positive, zero or negative. These three possibilities of net present value are briefly explained
below:
Positive NPV:
If present value of cash inflows is greater than the present value of the cash outflows, the
net present value is said to be positive and the investment proposal is considered to be
acceptable.
Zero NPV:
If present value of cash inflow is equal to present value of cash outflow, the net present
value is said to be zero and the investment proposal is considered to be acceptable.
Negative NPV:
If present value of cash inflow is less than present value of cash outflow, the net present
value is said to be negative and the investment proposal is rejected.
The summary of the concept explained so far is given below:

IRR – INTERNAL RATE OF RETURN:
(IRR) is the discount rate often used in capital budgeting that makes the net present
value of all cash flows from a particular project equal to zero. Generally speaking, the
higher a project's internal rate of return, the more desirable it is to undertake the project.
As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all
other factors are equal among the various projects, the project with the highest IRR would
probably be considered the best and undertaken first.
You can think of IRR as the rate of growth a project is expected to generate. While the
actual rate of return that a given project ends up generating will often differ from its estimated
IRR rate, a project with a substantially higher IRR value than other available options would still
provide a much better chance of strong growth.
IRRs can also be compared against prevailing rates of return in the securities market. If a
firm can't find any projects with IRRs greater than the returns that can be generated in the
financial markets, it may simply choose to invest its retained earnings into the market.
USES OF IRR
Profitability of an Investment
Corporations use IRR in capital budgeting to compare the profitability of capital projects
in terms of the rate of return. For example, a corporation will compare an investment in a new
plant versus an extension of an existing plant based on the IRR of each project. To maximize
returns, the higher a project's IRR, the more desirable it is to undertake the project.
If all projects require the same amount of up-front investment, the project with the highest
IRR would be considered the best and undertaken first.
Maximizing Net Present Value
The internal rate of return is an indicator of the profitability, efficiency, quality, or

yield of an investment. This is in contrast with the net present value, which is an indicator of the
net value or magnitude added by making an investment.
Applying the internal rate of return method to maximize the value of the firm, any
investment would be accepted, if its profitability, as measured by the internal rate of return, is
greater than a minimum acceptable rate of return. The appropriate minimum rate to maximize the
value added to the firm is the cost of capital, i.e. the internal rate of return of a new capital
project needs to be higher than the company's cost of capital. This is because an investment with
an internal rate of return which exceeds the cost of capital has a positive net present value.
However, the selection of investments may be subject to budget constraints, or they may
be mutually exclusive competing projects, such as a choice between or the capacity or ability to
manage more projects may be practically limited. In the example cited above, of a corporation
comparing an investment in a new plant versus an extension of an existing plant, there may be
reasons the company would not engage in both projects.
Fixed Income
IRR is also used to calculate yield to maturity and yield to call.
Liabilities
Both the internal rate of return and the net present value can be applied to liabilities as
well as investments. For a liability, a lower internal rate of return is preferable to a higher one.
Capital Management
Corporations use internal rate of return to evaluate share issues and stock buyback
programs.
A share repurchase proceeds if returning capital to shareholders has a higher internal rate of
return than candidate capital investment projects or acquisition projects at current market prices.
Funding new projects by raising new debt may also involve measuring the cost of the new debt
in terms of the yield to maturity (internal rate of return).
PAYBACK PERIOD:
The payback period is the length of time required to recover the cost of an
investment. The payback period of a given investment or project is an important determinant of
whether to undertake the position or project, as longer payback periods are typically not
desirable for investment positions. The payback period ignores the time value of money (TVM),
unlike other methods of capital budgeting such as net present value (NPV), internal rate of return
(IRR), and discounted cash flow.
CALCUALTION PROCEDURE:
The payback period is the time required for the amount invested in an asset to be repaid
by the net cash flow generated by the asset. It is a simple way to evaluate the risk associated with
a proposed project. An investment with a shorter payback period is considered to be better, since
the investor's initial outlay is at risk for a shorter period of time. The calculation used to derive
the payback period is called the payback method. The payback period is expressed in years and
fractions of years.
For example, if a company invests $300,000 in a new production line, and the production
line then produces positive cash flow of $100,000 per year, then the payback period is 3.0 years
($300,000 initial investment ÷ $100,000 annual payback).
The formula for the payback method is simplistic: Divide the cash outlay (which is
assumed to occur entirely at the beginning of the project) by the amount of net cash inflow
generated by the project per year (which is assumed to be the same in every year).
MAKE-OR-BUY DECISION
Make-or-Buy decision (also called the outsourcing decision) is a judgment made by

management whether to make a component internally or buy it from the market. While making
the decision, both qualitative and quantitate factors must be considered.
Examples of the qualitative factors in make-or-buy decision are:
 Control over quality of the component,

 Reliability of suppliers,
 Impact of the decision on suppliers and
 Customers, etc.,
The quantitative factors are actually the incremental costs resulting from making or buying the
component. For example:
 Incremental production cost per unit,

 Purchase cost per unit,
 Production capacity available to manufacture the component, etc.
Lease or Buy Decision
Lease or buy decision involves applying capital budgeting principles to determine if

leasing an asset is a better option than buying it.
Leasing in a contractual arrangement in which a company (the lessee) obtains an asset from
another company (the lessor) against periodic payments of lease rentals. It may typically also
involve an option to transfer the ownership of the asset to the lessee at the end of the lease.
Buying the asset involves purchase of the asset with company’s own funds or arranging a
loan to finance the purchase.
In finding out whether leasing is better than buying, we need to find out the periodic
cash flows under both the options and discount them using the after-tax cost of debt to see
wheredoes the present value of the cost of leasing stands as compared to the present value of the
cost of buying. The alternative with lower present value of cash outflows is selected.
SOCIAL COST BENEFIT ANALYSIS (SCBA)
A social cost benefit analysis is a systematic and cohesive method to survey all the
impacts caused by an (urban) development project or other policy measure. It comprises not just
the financial effects (investment costs, direct benefits like profits, taxes and fees, et cetera), but
all the societal effects, like: pollution, environment, safety, travel times, spatial quality, health,
indirect (i.e. labour or real estate) market impacts, legal aspects, et cetera. The main aim of a
social cost benefit analysis is to attach a price to as many effects as possible in order to uniformly
weigh the above-mentioned heterogeneous effects. As a result, these prices reflect the value a
society attaches to the caused effects, enabling the decision maker to form an opinion about the
net social welfare effects of a project.
Compare different project alternatives

A major advantage of a social cost benefit analysis is that it enables investors (mostly public
parties) to systematically and cohesively compare different project alternatives. Hence, these
alternatives will not just be compared intrinsically, but will also be set against the
“nullalternative hypothesis”. This hypothesis describes “the most likely” scenario development
in case a project will not be executed. Put differently, investments on a smaller scale will be
included in the null alternative hypothesis in order to make a realistic comparison in a situation
without “huge” investments. Calculate direct, indirect and external effects
The social cost benefit analysis calculates the direct (primary), indirect (secondary) and
external effects:
 Direct effects are the costs and benefits that can be directly linked to the owners/users of
the project properties (e.g., the users and the owner of a building, recreational area, wind
energy park, or highway).
 Indirect effects are the costs and benefits that are passed on to the producers and
consumers outside the market with which the project is involved (e.g., the owner of a
bakery nearby the new building, or a business company located near the newly planned
highway, recreational area, indirect tax incomes, etc.).
 External effects are the costs and benefits that cannot be passed on to any existing
markets because they relate to issues like the environment (noise, emission of CO2, etc.),
safety (traffic, external security) and nature (biodiversity, dehydration, etc.).
The result of a social cost benefit analysis

