Project analysis

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Project analysis

PAE 22232 - Project Analysis • Quality: Projects must adhere to certain

quality standards. The quality of the project is
Concept and Attributes of a Project
defined by the requirements and expectations
• A project is a temporary endeavor that is of the stakeholders. Quality assurance and
designed to achieve specific goals and control processes must be put in place to
objectives within a defined timeline, budget, ensure that the project meets the required
and scope. It involves a unique set of activities standards.
that are planned and executed to achieve a
• Change: Projects are subject to change.
desired outcome.
Changes can occur due to various factors such
Some key concepts and attributes of a project are as as changes in requirements, scope, or
follows: external factors. It is important to manage
changes effectively to ensure that the project
• Goals and Objectives: Projects are designed to stays on track.
achieve specific goals and objectives. These
Classification of Project
goals and objectives provide a clear direction
for the project team and serve as a benchmark • The projects are basically defined in two
for measuring success. The goals and objectives aspects or categories: Defensive and
must be clearly defined, measurable, and Aggressive
achievable within the given constraints.
• Scope: The scope of a project defines the 1. Defensive Project is the project initiated to stabilize
boundaries of the project and identifies what is and sustain the current business situation.
included and excluded from the project. A well- 2. Aggressive Project is the project initiated to enter
defined scope helps ensure that the project team new business in a commercial manner and
stays focused on delivering the desired majorly depends upon the future prospective rather
outcome. than the current scenario
• Timeline: Projects have a defined timeline or
schedule. The timeline outlines the key • There is other classification of projects as well
milestones, deadlines, and deliverables that which is based on the need of execution and
must be achieved within a specific timeframe. the time, these can be categorized as:
It helps the project team to stay on track and • Normal Project: Where the time
deliver the project on time. limits are set and adequate.
• Budget: Projects have a budget or cost
associated with them. The budget outlines the • Brash Project: Where additional cost
resources required to complete the project, are involved to gain time.
including labor, materials, equipment, and • Disaster Project: Anything is allowed
other expenses. It helps to ensure that the to gain time.
project is completed within the allocated
resources. • Projects can be further classified into various
other classifications like national and
• Risk: Projects are associated with risk. Risk can international projects, industrial and non-
be defined as any event or circumstance that industrial projects, based on technology, size,
can impact the project outcome. Identifying ownership, public or private projects, need ,
and managing risk is essential to ensure that expansion or diversification projects.
the project is completed successfully.
• National and International Projects: This kind
• Stakeholders: Projects involve multiple of projects is categorized on the basis of
stakeholders, including the project team, geographical location set as countries. If one
sponsors, customers, and other interested country tries to build projects with other
parties. It is important to identify the foreign country, such projects are said to be
stakeholders and their requirements and International projects and when it is done in
manage their expectations throughout the one's own country, then it is said to be a
project. domestic or national project.

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• Industrial and Non-industrial Projects: The Information technology parks,

projects initiate in one's own country with an Electricity plants and other similar
objective to make money and for natured projects.
commercialization, are called industrial
• Need based projects: Projects are basically
projects. For example, a car manufacturing is
driven by certain needs of the organization
an industrial project. While the project which
and these needs furthers forms the basis of
are done for the upliftment of the society
project categorization as Balancing Project,
and majorly done with social welfare
Modernization Project, Expansion Project,
objectives, are called non-industrial projects.
Diversification Project, Rehabilitation Project
For example, Building of a canal, agricultural
and Plant Relocation Project.
development comes under non-industrial
projects; these are mainly carried up by the • Balancing Project: Augmenting or
government. strengthening the capacity of
particular area within a chain of entire
• Projects based on Technology: These are
production plant with a purpose of
largely high technology projects which require
scaling to the capacity in order to
lots of investment and works on new or non-
have optimum utilization, is balancing
existent technologies like rocket launch
project.
project, space projects, etc. and some other
are those projects which use technology • Modernization Project: Upgrading
which are already proven like a software ERP the technology to increase the
project, automobile automation project, etc. productivity and inevitable approach
of technology is called modernization
• Projects based on its size: These projects are
project.
based on investment size or capacity of plant
to offer goods or services. This can be further • Expansion Project: When the
classified down to small, medium and large- production capacity of goods and
scale projects. services is to be increased, the project
that is undertaken is known as
• Project based on ownership: This can be
expansion project.
further classified as
• Diversification Project: Project undertaken by
• Public sector project: Projects which
the organization to completely divert from its
are of the state, center or both forms
core business is called diversification project.
of governments, are known as public
For example, if a Petroleum company decides
sector projects
to enter into Information Technology
• Private sector project: Projects with a business, then the project will be known as
complete ownership of promoters diversification project.
and investors is known as private
• Rehabilitation Project: When a project is
sector projects. Owners may be an
started to revive a loss bearing company, is
individual, partnership firm or a
known as rehabilitation project.
company. These projects are mostly
done with an objective to earn profit • Plant Relocation Project: When an
and thus have a commercial nature. organization decides to shift its plant from
one location to another, the project started
• Joint sector project: In these projects,
will be known as relocation project.
there exist a partnership between the
entrepreneurs and the government; it Project Management
may be from government. These
types of partnership occur on the • Project management is the art of directing
grounds of expertise and laisioning and coordinating the human and material
work and government arranges for resources throughout the project by using
the fund in large amounts. For modern management techniques.
example, Project of Train, Dams,

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• Project management is a set of skills and • Keeping up the quality of the project
techniques used to plan, organize, and
Project Management – Challenge
execute projects effectively and efficiently.
For successful project management, one must • So, Project Management is the discipline of
have a clear understanding of the project planning, organizing, and managing resources
goals, scope, timelines, and budget. to bring about the successful completion of
specific project goals and objectives.
• The main purpose of project management is
to achieve the predetermined objectives of • The primary challenge of project management
scope, cost, time, quality and the satisfaction is to achieve all of the project goals and
of the participant. objectives while adhering to classic project
constraints--usually scope, quality, time and
• Project management requires developing a
budget.
project plan, which outlines the tasks to be
completed, the resources needed, and the • The secondary and more ambitious--challenge
timelines for each task. This plan will also is to optimize the allocation and integration of
need to identify risks and potential issues that inputs necessary to meet pre-defined
may arise during the project and include objectives. A project is a carefully defined set
contingency plans to mitigate them. of activities that use resources (money,
people, materials, energy, space, provisions,
• During the project, one needs to manage the
communication, motivation, etc.) to achieve
team, track progress, and communicate
the project goals and objectives.
regularly with stakeholders to ensure that the
project is on track and meeting expectations. THE PROJECT MANAGER
The project plan must also accommodate
changes and unforeseen events. • Organizations face different challenges while
managing a project due to various reasons
Project Management –Activities such as lack of management skills and
disputes among the team members.
• Project management includes developing and
implementing a plan for the project while • Project manager is the individual who
considering the available resources such as manages the project effectively and
manpower, material and cost in the efficiently.
organization. Project management involves
the following activities: • In every organization, it is the duty or
responsibility of the project manager to
• Planning and analysing the objectives manage the projects
of the project
• Following are the different challenges in
• Measuring and controlling the risk- project management:
involved in the project
• Unrealistic deadlines: The biggest challenge
• Estimating the organizational project managers face is to complete the
resources required in the project project on time and meet project deadlines.
• Assigning tasks to the employees • Communication deficit: In most organizations,
related to the project project managers and team members do not
give adequate information to the customers.
• Directing and motivating employees
to improve their performance • Resource competition: There is a lot of
competition in resources required for projects
• Organizing project activities
due to availability of the resources such as
• Formulating the project manpower and material in the organization

