DEVELOPMENT PLANNING AND

PROJECT ANALYSIS II
Econ 3132

CHAPTER TWO:
Financial Analysis of Projects
2.1. Scope and Rationale
Financial analysis applies to private and public investments.

A private firm will be interested in undertaking a financial

analysis of any project it is considering and seldom will it
undertake an economic analysis.

The issue of financial sustainability of public projects justifies

the need for undertaking financial analysis.

But profit oriented public enterprises will usually make a

financial and an economic analysis of any project they
undertake.
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Even non-profit oriented government institutions may wish
to choose between alternative facilities on the basis of
financial objectives.

In the case of hospital service, the management of the

hospital may be required to provide the cheapest services.
Under such circumstances, a cost minimization exercise will
be undertaken.

Commercial profitability analysis is the first step in the

economic analysis of a project.

A broad financial analysis provides the basic data needed

for economic evaluation of the project.
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Economic analysis involves adjustment of information used
in financial analysis and a few additional ones.

The process and methodology used in financial analysis is

mostly the same as that of economic analysis.

The financial analyst should communicate and know what to

ask from the different team members to collect relevant
information on:
1. Revenue, both forecasted sales and selling price,
2. Initial investment costs distributed over the implementation
of the project, and
3. Operating costs of the envisaged operational unit/firm over
its operating life.
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Issues and concerns of financial analysis:
1. Identification of the required data,

2. Analysis of reliability of the data,

3. Analysis of the structure and significance of costs and

benefits,

4. Determination and evaluation of annual and accumulated

financial net benefits,

5. Consideration of the spread of flows of the costs and

benefits over time, the economic life of the envisaged
economic unit/firm/public entity, and

6. Costs of capital overt time.

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2.2. Identification of Costs and Benefits
The first step in financial analysis is the identification of costs
and benefits.

The costs and benefit of a project depend on the objectives

of the project.

So, the objectives of the analysis provide the standard

against which costs and benefits are defined.

A cost is anything that reduces an objective, and a benefit is

anything that contributes to the objective.

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Most often, the maximization of income is taken as the
dominant objective of the firm because the single most
important objective of an individual economic agent is to
increase income.

Increased national income is the most important objective

of national economic policy.

Anything that reduces national income is a cost and anything

that increases national income is a benefit.

Hence, anything that directly reduces the total final goods

and services is a cost, and anything that directly increases
them is a benefit.
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In this way, the project leads to an increase in the total
amount of final goods and services, i.e., it increases national
income

The task of the economic analyst is to estimate the amount

of this increase in national income available to the society;
i.e., to determine whether, and by how much, the benefits
exceed the costs in terms of national income

8
2.3. Classification of Costs and Benefits
Some of the project costs and benefits could be easily
quantifiable based on market prices while many more
are difficult to value them in market prices and will not
appear in the financial balance sheet of the project.

Thus, costs and benefits that are quantifiable in market

prices that are indicated on financial statements are
called tangible costs and benefits.

On the other hand, costs and benefits that are not

quantifiable in market prices and not indicated in
financial statements are called non-tangible costs and
benefits (Gittinger, 1982).
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Tangible Costs of a Project
In almost all project analysis costs are easier to identify
(and value) than benefits.

In examining costs the basic question is whether the item

reduces the net benefit of a firm or the net income of a
firm.

In general, the tangible cost of a project could be grouped

into the cost of a project and the cost of production
(Chandra, 2002).

These costs are sometimes termed as direct costs /explicit

costs/ financial costs that occur ‘out of pocket’.
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A. Cost of a project
According to Chandra (2002), the cost of a project is the
sum of the total outlays on the following items:
♦ Land and site development - this component comprises of
basic cost of land and costs incurred for preparing the land
for use. It includes payment for land charges, for lease,
leveling and development, internal roads, gates and tube
wells.

♦ Building and civil works - These costs cover expenses on

main building and auxiliary buildings. Auxiliary buildings
include laboratory, workshop, warehouse, garage, canteen,
staff residence quarters, guest houses, etc.

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Management often tends to deal irrationally with
intangibles by ignoring them.

If intangible costs and benefits are ignored, the outcome

of the evaluation may be quite different from when they
are included.

It indicates the degree of uncertainty surrounding the

estimation of costs and benefits.

If the project is evaluated on a purely tangible basis,

benefits exceed costs by a substantial margin.

Therefore, such a project is considered cost effective.