The result of a social cost benefit analysis are:
 An integrated way of comparing the different effects. All relevant costs and benefits of
the different project implementations (alternatives) are identified and monetized as far as
possible. Effects that cannot be monetized are described and quantified as much as
possible.
 Attention for the distribution of costs and benefits. The benefits of a project do not
always get to the groups bearing the costs. A social cost benefit analysis gives insight in
who bears the costs and who derives the benefits.
 Comparison of the project alternatives. A social cost benefit analysis is a good method to
show the differences between project alternatives and provides information to make a
well informed decision.
 Presentation of the uncertainties and risks. A social cost benefit analysis has several
methods to take economic risks and uncertainties into account. The policy decision
should be based on calculated risk.
PROBLEMS AND SOLUTIONS
1. Payback Period – Given the cash flows of the four projects, A, B, C, and D, and using the
Payback Period decision model, which projects do you accept and which projects do you reject
with a three year cut-off period for recapturing the initial cash outflow? Assume that the cash
flows are equally distributed over the year for Payback Period calculations.
Projects A(Rs) B(Rs) C(Rs) D(Rs)
Cost 10,000 25,000 45,000 100,000
Cash Flow Year One 4,000 2,000 10,000 40,000
Cash Flow Year Two 4,000 8,000 15,000 30,000
Cash Flow Year Three 4,000 14,000 20,000 20,000
Cash Flow Year Four 4,000 20,000 20,000 10,000
Cash Flow year Five 4,000 26,000 15,000 0
Cash Flow Year Six 4,000 32,000 10,000 0
Solution
Project A: Year One: -10,000 + 4,000 = 6,000 left to recover
Year Two: -6,000 + 4,000 = 2,000 left to recover
Year Three: -2,000 + 4,000 = fully recovered
Year Three: 2,000 / 4,000 = ½ year needed for recovery
Payback Period for Project A: 2 and ½ years, ACCEPT!
Project B: Year One: -25,000 + 2,000 = 23,000 left to recover

Year Three: -15,000 + 14,000 = 1,000 left to recover
Year Four: -1,000 + 20,000 = fully recovered
Year Four: 1,000 / 20,000 = 1/20 year needed for recovery
Payback Period for Project B: 3 and 1/20 years, REJECT!
Project C: Year One: -45,000 + 10,000 = 35,000 left to recover
Year Three: -20,000 + 20,000 = fully recovered
Year Three: 20,000 / 20,000 = full year needed
Payback Period for Project B: 3 years, ACCEPT!
Project D: Year One: -100,000 + 40,000 = 60,000 left to recover
Year Two: -Rs60,000 + 30,000 = 30,000 left to recover
Year Three: -Rs30,000 + Rs20,000 = Rs10,000 left to recover
Year Four: -Rs10,000 + Rs10,000 = fully recovered
Year Four: Rs10,000 / Rs10,000 = full year needed
Payback Period for Project B: 4 years, REJECT!
2. Payback Period – What are the Payback Periods of Projects E, F, G and H? Assume all cash
flows are evenly spread throughout the year. If the cut-off period is three years, which projects
do you accept?
Projects E F G H
Cost Rs40,000 Rs250,000 Rs75,000 Rs100,000
Cash Flow Year One Rs10,000 Rs40,000 Rs20,000 Rs30,000
Cash Flow Year Two Rs10,000 Rs120,000 Rs35,000 Rs30,000
Cash Flow Year Three Rs10,000 Rs200,000 Rs40,000 Rs30,000
Cash Flow Year Four Rs10,000 Rs200,000 Rs40,000 Rs20,000

Cash Flow year Five Rs10,000 Rs200,000 Rs35,000 Rs10,000
Cash Flow Year Six Rs10,000 Rs200,000 Rs20,000 Rs0
Solution
Project E: Year One: -Rs40,000 + Rs10,000 = Rs30,000 left to recover
Year Two: -Rs30,000 + Rs10,000 = Rs20,000 left to recover
Year Four: Rs10,000 / Rs10,000 = full year needed
Payback Period for Project A: 4 years
Project F: Year One: -Rs250,000 + Rs40,000 = Rs210,000 left to recover
Year Three: -Rs90,000 + Rs200,000 = fully recovered
Year Three: Rs90,000 / Rs200,000 = 0.45 year needed
Payback Period for Project B: 2.45 years

Project G: Year One: -Rs75,000 + Rs20,000 = Rs55,000 left to recover
Year Three: -Rs20,000 + Rs40,000 = fully recovered
Year Three: Rs20,000 / Rs40,000 = 0.5 year needed
Project H: Year One: -Rs100,000 + Rs30,000 = Rs70,000 left to recover
Year Four: Rs10,000 / Rs20,000 = 0.5 year needed

With a three year cut-off period, ACCEPT F and G, REJECT E and H.
3. Discounted Payback Period – Given the following four projects and their cash flows,
calculate the discounted payback period with a 5% discount rate, 10% discount rate, and 20%
discount rate. What do you notice about the payback period as the discount rate rises? Explain
this relationship.
Projects A B C D
Cost Rs10,000 Rs25,000 Rs45,000 Rs100,000
Cash Flow Year One Rs4,000 Rs2,000 Rs10,000 Rs40,000
Cash Flow Year Two Rs4,000 Rs8,000 Rs15,000 Rs30,000
Cash Flow Year Three Rs4,000 Rs14,000 Rs20,000 Rs20,000
Cash Flow Year Four Rs4,000 Rs20,000 Rs20,000 Rs10,000
Cash Flow year Five Rs4,000 Rs26,000 Rs15,000 Rs10,000
Cash Flow Year Six Rs4,000 Rs32,000 Rs10,000 Rs0
Solution at 5% discount rate
Project A: PV Cash flow year one -- Rs4,000 / 1.05 = Rs3,809.52
PV Cash flow year two -- Rs4,000 / 1.052 = Rs3,628.12
PV Cash flow year three -- Rs4,000 / 1.053 = Rs3,455.35
PV Cash flow year four -- Rs4,000 / 1.054 = Rs3,290.81
PV Cash flow year five -- Rs4,000 / 1.055 = Rs3,134.10
PV Cash flow year six -- Rs4,000 / 1.056 = Rs2,984.86
Discounted Payback Period: -Rs10,000 + Rs3,809.52 + Rs3,628.12 + Rs3,455.35 = Rs892.99

and fully recovered
Discounted Payback Period is 3 years.
Project B: PV Cash flow year one -- Rs2,000 / 1.05 = Rs1,904.76
Discounted Payback Period: -Rs25,000 + Rs1,904.76 + Rs7,256.24 + Rs12,093.73 +

Rs16,454.05 = Rs12,708.78 and fully recovered
Project C: PV Cash flow year one -- Rs10,000 / 1.05 = Rs9,523.81

Project D: PV Cash flow year one -- Rs40,000 / 1.05 = Rs38,095.24
PV Cash flow year six -- Rs0 / 1.056 = Rs0

Rs8,227.02 + Rs7,835.26 = Rs3,180.30 and fully recovered.
Discounted Payback Period: -Rs10,000 + Rs3,636.36 + Rs3,307.79 + Rs3,005.26 + Rs2,732.05

= Rs2,681.46 and fully recovered



Rs13,660.27 = Rs5174.07 and fully recovered

Rs6,830.13 + Rs6,209.21 = -Rs6,645.10 and never recovered.
Initial cash outflow is never recovered.
Discounted Payback Period: -Rs10,000 + Rs3,333.33 + Rs2,777.78 + Rs2,314.81+ Rs1,929.01 =

Rs354.93 and fully recovered

Discounted Payback Period: -Rs25,000 + Rs1,666.67 + Rs5,555.56 + Rs8,101.85 + Rs9,645.06

+ Rs10,448.82 = Rs10,417.96 and fully recovered

Rs9,645.06 + Rs6,028.16 = Rs997.29 and fully recovered

Rs4,822.53 + Rs4,018.78 = -Rs21,945.73 and initial cost is never recovered.
Discounted Payback Period is infinity.

