Project

Management
and
Agri Business
Entrepreneurship
ABM 542 : 3 (2+1)
 Definition
• Project is a unique process, consist of a set of coordinated and controlled
activities with start and finish dates, undertaken to achieve an objective
confirming to specific requirements, including the constraints of time cost
and resource.
• Examples of project include Developing a watershed, Creating irrigation
facility, Developing new variety of a crop, Developing new breed of an
animal, Developing agro processing centre, Construction of farm building,
sting of a concentrated feed plant etc.
• It may be noted that each of these projects differ in composition, type,
scope, size and time.
 Project management
• Project management is a distinct area of management that helps in
handling projects.
• It has three key features to distinguish it from other forms of management
and they include: a project manager, the project team and the project
management system.
• The project management system comprises organization structure,
information processing and decision making and the procedures that
facilitate integration of horizontal and vertical elements of the project
organization.
• The project management system focuses on integrated planning and
control.
Benefits of Project Management Approach
The rationale for following project management approach is as follows.
• Project management approach will help in handling complex, costly and risky
assignments by providing interdisciplinary approach in handling the assignments.
• Example: R&D organizations.
• Project management approaches help in handling assignments in a specified time
frame with definite start and completion points .
• Example handling customer orders by Industries involved in production of capital
goods.
• Project management approaches provide task orientation to personnel in an
Organization in handling assignments.
• Example: Organizations in IT sector handling software development assignments
for clients.
 Project Characteristics
1. Unique in nature.
2. Have definite objectives (goals) to achieve.
3. Requires set of resources.
4. Have a specific time frame for completion with a definite start and finish.
5. Involves risk and uncertainty.
6. Requires cross-functional teams and interdisciplinary approach.
 Classification
• There is no standard classification of the projects.

• However considering project goals, these can be classified into two broad
groups, industrial and developmental.

• Each of these groups can be further classified considering nature of

work (repetitive, non-repetitive), completion time (long term, shot term
etc.), cost (large, small, etc.), level of risk (high, low, no-risk), mode of
operation ( build, build-operate-transfer etc.).
• Industrial projects also referred as commercial projects, which are undertaken to provide goods
or services for meeting the growing needs of the customers and providing attractive returns to
the investors/stake holders.
• Following the background, these projects are further grouped into two categories i.e., demand
based and resource / supply based.
• The demand based projects are designed to satisfy the customers’ felt as well the latent needs
such as complex fertilizers, agro-processing infrastructure etc.
• The resource/ supply based projects are those which take advantage of the available resources
like land, water, agricultural produce, raw material, minerals and even human resource.
• Projects triggered by successful R&D are also considered as supply based. Examples of resource
based projects include food product units, metallurgical industries, oil refineries etc.
• Examples of projects based on human resource (skilled) availability include projects in IT
sector, Clinical Research projects in bio services and others.
• Development projects are undertaken to facilitate the promotion and
acceleration of overall economic development.
• These projects act as catalysts for economic development providing a
cascading effect.
• Development projects cover sectors like irrigation, agriculture,
infrastructure health and education.
 Project Identification
• Project identification is an important step in project formulation.
• These are conceived with the objective of meeting the market demand, exploiting natural
resources or creating wealth.
• The project ideas for developmental projects come mainly from the national planning
process, where as industrial projects usually stem from identification of commercial
prospects and profit potential.
• As projects are a means to achieving certain objectives, there may be several alternative
projects that will meat these objectives.
• It is important to indicate all the other alternatives considered with justification in favour of the
specific project proposed for consideration.
 Project Formulation

“Project Formulation” is the processes of presenting a project idea in a form in

which it can be subjected to comparative appraisals for the purpose of

determining in definitive terms the priority that should be attached to a project

under sever resource constraints.

 Project feasibility

Project feasibility 1 Market

is the study of a project's various elements to
determine if it has the potential for success.
2 Technical
Before a project begins, a company can
evaluate the project's feasibility to identify
3 Financial
obstacles, form strategies to overcome them
and ultimately attract investors.
4 Economic
 1. Economic Analysis
• In the recent years the market analysis has undergone a paradigm shift.
• The demand forecast and projection of demand supply gap for products / services can
no longer be based on extrapolation of past trends using statistical tools and techniques.
• One has to look at multiple parameters that influence the market.
• Demand projections are to be made keeping in view all possible developments.
• Review of the projects executed over the years suggests that many projects have failed
not because of technological and financial problems but mainly because of the fact that
the projects ignored customer requirements and market forces.
 2. Market Analysis
• In market analysis a number of factors need to be considered covering – product

specifications, pricing, channels of distribution, trade practices, threat of

substitutes, domestic and international competition, opportunities for exports etc.