• Forecasting trends in the project • Undefined vision and goals: Sometimes, the
goals of a project are not clearly defined.
• Completing the project on time

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• Failure to manage risk: Risk is involved in each

and every project.
Why do agricultural projects fail? …
• Insufficient team skills: The biggest challenge
• • Failure to appreciate the social and political
in managing a project is
environment.
• insufficient skills of team members
• • Administrative problems.
Project analysis
• Changing economic situations and market
• Project analysis is the assessment of every conditions.
expense or problem related to a project, prior
• Externally driven project initiatives.
to the commencement of work on it. After
evaluating the profitability of a project, the • Problems related to poor project analysis.
selection process is undertaken.
• Unrealistic expectations.
Why projects fail?
In Summary….
• Inadequate preparation
• It is necessary choose the best proposal
• Lack of data, outdated information, among large number of competing proposals
inadequate background information for implementation.
• Too many objectives, vague objectives • Main criteria- The project should be capable
enough to generate sufficient revenue to
• Unrealistic time targets
repay the loans or other benefits to justify the
• Unrealistic assumptions investment.

• Poor feasibility studies • How much you will get?..... Will depend on
your capacity to make a good deal with
• Inadequate supervision & monitoring
resource providers.
• Natural causes
• A well formulated comprehensive project
Why do agricultural projects fail? proposal will enhance your capacity to
negotiate for a better deal.
• History records the dismal failure of the so-
called project approach. What are the reasons Project life Cycle
for this? The concept clearly proves to be
• The Project Life Cycle refers to a series of
sound. It may, however, be that the project
activities which are necessary to fulfill project
design is flawed or that implementation is at
goals or objectives.
fault; it may be a poor inaccurate project
analysis; or it may be unforeseen economic, • Projects vary in size and complexity, but, no
natural or political changes. matter how large or small, all projects can be
mapped to the following life cycle structure:
A comprehensive list of “where things went wrong”
Starting the project, Organizing and
will include the following:
preparing.
• A lack of local ownership and responsibility,
• Most of the projects are likely to be private
ie. participative planning and development.
sector driven. They may be manufacturing
• Problems of project design and projects or they could be petrochemical or
implementation. civil engineering projects.

• The use of inappropriate technology, cropping • Your key task, as a project evaluator, is to
systems and animal husbandry. carefully consider each and every project
brought to your attention and see how useful
• Inadequate or inappropriate infrastructure. or valuable they are.
• A weak support system. • A project cycle tries to describe the various
stages that are involved, from the conception

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of a project idea to when the project is • Effective stakeholder management is

executed or actually takes off. essential for project success.

• There are multiple stakeholders involved in

each project. Some of the common
stakeholders involved in project management
• Initiation: are as follows:

The initiation phase marks the start of the project. • Project Sponsor
This is the phase where the project is defined, its
• Project Manager
goals and objectives are established, and its feasibility
is assessed. During this phase, the project team is • Project Team: The project team is responsible
identified, stakeholders are identified, and the project for executing the project's activities and
charter is developed. delivering the project's outputs. They may
include individuals from different
• Planning:
departments or functions within the
The planning phase is where the project plan is organization or external consultants.
developed. This includes identifying the scope of the
• Customers:
project, creating a work breakdown structure,
identifying resources, developing a schedule, and Customers are the people or organizations who will
defining the budget. The project team also identifies use or benefit from the project's outputs. They may
and analyzes potential risks during this phase and be internal or external to the organization.
comes up with risk management strategies.
• Suppliers:
• Execution:
• Suppliers are the people or organizations
The execution phase is where the project work is who provide the resources, materials, or
performed. This includes implementing the project services required for the project's success.
plan, managing resources, and monitoring and They may include vendors, contractors, or
controlling the project work. The project team also service providers. Regulators: Regulators are
communicates progress to stakeholders and makes the government or regulatory bodies that
necessary adjustments to keep the project on track have an interest in the project's outcomes.
They may set standards or guidelines that the
• Monitoring and Control:
project must adhere to.
The monitoring and control phase is where the
• Effective stakeholder management involves
project team monitors the project's progress against
identifying the stakeholders, understanding
the plan, identifies variances, and takes corrective
their interests, expectations, and
action. This includes tracking progress, managing
requirements, and engaging them
change requests, and managing risk.
throughout the project's lifecycle. It is
• Closure: essential for managing project risks,
managing change, and ensuring successful
The closure phase marks the end of the project. completion of the project.
During this phase, the project team completes all the
remaining tasks, obtains final approval from PROJECT ORGANIZATION
stakeholders, and closes the project. The team also
• Project organization refers to the specific
conducts a final review to identify the lessons learned
structure, roles, and responsibilities assigned
from the project
to individuals and teams involved in a project.
Stakeholders of a Project Let's understand this with the help of an
example. Suppose a large manufacturing
• Stakeholders are individuals or groups who company wants to launch a new product line.
have an interest or stake in the outcome of a To do so, they will need to create a project
project. They can affect or be affected by the team with the necessary skills and resources
project's activities, decisions, and results. to manage the project from start to finish.

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• The project organization structure may look often used in organizations where projects are critical
something like this: to the business but not the primary business function.

• Project Sponsor Work Breakdown Structure (WBS)

• Project Manager • Work Breakdown Structure (WBS) is a

hierarchical decomposition of project tasks,
• Project Team
deliverables, and work elements that
• Steering Committee: This group of senior organizes and defines the total scope of the
executives provides oversight and guidance to project. It is a critical tool in project
the project manager and project team. They management, used to break down the project
review project progress, provide direction, into smaller, more manageable components,
and make key decisions. and to establish a framework for organizing
and tracking project tasks. The WBS typically
• Stakeholders starts with the main project deliverable, and
Types of Project Organization then breaks it down into smaller, more
manageable components or work packages.
There are three main types of project organization These work packages can then be further
structures: broken down into smaller, more specific tasks,
1. Functional Organization: In this type of project which can be assigned to individual team
organization, the project team members are drawn members for execution. The WBS should be
from different functional areas of the organization, developed in collaboration with the project
such as engineering, marketing, and finance. Each team and stakeholders to ensure that all key
team member reports to their respective functional project elements are included and that
manager, and the project manager has limited everyone is clear on their responsibilitie
authority. The functional manager is responsible for Benefits of using a WBS in project management
the team member's performance, and the project
manager is responsible for coordinating and • Improved project planning
integrating the team's work • Better communication
2. Projectized Organization: • Enhanced project tracking and monitoring:
In this type of project organization, the project team • Increased stakeholder engagement
members are organized into a separate project team
for each project. Each team member reports directly PROJECT IDENTIFICATION
to the project manager, who has complete authority
• Project identification is the first step in the
and control over the project. The project manager is
project management process. It involves
responsible for managing the project budget,
identifying potential projects that align with
schedule, and resources. This structure is often used
an organization's goals and objectives,
in organizations where project work is the primary
evaluating them, and selecting the best
business function.
project(s) to pursue.
3. Matrix Organization:
• The goal of project identification is to
In this type of project organization, the project team determine whether a project is worth
members are drawn from different functional areas of pursuing and whether it has the potential to
the organization, and each team member has two provide a return on investment.
reporting lines – to their functional manager and to
• The steps involved in project identification are
the project manager. The project manager has
as follows
moderate authority, and the functional manager has
partial authority. This structure combines the  Idea generation:
strengths of functional and projectized organizations,
The first step in project identification is to generate
allowing organizations to balance resources and
ideas for potential projects. Ideas can come from
expertise while maintaining flexibility. This structure is
various sources, including customers, employees,

