DIRE DAWA UNIVERSITY

SCHOOL OF ELECTRICAL & COMPUTER

ENGINEERING

IEng 5382-Industrial Management

&
Engineering Economy

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 Chapter Five

Investment Evaluation
Points to be discussed:-
 Introduction;
 Total investment costs;
 Projects financing;
 Financial evaluations

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Introduction
 Investment Evaluation/Appraisal is an analysis
of alternative investment projects using standard
investment evacuation/appraisal techniques in
order to determine the investment most likely to
meet organisational objectives.
 This is usually undertaken with reference to the
following techniques:
 Payback ,Return on investment
 Net Present Value, Internal rate of return etc.
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 Introduction
 Reasons for Investment Appraisal

• Provides detailed analysis of options to

managers and help them make decisions on
capital investment projects
• Enables projects to be evaluated
• Can compare competing projects
• Decisions are based on financial criteria

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Introduction

 Hence, Project preparation should be geared towards

the requirements of financial and economic evaluation.

 Once all the elements of a feasibility study are

prepared, the next step is to compile the total
investment costs.
 Projects should also be, evaluated from the aspect of
their direct and indirect effects on the national
economy.
Total Investment Costs
 Investment costs are defined as the sum of fixed
capital (fixed investments plus production capital
costs) and net working capital.
 Fixed capital constitutes the resource referred for
constructing and equipping an investment project and
 Working capital corresponding to the resources
needed to operate the project totally or partially.
Fixed Assets (Capital)
Fixed assets (capital) comprise
 fixed investments and
 pre-production capital costs
i) Fixed Investments: include the following.
 Land and site preparation.
 Building and civil works.
 Plant machinery and equipment including auxiliary
equipment.
 Certain incorporate fixed assets such as industrial
property rights.
ii) Pre-production Capital Expenditure: This expenditure,
which has to be capitalized, includes a number of items
that originated during the various stages of project
formulation and implementation. These include:
 Consultant fees for preparing studies,
 Travel expenses
 Preparatory installations such as camps, temporary offices,
stores, etc.
 Training costs, including fees, travel and living expenses;
salaries and stipends of the trainees.
 Interest on loan during construction.
Working Capital

 Working capital indicates the financial means

required to operate the project according to its
production program.
 It is defined as the current assets minus current
liabilities
 Current assets comprise receivables, inventories (raw
material, auxiliary material, supplies packaging
materials, spares and small tools), work in progress,
finished products and cash.
 Current liabilities consist mainly of accounts payable
(creditors) and are free of interest.
Project Financing
 The financing of new projects continued to be a
problem, since corporate guarantees would usually be
required for loans to finance projects.
 Companies were therefore risking to the extent of
their total assets if a project failed.
 Development of project financing, therefore,
emerged from the need for companies to shield
themselves from such risks.
Sources of Financing
 It is a normal trend that use debt, equity and capital
obtained from different sources.

 However, there are cases where a single source

provides more than one type of capital, in which case
separate departments may handle the different
types of capital separately.
i) Equity Capital Providers: The main source of equity
capital for a project comes from the project sponsors
or other investors that have an active interest in the
project.
 This would include governments, contractors, equipment
suppliers, purchasers of output and entrepreneurs.
 Additional equity, if needed, would be sought from passive
sources, such as institutional investors and possibly the
general public through local or international capital markets.
 They are not normally involved in the promotion and
development or the management and operation of the
projects in which they invest. Their capital is used to top up
the equity requirements of a project that cannot be met by
sponsors.
ii) Commercial Banks:

 The most traditional source of debt financing are commercial

banks.
 Their operations essentially revolve around the
creditworthiness of their borrowers and the security of
their loans.