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Conversely, if intangible costs and benefits included, the
total tangible and intangible costs exceed the benefits,
the project is an undesirable investment.
♦ Plant and machinery - the most significant component of
project cost is the cost of plant and machinery. These costs
include the cost of imported machinery, cost of indigenous
machinery, cost of spare part, foundation and installation
charge.

♦ Technical know-how and Engineering Fees - Technical

consultants and engineers may be employed for assisting in
technical matters such as preparing project report, choice
of technology, detail engineering and selection of plant and
machinery. The fees paid to them are part of the project
cost.
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♦ Pre-operative Expenses - these are expenses incurred for
identifying the project, conducting the market survey,
preparing the feasibility study and incorporating the
company. The category includes establishment expenses,
rents, taxes, interest and commitment charges on
borrowings, insurance charges, mortgage expanses interest
and other miscellaneous expenses.

♦ Provision for contingencies - It may range from 10 to 20%

of total project cost. It aims at providing for certain
unforeseen expenditures and price increases over and
above the normal inflation rate, which is already
incorporated in the cost estimates.

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B. The cost of production: categorized into four groups
♦ Cost of materials - comprises cost of row materials,
chemicals, and consumable stores required for production.
In practice, it is done by using the base year cost of
materials as a result they usually have a fixed value.

♦ Cost of labour - comprises costs associated with all

employed human resource. The cost estimation should
include basic pay, all allowances, expected increments,
pension/provident fund and other fringe benefits.

♦ Cost of Utilities - they consist of outlays for power, water,

telephone and fuel.

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♦ Cost of factory overheads - This includes all expenses
associated with repair and maintenance, rent, taxes, and
insurance premium on factory asset. Note that repairs
and maintenance costs tend to be lower in the initial
years and higher in the later years of production. Rent,
taxes and insurance premium may be calculated at the
existing rates.

 In general, tangible benefits can be expected from:

♦ Increased production,
♦ Quality improvement
♦ Changes in time of sale i.e. improved marketing facilities.

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♦ Changes in location of sale: e.g. transport projects which
give locational value,

♦ Changes in product form (grading, packaging and processing

projects),

♦ Cost reduction through technological advancement,

♦ Reduced transport costs through better feeder roads and

highways, and

♦ Losses avoided.

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 Intangible costs and benefits:- Externalities
 There may be some costs and benefits that are intangible.
These may include:
 The creation of new employment opportunities;
 Better health and reduced infant mortality as a result of more
rural clinics;
 Better nutrition as a result of agricultural project, etc.

 These intangible benefits are real and reflect true value.

 Such intangible benefits, however, do not readily lend

themselves to valuation.

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 Under such circumstances one may have to resort to
least cost approach instead of benefit cost analysis.
 The “least cost combination” or “cost effectiveness”
approach compares projects by considering
intangible costs and benefits.

Example: The benefits of education have been valued by

comparing earnings of educated people with
uneducated ones.

 Finally, the least cost approach asks, e.g., can the

same health benefits be provided at less cost by
constructing fewer large hospitals instead of more
clinics manned by paramedical personnel?
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2.4. Valuation of Financial Costs and Benefits
The financial benefits of a project are just the revenues
received and the financial costs are the expenditures that
are actually incurred by the implementing the project.

All receipts and expenditures are valued as they appear in

the financial balance sheet of the project, and are therefore,
measured in the market prices

Since project implementers have to pay and receive market

prices for the inputs used and outputs produced, the
financial costs and benefits of the project are measured in
market prices.

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Prices may be defined in various ways, depending on
whether they are:
1. Market (explicit) or shadow (imputed) prices;

2. Absolute or relative prices

3. Current or constant prices

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 Market (Explicit) or Shadow (Imputed) Prices
Market prices are those prices present in the market, no
matter whether they are determined by the supply and
demand or by the government

They are the prices at which the firm will buy the inputs
and sell the outputs

In financial analysis, market prices are applied while in

economic analysis, if the market prices are distorted,
shadow (imputed) prices will have to be used for analysis

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Absolute/Relative Prices
Absolute prices reflect the value of a single product in an
absolute amount of money, while relative prices express
the value of one product in terms of another product

The level of absolute prices may vary over the lifetime of

the project because of inflation or productivity changes.

Both absolute and relative prices can be used in financial

analysis.

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Current/Constant Prices
Current and constant prices differ due to inflation, which is
understood as a general rise of price levels in an economy

If inflation can have a significant impact on project input

and output prices, such an impact must be dealt with in
financial analysis.