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management, and stakeholders. Brainstorming

sessions and market research can also help in
 Feasibility study
generating ideas.
Once the ideas have been screened, the next
Systems for Idea Generation
step is to conduct a feasibility study on the
 Formal system remaining ideas. The feasibility study helps in
- A management committee determining whether the project is technically
feasible, financially viable, and meets other criteria
-Planning department or group
such as legal and regulatory compliance.
-Strategy group
 Project selection
-Periodic strategic planning exercise
Based on the results of the feasibility study,
-Management audit the next step is to select the best project(s) to
pursue. The selection process involves evaluating the
-Periodic consulting by external expert potential projects against the organization's
 Semi-formal system goals, objectives, and available resources.
- Suggestion box system and committees  Project charter
- Innovation committees After selecting a project, the next step is to
- Joint departmental committees develop a project charter. A project charter
outlines the project's objectives, scope, timelines,
- Quality circles budgets, resources, and stakeholders. The
- Dialogue session and open house project charter helps in providing a clear
direction and framework for the project
- Task forces and individual reports/Proposals
FEASIBILITY STUDIES
 Informal system
- Individual experiments • Some investment proposals pass through the
stage of project feasibility study. Large
- Individuals encouraged to work as task-force projects usually need a feasibility test before a
significant amount of money is committed.
 Screening:
The strategic content in such projects is high
 After generating project ideas, the next step is
but availability or relevance of internal data is
to screen them. The screening process
less.
involves evaluating the ideas against a set of
criteria, such as feasibility, market potential, • Project feasibility is a test where the viability
and alignment with organizational goals. The of investment is evaluated. Evaluation is
purpose of screening is to eliminate ideas that based on secondary but comprehensive data.
are not feasible or do not align with There are basically three types of feasibilities
organizational goals. evaluated in the project feasibility study:
 An idea that is very risky and novel would a. Market feasibility
typically go through the following steps:
b. Technical feasibility
 Initial brainstorming
c. Financial feasibility
 Concept testing
Market Feasibility
 First feasibility report
• Market feasibility study aims at assessing the
 Market survey potential sales of a proposed product, if any.
This is also known as market analysis. The
 Test marketing or pilot project study of market feasibility is based on the
 Market research following factors:

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• Study of general economic factors and • Time Series Projection Method

indicators
• Trend projection method
• Demand estimate
• Exponential smoothing method
• Supply estimate
• Moving average method
• Identification of critical success
• Causal Methods: Chain ratio method,
factors
consumption level method, end use method,
• Estimating demand-supply gap bass diffusion method, leading indicator
method, econometric method
(a) General economic indicators
c) Supply estimate
• The demand potential of any product is likely
to have some kind of association with some • The past trend of supply of goods can be
economic indicators. Changes in demand and studied and further extrapolated. Projections
changes in a particular or some economic so made need to be adjusted with the help of
indicators may take place simultaneously or additional information like new projects
with lead or lag. Some of the important planned by businesses in the economy,
economic indicators include gross domestic import possibility as governed by import
product, per capita income, income disparity, policy, import tariff and international prices.
rate of urbanization, population growth rate, Information regarding entry barrier is also
literacy rate, government spending, money useful.
supply and others.
d) Estimating demand-supply gap
b) Demand estimate
• Demand and supply estimates, fine-tuned
Demand projection is a most important step in project with the changing factors, are compared with
feasibility study. Salient points related to demand each other for finding a gap. Demand-supply
estimation are given below: gap, for relevant geographical territory only, is
meaningful. It is quite likely that the forecast
• End-user profile
of demand and supply may not be a single
• Study of influencing factors point forecast. It may be in terms of various
scenarios.
• Regional, national and export market
potential • The demand and supply projections given
Table shows calculation of demand-supply
• Infrastructure facilities which may facilitate or gap for a particular product in the next five
constrain demand years.
• Demand forecasting:

-Qualitative methods Time Series Projection

Method

-Causal Methods

Demand forecasting
Demand and Supply Projections for Smartphones (in
• Qualitative method
units)
• Jury of executive method: This
method involves soliciting the opinion
of a group of managers on expected
future sales

• Delphi Method: This method is used

for eliciting the opinions of a group of
experts with the help of a mail survey.

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changing demand patterns and avoid excess

inventory.

II. Technical Feasibility

• Technical Feasibility" in project analysis refers

to the assessment of whether the proposed
project can be successfully implemented from
a technological perspective. It involves
evaluating the technical requirements,
capabilities, and constraints associated with
the project to determine if the necessary
• Assumptions: technology and expertise are available to
bring the project to completion.
• Yearly Growth Rate:
• Key components of technical feasibility
• The demand for smartphones is projected to analysis include:
grow at a yearly rate of 20% based on market
trends and consumer preferences. • Technology Requirements: Identify and
specify the technologies needed for the
• Supply Capacity: project. This could include hardware,
• The supply capacity is projected to increase software, equipment, and other technical
gradually due to production improvements, resources.
expanded manufacturing capabilities, and • Technical Expertise: Assess whether the
efficient supply chain management. required technical skills and expertise are
• Market Dynamics: available within the project team or if
additional training or hiring is necessary.
• The market is expected to experience
occasional fluctuations due to factors like new • Compatibility: Evaluate the compatibility of
product releases, technological the proposed technology with existing
advancements, and economic conditions. systems, infrastructure, and industry
standards. Ensure that the new technology
Observations and Analysis: can seamlessly integrate with the current
• In 2024, there is a demand-supply gap of environment.
20,000 units (100,000 demand - 80,000 • Risk Assessment: Identify and analyze
supply). potential technical risks and challenges that
• The gap narrows in 2025 as supply increases may arise during the project implementation.
to meet growing demand. This could include issues related to scalability,
data security, and technology dependencies.
• By 2026, the demand-supply gap is further
reduced, and supply is closer to meeting the • Prototyping and Testing: Consider developing
demand. prototypes or conducting testing to validate
the technical feasibility of the project. This
• In 2027 and 2028, supply has been increased allows for early identification of technical
to meet and potentially exceed the growing issues and adjustments.
demand, resulting in a surplus.
• Regulatory and Compliance Considerations:
• Key Considerations: Ensure that the project complies with relevant
regulations and industry standards. Assess
• The company may need to invest in increased
whether the proposed technology aligns with
production capacity, optimize the supply
legal and regulatory requirements.
chain, or adjust manufacturing processes to
close the initial demand-supply gap. • Resource Availability: Evaluate the availability
of key technical resources, including skilled
• Ongoing market monitoring and adjustments
personnel, materials, and equipment. Ensure
are necessary to align production with

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that there are no significant shortages that financial costs emanating from the financing
could impede project implementation. alternative considered for the project.

