Notes of

Lecture Five----- ‘Net Present Value Method ’

of the Program on
Project Appraisal [Financial Aspect] and introduction to
Risk Analysis

Conducted by
Project Appraisal Consultants
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Topics to be covered

•What are alternate or different project appraisal

•What is Net Present Value [NPV] Method
•How to lay out table and exercise to find out NPV
•Illustrated examples for finding out NPV
•Selection of projects when there is fund constraint
•Selection of projects which are mutually exclusive
• Projects which complement on cost side
• Projects which are substitute on cost side
• Projects which complement on benefit side
• Projects which substitute on benefit side
•Why is NPV method best for project appraisal

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 ALTERNATIVE INVESTMENT ANALYSIS CRITERIA
Following investments analysis criteria are used to appraise and judge the viability the

Project, rank the projects for investment and weed out unviable projects.

1. Net Present Value (NPV) Method

2. Internal Rate of Return (IRR) Method

3. Benefits Cost Ratio (B C Ratio) Method

4. Pay Back Period / Pay Out Period Method

5. Cost Effective Method

These will be discussed one by one.

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NET PRESENT VALUE (NPV) METHOD
 Economic development projects are taken up in private and public sector
 The costs and benefits of projects generally occurs in different periods of time.
 For comparison and evaluation of such projects, the NPV method uses discounting
of Net Cash Flows [ Cash In Flows minus Cash Out Flows] or Net Benefits [Gross
Benefits minus Gross Costs].
 ‘A’ rupees invested today will grow in ‘n’ years to A (1+d) n where d is the interest
rate
 Similarly A after ‘n’ years is equal to = A . Today
(1+d)n

 PV of A after ‘n’ years = A .

(1+d)n

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 ILLUSTRATED EXAMPLE

If B0, B1, B2, …….Bn are the benefits of a project in years 0 1 2 3 …….n years.

C0 C1 and C2 and Cn are costs in 0 1 2 ………….n years,

The discount rate is ‘d’.

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NPVdn = Bo – C 0 B1 – C 1 B2- C2 …………….. Bn- Cn
+ + +
(1+d) 0
(1+d)1 (1+d)2 ………… (1+d)n

Or NPVdn =
∑ n

(1+d)n
Bt – C t

t = 0

Where ‘t’ is any year from 0,1,2,……n

Here . 1 . is the discount factor for year ‘t’

(1+d)t

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 NET PRESENT VALUE
Whenever a present has positive NPV, select the project.

Example: Project life 5 years, discount rate 10 % and cash flows as follows:

Years 0 1 2 3 4 5
Cash outflow -100 -80 -20 -20 -20 0
Cash inflow 160 160 160 18
Net Cash flow -100 -80 140 140 140 18

NPV10% = -100 -80 +140 +140 +140 18

(1.1)1 (1.1) 2 (1.1)3 (1.1)4 (1.1)5

= -100 -727 +115.70 +105.18 +95.61 +86.9

= -172.70 +403.39
NPV10% = +230.69
Hence project should be taken up
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 ILLUSTRATED EXAMPLE

In a project , the Investment in year 0 and 1 are Rs. 2 Lakhs each. Project

operates for 4 Years. Annual operation and maintenance costs are Rs. 0.2 Lakhs.

Annual benefits are Rs 2 lakhs. Salvage value of project is Rs. 0.5 Lakhs. Find out the

NPV of the project. The discount rate is 10%. All costs, benefits, discount rate are in

real values.

Solutions is given in the next slide.

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 (Fig in Rs lakhs)
Years 0 1 2 3 4 5 6
Cash Out Flow
• Investment 2 2
• O & M Costs 0.2 0.2 0.2 0.2 -
Total COF 2 2 0.2 0.2 0.2 0.2 0
Cash In Flow
• Benefits 0 0 2 2 2 2 0
• Salvage Value 0 0 0 0 0 0 0.4
Total CIF 0 0 2 2 2 2 0.4
Net Cash Flow -2 -2 1.8 1.8 1.8 1.8 0.4
(NCF)
1.8 18 0.4
Discounted NCF -2/ (1.1)0 -2/(1.1)1 1.8/(1.1) 2 1.8/(1.1)3 (1.1)4 (1.1)5 (1.1)6
-2 -1.818 1.488 1.352 1.23 1.12 0.226

NPVdn = 1.598 (Rs lakhs)

Therefore Net Present Value of Project is Rs 1.598 Lakhs
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 INVESTMENT CRITERIA FOLLOWED
While using NPV method, following criteria should be fgollowed for taking a decision.
I: When to Select or Reject a Project:
 If NPV is negative, reject the project.