• It should aim at providing analysis of future market scenario so that the decision

on project investment can be taken in an objective manner keeping in view the

market risk and uncertainty.

 3. Technical Analysis
• Technical analysis is based on the description of the product and specifications and also the
requirements of quality standards.

• The analysis encompasses available alternative technologies, selection of the most appropriate
technology in terms of optimum combination of project components, implications of the
acquisition of technology, and contractual aspects of licensing.

• Special attention is given to technical dimensions such as in project selection.

• The technology chosen should also keep in view the requirements of raw materials and other
inputs in terms of quality and should ensure that the cost of production would be competitive.
 4. Financial Analysis
The Financial Analysis, examines the viability of the project from financial or
commercial considerations and indicates the return on the investments.

Some of the commonly used techniques for financial analysis are as follows.
1. Pay-back period.
2. Return on Investment (ROI)
3. Net Present Value (NPV)
4. Profitability Index(PI)/Benefit Cost Ratio
5. Internal Rate of Return (IRR)
 Risk and Uncertainty
• Risk and Uncertainty are associated with every project.
• Risk is related to occurrence of adverse consequences and is quantifiable.
• It is analysed through probability of occurrences.
• Where as uncertainty refers to inherently unpredictable dimensions and is
assessed through sensitivity analysis.
• It is therefore necessary to analyse these dimensions during formulation and
appraisal phase of the programme.
Factors attributing to risk and uncertainties of a project are grouped under the
following:
• Technical –relates to project scope, change in technology, quality and quantity
of inputs, activity times, estimation errors etc.
• Economical- pertains to market, cost, competitive environment, change in
policy, exchange rate etc.
• Socio-political- includes dimensions such as labour, stakeholders etc.
• Environmental – factors could be level of pollution, environmental degradation
etc.
 Network Analysis
 Project design and network analysis are important tools for effective implementation
of the project.
 They are very useful for development of a detailed work plan of the project and project
time profile.
 A project consists of a numerous activities.
 It is examined in detail and details are utilized to compile the series wise explanation
of the constituent activities of a project.
 The compilation is known as the project logic.
 When it is presented in the form of a graphical presentation, it is called the network.
 Importance
 It helps management to minimize the total cost and total maintenance time.
 Network analysis ensures the effective utilization of limited resources.
 Network analysis facilitates co-ordination among the activities as well the persons
responsible for project.
 Time management plays a crucial role in every project.
 Network analysis helps the managers to manage activities without any delay.
 Network analysis is great tool which helps in planning, scheduling and controlling
the activities of the project.
 Network analysis also creates inter-relationship as well as inter-dependence of
various activities of project.
 Network analysis provides the project formulation team an apparent picture of the
work elements and also sequential relationship of the project.
 Classification
Classification of Network Techniques: There are number of network techniques which are
used by the various people according to their purpose. The main techniques are given below:
1. CPM: It is popularly known as Critical Path Method.
 Critical path method is a project management tool used to formulate a time frame for a
project in order to determine where potential delays are most likely to take place.
2. PERT: The Programme Evaluation and Review Technique is basically a scheduling
technique.
 It helps project manager in planning, scheduling, monitoring, evaluating, and controlling
large and complex projects.
 It is a probabilistic model and introduces uncertainties in project network.
 PERT
 It shows any project or job as a set of processes of operations called activities which
must take place in a certain sequence.
 It involves diagrammatic presentation of activities and events involved in a long
term project.
 The diagrammatic presentation is known as Network Drawing/technique and these
techniques are most commonly used in project management.
 Basic objective of PERT is to control time.
 The execution of project becomes very difficult where long times involved in the
planning and scheduling of the project because it involved lot of complexities and
inter related activities.
 So for the successful implementation of the project, project manager is to take
some important decisions such as estimation of resource requirement, time for
each activity, and maintaining inter-relationship amongst the activities.
 PERT is helpful to the project manager for taking decisions about these
questions.
 It is a technique which helps project manager in planning, scheduling,
monitoring, evaluating and controlling large and difficult projects.
 In simple words we can say that projects whose time duration of activities is not
exactly known, PERT is used.
 It depends upon three time estimates of activities.
 The most optimistic time (𝒕𝒐 ): The minimum time that would be required to perform
the activity if everything goes extremely well, the chance of such an optimum activity
actually takes place is one in hundred.