• Cost Estimation: Estimate the costs associated • This provides enough information for the
with acquiring and implementing the required calculation of the financial bottom line of the
technology. This includes not only the initial project. The financial feasibility check involves
investment but also ongoing maintenance and a detailed financial analysis. Financial analysis
operational costs. includes quite a few assumptions and
calculations. Some are briefly described
• If there is an ample market demand without
below:
enough supply, the focus should shift over to
technology. The following inquiries must be • Estimates
made with respect to technology analysis:
Projections are made for price of product, the cost of
a) Availability of commercially exploitable various resources required for manufacturing goods
technology and its alternatives: and capacity utilization. Use of the thumb rule or
actual data of some comparable projects are generally
If technology is available, then should one buy the
included in the estimates.
latest technology or would an old one be fine?
Usually, in a cheap labour economy, less than the • Period of analysis
latest technology works fine from the labour-to-
The period of estimate is determined and the terminal
capital ratio angle. However, the choice has to
value of the project is forecast. The period of estimate
depend on the effects of technology on the
should be justified by factors like, the product life
desired quality of product and cost of product
cycle, business cycle, ability to forecast, period of debt
versus investment needed in a given technology.
funds, etc.
b) Transferability of those technologies
• Financing alternatives
• Whether the transfer of technology is possible
Financing alternatives are considered and a tentative
from the political angle
choice of financing mix is made together with
• Whether transfer of technology is possible assumptions regarding the cost of funds and
from the operations (environment) angle repayment schedules

• Either due to the import restrictions imposed • Basic working

by the government or because of export
Based on assumptions and estimates, some schedules
restriction or economic sanctions imposed by
are prepared. Some of the schedules made for this
an exporting nation, a particular technology
purpose include:
cannot be transferred. In today’s regime of
the World Trade Organization, normally one • Debt servicing schedule (interest payment
cannot expect import restrictions (unless and principal repayment schedule)
there is no political relationship between the
two countries) but economic sanctions from • Working capital schedule
the exporting nations are quite possible, • Working financing schedule (working capital
making it impossible to transfer technology loan, interest and repayment schedule)
from one country to another. Sometimes, the
technology owner may not be willing to • Depreciation schedule for income tax purpose
transfer the technology. • Schedule of cash flow from operations
III. Financial Feasibility • Project cash flow schedule
• Demand and price estimates are derived from Financial indicators
the market feasibility study. Project costs and
operating costs are derived from the technical • Financial indicators play a crucial role in
feasibility study. The estimates need to be project analysis by providing quantitative
supplemented with tax implications measures to assess the economic viability,
depending upon the prevailing tax laws and profitability, and financial health of a project.

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These indicators help stakeholders make • Return on Equity (ROE)

informed decisions about whether to invest • Break-Even Point (BEP)

in, continue, or terminate a project. Impact of delays in project completions

• Based on the projected financial statements, • Project delays can plague any industry, any
some important financial indicators are team and any individual project.
calculated for a quick viability check. Here are
• Delay and cost overrun are intrinsic part of
some key financial indicators commonly used
most projects despite the much acquired
in project analysis
knowledge in project management. Although
• The interest cover ratio (also known as times- some may argue that this is negligible.
interest-earned or TIE)
• A project delay can represent a costly
Since indicates the safety and timely payment occurrence for any organization especially in
of interest to the lenders of money, it is calculated the present age of cut throat competition and
with the help of the following formula: diminishing margins.
• Therefore, it is important for an organization
• Interest Cover Ratio = PAT + Interest Expense/
to understand what causes a delay and how
Interest Expense
to prevent it from occurring. The major causes
• The payback period (PBP) of project delay are as follows:
• Design errors
• Discounted payback period • Subcontractor Delays
• The net present value (NPV) • Scope change
• Shipping and Supply Delays
• The internal rate of return (IRR) • Inappropriate and inadequate
• MIRR procurement
• Climate Delays
• Profitability Index (PI) • Complexity of project
• Client-End Delays
• Sensitivity Analysis
• Post execution phase Delay
• Return on Investment (ROI):

ROI calculates the percentage return on an

investment relative to its cost. It is expressed as a
percentage and is calculated using the formula:

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• Risk Analysis: This section identifies and

assesses the risks associated with the project
and provides a risk management plan to
mitigate those risks.

• Project Organization and Management

This section outlines the organizational structure of

the project team, including roles and responsibilities.
It also provides details on project management tools,
communication channels, and reporting mechanisms.

• Project Implementation Plan:

This section provides a detailed implementation plan,

including timelines, milestones, and resource
allocation.

• Monitoring and Evaluation Plan: This section

outlines the monitoring and evaluation plan
for the project, including the indicators to be
Preparation of Detailed Project Report used to measure progress and the methods to
be used to evaluate project outcomes.
• A Detailed Project Report (DPR) is a
comprehensive document that outlines the • Conclusion: This section summarizes the key
various aspects of a project in detail. It serves findings of the report and provides
as a roadmap for project execution and recommendations for project
provides a clear understanding of the implementation.
project's scope, objectives, timelines,
resource requirements, risks, and Questions
deliverables. 1. State the benefits of project management.
• Contents of a DPR: 2. What are the challenges in project management?
The DPR typically includes the following sections: 3. Discuss the major causes for delay in project
Introduction: This section provides an overview of the management
project, including its background, objectives, and 4. Describe the 5 stages of project lifecycle
scope.
5. Who are the common stakeholders in a project?
Project Description: This section provides a detailed
description of the project, including its methodology, 6. List the steps involved in project identification.
timelines, deliverables, and resource requirements. 7. Describe the contents of DPR.
• Market Analysis: This section provides a
detailed analysis of the market in which the
project will operate, including an assessment Detailed Project Report
of the competition, customer needs, and
Example:
market trends.
The project is to design and develop a mobile
• Technical Feasibility: This section assesses the
application that helps users track their daily water
technical feasibility of the project, including
intake and reminds them to stay hydrated throughout
the availability of technology, infrastructure,
the day. The application will be available for both iOS
and human resources.
and Android platforms.
• Financial Analysis: This section assesses the
The DPR for this project can be prepared in the
financial viability of the project, including an
following manner.
analysis of the project's costs, revenue
potential, and profitability. Define the Project Objectives and Scope:

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The project objectives are to:  Creating a development environment with the
necessary tools and infrastructure.
 Develop a mobile application that helps users
track their daily water intake and reminds Prepare a Financial Plan:
them to stay hydrated.
The financial plan includes:
 Improve users' health and well-being by
 Identifying the project costs, including
promoting healthy hydration habits.
salaries, infrastructure, and marketing
 Generate revenue by selling the application expenses.
to users.
 Developing a revenue model based on the
The project scope includes: application's price and projected sales
volume.
 Designing and developing the application for
both iOS and Android platforms.  Analyzing the project's financial viability,
including the return on investment and
 Integrating the application with third-party
break-even analysis.
tools for tracking and analysis.
Develop a Risk Management Plan:
 Testing and debugging the application.
The risk management plan includes:
 Launching the application in the market.
 Identifying potential risks such as
Conduct a Feasibility Study technical issues, market competition, and
The feasibility study includes: regulatory compliance.

 Technical feasibility: We have the necessary  Developing strategies to mitigate the

expertise in mobile app development and can risks, such as implementing a quality
leverage existing technologies to develop the assurance process, conducting market
application. research, and adhering to regulatory
guidelines.
 Financial feasibility: The project budget is
estimated to be $100,000, which can be  Establishing a contingency plan in case of
funded through a combination of investment unforeseen circumstances.
and revenue generated from the sale of the Create a Monitoring and Evaluation Plan:
application.
The monitoring and evaluation plan includes:
 Operational feasibility: We have a skilled team
of developers who can work on the project,  Establishing key performance indicators
and we can source additional resources as such as application downloads, user
needed. engagement, and revenue.

