MODULE 5

PROJECTS MANAGEMENT

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PROJECT EVALUATION METHODS
• The following points highlight the top seven methods used for
evaluating the investment proposals by a company.
• The methods are:
1. Payback Period Method 2. Accounting Rate of Return Method 3. Net Present
Value Method 4. Internal Rate of Return Method 5. Profitability Index Method
6. Discounted Payback Period Method 7. Adjusted Present Value Method.

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PAYBACK PERIOD METHOD
• The payback period is usually expressed in years, which it takes the
cash inflows from a capital investment project to equal the cash
outflows. The method recognizes the recovery of original capital
invested in a project. At payback period the cash inflows from a
project will be equal to the project’s cash outflows.
• This method specifies the recovery time, by accumulation of the cash
inflows (inclusive of depreciation) year by year until the cash inflows
equal to the amount of the original investment. The length of time
this process takes gives the ‘payback period’ for the project. In simple
terms it can be defined as the number of years required to recover
the cost of the investment.

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PAYBACK PERIOD METHOD
• In case of capital rationing situations, a company is compelled to
invest in projects having shortest payback period. When deciding
between two or more competing projects the usual decision is to
accept the one with the shortest payback. Payback is commonly used
as a first screening method. This method recognizes the recovery of
the original capital invested in a project.

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ADVANTAGES OF PAYBACK PERIOD METHOD
• It is simple to apply, easy to understand and of particular importance to business
which lack the appropriate skills necessary for more sophisticated techniques.
• In case of capital rationing, a company is compelled to invest in projects having
shortest payback period.
• This method is most suitable when the future is very uncertain. The shorter the
payback period, the less risky is the project. Therefore, it can be considered as an
indicator of risk.
• This method gives an indication to the prospective investors specifying when
their funds are likely to be repaid.
• Ranking projects according to their ability to repay quickly may be useful to firms
when experiencing liquidity constraints. They will need to exercise careful control
over cash requirements.

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DISADVANTAGES OF PAYBACK PERIOD METHOD
• It does not indicate whether an investment should be accepted or rejected,
unless the payback period is compared with an arbitrary managerial target.
• The method ignores cash generation beyond the payback period and this
can be seen more a measure of liquidity than of profitability.
• It fails to take into account the timing of returns and the cost of capital. It
fails to consider the whole life time of a project. It is based on a negative
approach and gives reduced importance to the going concern concept and
stresses on the return of capital invested rather than on the profits
occurring from the venture.
• The traditional payback approach does not consider the salvage value of an
investment. It fails to determine the payback period required in order to
recover the initial outlay if things go wrong. The bailout payback method
concentrates on this abandonment alternative.
• This method makes no attempt to measure a percentage return on the
capital invested and is often used in conjunction with other methods.
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EXERCISE
• The project involves a total initial expenditure of E200,000 and it is
estimated to generate future cash inflow of E30,000, E38,000,
E25,000, E22,000, E36,000, E40,000, E40,000, E28,000, E24,000 and
E24,000 in its last year.

• Calculate the payback period

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ACCOUNTING RATE OF RETURN METHOD
• The accounting rate of return is also known as ‘return on investment’
or ‘return on capital employed’ method employing the normal
accounting technique to measure the increase in profit expected to
result from an investment by expressing the net accounting profit
arising from the investment as a percentage of that capital
investment.
• The method does not take into consideration all the years involved in
the life of the project.

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ACCOUNTING RATE OF RETURN METHOD
• In this method, most often the following formula is applied to arrive
at the accounting rate of return:

• Sometimes, initial investment is used in place of average investment.

Of the various accounting rates of return on different alternative
proposals, the one having highest rate of return is taken to be the
best investment proposal.

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ADVANTAGES OF ACCOUNTING RATE OF RETURN
• It is easy to calculate because it makes use of readily available
accounting information.
• It is not concerned with cash flows but rather based upon profits
which are reported in annual accounts and sent to shareholders.
• Unlike payback period method, this method does take into
consideration all the years involved in the life of a project.
• Where a number of capital investment proposals are being
considered, a quick decision can be taken by use of ranking the
investment proposals.
• If high profits are required, this is certainly a way of achieving them.

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DISADVANTAGES OF ACCOUNTING RATE OF RETURN
• It does not take into accounting time value of money.
• It fails to measure properly the rates of return on a project even if the
cash flows are even over the project life.
• It uses the straight line method of depreciation. Once a change in
method of depreciation takes place, the method will not be easy to
use and will not work practically.
• This method fails to distinguish the size of investment required for
individual projects. Competing investment proposals with the same
accounting rate of return may require different amounts of
investment.