As the discount rate increases, the Discounted Payback Period also increases. The reason is that
the future dollars are worth less in present value as the discount rate increases requiring more
future dollars to recover the present value of the outlay.
4. Discounted Payback Period – Graham Incorporated uses discounted payback period for
projects under Rs25,000 and has a cut off period of 4 years for these small value projects. Two
projects, R and S are under consideration. The anticipated cash flows for these two projects are
listed below. If Graham Incorporated uses an 8% discount rate on these projects are they
accepted or rejected? If they use 12% discount rate? If they use a 16% discount rate? Why is it
necessary to only look at the first four years of the projects’ cash flows?
Cash Flows Project R Project S
Initial Cost Rs24,000 Rs18,000
Cash flow year one Rs6,000 Rs9,000
Cash flow year two Rs8,000 Rs6,000
Cash flow year three Rs10,000 Rs6,000
Cash flow year four Rs12,000 Rs3,000
Solution at 8%
Project R: PV Cash flow year one -- Rs6,000 / 1.08 = Rs5,555.56
Discounted Payback Period: -Rs24,000 + Rs5,555.56 + Rs6,858.71 + Rs7,938.32

+ Rs8,820.36 = Rs5,172.95 and initial cost is in first four years, project accepted.
Project S: PV Cash flow year one -- Rs9,000 / 1.08 = Rs8,333.33


Solution at 12%


+ Rs1,906.55 = Rs996.10 and initial cost is in first four years, project accepted.
Solution at 16%

+ Rs6,627.49 = Rs151.78 and initial cost is in first four years, project accepted.


+ Rs1,656.87 = -Rs251.58 and initial cost is not recovered in first four years, project rejected.
Because Graham Incorporated is using a four year cut-off period, only the first four years of cash
flow matter. If the first four years of anticipated cash flows are insufficient to cover the initial
outlay of cash, the project is rejected regardless of the cash flows in years five and forward.
5. Comparing Payback Period and Discounted Payback Period – Mathew Incorporated is

debating using Payback Period versus Discounted Payback Period for small dollar projects. The
Information Officer has submitted a new computer project of Rs15,000 cost. The cash flows will
be Rs5,000 each year for the next five years. The cut-off period used by Mathew Incorporated is
three years. The Information Officer states it doesn’t matter what model the company uses for
the decision, it is clearly an acceptable project. Demonstrate for the IO that the selection of the
model does matter!
Solution
Calculate the Payback Period for the project:
Payback Period = -Rs15,000 + Rs5,000 + Rs5,000 + Rs5,000 = 0 so the payback

period is 3 years and the project is a go!
Calculate the Discounted Payback Period for the project at any positive discount rate, say
1%...
Present Value of cash flow year one = Rs5,000 / 1.01 = Rs4,950.50
Present Value of cash flow year two = Rs5,000 / 1.012 = Rs4,901.48
Present Value of cash flow year three = Rs5,000 / 1.013 = Rs4,852.95
Discounted Payback Period = -Rs15,000 + Rs4,950.50 + Rs4,901.48 +

Rs4,852.95 = -Rs295.04 so the payback period is over 3 years and the project is a no-go!
6. Comparing Payback Period and Discounted Payback Period – Neilsen Incorporated is

switching from Payback Period to Discounted Payback Period for small dollar projects. The cut-
off period will remain at 3 years. Given the following four projects cash flows and using a 10%
discount rate, which projects that would have been accepted under Payback Period will now be
rejected under Discounted Payback Period?
Project Project
Three Four
Cash Project One Project Two
Flows
Initial cost Rs10,000 Rs15,000 Rs8,000 Rs18,000
Year One Rs4,000 Rs7,000 Rs3,000 Rs10,000
Year Two Rs4,000 Rs5,500 Rs3,500 Rs11,000
Year Three Rs4,000 Rs4,000 Rs4,000 Rs0
Solution
Calculate the Discounted Payback Periods of each project at 10% discount rate:
Project One

Rs3,005.26 = -Rs52.60 so the discount payback period is over 3 years and the project is a no-
go!
Project Two

Rs3,005.26 = Rs327.58 so the discount payback period is 3 years and the project is a go!
Project Three

Discounted Payback Period = -Rs8,000 + Rs2,272.73+ Rs2,479.34 + Rs2,629.20

= -Rs618.33 so the discount payback period is over 3 years and the project is a no-go!
Project Four
Present Value of cash flow year three = Rs0 / 1.103 = Rs0
Discounted Payback Period = -Rs18,000 + Rs9,090.91 + Rs9,090.91 + Rs0 = Rs181.82

so the discount payback period is 3 years and the project is a go!
Projects one and three will now be rejected using discounted payback period with a
discount rate of 10%.
7. Net Present Value – Swanson Industries has a project with the following projected cash
flows:
Initial Cost, Year 0: Rs240,000
Cash flow year one: Rs25,000
Cash flow year two: Rs75,000
Cash flow year three: Rs150,000
Cash flow year four: Rs150,000
a. Using a 10% discount rate for this project and the NPV model should this project
be accepted or rejected?
b. Using a 15% discount rate?
c. Using a 20% discount rate?
Solution
a. NPV = -Rs240,000 + Rs25,000/1.10 + Rs75,000/1.102 + Rs150,000/1.103 +

Rs150,000/1.104
NPV = -Rs240,000 + Rs22,727.27 + Rs61,983.47 + Rs112,697.22 + Rs102,452.02
NPV = Rs59,859.98 and accept the project.
b. NPV = -Rs240,000 + Rs25,000/1.15 + Rs75,000/1.152 + Rs150,000/1.153 +

Rs150,000/1.154
NPV = -Rs240,000 + Rs21,739.13 + Rs56,710.76 + Rs98,627.43 + Rs85,762.99
c. NPV = -Rs240,000 + Rs25,000/1.20 + Rs75,000/1.202 + Rs150,000/1.203 +

Rs150,000/1.204
NPV = -Rs240,000 + Rs20,833.33 + Rs52,083.33 + Rs86,805.56 + Rs72,337.96
NPV = -Rs7,939.82 and reject the project.
8. Net Present Value – Campbell Industries has a project with the following projected cash
flows:
Initial Cost, Year 0: Rs468,000
Cash flow year one: Rs135,000
Cash flow year two: Rs240,000
Cash flow year three: Rs185,000
Cash flow year four: Rs135,000
a. Using an 8% discount rate for this project and the NPV model should this project
be accepted or rejected?
b. Using a 14% discount rate?
c. Using a 20% discount rate?
Solution
a. NPV = -Rs468,000 + Rs135,000/1.08 + Rs240,000/1.082 + Rs185,000/1.083 +