 If NPV is Positive, select the Project

II : What to do when there is fund constraint:

 Suppose there is a shelf of projects which have positive NPVs.

 There is a total budget constraint to fund all these projects.

 How to go about selection of projects which should be implemented within budget

constraints ?
 In that situation we should select a combination of projects which give maximum
NPV.
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ILLUSTRATED EXAMPLE
There are four Projects A,B, C, D with following costs and NPV.
 Project A Rs Crores
PV of Costs 80
NPV of Project 30

 Project B Rs Crores
PV of Costs 120
PV of Project 60

 Project C Rs Crores
PV of Costs 100
PV of Project 40

 Project D Rs Crores
PV of Costs 150
PV of Project 70

 Total Budget constraint is Rs 300 crores. Find out projects which should be taken up (assume
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these projects are non-exclusive)
Solution:
Non-Exclusive means that any of these projects can be implemented in combination
with any other project.
(i) If Projects A,B and C are implemented,
PV of Costs = 80+120+100 =Rs 300 Crores
NPV of Projects A,B and C = 30+60+40 = Rs 130 Crores
(ii)If Projects B and D are implemented,
PV of Costs = 120+150 =Rs 270 Crores
NPV of Projects B and D = 60+70 = Rs 130 Crores
(iii) Similarly others combinations can be tried subjected to budget constraint
of Rs 300 crores,
(iv) Implement Project D twice,
PV of Costs = 2x150 = Rs 300 Crores
NPV of Projects D = 2x70 = Rs 140 Crores
 From all these we find that implementation of Project D twice gives highest NPV of
Rs 140 crores. Hence this is the solution
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Projects are strict Alternatives or Mutually Exclusive

Let us discus it in the context of the preceding example

 This means that only one of the available projects can be implemented.

 Mutually exclusive means that due to locational issues (such as one site for hydro

power project) only one project can be taken up.

 Project D if implemented will give you highest equal to Rs 70 crores. All other

projects will give lesser NPV. 13

PROJECTS HAVE DIFFERENT LENGTHS BUT MUTUALLY
EXCLUSIVE
Let us discuss following example of two projects.
 There could be projects which have different length or life.

 Projects are mutually exclusive.

Assume there are two types of Roads which can be built at the same location. One is a
WBM road and second one is Coal Tar road.
 WBM Road has five year life span and after that it has to be redone.

 Coal Tar Road Life is 15 years.

In this case
 Find out NPV of WBM Road three times as WBM road has to be built three times.
Each WBM road lasts for five years. Three times built WBM road will have 15 years
life span.
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 In these two alternatives, which is large ?
• NPV of three time WBM Road

or
• NPV of Coal Tar Road

 Choose the alternative whichever is higher.

Illustrations :
• NPV of WBM Road of 5 years life is Rs 400 lakhs

• NPV of Coal Tar Road is Rs 1100 lakhs.

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 Comparing the NPV of roads over 15 years.

 NPV of WBM Road done three times

= 400 x 3 = Rs 1200 Lakhs

 NPV of Coal Tar Road = Rs 100 lakhs
There we see that the NPV of WBM Road done three times is higher vis-a vis the
NPV of Coal Tar Road.
Hence we should implement WBM Road three times.
Caution:
 It may not be correct to multiply NPV of WBM Road 3 times. The benefits increases
over time. The NPV of last WBM Road built in eleventh year would be more tan Rs
400 Lakhs. Hence this method should be applied very carefully.
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PROJECTS COMPLEMENT ON COSTS AND BENEFITS SIDE
Projects are Substitutes on Benefit Side
When ever multi purpose projects are built, they do not maximize individual benefits. A multi
purpose power project may not produce maximum power as it has to utilize water for
irrigation purpose also.
Maximised as it produces power also.

If PV of Benefit of Project for Power = PVBa

PV of Benefit of Irrigation =PVBb
PV of total benefits of power
and irrigation =PVBa+b
Here PVBa +PVBb > PVBa+b
If projects are taken up separately, then It could be that

PVBa =100
PVBa =60
If the projects are taken up together as a multi-purpose project, then
PVBa+b =120
Because utilisation of water for power and irrigation has take care of their both needs and 22