Develop a Project Implementation Plan:  Developing a reporting mechanism to

track progress and evaluate outcomes.
The project implementation plan includes:
 Conducting periodic reviews to assess the
 Establishing a project team with a project
project's performance and identify areas
manager, developers, and a quality assurance
for improvement.
team.
Compile the Detailed Project Report:
 Assigning roles and responsibilities to team
members. The DPR should be structured in a logical manner,
with clear headings and sections. It should include all
 Developing a project schedule with clear the relevant information needed to make informed
milestones and deadlines. decisions about the project, such as the project
 Establishing a communication plan with description, feasibility study, project implementation
regular team meetings and progress reports. plan, financial plan, risk management plan, and
monitoring and evaluation plan.

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Time Value of Money  Interest paid (earned) on only the original

 An important principle in f inance is that amount, or principal, borrowed (lent).
the value of Compound Interest
money is time dependent.
 Interest paid (earned) on any previous interest
 The value of a unit of money is different in earned, as well as on the principal borrowed (lent).
different
time periods. Simple Interest Formula
 The value of a sum of money received
Formula
today is more
than its value received after some time. SI = P0(i)(n)
 Conversely, a sum of money received in SI: Simple Interest
future is less P0: Deposit today (t=0)
valuable than it is today. i: Interest Rate per Period
 The time value of money is also referred n: Number of Time Periods
as time
preference for money.

Reasons for Time Value of Money

Investment Opportunities: Money has the Simple Interest Example
potential to grow over a period of time
because it can be invested somewhere. For •Assume that you deposit Rs.1,000 in a saving
example, if Rs. 1000 can be invested in a f account paying 8% simple interest for 10 years. What
ixed deposit for one year at 7% p.a., the is the accumulated interest at the end of the 10
money will grow to Rs, Rs. 1070 at the years?
end of one year. Therefore, given the
 SI = P0(i)(n)
choice of Rs. 1000 now or the same = 1,000(.08)(10) = 800
amount in one year’s time, it is always
preferable to take Rs. 1000 now.  FV10= 1000+800=1800
Inflation: Inflation is the fall in the Compound interest(Formula)
purchasing power of money. It makes Compound interest can be calculated by using
money cheaper and the goods and services following formula.
costlier. Suppose you can buy 1 kg of rice
with Rs. 50 today. If the inf lation rate is FVn = P0 (1+i)n
10%, You need Rs. 55 to buy 1 kg of rice a or FVn = P0 (FVIFi,n)
year from now. P= Present value
Risk: Money received now is certain, i = Interest rate the bank pays you.
whereas money tomorrow is less certain.
Future Value
This ’bird in the hand’ principle is
 Compounding is the process of f inding the
extremely important in investment
future values of cash f lows by applying the
appraisals.
concept of compound interest.
Personal consumption preference: Many
 The general form of equation for calculating
people have a strong preference for
the future value of a lump sum after n periods
immediate rather than delayed
may, therefore, be written as follow:
consumption. For a hungry man, promise
FVn = P0 (1+i)n
of a meals next month means nothing.
 The term (1+i) n is the Future value factor
Calculating future values
(FVF) of a lump sum of Rs. 1, and it
 The interest rate always has a value greater than 1 for
 Simple interest positive i, indicating that FVF increases as
 Compound interest i and n increase.
 Muliti- period compounding FVn= P0 x FVF n,i
Future Value Single Deposit
Typs of interest Assume that you deposit Rs.1,000
Simple Interest at a compound interest rate of 8% for one
year.

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FV1 = P0 (1+i)1 Example

= 1,000 (1.08)
= 1,080 •If you deposit Rs.50,000 in a bank which is paying 8
Assume that you deposit Rs.1,000 at a compound percent compounded interest per year of a 5 year
interest rate of 8% for 10 years. time deposit, how much will you have accumulated
after 5 years?
FV1 = P0 (1+i)1 = 1,000 (1.08)
= 1,080 Frequency of Compounding
=1080(1.08)
General Formula:
FVn = PV0 (1 + [i/m])mn
FV2 = P0 (1+i)(1+i) =1,000(1.08)(1.08)
= P0 (1+i)2 = 1,000(1.08)2 = 1,166.40 n: Number of Years
m: Compounding Periods per Year
FV8 = 1000(1.08)^10=3158.90-800 i: Annual Interest Rate
You earned an EXTRA Rs.1358.92 in Year 10 with FVn,m: FV at the end of Year n
compound over simple interest. PV0 : PV of the Cash Flow today
Impact of Frequency

Three Ways to Find FVs

-Solve the equation with a regular calculator.

-Use a FV table.

-Use a spreadsheet.

Using Future Value Tables

Effective Annual Interest Rate

Effective Annual Interest Rate

The actual rate of interest earned (paid) after

adjusting the nominal rate for factors such as the
number of compounding periods per year.

EIR = (1 + [ i / m ] )m – 1

Example
Future Value of a Single Amount
Suppose you invest Rs.1,000 CD in a bank. The
(Spreadsheet Example)
interest rate is 6% compounded quarterly for 1 year.
-FV(rate,nper,pmt,pv,type) What is the Effective Annual Interest Rate (EAR)?

-fv is the future value Effect of Compounding Frequency on Future Value &
EAR
-Rate is the interest rate per period
Find the future value at the end of one year if the
-Nper is the total number of periods present value is Rs.20,000 and the interest rate is
-Pmt is the annuity amount 16%. Use the following compounding frequencies:
 Annual Compounding
-pv is the present value  Semiannual Compounding
 Quarterly Compounding
-Type is 0 if cash flows occur at the end of the period
 Monthly Compounding
-Type is 1 if cash flows occur at the beginning of the  Daily Compounding
period Effect of Compounding Frequency on Future Value

-Example: =fv(8%,2,0,-1000,0) is equal to 1166.40

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Examples
1. Find out compound value of Rs.1,000, interest
rate being 12 percent per annum if compounded
annually, semi-annually, quarterly and monthly.

2.Suppose Bank A pays 15% interest on deposit,

compounded monthly. Bank B pays 15% interest
on deposit, compounded quarterly. Bank C pays
15% interest on deposit, compounded half yearly.
Fin Find the effective annual rate.