Rs135,000/1.084
NPV = -Rs468,000 + Rs125,000.00 + Rs205,761.32 + Rs146,858.96 + Rs99,229.03
b. NPV = -Rs468,000 + Rs135,000/1.14 + Rs240,000/1.142 + Rs185,000/1.143 +

Rs135,000/1.144
NPV = -Rs468,000 + Rs118,421.05 + Rs184,672.21 + Rs124,869.73 + Rs79,930.84

c. NPV = -Rs468,000 + Rs135,000/1.20 + Rs240,000/1.202 + Rs185,000/1.203 +
Rs135,000/1.204
NPV = -Rs468,000 + Rs112,500.00 + Rs166,666.67 + Rs107,060.19 + Rs65,104.17
NPV = -Rs16,668.97 and reject the project.
9. Net Present Value – Swanson Industries has four potential projects all with an initial cost of
Rs2,000,000. The capital budget for the year will only allow Swanson industries to accept one of
the four projects. Given the discount rates and the future cash flows of each project, which
project should they accept?
Cash Flows Project M Project N Project O Project P
Year one Rs500,000 Rs600,000 Rs1,000,000 Rs300,000
Year two Rs500,000 Rs600,000 Rs800,000 Rs500,000
Year three Rs500,000 Rs600,000 Rs600,000 Rs700,000
Year four Rs500,000 Rs600,000 Rs400,000 Rs900,000
Year five Rs500,000 Rs600,000 Rs200,000 Rs1,100,000
Discount Rate 5% 9% 15% 22%
Solution, find the NPV of each project and compare the NPVs.
Project M’s NPV = -Rs2,000,000 + Rs500,000/1.05 + Rs500,000/1.052 +

Rs500,000/1.053 + Rs500,000/1.054 + Rs500,000/1.055
Project M’s NPV = -Rs2,000,000 + Rs476,190.48 + Rs453,514.74 + Rs431,918.80 +

Rs411,351.24 + Rs391,763.08
Project N’s NPV = Rs164,738.34
Project N’s NPV = -Rs2,000,000 + Rs600,000/1.09 + Rs600,000/1.092 +

Rs600,000/1.093 + Rs600,000/1.094 + Rs600,000/1.095
Project N’s NPV = -Rs2,000,000 + Rs550,458.72 + Rs505,008.00 + Rs463,331.09 +

Rs425,055.13 + Rs389,958.83
Project N’s NPV = Rs333,790.77

Project O’s NPV = -Rs2,000,000 + Rs1,000,000/1.15 + Rs800,000/1.152 +
Rs600,000/1.153 + Rs400,000/1.154 + Rs200,000/1.155
Project O’s NPV = -Rs2,000,000 + Rs869,565.22 + Rs604,914.93 + Rs394,509.74 +

Rs228,701.30 + Rs99,435.34
Project O’s NPV = Rs197,126.53
Project P’s NPV = -Rs2,000,000 + Rs300,000/1.22 + Rs500,000/1.222 +

Rs700,000/1.223 + Rs900,000/1.224 + Rs1,100,000/1.225
Project P’s NPV = -Rs2,000,000 + Rs245,901.64 + Rs335,931.20 + Rs385,494.82 +

Rs406,259.18 + Rs406,999.18
Project P’s NPV =-Rs219,413.98 (would reject project regardless of budget)
And the ranking order based on NPVs is,
Project N – NPV of Rs333,790.77
Project O – NPV of Rs197,126.53
Project M – NPV of Rs164,738.34
Project P – NPV of -Rs219,413.98
Swanson Industries should pick Project N.
10. Net Present Value – Campbell Industries has four potential projects all with an initial cost of
Rs1,500,000. The capital budget for the year will only allow Swanson industries to accept one of
the four projects. Given the discount rates and the future cash flows of each project, which
project should they accept?
Cash Flows Project Q Project R Project S Project T
Year one Rs350,000 Rs400,000 Rs700,000 Rs200,000

Solution, find the NPV of each project and compare the NPVs.
Project Q’s NPV = -Rs1,500,000 + Rs350,000/1.04 + Rs350,000/1.042 +

Rs350,000/1.043 + Rs350,000/1.044 + Rs350,000/1.045
Project Q’s NPV = -Rs1,500,000 + Rs336,538.46 + Rs323,594.67 + Rs311,148.73 +

Rs299,181.47 + Rs287,674.49
Project Q’s NPV = Rs58,137.84
Project R’s NPV = -Rs1,500,000 + Rs400,000/1.08 + Rs400,000/1.082 +

Rs400,000/1.083 + Rs400,000/1.084 + Rs400,000/1.085
Project R’s NPV = -Rs2,000,000 + Rs370,370.37 + Rs342,935.53 + Rs317,532.90 +

Rs294,011.94 + Rs272,233.28
Project R’s NPV = Rs97,084.02
Project S’s NPV = -Rs1,500,000 + Rs700,000/1.13 + Rs600,000/1.132 +

Rs500,000/1.133 + Rs400,000/1.134 + Rs300,000/1.135
Project S’s NPV = -Rs1,500,000 + Rs619,469.03 + Rs469,888.01 + Rs346,525.08 +

Rs245,327.49 + Rs162,827.98
Project S’s NPV = Rs344,037.59
Project T’s NPV = -Rs1,500,000 + Rs200,000/1.18 + Rs400,000/1.182 +

Rs600,000/1.183 + Rs800,000/1.184 + Rs1,000,000/1.185
Project T’s NPV = -Rs1,500,000 + Rs169,491.53 + Rs287,273.77 + Rs365,178.52 +

Rs412,631.10 + Rs437,109.22
Project T’s NPV = Rs171,684.14
And the ranking order based on NPVs is,
Project S – NPV of Rs344,037.59
Project T – NPV of Rs171,684.14
Project R – NPV of Rs97,084.02
Project Q – NPV of Rs58,137.84
Campbell Industries should pick Project S.

11. Internal Rate of Return – What are the IRRs of the four projects for Swanson Industries in
problem #9?
Solution, this is an iterative process but can be solved quickly on a calculator or
spreadsheet.
Enter the keys noted for each project in the CF of a Texas BA II Plus calculator
Cash Flows Project M Project N Project O Project P
CFO -Rs2,000,000 -Rs2,000,000 -Rs2,000,000 -Rs2,000,000
CO1, F1 Rs500,000, 1 Rs600,000, 1 Rs1,000,000, 1 Rs300,000, 1
CO2, F2 Rs500,000, 1 Rs600,000, 1 Rs800,000, 1 Rs500,000, 1
Year three Rs500,000, 1 Rs600,000, 1 Rs600,000, 1 Rs700,000, 1
Year four Rs500,000, 1 Rs600,000, 1 Rs400,000, 1 Rs900,000, 1
Year five Rs500,000, 1 Rs600,000, 1 Rs200,000, 1 Rs1,100,000, 1
CPT IRR 7.93% 15.24% 20.27% 17.72%
12. Internal Rate of Return -- Internal Rate of Return – What are the IRRs of the four projects for
Campbell Industries in problem #10?
Solution, this is an iterative process but can be solved quickly on a calculator or
spreadsheet.
Enter the keys noted for each project in the CF of a Texas BA II Plus calculator
Cash Flows Project Q Project R Project S Project T
CFO -Rs1,500,000 -Rs1,500,000 -Rs1,500,000 -Rs1,500,000
CO1, F1 Rs350,000, 1 Rs400,000, 1 Rs700,000, 1 Rs200,000, 1