 The most likely time (𝒕𝒎 ): The length of time that will, in all probability, be required
to perform the job under the given circumstances or normal circumstances.

 The most pessimistic time (𝒕𝒑 ): This is the longest or maximum probable time
involved if everything that might logically go wrong does actually go wrong. It includes
time for unusual days or unforeseen circumstances. The chance of its happening might
also be one in hundred or very less.
 With the help of these above mentioned time estimates i.e. optimistic
time, most likely time, and pessimistic time, average expected time
for each activity would be determined.
 Average expected time (𝒕𝒆 ) of the activity

𝒕𝒐 + 𝟒𝒕𝒎 + 𝒕𝒑
𝒕𝒆 =
𝟔
 Condition
1. 𝑬𝑺𝒊 = 𝑳𝑭𝒊

2. 𝑬𝑺𝒋 = 𝑳𝑭𝒋

3. 𝑬𝑺𝒋 - 𝑬𝑺𝒊 = 𝑳𝑭𝒋 - 𝑳𝑭𝒊 = 𝒕𝒊𝒋

𝑳𝑭𝒊 𝑳𝑭𝒋
𝑬𝑺𝒊 𝑬𝑺𝒊
Starting event i j Finishing event
 Procedure followed in PERT
 First of all, the network of activities is drawn to indicate what activity follows what.
 Then estimation of time to complete each activity is noted on the network.
 Estimation of minimum time taken to complete the project.
 Identification of critical activities and allocation of resources so that project can be
completed in time.
 Calculation of project variability duration and profitability of the project in given
period.
 In order to complete project in time closer watch on critical and other activities.
 Advantages of PERT
1. It is very helpful in determine the schedule for a project within time limit.
2. It helps the management to optimum allocation of resources for the project.
3. It helps in taking right decision for the projects at a right time.
4. It is very helpful in determine the expected duration of activities.
5. It helps the management in handling the uncertainties involved in the project.
6. It helps the management to reduce the risk element in the project.
7. It suggests area of increasing efficiency, decreasing cost and maximizing profits.
8. It helps in coordinating the various activities involved in a project.
9. It enables the use of statistical analysis.
 Limitations of PERT
1. PERT emphasis only on time. It ignores the cost of a project.
2. It cannot be useful for programmes that are indefinite and vague.
3. Assumption of normal probability distribution is not true.
4. It does not consider the matter of resources required for various types of
activities of a project.
5. It seems to be simple but in reality its application is too complex.
6. It is not practicable for routine planning of recurring events.
 CPM
 Critical path method is a special application of network analysis.
 It uses network analysis for scheduling production, construction projects as well as
research and development activities.
 It is also useful in situations which require estimates of time and performance.
 Critical path method deals with repetitive type projects, such as overhaul of
generating plant, which has to be carried repeatedly after set time intervals.
 The critical path, is the overall time, it will take to complete the project.
 It is the longest path in time through the network.
 In other words, the longest path in the network is called critical path. Identifying the
critical path is of great importance as it determines the duration of entire project.
 Critical path method differentiates between the planning and scheduling of the
project.
 A Critical path method is a very important project management tool used to
formulate a time frame for a project in order to determine where potential delays are
most likely to occur.
 The process includes a step by step process that provides the developer with a visual
representation of potential bottleneck, throughout the course of the project.
 Identification of the Critical Path
 Earliest start time for activity (ES): It is the earliest possible time at which the
activity should start if only the ongoing activities are first completed.
 Earliest finish time (EF): It is the earliest possible time to finish the activity. It is
equal to the earliest start time for activity plus the time required completing the activity.
 Latest possible finish time for activity (LF): It is the latest time at which the activity
can be completing without any postpone or within the time framework.
 Latest possible start time for activity (LS): it is the latest start time for an activity
and equal to the latest finish time minus the time required to complete the activity.
 Slack time: Slack time is the difference between earliest start time for activity and
latest start time for activity, or between earliest finish time for activity and latest finish
time for activity.
 Advantages of Critical path method
1. It is very useful for scheduling and controlling of large projects.
2. It is simple concept and not mathematically complex.
3. It is very helpful in pinpoint activities that needed to be closely watched.
4. In CPM, Project documentation and graphics point out who is responsible for
various activities.
5. It is applicable to a wide variety of projects.
6. It is very useful in monitoring schedules and costs.
7. It makes better and detailed planning possible.
8. It is helpful at many stages of project management.
9. It enables standard method for communicating project plans, schedules, time
and cost performance.
10. With the help of CPM most critical activities are identified and thus more
attention can be paid to these activities for the successful completion of project.
 Limitations of CPM

 It ignores to incorporate statistical analysis in determining the time estimates.