Wherever relative input and output prices remain stable, it

is sufficiently accurate to compute the profitability or yield
of an investment at constant prices

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Only when relative price change and project input prices
grow faster (or slower) than output prices, or vice versa,
then the corresponding impacts on net cash flows and
profits must be included in financial analysis

If inflation impacts are negligible, the problem of choosing

between current and constant prices does not exist

Since they are equal and we may use either

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2.5. Project Profitability Analysis Using ‘FA’
 A financial analysis must be undertaken in order to
determine the financial profitability of a project to the
project implementer
 It is usually undertaken to ensure the selection of
alternative methods of production based on cost
effectiveness and profit maximization objective during
project preparation
 We undertake financial analysis of projects to compare
costs with benefits and determine which among alternative
projects have an acceptable return (financial viability)
 We may use non-discounted or discounted methods to
evaluate financial viability
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2.5.1 Non-Discounted Methods of Evaluating Project
Worth
 The most common non-discounted measures of project
worth are:
 Pay Back Period (PBP) &
 Accounting Rate of Return (ARR)
1. Payback Period
 The payback period is the length of time from the
beginning of the project until the net value of the
incremental production stream reaches the total
amount of capital investment

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 Sometimes it is called as pay off period and measured in
years.
 Many firms use this method to establish the number of
years required to recover the initial investment outlay
 When the annual cash inflow is uniform across each
year, the payback period is simply the initial investment
outlay divided by the annual cash inflow. That is
PBP = Initial Investment outlay
Annual cash inflow
Decision Rule: Accept the project with less ‘PB’ period

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Examples:
1) Assume an project with initial outlay of Birr 100,000 is
expected to bring in an annual cash flow of Birr 25,000 for 8
years. PBP= 100,000/25,000 = 4
 Clearly it will take 4 years for the initial investment to be
recovered and therefore, the PP is 4 years
2) Another project worth with a similar outlay of 100,000 Birr
but with an annual cash flow of 50,000 Birr for 3 years.
PBP= 100,000/50,000 = 2
 It will take 2 years to recover its initial investment, and will
therefore, be preferred than the former project

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 If annual cash inflows (receipts) fluctuate overtime, as they
often do, we must add together to workout the length of
time taken for initial outlay (Investment cost) to be
recovered
Example: Consider two projects A with initial investment
outlay of birr 15,000 & project B with initial outlay of birr
12,000 has the ‘ff’ expected cash inflow as indicated below

Years Project A Project B

1 6,000 3,000
2 6,000 5,000
3 3,000 2,000
4 500 1,000
5 300 1,000

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Question:
a) What is the pay back period for each project?
b) Which of the two projects would you choose? Why?
Answer:
a) Project A has a PBP of 3 years & B has a PBP of 5 years
b) Project A should be preferred over project B

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Note: For Unequal cash flows PBP is calculated as:
PBP= E + B/C
where E = number of years immediately preceding the year
of final recovery
B = the remaining balance amount to be recovered
C = cash flow during the final recovery
Example: A company is considering investing on a particular
project. The alternative projects available are: Project A that
costs Br. 100,000 and Project B that Costs Br. 70,000. The net
cash inflows estimates are given as follows

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 PROJECT A PROJECT B
Year
Net cash inflow Accumulated net Net cash Accumulated net
cash inflow inflow cash inflow

1 30,000 30,000 7,000 7,000

2 30,000 60,000 15,000 22,000

3 35,000 95,000 20,000 42,000

4 35,000 130,000 56,000 98,000

5 40,000 170,000 45,000 143,000

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# Which project is good? Why?
Payback period for Project A:
PBP = 3 + (100,000-95,000)/35,000
PBP = 3+ (5,000)/35,000
PBP = 3.14 year or 3 years & 2 months
Payback period for Project B
PBP = 3 + (70,000-42,000)/56,000
PBP = 3+ (28,000)/56,000
PBP = 3.5 year or 3 years & 6 months
 Thus, project A is preferable than B

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 Note: If two projects have the same investment cost and
pay back period; the one with more earlier benefits is
desirable and preferred since the earlier a benefit is
received the earlier it can be re-invested or consumed
Limitation/drawbacks of payback period
 The payback period is a very crude measure of project
worth because it completely ignores benefits/ cash flows
after the period when the initial investment has been repaid
 It discriminates heavily against projects with a long
gestation period.