CO2, F2 Rs350,000, 1 Rs400,000, 1 Rs600,000, 1 Rs400,000, 1
Year three Rs350,000, 1 Rs400,000, 1 Rs500,000,1 Rs600,000, 1
Year four Rs350,000, 1 Rs400,000, 1 Rs400,000, 1 Rs800,000, 1
Year five Rs350,000, 1 Rs400,000, 1 Rs300,000, 1 Rs1,000,000, 1
CPT IRR 5.37% 10.42% 23.57% 21.86%
13. Comparing NPV and IRR – Chandler and Joey were having a discussion about which
financial model to use for their new business. Chandler supports NPV and Joey supports IRR.
The discussion starts to get heated when Ross steps in and states, “gentlemen, it doesn’t matter
which method we choose, they give the same answer on all projects.” Is Ross right? Under what
conditions will IRR and NPV be consistent when accepting or rejecting projects?
Solution: Ross is partially right as NPV and IRR both reject or both accept the same
projects under the following conditions:
 The projects have standard cash flows

 The hurdle rate for IRR is the same as the discount rate for NPV
 All projects are available for acceptance regardless of the decision made
on another project (projects are not mutually exclusive)
14. Comparing NPR and IRR – Monica and Rachel are having a discussion about IRR and NPV
as a decision model for Monica’s new restaurant. Monica wants to use IRR because it gives a
very simple and intuitive answer. Rachel states that there can be errors made with IRR that are
not made with NPV. Is Rachel right? Show one type of error can be made with IRR and not with
NPV?
Solution: The most typical example here is with two mutually exclusive projects
where the IRR of one project is higher than the IRR of the other project but the NPV
of the second project is higher than the NPV of the first project. When comparing two
projects using only IRR this method fails to account for the level of risk of the project
cash flows. When the discount rate is below the cross-over rate one project is better
under NPV while the other project is better if the discount rate is above the cross-over
rate and still below the IRR.
15. Profitability Index -- Given the discount rates and the future cash flows of each project,
which projects should they accept using profitability index?
Cash Flows Project U Project V Project W Project X
Year zero -Rs2,000,000 -Rs2,500,000 -Rs2,400,000 -Rs1,750,000
Year one Rs500,000 Rs600,000 Rs1,000,000 Rs300,000
Solution, find the present value of benefits and divide by the present value of the costs for
each project.
Project U’s PV Benefits = Rs500,000/1.05 + Rs500,000/1.052 + Rs500,000/1.053 +

Rs500,000/1.054 + Rs500,000/1.055
Project U’s PV Benefits = Rs476,190.48 + Rs453,514.74 + Rs431,918.80 +

Rs411,351.24 + Rs391,763.08 = Rs2,164,738.34
Project U’s PV Costs = Rs2,000,000
Project U’s PI = Rs2,164,738.34 / Rs2,000,000 = Rs1.0824 accept project.
Project V’s PV Benefits = Rs600,000/1.09 + Rs600,000/1.092 + Rs600,000/1.093 +

Rs600,000/1.094 + Rs600,000/1.095
Project V’s PV Benefits = -Rs2,000,000 + Rs550,458.72 + Rs505,008.00 +
Rs463,331.09 + Rs425,055.13 + Rs389,958.83 = Rs2,333,790.77
Project V’s PV Costs = Rs2,500,000
Project V’s PI = Rs2,333,790.77 / Rs 2,500,000 = 0.9335 and reject project.
Project W’s PV Benefits = Rs1,000,000/1.15 + Rs800,000/1.152 + Rs600,000/1.153 +

Rs400,000/1.154 + Rs200,000/1.155
Project W’s PV Benefits = Rs869,565.22 + Rs604,914.93 + Rs394,509.74 +

Rs228,701.30 + Rs99,435.34 = Rs2,197,126.53
Project W’s PV Costs = Rs2,400,000
Project W’s PI = Rs2,197,126.53 / Rs2,400,000 = 0.9155 and reject project.
Project X’s PV Benefits= -Rs2,000,000 + Rs300,000/1.22 + Rs500,000/1.222 +

Rs700,000/1.223 + Rs900,000/1.224 + Rs1,100,000/1.225
Project X’s PV Benefits= -Rs2,000,000 + Rs245,901.64 + Rs335,931.20 +

Rs385,494.82 + Rs406,259.18 + Rs406,999.18 = Rs1,780,586.02
Project X’s PV Cost = Rs1,750,000
Project X’s PI = Rs1,780,586.02 / Rs1,750,000 = 1.0175 and accept project.
16. Profitability Index -- Given the discount rates and the future cash flows of each project,
which projects should they accept using profitability index?
Cash Flows Project A Project B Project C Project D
Year zero -Rs1,500,000 -Rs1,500,000 -Rs2,000,000 -Rs2,000,000
Year one Rs350,000 Rs400,000 Rs700,000 Rs200,000

Solution, find the present value of benefits and divide by the present value of the costs for
each project.
Project A’s PV Benefits = Rs350,000/1.04 + Rs350,000/1.042 + Rs350,000/1.043 +

Rs350,000/1.044 + Rs350,000/1.045
Project A’s PV Benefits = Rs336,538.46 + Rs323,594.67 + Rs311,148.73 +

Rs299,181.47 + Rs287,674.49 = Rs1,558,137.84
Project A’s PV Costs = Rs1,500,000
Project A’s PI = Rs1,558,137.84 / Rs1,500,000 = 1.0388 and accept project.
Project B’s PV Benefits = Rs400,000/1.08 + Rs400,000/1.082 + Rs400,000/1.083 +

Rs400,000/1.084 + Rs400,000/1.085
Project B’s NPV = -Rs2,000,000 + Rs370,370.37 + Rs342,935.53 + Rs317,532.90 +

Rs294,011.94 + Rs272,233.28 = Rs1,597,084.02
Project B’s PV Costs = Rs1,500,000
Project B’s PI = Rs1,597,084.02 / Rs1,500,000 = 1.0647 and accept project.
Project C’s PV Benefits = Rs700,000/1.13 + Rs600,000/1.132 + Rs500,000/1.133 +

Rs400,000/1.134 + Rs300,000/1.135
Project C’s PV Benefits = Rs619,469.03 + Rs469,888.01 + Rs346,525.08 +

Rs245,327.49 + Rs162,827.98 = Rs1,844,037.59
Project C’s PV Costs = Rs2,000,000
Project C’s PI = Rs1,844,037.59 / Rs2,000,000 = 0.9220 and reject project.
Project D’s PV Benefits = Rs200,000/1.18 + Rs400,000/1.182 + Rs600,000/1.183 +

Rs800,000/1.184 + Rs1,000,000/1.185
Project D’s PV Benefits = Rs169,491.53 + Rs287,273.77 + Rs365,178.52 +