 It is presumed in CPM that there is a precise known time that each activity in
the project will take. But in reality it is not happen.
 Basically it developed as a static planning model and not as a dynamic
controlling device. So it cannot be used as a dynamic controlling device
 Similarities between PERT and CPM
 PERT and CPM both are the networking techniques. Both are the important tools of project
implementation. Below are the similarities between PERT and CPM:
 Both PERT and CPM have the same procedure and network diagrams are used in the both the
techniques.
 Both PERT and CPM are used to determine the earliest/latest start and finish times for each
activity.
 Both PERT and CPM techniques help management to plan, schedule and control the project.
 All significant task and activities are defined in the project by both the techniques.
 The networking principles used in both the techniques is more or less the same
 Comparison between PERT and CPM
 Origin: the origin of PERT is military organization whereas origin of CPM is chemical plant
 Uncertainty: in PERT estimates are uncertain whereas in CPM does not allow any uncertainty.
 Nature: PERT is used for non-repetitive jobs whereas CPM is used for repetitive jobs.
 Time/Cost: PERT stresses on time based concept whereas CPM stresses on cost based concept.
 Model: PERT is a probabilistic model whereas CPM is a deterministic model.
 Time estimates: PERT has three time estimates whereas CPM has only one single estimate of time.
 Critical activities/Dummy activities: in PERT, Critical activities is not used whereas in CPM
dummy activities is not used.
 Suitability: PERT is suitable where high precision is required in time estimates such as defence
projects whereas CPM is suitable where reasonable precision is required such as civil construction.
 Event /Activity: PERT is an event oriented whereas CPM is an activity oriented.
 Estimated duration 𝒕𝒐 + 𝟒𝒕𝒎 + 𝒕𝒑
𝒕𝒆 =
Activity 𝒕𝒐 𝒕𝒎 𝒕𝒑 𝟔

1-2 1 7 13 7
1-6 2 5 14 6
2-3 2 14 26 14
2-4 2 5 8 5
3-5 7 10 19 11
4-5 5 5 17 7
6-7 5 8 29 11
5-8 3 3 9 4
7-8 8 17 32 18
 Earliest Latest Total
Time Free Float
Start Finish Start Finish Float
Activity (Days) 𝑬𝒋
(ES) (EF) (LS) (LF) (TF)
𝒕𝒊𝒋 𝑬𝒋 − 𝑬𝒊 − 𝒕𝒊𝒋
𝑬𝒊 𝑬𝒊 - 𝒕𝒊𝒋 𝑳𝒋 - 𝒕𝒊𝒋 𝑳𝒋 LS-ES
1-2 4 0 4 5 9 5 4 0
1-3 1 0 1 0 1 0 1 0
2-4 1 4 5 9 10 5 5 0
3-4 1 1 2 9 10 8 5 3
3-5 6 1 7 1 7 0 7 0
4-9 5 5 10 10 15 5 10 0
5-6 4 7 11 12 16 5 11 0
5-7 8 7 15 7 15 0 15 0
6-8 1 11 12 16 17 5 17 5
7-8 2 15 17 15 17 0 17 0
8-10 5 17 22 17 22 0 22 0
9-10 7 10 17 15 22 5 22 5
Financial evaluation
techniques
 Non-discounted Cash Flow Criteria
1. Payback Period (PB)
2. Average / Accounting Rate of Return (ARR)

 Discounted Cash Flow Criteria

3. Net Present Value (NPV)
4. Internal Rate of Return (IRR)
5. Profitability Index (PI)
6. Discounted Payback Period (DPB)
 1. Payback Period Method
• Payback is the number of years required to recover the original cash
outlay invested in a project.
• If the project generates constant annual cash inflows, the payback
period can be computed by dividing cash outlay by the annual cash
inflow.
• That is:

𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
𝐏𝐚𝐲𝐛𝐚𝐜𝐤 =
𝐀𝐧𝐧𝐮𝐚𝐥 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰
Initial Investment = 2,5,00,000
Annual Cash Inflow = 5,00,000 for 8 years
Calculate the payback period.
 𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
𝐏𝐚𝐲𝐛𝐚𝐜𝐤 =
𝐀𝐧𝐧𝐮𝐚𝐥 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰

𝟐, 𝟓, 𝟎𝟎, 𝟎𝟎𝟎
=
𝟓, 𝟎𝟎, 𝟎𝟎𝟎
= 5 years
 An industry is considering investment in a project which cost 6,00,000
 Cash Inflows are ₹1,20,000, ₹1,40,000, ₹1,80,000, ₹2,00,000, ₹2,50,000
 Calculate Payback Period

Years Cash flows Cumulative Cash Flows

0 6,00,000
1 1,20,000
2 1,40,000
3 1,80,000
4 2,00,000
5 2,50,000
Years Cash flows Cumulative Cash Flows
0 6,00,000 6,00,000
1 1,20,000 4,80,000
2 1,40,000 3,40,000
3 1,80,000 1,60,000
4 2,00,000 40,000
5 2,50,000

𝟏, 𝟔𝟎, 𝟎𝟎𝟎
𝐏𝐚𝐲𝐛𝐚𝐜𝐤 = 𝟑 𝐲𝐞𝐚𝐫𝐬 +
𝟐, 𝟎𝟎, 𝟎𝟎𝟎
= 3 years + 0.8
= 3.8 years
 Acceptance Rule
 The project would be accepted if its payback period is less than the
maximum or standard payback period set by management.
 As a ranking method, it gives highest ranking to the project, which has the
shortest payback period and lowest ranking to the project with highest
payback period.
 Merits
1. It is one of the earliest methods of evaluating the investment projects.
2. It is simple to understand and to compute.
3. It dose not involve any cost for computation of the payback period
4. It is one of the widely used methods in small scale industry sector
5. It can be computed on the basis of accounting information available
from the books.
 Demerits
1.This method fails to take into account the cash flows received by the company
after the pay back period.
2. It doesn’t take into account the interest factor involved in an investment outlay.
3. It doesn’t take into account the interest factor involved in an investment outlay.
4. It is not consistent with the objective of maximizing the market value of the
company’s share.
5. It fails to consider the pattern of cash inflows i.e., the magnitude and timing of
cash in flows.
 2. Average Rate of Return
The accounting rate of return is the ratio of the average after-tax profit divided by
the average investment. The average investment would be equal to half of the original
investment if it were depreciated constantly.

𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐩𝐫𝐨𝐟𝐢𝐭
ARR =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
Profit = Cash inflows – Depreciation – Tax
Average Profit = Profit / No. of Years
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 + 𝐒𝐜𝐫𝐚𝐩 𝐕𝐚𝐥𝐮𝐞
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 = + Additional Working Capital
𝟐
Initial Investment = 1,60,000 ; No Scrap Value
Cash Inflows :- Year 1 2 3 4 5
₹ 56,000 48,000 30,000 64,000 80,000

Depreciation on straight line basis

Tax rate is 40%
Cash flows = 56,000 + 48,000 + 30,000 + 64,000 + 80,000
=2,78,000

Profit = Cash inflows – Depreciation – Tax

= 2,78,000 – 1,60,000 – 47,200
= 70,800

Average Profit = Profit / No. of Years

= 70,800 / 5
= 14,160
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 + 𝐒𝐜𝐫𝐚𝐩 𝐕𝐚𝐥𝐮𝐞
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 = + Additional Working Capital
𝟐

= 1,60,000 / 2 = 80,000

𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐩𝐫𝐨𝐟𝐢𝐭 14,160

ARR = = × 100 = 17.7 %
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 80,000
 Acceptance Rule
• This method will accept all those projects whose ARR is higher than the
minimum rate established by the management and reject those projects
which have ARR less than the minimum rate.
• This method would rank a project as number one if it has highest ARR
and lowest rank would be assigned to the project with lowest ARR.
 Merits
1. It is very simple to understand and calculate.
2. It can be readily computed with the help of the available accounting data.
3. It uses the entire stream of earning to calculate the ARR.
 Demerits

