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4 Method of Project Evaluation

The document discusses four main methods for evaluating projects: 1. Net present value (NPV) which measures a project's net cash flows discounted at the required rate of return against the initial investment. A positive NPV means the project increases shareholder wealth. 2. Internal rate of return (IRR) which is the discount rate that sets a project's net present value to zero. If the IRR exceeds the required rate of return, the project should be accepted. 3. Benefit-cost ratio which is the present value of a project's future net cash flows divided by the initial cash outlay. Ratios over 1 are accepted and under 1 are rejected. 4. Payback period which is

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Karen Small
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69 views

4 Method of Project Evaluation

The document discusses four main methods for evaluating projects: 1. Net present value (NPV) which measures a project's net cash flows discounted at the required rate of return against the initial investment. A positive NPV means the project increases shareholder wealth. 2. Internal rate of return (IRR) which is the discount rate that sets a project's net present value to zero. If the IRR exceeds the required rate of return, the project should be accepted. 3. Benefit-cost ratio which is the present value of a project's future net cash flows divided by the initial cash outlay. Ratios over 1 are accepted and under 1 are rejected. 4. Payback period which is

Uploaded by

Karen Small
Copyright
© © All Rights Reserved
Available Formats
Download as XLSX, PDF, TXT or read online on Scribd
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Different methods of project evaluation include:

Net present value (NPV).


Difference between the PV of the net cash flows (NCF)
from an investment,
discounted at the required rate of return, and the initial
investment outlay.
Measuring a projects net cash flows:
Forecast expected net profit from project.
Estimate net cash flows directly.
Evaluation of NPV

NPV method is consistent with the companys objective of maximising shareholders we

A project with a positive NPV will leave the company


better off than before the project and,
other things being equal, the market value of the
companys shares should increase.
Decision rule for NPV method:
Accept a project if its NPV is positive when the projects NCFs are discounted at the requ

Internal rate of return (IRR).

The internal rate of return (IRR) is the discount rate that equates the PV of a projects ne
IRR is the discount rate (or rate of return) at which the net present value is zero.
The IRR is compared to the required rate of _x000B_return (k).
If IRR > k, the project should be accepted

Benefit-cost ratio (profitability index).


The profitability index is calculated by dividing the present value of the future net cash fl
Decision rule:
Accept if benefitcost ratio > 1
Reject if benefitcost ratio < 1

Benefit Cost Ratio


4

PV of net cash flows


Initial cash outlay

Payback period (PP).


The time it takes for the initial cash outlay on a project to be recovered from the project
Decision:
Compare payback to some maximum acceptable payback period.
What length of time represents the correct payback period as a standard against which

maximising shareholders wealth.

CFs are discounted at the required rate of return.

quates the PV of a projects net cash flows with its initial cash outlay.
present value is zero.

t value of the future net cash flows by the initial cash outlay:

be recovered from the projects after-tax net cash flows.

d as a standard against which to measure the acceptability of a particular project?

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