Rs412,631.10 + Rs437,109.22 = Rs1,671,684.14
Project D’s PV Costs = Rs2,000,000
Project D’s PI = Rs1,671,684.14 / Rs2,000,000 = 0.8358 and reject project.
17. Comparing All Methods -- Given the following After Tax Cash Flows for Tyler’s Tinkering
Toys on a new toy find the Payback Period, NPV, and Profitability Index of this project. The
appropriate discount rate for the project is 12%. If the cut-off period is six years for major
projects, determine if the project is accepted or rejected under the four different decision models.
Year 0 cash outflow: Rs10,400,000
Years 1 to 4 cash inflow: Rs2,600,000 each year
Year 5 cash outflow: Rs1,200,000
Years 6 – 8 cash inflow: Rs750,000 each year

Solution:
Payback Period: -Rs10,400,000 + Rs2,600,000 + Rs2,600,000 + Rs2,600,000 +

Rs2,600,000 = Rs0 (Four years but year five is also an outflow so we need to continue) -
Rs1,200,000 + Rs7,500,000 + Rs7,500,000 = Rs300,000 so we only need part of year
seven, Rs4,500,000 / Rs7,500,000 = 0.6 so total Payback is 7.6 years and project is
rejected with six year cut-off.
Net Present Value: -Rs10,400,000 + Rs2,600,000/1.12 + Rs2,600,000/1.122 +
Rs2,600,000/1.123 + Rs2,600,000/1.124 - Rs1,200,000/1.125 + Rs7,500,000/1.126 +
Rs7,500,000/1.127 + Rs750,000/1.128
NPV = -Rs10,400,000 + Rs2,321,428.57 + Rs2,072,704.08 + Rs1,850,628.64 +

Rs1,652,347.00 - Rs680,912.23 + Rs379,973.34 + Rs339,261.91 + Rs302,912.42
NPV = -Rs2,161,656.25 and reject project under NPV rules.
Present Value of Benefits = Rs2,600,000/1.12 + Rs2,600,000/1.122 + Rs2,600,000/1.123

+ Rs2,600,000/1.124 - + Rs7,500,000/1.126 + Rs7,500,000/1.127 + Rs750,000/1.128 =
Rs2,321,428.57 + Rs2,072,704.08 + Rs1,850,628.64 + Rs1,652,347.00 + Rs379,973.34 +
Rs339,261.91 + Rs302,912.42 = Rs8,919,255.73
Present Value of Costs: Rs10,400,000 + Rs1,200,000/1.125 = Rs10,400,000 +

Rs680,912.23 = Rs11,080,912.23
Profitability Index = Rs8,919,255.73 / Rs11,080,912.23 = 0.8049 and reject.
18. Comparing All Methods -- Tom’s Risky Business is looking at a project with the estimated
cash flows as follows:
Initial Investment at start of project: Rs3,600,000
Cash Flow at end of Year 1: Rs500,000

Cash Flow at end of Years 2 through 6: Rs625,000 each year
Cash Flow at end of Year 7 through 9: Rs530,000 each year
Cash Flow at end of Year 10: Rs385,000
Risky Business wants to know the Payback Period, NPV, and Profitability Index of this
project. The appropriate discount rate for the project is 14%. If the cut-off period is six
years for major projects, determine if the project is accepted or rejected under the four
different decision models.
Solution:
Payback Period = -Rs3,600,000 + Rs500,000 + Rs625,000 + Rs625,000 + Rs625,000 +

Rs625,000 + Rs625,000 = Rs 25,000 and we only need part of year 6 so,
Rs600,000 / Rs625,000 = 0.96 and Payback Period is 5.96 years and project is accepted.
NPV = -Rs3,600,000 + Rs500,000 / 1.14 + Rs625,000/1.142 + Rs625,000/1.143 +

Rs625,000/1.144 + Rs625,000/1.145 + Rs625,000/1.146 + Rs530,000/1.147
+ Rs530,000 /1.148 + Rs530,000/1.149 + Rs385,000/1.1410
NPV = -Rs3,600,000 + Rs438,596.49 + Rs480,917.21 + Rs421,857.20 + Rs370,050.17
+ Rs324,605.42 + Rs284,741.59 + Rs211,807.78 + Rs185,796.30 + Rs162,979.21
+ Rs103,851.37 = -Rs614,797.27 and project is rejected using NPV rules.
Present Value of Benefits = Rs500,000 / 1.14 + Rs625,000/1.142 + Rs625,000/1.143 +

Rs625,000/1.144 + Rs625,000/1.145 + Rs625,000/1.146 + Rs530,000/1.147
+ Rs530,000 /1.148 + Rs530,000/1.149 + Rs385,000/1.1410
Present Value of Benefits = Rs438,596.49 + Rs480,917.21 + Rs421,857.20 +

Rs370,050.17 + Rs324,605.42 + Rs284,741.59 + Rs211,807.78 + Rs185,796.30 +
Rs162,979.21+ Rs103,851.37 = Rs2,985,202.73
Present Value of Costs: Rs3,600,000
Profitability Index = Rs2,985,202.73 / Rs3,600,000 = 0.8292 and reject.

MAKE OR BUY DECISION
1 Introduction
In the process of carrying out business activities of an organization, a component/product
can be made within the organization or bought from a subcontractor. Each decision involves its
own costs. So, in a given situation, the organization should evaluate each of the above make or
buy alternatives and then select the alternative which results in the lowest cost. This is an
important decision since it affects the productivity of the organization. In the long run, the make
or buy decision is not static. The make option of a component/product may be economical today;
but after some time, it may turn out to be uneconomical to make the same.
Thus, the make or buy decision should be reviewed periodically, say, every 1 to 3 years. This is
mainly to cope with the changes in the level of competition and various other environmental
factors.
2. Criteria for Make or Buy
In this section the criteria for make or buy are discussed.
Criteria for make
The following are the criteria for make:
1. The finished product can be made cheaper by the firm than by outside suppliers.
2. The finished product is being manufactured only by a limited number of outside firms
which are unable to meet the demand.
3. The part has an importance for the firm and requires extremely close quality control.
4. The part can be manufactured with the firm's existing facilities and similar to other
items in which the company has manufacturing experience.
Criteria for buy
The following are the criteria for buy:
1. Requires high investments on facilities which are already available at supplier’s plant.
2. The company does not have facilities to make it and there are more profitable
opportunities for investing company's capital.
3. Existing facilities of the company can be used more economically to make other parts.
4. The skill of personnel employed by the company is not readily adaptable to make the
part.
5. Patent or other legal barriers prevent the company for making the part.
6. Demand for the part is either temporary or seasonal
3 Approaches for Make or Buy Decision

Types of analysis followed in make or buy decision are as follows:
1. Simple cost analysis 2. Economic analysis 3. Break-even
analysis
3.1 Simple Cost Analysis
The concept is illustrated using an example problem.
3.2 Economic Analysis
The following inventory models are considered to illustrate this concept:
• Purchase model • Manufacturing model
The formulae for EOQ and total cost (TC) for each model are given in the following table:
Purchase model Manufacturing model
2𝐶𝑂 𝐷 2𝐶𝑂 𝐷
𝑄1 = √ 𝑄1 = √
𝐶𝐶 𝐶𝐶 (1 − 𝑟⁄𝑘)
DC0 Q1CC DC0 CC (k − r) Q2