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DISADVANTAGES OF ACCOUNTING RATE OF RETURN
• It is biased against short-term projects in the same way that payback
is biased against longer-term ones.
• Several concepts of investment are used for working out accounting
rates of return.
• The accounting rates of return does not indicate whether an
investment should be accepted or rejected, unless the rates of return
is compared with the arbitrary management target.

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EXERCISE
• A machine is available for purchase at a cost of E80,000. We expect it
to have a life of five years and to have a scrap value of E10,000 at the
end of the five year period.
• We have estimated that it will generate additional profits over its
life as follows:
• Year 1: E20,000.00
• Year 2: E40,000.00
• Year 3: E30,000.00
• Year 4: E15,000.00
• Year 5: E5,000.00
• These estimates are of profits before depreciation. You are required
to calculate the return on capital employed.

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NET PRESENT VALUE METHOD
• The objective of the firm is to create wealth by using existing and
future resources to produce goods and services. To create wealth,
inflows must exceed the present value of all anticipated cash
outflows. Net present value (NPV) is obtained by discounting all cash
outflows and inflows attributable to a capital investment project by a
chosen percentage e.g., the entity’s weighted average cost of capital.
• The method discounts the net cash flows from the investment by the
minimum required rate of return, and deducts the initial investment
to give the yield from the funds invested. If yield is positive the
project is acceptable. If it is negative the project in unable to pay for
itself and is thus unacceptable.

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NET PRESENT VALUE METHOD
• The exercise involved in calculating the present value is known as
‘discounting and the factors by which we have multiplied the cash flows are
known as the ‘discount factors’.
• Discount factor = 1/(1+r)n
• Where, r = Rate of interest p.a.
• n = number of years over which we are discounting.
• Discounted cash flow is an evaluation of the future net cash flows
generated by a capital project, by discounting them to their present day
value. The method is considered better for evaluation of investment
proposal as this method takes into account the time value of money as well
as, the stream of cash flows over the whole life of the project. The
discounting technique converts cash inflows and outflows for different
years into their respective values at the same point of time, allows for the
time value of money.

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NET PRESENT VALUE METHOD
• Discounted cash flow is an evaluation of the future net cash flows
generated by a capital project, by discounting them to their present
day value. The method is considered better for evaluation of
investment proposal as this method takes into account the time value
of money as well as, the stream of cash flows over the whole life of
the project. The discounting technique converts cash inflows and
outflows for different years into their respective values at the same
point of time, allows for the time value of money.

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ADVANTAGES OF NET PRESENT VALUE METHOD
• It explicitly recognizes the time value of money.
• It considers the cash flow stream in its entirety.
• It squares neatly with the financial objective of maximization of the wealth
of stockholders. The net present value represents the contribution to the
wealth of stockholders.
• The net present value (NPV) of various projects, measured as they are in
today’s rupees, can be added.
For example, the NPV of a package consisting of two projects A and B, will simply be
the sum of NPV of these projects individually:
• NPV(A + B) = NPV(A) + NPV(B)
• The additivity property of NPV ensures that a poor project (one which has a
negative NPV) will not be accepted just because it is combined with a good
project (which has a positive NPV).
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ADVANTAGES OF NET PRESENT VALUE METHOD
• The additivity property of NPV ensures that a poor project (one which
has a negative NPV) will not be accepted just because it is combined
with a good project (which has a positive NPV).
• A changing discount rate can be built into NPV calculations by altering
the denominator. This feature becomes important as this rate normally
changes because the longer the time span, the lower is the value of
money and the higher is the discount rate.
• This method is particularly useful for the selection of mutually
exclusive projects.

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DISADVANTAGES OF NET PRESENT VALUE METHOD
• It is difficult to calculate as well as understand and use.
• The ranking of projects on the NPV dimension is influenced by the discount
rate – which is usually the firm’s cost of capital. But cost of capital is quite a
difficult concept to understand and measure in practice.
• It may not give satisfactory answer when the projects being compared
involve different amounts of investment. The project with higher NPV may
not be desirable if it also requires a large investment.
• It may mislead when dealing with alternative projects of limited funds
under the condition of unequal lives.
• The NPV measures an absolute measure, does not appear very meaningful
to businessmen who think in terms of rate of return measures.

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EXERCISE
• A firm can invest E10,000 in a project with a life of three years.
• The projected cash inflows are:
• Year 1 – E4,000,
• Year 2 – E5,000 and
• Year 3 – E4,000.
• The cost of capital is 10% p.a. should the investment be made?

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