 Much stress is put on prudential lending and actions aimed at

ensuring loan repayment.
iii) Export Credit Agencies: Export credit agencies (ECA)
are considered to be an important source of long-term
credit.
 As lenders, ECAs have the same concerns and requirements
as commercial banks and would also be signatories to the
credit agreement.
 However, ECAs are usually state-owned, and their primary
objective is the promotion of their country’s exports and the
grants are usually tied to the purchase of equipment from the
ECA’s country.
 ECAs are usually substantially more generous than those of
commercial banks and highly suited to the financing of long-
term infrastructure projects.
iv) Bilateral and Multilateral Aid Agencies: Many developing
countries can also access debt, equity and other financing from
bilateral and multilateral agencies, such as;
 United States Agency for International Development
(USAID),
 The Canadian International Development Agency (CIDA),
 The Overseas Development Administration of the United
Kingdom (ODA),
 The World Bank,
 The Asian Development Bank (ADB) and
 The European Bank for Reconstruction and Development
(EBRD), etc.
v) Institutional investors: Institutional investors as a source of
debt, equity and other financing are non-bank financial
institutions such as insurance companies, pension funds and
investment funds.
 Institutional investors distinguish themselves from
commercial banks in that they mobilize long-term contractual
savings as opposed to short-term deposits.
 By virtue of the long-term nature of the funds, many
institutional investors are able to provide long-term and pure
equity financing.
 Institutional investors are therefore an important source of
long-term funds for large projects.
vi) National and Regional Development Banks
Financial Evaluation
 The study of a new enterprise, or the design of a new
plant, or the evaluation of two or more alternative
solutions always requires the consideration of
economic concepts.
 The decisions that are made each day in engineering
economy in industry, determine whether proposals
for investment in new plants and equipment should be
accepted or rejected.
 Interest formulas are developed for use in
engineering economy studies.
 Evaluation Techniques

Non–discounting techniques Discounting techniques

Considers the time value of

Traditional Techniques
money
Ignores the time value of
1. Net Present Value (NPV)
money
2. Internal Rate of Return (IRR)
1. Payback period (PB)
3. Modified Internal Rate of Return
2. Discounted Payback Period
(MIRR)
(DPB)
4. Terminal Value (TV)
3. Accounting Rate of Return (ARR)
5. Profitability Index (PI) or
benefit/Cost Ratio
1. Non-DCF Methods: does not consider the time value of
money

 Payback Period

 Return on Investment (ROI)

Payback Period
 The pay back period is defined as the length of time required
to recover one’s investment.

 The time period is usually expressed in years and months.

Net investment
Pay back Period =
Net annual income from investment

 Uniform (equal) cash-in-flow over a period of time or

 Unequal cash-in-flow over a period of time.

Payback Period
 To calculate the pay back period, simply work out how long it will
take to recover the initial outlay.

Decision Rule
• Accept the project only if its payback period is LESS
than the target payback period.

• In multi-projects evaluations, select the least payback

period project
 Cash flow of two alternative machines

Year 0 1 2 3 4
Machine A
Cash flow (Birr) -35,000 +20,000 +15,000 +10,000 +10,000
Machine B
Cash flow (Birr) -35,000 +10,000 +10,000 +15,000 +20,000

 Pay back period for machine A is two years where as for machine
B it is three years.
 That is machine A will recover its investment cost one year
sooner than machine B.
 Where project’s are ranked by the shortest pay back period,
machine A is selected in preference to machine B.
Exercise: Payback Period (PBP)

Company XJ is planning to undertake an

expansion project requiring initial investment
of Birr 50 million and is expected to generate
Birr 10 million in Year 1, Birr 13 million in Year
2, Birr 16 million in year 3, Birr 19 million in
Year 4 and Birr 22 million in Year 5.
a)Calculate the payback value of the project.
b)If the target pay back period is 3.5 years,
can the project be accepted?
The advantages of the payback method are:
 It is simple and easy to use.
 It uses readily available accounting data to determine cash-
flows.
 It reduces the project's exposure to risk and uncertainty by
selecting the project that has the shortest payback period.

Disadvantages of the Pay back Period:

 It does not consider the profitability of the projects.
 It dose not consider the time value of money.
Return on Investment (ROI)
 This method first calculates the average annual profit, which is
simply the project outlay deducted from the total gains, divided
by the number of years the investment will run.

 The profit is then converted into a percentage of the total outlay

using the following equations:

Average Annual Profit = (Total gains)-(Total outlay)

Number of years

Return on Investment = Average Annual Profit

X 100%
Original Investment
Example: ROI

 Using the machine selection project

Using the machine selection project

Profit (A & B) = $55,000 - $35,000

Annual Profit = 20,000 = $5,000 per year (same for both machines)
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Return on Investment = 5,000 X 100% = 14%

35,000
 The return on investment method has the advantage of also
being a simple technique like pay back period, but further, it
considers the cash-flow over the whole project.