𝑇𝐶 = 𝐷xP + + 𝑇𝐶 = 𝐷xP + +
Q1 2 Q2 2 2∗k
Where
P = purchase price/unit Cc = carrying cost/unit/year Co = ordering cost/order or set-up
cost/set-up
k = production rate (No. or units/year) D = demand/year r = demand/year
Ql = economic order size Q2 = economic production size TC = total cost per
year
3.3 Break-even Analysis
The break-even analysis chart is shown in Fig. 13.1. In the figure
TC = Total cost
FC = Fixed cost
TC = FC + Variable cost
B = the intersection of TC and sales (no loss or no gain situation)
A = Break-Even sales
C = Break-Even Quantity/ Break-Even Point (BEP)
The formula for the Break-Even Point (BEP) is
FC
BEP =
Selling price⁄unit − Variable cost⁄unit
Fig.1. Break-even analysis chart

Example:1. A Company has extra capacity that can be used to produce a sophisticated fixture
which it has been buying for Rs. 900 each. If the company makes the fixtures, it will incur
materials cost of Rs. 300 per unit, labour costs of Rs. 250 per unit, and variable overhead costs of
Rs. 100 per unit. The annual fixed cost associated with the unused capacity is Rs. 10, 00,000.
Demand over the next year is estimated at 5,000 units. Would it be profitable for the company to
make the fixtures?
Solution: We assume that the unused capacity has alternative use.
Cost to make
Variable cost/unit = Material + labour + overheads = Rs. 300 + Rs. 250 + Rs. 100 = Rs.
650
Total variable cost = (5,000 units) (Rs. 650/unit) =Rs.32, 50,000
Add fixed cost associated with unused capacity =Total cost + Rs. 10, 00,000 = Rs. 42,
50,000
Cost to buy
Purchase cost = (5,000 units) (Rs. 900/unit) = Rs. 45, 00,000
Add fixed cost associated with unused capacity =Total cost + Rs. 10, 00,000 = Rs. 55,
00,000
The cost of making fixtures is less than the cost of buying fixtures from outside.
Therefore, the organization should make the fixtures.
Example: 2. An item has a yearly .demand of 2,000 units. The different costs in respect of make
and buy are as follows. Determine the best option.
Buy Make
Item cost/unit Rs. 8.00 Rs. 5.00
Procurement cost/order Rs.120.00 ------
Set-up cost/set-up ------ Rs.60.00
Annual carrying cost/item/year Rs. 1.60 Rs. 1.00
Production rate/year ------ 8,000Units
Solution:
Buy option
D = 2,000 units/year Co = Rs. 120/order Cc = Rs. 1.60/unit/year
2𝐶𝑂 𝐷 2x2000x120
𝑄1 = √ =√ = 548 units (approx. )
𝐶𝐶 1.60
DC0 Q1CC 2,000x120 548x1.60

𝑇𝐶 = 𝐷xP + + = 2000x8 + + = Rs. 16,876.36
Q1 2 548 2
Make option
Co = Rs. 60/set-up r = 2,000 units/year Cc = Re l/unit/year K = 8,000
units/year
2𝐶𝑂 𝐷 2x60x2,000
𝑄1 = √ = √ = 566 𝑢𝑛𝑖𝑡𝑠(𝑎𝑝𝑝𝑟𝑜𝑥)
𝐶𝐶 (1 − 𝑟⁄𝑘) 1(1 − 2000⁄8000
DC0 CC (k − r) Q2
𝑇𝐶 = 𝐷xP + +
Q2 2 2∗k
2,000x60 566
= 2,000x5.00 + + 1.0(8,000 − 2,000) 2x8,000 = Rs. 10,424.26
566
Result: The cost of making is less than the cost of buying. Therefore, the firm should go in for
the making option.
Example:3. A manufacturer of TV buys TV cabinet at Rs. 500 each. In case the company makes
it within the factory, the fixed and variable costs would he Rs. 4,00,000 and Rs. 300 per cabinet
respectively. Should the manufacturer make or buy the cabinet if the demand is 1,500 TV
cabinets?
Solution
Selling price/unit (SP) = Rs. 500 Variable cost/unit (VC) = Rs. 300
Fixed cost (FC) = Rs. 4,00,000
4,00,000
BEP = = 2,000 units
500 − 300
Since the demand (l,500 units) is less than the break-even quantity, the company should buy the
cabinets for its TV production.
Example: 4.There are three alternatives available to meet the demand of a particular product.
They are as follows:
(a) Manufacturing the product by using process A (b) Manufacturing the product by using
process B
(c) Buying the product
The details are as given in the following table:
Cost elements Manufacturing the product Manufacturing the product by Buy
by process A process B
Fixed cost/year (Rs.) 5,00,000 6.00,000 ----
Variable/unit (Rs.) 175 150 ----
Purchase price/unit Rs.) ----- ---- 125
The annual demand of the product is 8,000 units. Should the company make the product using
process A or process B or buy it?
Solution
Annual cost of process A = FC + VC x Volume = 5,00,000 + 175 x 8,000 = Rs.
19,00,000
Annual cost of process B = FC + VC x Volume = 6,00,000 + 150 x 8,000 =Rs.
18,00,000
Annual cost of buy= Purchase price/unit x Volume=125x8, 000 = Rs.10, 00,000.
Since the annual cost of buy option is the minimum among all till alternatives, the company
should buy the product.
Break-Even Analysis
The main objective of break-even analysis is to find the cut-off production volume from where a
firm will make profit. Let
s = selling price per unit v = variable cost per unit
FC = fixed cost per period Q = volume of production
The total sales revenue (S) of the firm is given by the following formula:
S=sxQ
The total cost of the firm for a given production volume is given as
TC = Total variable cost + Fixed cost = v x Q + FC
The linear plots of the above two equations are shown in Fig. 3. The intersection point of
the total sales revenue line and the total cost line is called the break-even point. The
corresponding volume of production on the X-axis is known as the break-even sales quantity. At
the intersection point, the total cost is equal to the total revenue. This point is also called the no-
loss or no gain situation. For any production quantity which is less than the break-even quantity,
the total cost is more than the total revenue. Hence, the firms will be making loss
For any production quantity which is more than the break even quantity, the total revenue
will be more than the total cost. Hence, the firm will be making profit.
Profit = Sales - (Fixed cost + Variable costs)
= s x Q - (FC + v x Q)
The formulae to find the break-even quantity and break-even sales quantity
Fixed cost
Break − even quantity = 𝑋100
Selling price/unit − Variable cost/unit
FC
= (in units)
s − v
Fixed cost
Brea k − even sa1es = 𝑋 Selling price/unit
FC
= x s (Rs. )
s − v
The contribution is the difference between the sales and the variable costs. The margin of safety
(M.S.) is the sales over and above the break-even sales. The formulae to compute these values
are
Contribution = Sales - Variable costs
Contribution/unit = Selling price/unit - Variable cost/unit
M.S. = Actual sales - Break-even sales
Profit
= x sa1es (Rs. )
Contribution
M.S. as a percent of sales = (M.S./Sales) x 100
8.1. Profit Volume Ratio (P/V Ratio)
P/V ratio is a valid ratio which is useful for further analysis. The different Formulae for the PIV
ratio are as follows:
𝑃 Contribution Sales − Variable costs
ratio = =
𝑉 sa1es sa1es
The relationship between BEP and P/V ratio is as follows:
FIXED COST
𝐵𝐸𝑃 = 𝑃
( 𝑉 ) ratio
The following formula helps us find the M.S. using the P/V ratio
Profit
𝑀. 𝑆 = 𝑃
( 𝑉 ) ratio
Example.1 Alpha Associates has the following details:

