PFS: FINANCIAL ASPECT

PROJECT FINANCING AND

EVALUATION
(CHAPTER 26)

Rose Ann Glorian

NET PRESENT VALUE

Is a method that screens and ranks
investment proposals by determining
the difference between present value of
the cash inflows and the cash outflows
associated with the investment projects

Decision Rule
1. If NPV is POSITIVE = ACCEPTED
2. If NPV is NEGATIVE = REJECTED
3. If two projects are mutually exclusive, the one with the
higher NPV should be chosen, provided its NPV is POSITIVE

Example
Rain Mines is considering investing in the mining
rights to a large tract of land in a mountainous
area. The tract contains mineral deposit that the
company believes might be commercially
attractive to mine and sell. An engineering and
cost analysis has been made and it is expected
that the following cash flows would be associated
with opening and operating a mine in the area.

Cost of Equipment required 850,000

*Net Annual Cash Receipts 230,000
Working Capital required 100,000
Cost of road repairs in 3 years 60,000
Salvage value of equipment in 5 years

200,000

*Receipts from sales of ore, less out of pocket cost of salaries,

utilities, insurance and so forth
It is estimated that the mineral deposit would be exhausted after 5
years of mining. At that point, the working capital would be released
for reinvestment elsewhere. The companys cost of capital is 14%

Solution
Relevant Items

Cost of Equipment
Working Capital
Required
Net Annual Cash
Receipts
Cost of road repairs
Salvage value of
equipment
Working Capital
released
Net Present Value

End of
Year(s)

Amount of 14% Factor

Cash Flows

Present
Value of
Cash Flows

0
0

(850,000)
(100,000)

1.000
1.000

(850,000)
(100,000)

1-5

230,000

3.433

789,590

3
5

(60,000)
200,000

0.675
0.519

(40,500)
103,800

100,000

0.519

51,900
P(45,210)

NPV is Negative = REJECTED

The project should not be
undertaken because it will not
earn the minimum desired rate of
return of 14%

INTERNAL RATE OF RETURN (IRR)

Is the discount rate that will cause the net
present value of an investment project to
be equal to zero; thus, the IRR represents
the internal yield promised by a project
over its useful life. This term is synonymous
with discounted rate of return and time
adjusted rate of return.

Decision Rule
1. If the IRR exceeds or equals the minimum desired
rate of return or the cost of capital, the investment
proposal may be accepted
2. If the IRR is less than the minimum desired rate of
return or the cost of capital, the investment proposal
should be rejected
3. If two projects are mutually exclusive, the one with the
higher IRR should be chosen, provided the IRR
exceeds or equals the cost of capital

Example
Julie Miller is evaluating a new
project for her firm, Basket
Wonders (BW). Miller expected
to generate net cash flows of
$10,000; $12,000; $15,000;
$10,000; and $7,000, from the
project respectively, for each of
the Years 1 through 5. The initial
cash outlay will be $40,000.

Solution
$10,000
$12,000
$40,000 =
+
+
(1+IRR)1 (1+IRR)2
$15,000
$10,000
$7,000
+
+
(1+IRR)3 (1+IRR)4 (1+IRR)5

(Try 10%)

(Try 15%)

INTERPOLATE

INTERPOLATE

No! The firm will receive

11.57% for each dollar
invested in this project at a
cost of 13%. [ IRR < Hurdle
Rate ]

BREAK-EVEN TIME or DISCOUNTED

PAYBACK PERIOD
Discounted Payback Period is the length of
time required for the net revenues of an
investment discounted at the investments
cost of capital to cover the cost of the
investment. Like the regular payback
method, it ignores cash flows beyond the
discounted payback period

Decision Rule
The shorter the discount payback period, the
better. It could be compared with the maximum
discounted payback period set by management.
Accept the project if DPP is shorter than
the maximum allowable DPP.

PAYBACK PERIOD
Payback period is the length of time that it
takes for an investment project to recoup
its own initial cost out of the cash receipts
that it generates. Bail out payback period
considers the salvage value of the asset as
part of cash inflows.

Decision Rule
1. If the payback period is equal to or shorter
than the maximum allowable payback
period by the investor, ACCEPT the
project.
2. If the payback period is longer than the
maximum allowable payback period,
REJECT the project.

SIMPLE OR ACCOUNTING RATE OF

RETURN (ARR)
ARR is the rate of return promised by an investment project
when the time value of money is not considered. It is
computed by dividing a project s annual accounting net
income by the initial investment required.

Decision Rule
If ARR is equal to or exceeds the minimum
desired rate of return, project proposal may
be ACCEPTED
If ARR is less than the minimum desired
rate of return, REJECT the proposal

SENSITIVITY ANALYSIS

THANK
YOU!