1. It is not based on cash flows generated by a project.

2. This method does not consider the objective of wealth maximization
3. It ignores the length of the projects useful life.
4. It does not take into account the fact that the profits can be re-invested.
 3. Net present value
 The NPV takes into consideration the time value of money.
 The cash flows of different years and valued differently and made
comparable in terms of present values for this the net cash inflows of
various period are discounted using required rate of return which is
predetermined.
Calculate NPV of the two projects and suggest which of the two project should be accepted
assuming discount rate @ 10%
Project X Project Y
Initial Investment 40,000 60,000
Estimated life 5 years 5 Years
Scrap Value 2,000 4,000
Cash Inflows
Year 1 2 3 4 5
Project X 10,000 20,000 20,000 6,000 4,000
Project Y 40,000 20,000 10,000 6,000 4,000

PV factor @ 10% discount

Year 1 2 3 4 5
PV factor @ 10% 0.909 0.826 0.751 0.683 0.621
 Discount factor
 It’s a weighing term used in mathematics and economics, multiplying future
income or losses to determine the precise factor by which the value is
multiplied to get today’s net present value.
 This can be applied to goods, services, or investments, and is frequently used
in corporate budgeting to determine whether a proposal will add future value.

1
Discount Factor =
(1 + r)𝒏
 where “r” is the discount rate and “n” is the number of periods.
 Project X
Year Cashflows DF @ 10% PV
0 (40,000) 1 (40,000)
1 10,000 0.909 9,090
2 20,000 0.826 16,520
3 20,000 0.751 15,020
4 6,000 0.683 4,098
5 4,000 0.621 2,484

5 (Scrap) 2,000 0.621 1,242

NPV 8,454
 Project Y

Year Cashflows DF @ 10% PV

0 (60,000) 1 (60,000)
1 40,000 0.909 36,360
2 20,000 0.826 16,520
3 10,000 0.751 7,510
4 6,000 0.683 4,098
5 4,000 0.621 2,484

5 (Scrap) 4,000 0.621 2,484

NPV 9,456
 Acceptance Rule

 Accept the project when NPV is positive NPV > 0

 Reject the project when NPV is negative NPV < 0

 May accept the project when NPV is zero NPV = 0

 The NPV method can be used to select between mutually exclusive projects; the

one with the higher NPV should be selected.

 Merits
1. It recognizes the time value of money.
2. It is based on the entire cash flows generated during the useful life
of the asset
3. It is consistent with the objective of maximization of wealth of the
owners.
4. The ranking of projects is independent of the discount rate used for
determining the present value
 Demerits
1. It is different to understand and use.
2. The NPV is calculated by using the cost of capital as a discount rate. But the
concept of cost of capital. If self is difficult to understood and determine.
3. It does not give solutions when the comparable projects are involved in
different amounts of investment.
4. It does not give correct answer to a question whether alternative projects or
limited funds are available with unequal lines.
 4. Internal Rate of Return
The internal rate of return (IRR) is the rate that equates the investment outlay with the
present value of cash inflow received after one period.
This also implies that the rate of return is the discount rate which makes NPV = 0
Calculation:
1) Calculate two NPVs for the project at two different cost of capital
2) Use following formula

𝑵𝑳
𝐈𝐑𝐑 = 𝐋 + × (𝑯 − 𝑳)
𝑵 𝑳 − 𝑵𝑯

Where, L = Lower rate ; 𝑵𝑳 = NPV at Lower rate

H = Higher rate ; 𝑵𝑯 = NPV at Higher rate
If Calculated NPV is (-), then calculate NPV with Lower rate → (+) NPV
If Calculated NPV is (+), then calculate NPV with Higher rate → (-) NPV

Calculate the internal rate of returns of an investment of ₹ 136000 which yields the
following cash inflows
Year Cash Inflow
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
Year Cash Inflow DF @ 10% PV DF @ 12% PV
0 (1,36,000) 1 (1,36,000) 1 (1,36,000)
1 30,000 0.909 27,270 0.893 26,790
2 40,000 0.826 33,040 0.797 31,880
3 60,000 0.751 45,060 0.712 42,720
4 30,000 0.683 20,490 0.636 19,080
5 20,000 0.621 12,420 0.567 11,340
NPV 2,280 NPV - 4,190
 𝑵𝑳
𝐈𝐑𝐑 = 𝐋 + × (𝑯 − 𝑳)
𝑵𝑳 − 𝑵𝑯