Fixed cost = Rs. 20, 00,000 Variable cost per unit = Rs. 100 Selling price per unit = Rs.
200
Find: (a) The break-even sales quantity, (b) The break-even sales,
(c) If the actual production quantity is 60,000, find (i) contribution; and (ii) margin of safety by nil
methods.
Solution:
Fixed cost (FC) = Rs. 20, 00,000 Variable cost per unit (v) = Rs. 100 Selling price per unit(s) = Rs.
200
Fixed cost FC
Break − even quantity = 𝑋100 = (in units)
Selling price/unit − Variable cost/unit s − v
20,00,000
= = 20,000 units
200 − 100
Fixed cost
Brea k − even sa1es = 𝑋 Selling price/unit
FC
= x s (Rs. )
s − v
20,00,000
= x 200 (Rs. ) = Rs. 40,00,000
200 − 100
(i) Contribution = Sales - Variable costs
= s x Q-v x Q
= 2X60, 000-100X 60,000 =1, 20, 00,000-60, 00,000=
Rs.60,00,000
(ii) Margin of safety
Method I M.S. = Sales - Break-even sales

= 60,000 x200 - 40,00,000= 1,20,00,000 - 40,00,000 = Rs.
80,00,000
Method II
Profit
M. S = x sa1es (Rs. )
Contribution
Profit = Sales - (FC + v x Q)
= 60,000 x 200 - (20, 00,000 + 100 x 60,000)= 1, 20, 00,000 - 80, 00,000 = Rs. 40,
00,000
40, 00,000
M. S = x1,20,00,000) = Rs. 80,00 ,000
60,00,000
80,00,000
M. S as a per cent or sales = x 100 = 67%
1,20,00,000
Example .2 Consider the following data of a company for the year 1997:
Sales = Rs. 1, 20,000 Fixed cost = Rs. 25,000 Variable cost = Rs. 45,000
Find the following:
(a) Contribution, (b) Profit, (c) BEP, (d) M.S.
Solution:
(a) Contribution = Sales - Variable costs = Rs. 1,20,000 - Rs. 45,000 = Rs.
75,000
(b) Profit = Contribution - Fixed cost = Rs. 75,000 - Rs. 25,000 = Rs.
50,000
𝑃 Contribution 75,000
ratio = = = 62.50%
𝑉 sa1es 1,20,000
FIXED COST 25,000
𝐵𝐸𝑃 = 𝑃 = x 100 = Rs. 40,000.
( 𝑉 ) ratio 62.50
Profit 50,000
𝑀. 𝑆 = 𝑃 = x100 = Rs. 80,000.
( 𝑉 ) ratio 62.50
Example.3 Consider the following data of a company for the year 1998:
Sales = Rs. 80,000 Fixed cost = Rs. 15,000 Variable cost =
35,000
Find the following:
(a) Contribution (b) Profit (c) BEP (d) M.S.
(a) Contribution = Sales - Variable costs = Rs.80,000 - Rs. 35,000 = Rs. 45,000
(b) Profit = Contribution - Fixed cost = Rs. 45,000 - Rs. 15,000 = Rs.
30,000
𝑃 Contribution 45,000
ratio = = = 56.25%
𝑉 sa1es 80,000
FIXED COST 15,000
𝐵𝐸𝑃 = 𝑃 = x 100 = Rs. 26,667.
( 𝑉 ) ratio 56.25
Profit 30,000
𝑀. 𝑆 = 𝑃 = x100 = Rs. 53,333.33.
( 𝑉 ) ratio 56.25

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SUBJECT NAME: PROJECT MANAGEMENT AND FINANCE CREDITS: 3

SUBJECT CODE: 1150MG101 HOURS: 3

UNIT – V: PROJECT EVALUATION UNDER CERTINITY

Objectives, essential of a project methodology – Market appraisal – Technical appraisal –

1. Determine what information you will need to collect:

 To see how your project is doing day to day (on-going monitoring)

2. Determine your information sources/data collection methods. Sources of information may

- Sample evaluation plan: Objectives

Phase 1 Number of Project Minutes taken at Monthly

Enhanced Number of Letters of Comparison of project End of

Phase 2 Extent to which Project Plan Comparison of project End of

Phase 3 Increased Level of knowledge Participants Test of participant Before

Improved Level of Participants Analysis of video- Start and end

Percentage of Attendees at One-page survey of a End of the

Percentage of Attendees at One-page survey of a End of the

Different types of appraisal include technical, economic, organizational and managerial,

Type 1. Technical Appraisal:

The cautions in general in this area are:

(v) Design should not have unnecessarily burdensome specifications.

The major clauses are:

(iv) payment of know-how fee should be by stages, not in one go.

Type 2. Economic Appraisal:

The economic appraisal of the project covers the following areas:

b. When the product is ‘intermediate.’ in nature and the customer is in particular

c. Government subsidy; helps for procurement of land/space at suitable location;

Type 3. Organizational and Managerial Appraisal:

The organizational and managerial appraisal is carried out recognising that:

Type 4. Commercial Appraisal:

The points for consideration are:

(iii) The international market and the possibility of export;

a. International standard quality;

FACTORS AFFECTING CAPITAL BUDGETING:

TECHNIQUES OF PROJECT APPRAISAL AND THEIR APPLICATIONS:

NET PRESENT VALUE (NPV)

The summary of the concept explained so far is given below:

The internal rate of return is an indicator of the profitability, efficiency, quality, or

Make-or-Buy decision (also called the outsourcing decision) is a judgment made by

Examples of the qualitative factors in make-or-buy decision are:

 Control over quality of the component,

 Incremental production cost per unit,

Lease or buy decision involves applying capital budgeting principles to determine if

SOCIAL COST BENEFIT ANALYSIS (SCBA)

Compare different project alternatives

The result of a social cost benefit analysis

Projects A(Rs) B(Rs) C(Rs) D(Rs)

Cost 10,000 25,000 45,000 100,000

Cash Flow Year One 4,000 2,000 10,000 40,000

Cash Flow Year Two 4,000 8,000 15,000 30,000

Cash Flow Year Three 4,000 14,000 20,000 20,000

Cash Flow Year Four 4,000 20,000 20,000 10,000

Cash Flow year Five 4,000 26,000 15,000 0

Cash Flow Year Six 4,000 32,000 10,000 0

Project A: Year One: -10,000 + 4,000 = 6,000 left to recover

Year Two: -6,000 + 4,000 = 2,000 left to recover

Year Three: -2,000 + 4,000 = fully recovered

Year Three: 2,000 / 4,000 = ½ year needed for recovery

Payback Period for Project A: 2 and ½ years, ACCEPT!

Project B: Year One: -25,000 + 2,000 = 23,000 left to recover

Year Three: -15,000 + 14,000 = 1,000 left to recover

Year Four: -1,000 + 20,000 = fully recovered

Year Four: 1,000 / 20,000 = 1/20 year needed for recovery

Payback Period for Project B: 3 and 1/20 years, REJECT!

Project C: Year One: -45,000 + 10,000 = 35,000 left to recover