Future Value of an Annuity

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Nature of Investment Decisions • It should recognise the fact that bigger

• The investment decisions of a firm are cash flows are preferable to smaller ones
generally known as the capital budgeting, and early cash flows are preferable to later
or capital expenditure decisions. ones.
• The firm’s investment decisions would • It should help to choose among mutually
generally include expansion, acquisition, exclusive projects that project which
modernisation and replacement of the maximises the shareholders’ wealth.
long-term assets. Sale of a division or • It should be a criterion which is applicable
to any conceivable investment project
business is also as an investment decision.
independent of others.
• Decisions like the change in the methods
DETERMINING CASH FLOWS FOR INVESTMENT
of sales distribution, or an advertisement ANALYSIS
campaign or a research and development • Sound investment decisions should be
programme have long-term implications based on the net present value (NPV) rule.
for the firm’s expenditures and benefits,
and therefore, they should also be • Problems to be resolved in applying the
evaluated as investment decisions. NPV rule
– What should be discounted? In
Features of Investment Decisions theory, the answer is: We should
• The exchange of current funds for future always discount cash flows.
benefits. – What rate should be used to
• The funds are invested in long-term assets. discount cash flows? In principle,
• The future benefits will occur to the firm the opportunity cost of capital
over a series of years. should be used as the discount rate.
Types of Investment Decisions CASH FLOWS VERSUS PROFIT
• One classification is as follows: • Cash flow is not the same thing as
– Expansion of existing business profit, at least, for two reasons.
– Expansion of new business – First, profit, as measured by an
– Replacement and modernisation accountant, is based on accrual
• Yet another useful way to classify concept.
investments is as follows: – Second, for computing profit,
– Mutually exclusive investments expenditures are arbitrarily divided
– Independent investments into revenue and capital
– Contingent investments expenditures.
Investment Evaluation Criteria CF  (REV  EXP  DEP)  DEP  CAPEX
• Three steps are involved in the evaluation
of an investment: CF  Profit  DEP  CAPEX
1. Estimation of cash flows
2. Estimation of the required rate of INCREMENTAL CASH FLOWS
return (the opportunity cost of • Every investment involves a comparison
capital) of alternatives:
3. Application of a decision rule for – When the incremental cash flows
making the choice for an investment are calculated by
Investment Decision Rule comparing with a hypothetical
• It should maximise the shareholders’ zero-cash-flow project, we call
wealth. them absolute cash flows.
• It should consider all cash flows to – The incremental cash flows found
determine the true profitability of the out by comparison between two
project. real alternatives can be called
• It should provide for an objective and relative cash flows.
unambiguous way of separating good • The principle of incremental cash flows
projects from bad projects. assumes greater importance in the case of
• It should help ranking of projects replacement decisions.
according to their true profitability.
Example 1

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• Suppose a firm is considering replacing an Net cash flow Revenues Expenses Taxes
equipment at book value of Rs. 5000 and NCF REV EXP TAX
market value of Rs. 3000. New equipment • The computation of the after-tax cash
will require an initial cash outlay of Rs flows requires a careful treatment of non-
10,000, and is estimated to generate cash cash expense items such as depreciation.
flows of Rs 8,000, Rs 7,000 and Rs 4,500 • Depreciation, calculated as per the income
for the next 3 years. tax rules influences cash flows indirectly
• The book value of old machine is a sunk by way of depreciation tax shield.
cost. Market value is opportunity cost. Example
• Thus, on an incremental basis the net cash
outflow of new equipment is: Rs 10,000 –
Rs 3,000 = Rs 7,000.
• Also, The differences of the cash flows of
new equipment over the cash flows of old
equipment are incremental cash flows.
COMPONENTS OF CASH FLOWS
• Initial Investment
• Net Cash Flows
– Depreciation and Taxes
– Net Working Capital
• Change in accounts
receivable
• Change in inventory
• Change in accounts • Calculate operating cash flow. =
payable 17,160+75,000=92160
– Free Cash Flows
• Terminal Cash Flows Net working capital
– Salvage Value
• It is the difference between change in current
• Salvage value of the new
asset assets (e.g., receivable and inventory) and
• Salvage value of the change in current liabilities (e.g., accounts
existing asset now payable) to profit.
• Salvage value of the • Increase in net working capital should be
existing asset at the end of subtracted from and decrease added to after-
its normal tax operating profit.
• Tax effect of salvage
value NCF EBIT (1 T ) + DEP NWC
– Release of Net Working Capital
Initial Investment Terminal Cash Flow: Salvage Value
• Initial investment is the net cash outlay in
the period in which an asset is purchased. • Salvage value is a terminal cash flow.
• A major element of the initial investment • Salvage value may be defined as the market
is gross outlay or original value (OV) of
price of an investment at the time of its sale.
the asset, which comprises of its cost
(including accessories and spare parts) and • No immediate tax liability (or tax savings)
freight and installation charges. arises on the sale of an asset because the
• Original value is included in the existing value of the asset sold is adjusted in the
block of assets for computing annual depreciable base of assets.
depreciation.
Net Cash Flows Cash Flow Estimates for New Products
• Consist of annual cash flows occurring
• It depends on forecasts of sales and operating
from the operation of an investment, but it
expenses.
is also be affected by changes in net
working capital and capital expenditures • Sales forecasts require information on the
during the life of the investment. quantity of sales and the price of the product.

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• Anticipation of the competitors’ reactions. • Suppose that a project requires a cash outlay
of Rs 20,000, and generates cash inflows of Rs
Cash Flow Estimates for Replacement Decisions
8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during
• The initial investment of the new machine will the next 4 years. What is the project’s
be reduced by the cash proceeds from the payback?
sale of the existing machine.
3 years + 12 × (1,000/3,000) months
• The annual cash flows are found on
3 years + 4 months
incremental basis.
DISCOUNTED PAYBACK PERIOD
• The incremental cash proceeds from salvage
value is considered. • The discounted payback period is the number
of periods taken in recovering the investment
Evaluation Criteria
outlay on the present value basis.
– Payback Period (PB)
• The discounted payback period still fails to
– Discounted payback period (DPB) consider the cash flows occurring after the
payback period.
– Accounting Rate of Return (ARR)
ACCOUNTING RATE OF RETURN METHOD
– Net Present Value (NPV)
• The accounting rate of return is the ratio of
– Internal Rate of Return (IRR) the average after-tax profit divided by the
– Modified Internal Rate of Return average investment. The average investment
(MIRR) would be equal to half of the original
investment if it were depreciated constantly.
– Profitability Index (PI)

PAYBACK

• Payback is the number of years required to

recover the original cash outlay invested in a
project. • A variation of the ARR method is to divide
• If the project generates constant annual cash average earnings after taxes by the original
inflows, the payback period can be computed cost of the project instead of the average
by dividing cash outlay by the annual cash cost.
inflow. That is: Example

Initial Investment C • A project will cost Rs 40,000. Its stream of

Payback =  0 earnings before depreciation, interest and
Annual Cash Inflow C
taxes (EBDIT) during first year through five
Example years is expected to be Rs 10,000, Rs 12,000,
Rs 14,000, Rs 16,000 and Rs 20,000. Assume a
Assume that a project requires an outlay of Rs
50 per cent tax rate and depreciation on
50,000 and yields annual cash inflow of Rs 12,500
straight-line basis.
for 7 years. The payback period for the project is:

Rs 50,000
PB   4 years
Rs 12,500
• Unequal cash flows In case of unequal cash Calculation of Accounting Rate of Return
inflows, the payback period can be found out
by adding up the cash inflows until the total is
equal to the initial cash outlay.