𝟐, 𝟐𝟖𝟎
𝐈𝐑𝐑 = 𝟏𝟎 + × (𝟏𝟐 − 𝟏𝟎)
𝟐, 𝟐𝟖𝟎 + 𝟒, 𝟏𝟗𝟎

𝟐, 𝟐𝟖𝟎
𝐈𝐑𝐑 = 𝟏𝟎 + ×𝟐
𝟔, 𝟒𝟕𝟎

IRR = 10 + 0.70
IRR = 10.70 %
 Acceptance Rule
 Accept the project when r > k. k = Cost of Capital
 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.
 Merits
1. It consider the time value of money

2. It takes into account the cash flows over the entire useful life of the asset.

3. It always suggests accepting to projects with maximum rate of return.

4. It is inconformity with the firm’s objective of maximum owner’s welfare.

5. It has a psychological appear to the user because when the highest rate of return

projects are selected, it satisfies the investors in terms of the rate of return an

capital
 Demerits

1. It is very difficult to understand and use.

2. It involves a very complicated computational work.
3. It may not give unique answer in all situations.
 5. Profitability Index
 Profitability index is the ratio of the present value of cash inflows, at the
required rate of return, to the initial cash outflow of the investment.
 PI is a Useful tool for ranking investment projects and showing the value
created per unit of investment

𝐏𝐕 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰𝐬
Profitability Index =
𝐏𝐕 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐎𝐮𝐭𝐟𝐥𝐨𝐰𝐬
The initial cash outlay of a project is Rs 100,000 and it can generate cash inflow of ₹40,000,
₹30,000, ₹50,000 and ₹20,000 in year 1 through 4. Assume a 10 % rate of discount. The PV of
cash inflows at 10 % discount rate is:

Year
1
2
3
4
Year Cash Inflow DF @ 10% PV
1 40,000 0.909 36,360
2 30,000 0.826 24,780
3 50,000 0.751 37,550
4 20,000 0.683 13,660
NPV 12,350

NPV = 1,12,350 – 1,00,000 = 12,350

𝐏𝐕 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰𝐬
Profitability Index =
𝐏𝐕 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐎𝐮𝐭𝐟𝐥𝐨𝐰𝐬

𝟏, 𝟏𝟐, 𝟑𝟓𝟎
Profitability Index =
𝟏, 𝟎𝟎, 𝟎𝟎𝟎

= 1.1235
 Acceptance Rule
The following are the PI acceptance rules:
 Accept the project when PI is greater than one. PI > 1
 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.
 Merits

1. It requires less computational work then IRR method

2. It helps to accept / reject investment proposal on the basis of value of the index.
3. It is useful to rank the proposals on the basis of the highest/lowest value of the index.
4. It is useful to tank the proposals on the basis of the highest/lowest value of the index.
5. It takes into consideration the entire stream of cash flows generated during the
useful life of the asset.
 Demerits
1. It is some what difficult to understand
2. Some people may feel no limitation for index number due to several limitation
involved in their competitions
3. It is very difficult to understand the analytical part of the decision on the basis
of probability index.
 6. Discounted Payback Period
 The discounted payback period is the number of periods taken in
recovering the investment outlay on the present value basis.
 It is Similar to Payback Period Method, but uses Discounted
cashflows to measure the payback period. It is also known as
Adjusted payback.
 DDP method takes Time Value of Money into consideration
Calculate Discounted Payback Period of the following project and give
recommendation. (Maximum Discounted Payback Period 3 years )
Use 10% for Discounting

Year Cash Flow

0 (1,00,000)
1 30,000
2 50,000
3 40,000
4 30,000
5 20,000
 Year Cash Flow DF @ 10% PV Cumulative NPV
0 (1,00,000) 1 (1,00,000) (-1,00,000)
1 30,000 0.909 27,270 -72,730
2 50,000 0.826 41,300 -31,430
3 40,000 0.751 30,040 -1,390
4 30,000 0.683 20,490 19,100
5 20,000 0.621 12,420 31,520
NPV 31,520

𝟏, 𝟑𝟗𝟎
DPP = 𝟑 +
𝟐𝟎, 𝟒𝟗𝟎
= 3 + 0.067
= 3.067 Years
= 3 + (0.067 × 12)
= 3 years & 0.8 Months
Project should be rejected because DPP exceeds target DPP (3 years)
 Acceptance Rule
A company can set a target DPP and choose not to undertake any
project with a DPP in excess of a certain number of a year