 The main criticism of return on investment is that it averages

out the profit over successive years. An investment with high
initial profits would be ranked equally with a project with high
profits later if the average profit was the same.
 It does not consider the time value of money
2. Discounted Cash flow Method (DCF)
 The discounted cash-flow (DCF) technique takes into
consideration the time value of money.
 For example, a 100Birr today will not have the same worth or
buying power as a 100Birr this time next year.
 The basic DCF techniques which can model this effect are
Compound interest, net present value (NPV) and internal rate
of return (IRR).
 These discounting techniques enable the project manager to
compare two projects with different investment and cash-flow
profiles.
 There is, however, one major problem with DCF, besides being
dependent on the accurate forecast of the cash-flows, it also
requires an accurate prediction of the interest rates.
Net Present Value
 If you were offered $120 one year from now and the inflation
and interest rate was 20%, working backwards its value in
today's terms would be $100. This is called the present value,
and when the cash-flow over a number of years is combined in
this manner the total figure is called the net present value
(NPV).
Net Present Value
NPV = NCF0 + (NCF1 x DF1) + NCF2 x DF2) + …. + (NCFn x an)

Where, NCFn = annual net cash flow

n = number of years
an = discount factor

Net present value ratio (NPVR) = Profitability index

= PV of cash inflows
PV of investment
The NPV rule:

Accept project if NPV > 0

If we accept a project with NPV > 0
 increase shareholder wealth
If we accept a project with NPV < 0
 decrease shareholder wealth
E.g.1. A company receives USD 136 in 3 yrs. attaching a 13% per annum
time value of money. What amount would the company receive today?
 Present Value (PV) = discounted value = 136
 (1 + 13)3
 100
 = 136 x 0.693
 = USD 94.25
 Discounting rate, cut-off rate, minimum rate of return hurdle rate,
cost of capital, opportunity cost of capital
 1 = discount factor
 (1 + r) n
E.g.2. A company is considering several investments in the production of
facilities for the new products with an estimated useful life of 4 years. The cash
inflows and out flows are shown in the following Table. Calculate NPV of each
alternative and select the best based on NPV. ( Use discount rate 12%)

Year Cash Flows ($)

A B C D
Initial Investment -900000 -1000000 -303730 -1500000
(year 0)

Year1 120000 400000 100000 10000

Year2 250000 400000 100000 10000
Year3 400000 400000 100000 100000
Year4 1300000 400000 100000 100000
 Solution:
NPV = NCF0 + (NCF1 x DF1) + NCF2 x DF2) + …. + (NCFn x an)
And
DFn = 1
(1 + r) n

Project A Project B

Year Cash flow ($) DF PV ($) Cash flow DF PV ($)

0 -900,000 1 -900000 -1000000 1 -1000000
1 120000 0.892857 107142.9 400000 0.892857 357142.9
2 250000 0.797194 199298.5 400000 0.797194 318877.6
3 400000 0.71178 284712.1 400000 0.71178 284712.1
4 1300000 0.635518 826173.5 400000 0.635518 254207.2
NPV 517326.9 NPV 214939.7
 Project C Project D
Cash flow
Year ($) DF PV ($) Cash flow DF PV ($)
0 -303730 1 -303730 -1500000 1 -1500000
1 100000 0.892857 89285.71 10000 0.892857 8928.571
2 100000 0.797194 79719.39 10000 0.797194 7971.939
3 100000 0.71178 71178.02 100000 0.71178 71178.02
4 100000 0.635518 63551.81 100000 0.635518 63551.81
NPV 4.93 NPV -1348370

 Therefore NPV for Project A, Project B, Project C and Project D

are 517326.9, 214939.7, 4.934663 and -1348370 respectively,.
 The best project to be selected based on NPV analysis is
Project A.
Net Present Value

The advantages of using NPV are:

 It introduces the time value of money.
 It expresses all future cash-flows in today's values, which
enables direct comparisons.
 It allows for inflation and escalation.
 It looks at the whole project from start to finish.
 It can simulate project what-if analysis using different values.
 It gives a more accurate profit and loss forecast than non DCF
calculations.
Net Present Value
The disadvantages are:-
 Its accuracy is limited by the accuracy of the predicted future
cash-flows and interest rates.
 It is biased towards short run projects.
 It excludes non financial data e.g. market potential.
 It uses a fixed interest rate over the duration of the project.
Internal rate of return (IRR)
 The IRR is the value of the discount factor when the NPV is
zero. It is assumed that the costs are committed at the end
of the year and these are the only costs during the year.

IRR = I1 + PV (i2 – i1 ) , where

PV + /NV/
PV= positive NPV
NV= negative NPV
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