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 C C2 C3 Cn 
NPV   1      C0
 (1  k ) (1  k ) (1  k ) (1  k ) n 
2 3
Acceptance Rule
• This method will accept all those projects n
Ct
whose ARR is higher than the minimum NPV    C0
t 1 (1  k )
t
rate established by the management and
reject those projects which have ARR less
than the minimum rate. Example
• This method would rank a project as • Consider an investment which has the
number one if it has highest ARR and following cash flows:
lowest rank would be assigned to the • Initial investment is 32,000/-
project with lowest ARR. • Compute NPV at 14% Cost of capital/
Evaluation of ARR Method
discount rate. Should this project be
accepted or not?
• The ARR method may claim some merits
Evaluation of the NPV Method
 Simplicity
• NPV is most acceptable investment rule
 Accounting data
for the following reasons:
 Accounting profitability
– Time value
• Serious shortcomings
– Measure of true profitability
 Cash flows ignored
– Value-additivity
 Time value ignored
– Shareholder value
 Arbitrary cut-off
• Limitations:
Net Present Value Method
– Involved cash flow estimation
• Cash flows of the investment project
– Difficult to determine the discount
should be forecasted based on realistic
rate
assumptions.
– Mutually exclusive projects
• Appropriate discount rate should be
– Ranking of projects
identified to discount the forecasted cash
INTERNAL RATE OF RETURN METHOD
flows.
• The internal rate of return (IRR) is the rate
• Present value of cash flows should be
that equates the investment outlay with the
calculated using the opportunity cost of
present value of cash inflow received after
capital as the discount rate.
one period. This also implies that the rate
• Net present value should be found out by
of return is the discount rate which makes
subtracting present value of cash outflows
NPV = 0.
from present value of cash inflows. The
project should be accepted if NPV is
positive (i.e., NPV > 0).
Net Present Value Method
• The formula for the net present value can
be written as follows:

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CALCULATION OF IRR
• Level Cash Flows
-Let us assume that an investment would cost
Rs.20,000 and provide annual cash inflow of Rs.5,430
for 6 years

-The IRR of the investment can be found out as

follows
CALCULATION OF IRR NPV   Rs 20,000 + Rs 5,430(PVAF6,r ) = 0
• Uneven Cash Flows: Calculating IRR by
Trial and Error Rs 20,000  Rs 5,430(PVAF6,r )
– The approach is to select any PVAF6,r 
Rs 20,000
 3.683
discount rate to compute the Rs 5,430
present value of cash inflows. If the • The rate, which gives a PVFA of 3.683 for
calculated present value of the 6 years. We find this value under the 16%
expected cash inflow is lower than column in Table PVFA.
the present value of cash outflows, NPV Profile and IRR
a lower rate should be tried. On the
other hand, a higher value should
be tried if the present value of
inflows is higher than the present
value of outflows. This process
will be repeated unless the net
present value becomes zero.
Example
A project costs Rs.16,000 and is expected
to generate cash inflows of Rs.8,000, Rs.7,000
and Rs.6,000 at the end of each year for next three
years.
Find the IRR.

Year Cash flow Rate 0 1 2 3 NPV

0 -16000 0% -16000 8000 7000 6000 5000.00
1 8000 5% -16000 8000 7000 6000 3151.28
2 7000 10% -16000 8000 7000 6000 1565.74
3 6000 15% -16000 8000 7000 6000 194.62
IRR 16% 20% -16000 8000 7000 6000 -1000.00

Rate NPV 6000

0% 5000 5000
5000
5% 3151
10% 1566 4000
15% 195 3151
20% -1000 3000

2000 1566

IRR 0.161014 1000

195
0
0% 5% 10% 15% 20%
-1000
-1000
DF PV -2000

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3 -3,750

Acceptance Rule
• Accept the project when r > k
• Reject the project when r < k
• May accept the project when r = k
• In case of independent projects, IRR and
NPV rules will give the same results if the
firm has no shortage of funds.
Evaluation of IRR Method Example
• IRR method has following merits: • Suppose we have a strip-mining project that
 Time value requires a Rs.6,000/- investment. The
 Profitability measure investment cash flow in the first year will be
 Acceptance rule Rs.15,500/-. In the second year, the mine will
 Shareholder value be depleted, but we will have to spend
• IRR method may suffer from Rs.10,000/- to restore the terrain.
 Multiple rates
 Mutually exclusive projects
 Value additivity
NPV vs. IRR
• Conventional Independent Projects:
In case of conventional investments, which Case of Ranking Mutually Exclusive Projects
are economically independent of each other, NPV
and IRR methods result in same accept-or-reject •Investment projects are said to be mutually
decision if the firm is not constrained for funds in exclusive when only one investment could
accepting all profitable projects. be accepted and others would have to be
• Lending and borrowing-type projects: excluded.
Project with initial outflow followed by inflows is • Two independent projects may also be
a lending type project, and project with initial mutually exclusive if a financial constraint
inflow followed by outflows is a borrowing type is imposed.
project, Both are conventional projects. • The NPV and IRR rules give conflicting
ranking to the projects under the following
conditions:
– The cash flow pattern of the
projects may differ. That is, the
cash flows of one project may
increase over time, while those of
Problem of Multiple IRRs others may decrease or vice-versa.
• A project may have both lending and – The cash outlays of the projects
borrowing features together. IRR method, may differ.
when used to evaluate such non- – The projects may have different
conventional investment can yield multiple expected lives.
internal rates of return because of more Timing of cash flows
than one change of signs in cash flows. The most commonly found condition for the conflict
• Consider the following project between the NPV and IRR methods is the difference in
Period Cash flow the timing of cash flows. Let us consider the following
1 -1,000 two Projects, M and N.
2 4,000

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– Project indivisibility.

• Limitations of Profitability Index

MODIFIED INTERNAL RATE OF RETURN (MIRR) – Multi-period capital constraints
• The modified internal rate of return – Project indivisibility
(MIRR) is the compound average annual PROFITABILITY INDEX
rate that is calculated with a reinvestment • Profitability index is the ratio of the
rate different than the project’s IRR. present value of cash inflows, at the
The procedure for calculating MIRR is as follows: required rate of return, to the initial cash
Step1: Calculate the present value of the costs outflow of the investment.
associated with the project • The formula for calculating benefit-cost
ratio or profitability index is as follows:
Step2: Calculate the terminal value (TV) of the
cash inflows expected from the project

Step3: Obtain MIRR by solving the following

equation

PVC = TV/ (1+MIRR)n

Example

• The initial cash outlay of a project is Rs

100,000 and it can generate cash inflow of
Rs 40,000, Rs 30,000, Rs 50,000 and Rs
The cost of capital is 15% 20,000 in year 1 through 4. Assume a 10
percent rate of discount. The PV of cash
inflows at 10 percent discount rate is:
What is the MIRR?

Profitability Index
• The objective of the NPV rule under
capital constraint should be to maximise
NPV per rupee of capital rather than to
maximise NPV.
• Projects should be ranked by their
profitability index, and top-ranked projects
should be undertaken until funds are Acceptance Rule
exhausted.
• The following are the PI acceptance rules:
• The Profitability Index does not always
– Accept the project when PI is
work. It fails in two situations: greater than one. PI > 1
– Multi-period capital constraints.

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– Reject the project when PI is less

than one. PI < 1
– May accept the project when PI is
equal to one. PI = 1
• The project with positive NPV will have
PI greater than one. PI less than means that
the project’s NPV is negative.
Evaluation of PI Method
• Time value:It recognises the time value of Examples
money.
• Value maximization: It is consistent with
the shareholder value maximisation
principle. A project with PI greater than
• one will have positive NPV and if
accepted, it will increase shareholders’
wealth.
• Relative profitability:In the PI method,
since the present value of cash inflows is
divided by the initial cash outflow, it is a
relative measure of a project’s
profitability. Capital Rationing in Practice
• Like NPV method, PI criterion also • Capital rationing does not seem to be a
requires calculation of cash flows and serious problem in practice.
estimate of the discount rate. In practice, • It may arise due to the internal constraint
estimation of cash flows and discount rate or the management’s reluctance to raise
pose problems. external funds.
Investment Decisions Under Capital Rationing • When companies face the problem of
shortage of funds, they use simple rules of
• Capital rationing refers to a situation choosing projects rather than the
where the firm is constrained for external, complicated mathematical models
or self-imposed, reasons to obtain Investment Decisions Under Inflation
necessary funds to invest in all investment
projects with positive NPV. • Executives generally estimate cash flows
• Under capital rationing, the management assuming unit costs and selling price
has to decide to obtain that combination prevailing in year zero to remain
of the profitable projects which yields unchanged. They argue that if there is
highest NPV within the available funds. inflation, prices can be increased to cover
Why Capital Rationing? increasing costs; therefore, the impact on
the project’s profitability would be the
• There are two types of capital rationing: same if they assume rate of inflation to be
1. External capital rationing: zero.
imposed by capital markets • This line of argument, although seems to
2. Internal capital rationing: self- be convincing, is fallacious for two
imposed by the company internally reasons.
Profitability Index: Example – First, the discount rate used for
• The NPV and profitability index of the discounting cash flows is generally
following four projects are shown. expressed in nominal terms. It
Given the budget constraint of Rs 50, would be inappropriate and
projects M and N will be selected as per inconsistent to use a nominal rate
PI. to discount constant cash flows.
– Second, selling prices and costs
show different degrees of
responsiveness to inflation
• The depreciation tax
shield remains unaffected

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Project analysis

by inflation since
1.14
depreciation is allowed on K 1 0.0654
the book value of an asset, 1.07
irrespective of its
replacement or market
price, for tax purposes.

Example
Nominal VS. Real Rates of Return
• A company has the following projected
• For a correct analysis, two alternatives are cash flows estimated in real terms:
available:
– either the cash flows should be
converted into nominal terms and
then discounted at the nominal
required rate of return, or
– the discount rate should be
converted into real terms and used
to discount the real cash flows

• Important: Discount nominal cash flows

at nominal discount rate; or discount real Complex Investment Problems
cash flows at real discount rate.
• Example: If a firm expects a 10 per cent • How shall choice be made between
real rate of return from an investment investments with different lives?
project under consideration and the • Should a firm make investment now, or
expected inflation rate is 7 per cent, the should it wait and invest later?
nominal required rate of return on the • When should an existing asset be
project would be: replaced?
• It would be inconsistent to discount the • How shall choice be made between
real cash flows of the project by the investments under capital rationing?
nominal discount rate. For example, in Projects with Different Lives
case of following cash flows discounting • The choice between projects which have
with 14% nominal rate of real cash flows different lives should be made by
returns negative NPV: evaluating them for equal periods of time.
• Example: A firm has to choose between
two projects X and Y, which are designed
differently, but perform essentially the
same function. Cash flows of projects are
in real terms and the real discount rate is
10 per cent. The present value of costs are
shown below:( Rs.120,000 Initial outlay
and operating cash expenses of Rs.30,000
• The cash flows should be discounted with per year for 4 years).
real discount rate as follows:

• Project X has 4-year life while Project Y has 2-

year life. Project Y will be replicated to

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Project analysis

compare it with Project X. Project Y costs investment for the original life, n and k is the
more than project X. opportunity cost of capital.

Nominal Cash Flows and Annual Equivalent Value

• Continue with earlier example. Let us assume

expected inflation of 4% . The real cash flows
of X and Y can be converted into nominal cash
Annual Equivalent Value (AEV) Method flow (as shown below) and the real discount
rate into nominal discount rate: (1.04) x(1.10)
• The method for handling the choice of the -1=0.144. Notice that the ranking of projects
mutually exclusive projects with different changes at higher inflation rate of 15%. Thus,
lives, as discussed in last slide, can become the choice should be based on real AEV.
quite cumbersome if the projects’ lives are
very long.

• We can calculate the annual

equivalent value (AEV) of cash
flows of each project. We shall
select the project that has lower
annual equivNPV
alent cost.
AEV 
Annuity factor

AEV: Example

• In the earlier example, the present

value of cash flows of X is Rs
215,100. You can divide Rs 215,100
by a 4-year present value factor for
an annuity of Rs 1 at 10 per cent (3.1699) to
obtain AEV. Similarly, AEV for Y can be Investment Timing and Duration
calculated. Y is more costly. • The rule is straightforward: undertake the
project at that point of time, which maximizes
NPV
AEVProject X the NPV.
Annuity factor
215,100
Rs 67,857
3.1699
129, 420
AEVProject Y Rs 74,572
1.7355
AEV for Perpetuities

• When we assume that projects can be

Replacement of an Existing Asset
replicated at constant scale indefinitely, we
imply that an annuity is paid at the end of • Replacement decisions should be governed by
every n years starting from the first period. the economics and necessity considerations.

•
 (1  k ) n  An equipment or asset should be replaced

NPV  (NPVn )   
whenever a more economic alternative is

 (1  k ) n
 1 
available.

Example
where NPV∞ is the present value of the investment
indefinitely, NPVn is the present value of the • A company is operating equipment, which is
expected to produce net cash inflows of Rs
4,000, Rs 3,000 and Rs 2,000 respectively for

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Project analysis

next 3 years. A design, which is considered to will cost Rs.24,500/- and will produce net cash
be a technological improvement and more saving of Rs.4800/- per year. Machine B has
efficient to operate, has appeared in the an expected life of 5 years will cost
market. It is expected that the new machine Rs.20,000/- and will produce net cash savings
will cost Rs 12,000 and will provide net cash in operating costs of Rs.6000/- per year.
inflow of Rs 6,000 a year for 5 years. What Company’s cost of capital is 14%.
should the company do? Assume 12 per cent
discount rate. Activities
01. Assume that you are a financial analyst for
Example
the H Company. The director of capital
• The correct method of analysis is to compare budgeting has asked you to analyze two
the annual equivalent value (AEV) of the old proposed capital investments, Projects X
and new equipments as given below. and Y. Each project has a cost of
Rs.1,000,000, and the cost of capital for
• A chain of new machines is equivalent to an each is 12%. The projects’ expected net
annuity of Rs 9,630  3.605 = Rs 2,671 a year cash flows are as follows:
for the life of the chain. The existing machine
is still capable of providing an annuity of: Rs
7,390  2.402 = Rs 3,076. So long as the
existing machine generates a cash inflow of
more than Rs 2,671 there does not seem to
be an economic justification for replacing it.

i. Calculate each project’s payback period, net

present value (NPV), internal rate of return (IRR),
modified internal rate of return (MIRR), and
Exercise
profitability index (PI).

Example ii. Which project should be accepted if they are

• X ltd considering two machines to replace an mutually exclusive?
old machine. Machine A has a life of 10 years

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02.Briarcliff Stove Company is considering a new

product line to supplement its range line. It is
anticipated that the new product line will involve cash
investment of Rs.700,000 at time 0 and Rs.1.0 million
in year 1. After-tax cash inflows of Rs.250,000 are
expected in year 2, Rs.300,000 in year 3, Rs.350,000 in
year 4, and Rs.400,000 each year thereafter through
year 10. Though the product line might be viable after
year 10, the company prefers to be conservative and
end all calculations at that time.

i.What is the project’s payback period?

ii.If the required rate of return is 15 percent, what is
the net present value of the project? Is it acceptable?
Why?
iii.What is its internal rate of return?
iv.If the required rate of return is 15 percent, what is
the Modified Internal Rate of Return (MIRR)?

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