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 It ignores the time value of money
 It is unsuitable while comparing the payback periods of two
or more projects where the net cash inflows are of widely
different amounts for different projects.
 Projects with initial lower earnings but with very high
profitability in later years may be rejected
 It requires an estimation of a safe period, in reality that
varies between types of industry. For example, in heavy
industry the payback period is very long
Advantages of Payback period
 Easy to understand, quick in calculations and
 Emphasizes in liquidity.
 Preferable for "short term" investments

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2. Accounting Rate of Return (ARR)
 This method is also called simple rate of return (SRR) or
return on equity capital
 ARR is defined as the ratio of net profit during project full
operation (production) to the original investment outlay
 ARR considers the total profitability of a project over its
entire life period
ARR=Average Profit/Total Investment

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NB: The ARR method is concerned with profit and not just
cash flow and hence, depreciation is also taken in to account
 It also considers the project’s whole life span and not just
the period over which it can pay back the initial capital
investment
Example: Project ‘X’ requires an initial capital investment of
Birr 45,000. Its annual net cash flow over a five years period is
given as follows
Year 1 2 3 4 5

Cash flow 24 15 11 10 10
(in ‘000)

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Question: Find rate of return on capital employed (ARR)
assuming that the firm employs a straight-line depreciation
method to write off capital
Solution: Average profit can be found by deducting annual
depreciation. Annual depreciation= (initial inv’t/project years)
= (45000/5 years)= 9,000

Year 1 2 3 4 5
Cash flow 24 15 11 10 10
(‘000)
Depreciation 9 9 9 9 9
(‘000)
Profit (‘000) 15 6 2 1 1

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Now, total profit during 5 year project life = 25,000
 Average profit= 25,000/5 year
 Average Profit= 5,000 &
 ARR= (Average profit)/initial outlay
 ARR= 5,000/45,000
 ARR= 0.111 Or ARR= 11.1%

Note: The higher the accounting rate of return, the better

the project worth.

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Decision Rule: Projects that have an ARR equal to or greater
than a pre-specified cut off rate of return- which is usually
between 15% and 30%- are accepted; others are rejected.
Advantages of ARR method
 It is simple to calculate
 It considers benefits over the entire life of a project as well
as the profitability of employed resources
Limitation of ARR method
 The presence of numerous measures of ARR creates
controversy, confusion, and problems of interpretation.
 It is based upon accounting profit, not cash flow

41
 It fails to take in to account the time value of money
 It also fails to take into account the timing of benefit stream
 Fails to consider the fluctuation in depreciation

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 2.5.2 Discounted Measures of Project Worth
Time value of money states that present values are better
than the same future values, and earlier returns are better
than later.
 This notion helps to overcome the weaknesses of non-
discounted measures of project worth i.e. they fail to take
in to account the timing of the benefit stream, and include
a time dimension in our evaluation through the use of
discounting
 People prefer the present worth of money to its future use
because of uncertainty and inflation (loses in purchasing
power of money)

43
 Discounting is a technique by which one can “reduce” future
benefit and cost streams to their “present worth”
 The process of finding the present worth of a future value is
called “discounting”
 The interest rate assumed for discounting is called the
“discount rate”

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 The interest rate used for computing assumes a view point
from here to the future, whereas discounting looks
backward from the future to the present

 Discussing the time value of money and using a phrase like

“money has time value” refers to the fact that a Birr
obtained today is worth more than a Birr obtained at a
future date

 Put it differently, a Birr obtained in the future is less

valuable than a Birr obtained today OR

 A Birr today is worth more than a Birr tomorrow, because

the Birr today can be invested to start earning interest
immediately
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 The most prominent discounted measures of project
worth are:

1. Net Present Value (NPV)

2. Benefit Cost Ratio (BCR), and

3. The Internal Rate of Return (IRR).

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 What is Present Value? Why we use PV?
 We know that a birr today is worth more than a birr
tomorrow, because the birr today can be invested to start
earning interest immediately

 Thus, the PV of a delayed pay off may be found by

multiplying the pay off by discounting factor, which is less
than 1

 If C1 denotes the expected payoff (future value) at time

period 1, then PV = (discounting factor) x C1

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This discounting factor is expressed as the reciprocal of 1
plus a rate of return:
1
Discounting factor (DF) = 1 r
The rate of return r is the reward that investors demand for
accepting delayed payment

To calculate PV, we discount expected future pay offs by the

rate of return of comparable investment alternatives

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 This rate of return is often referred to as discount rate,
hurdle rate, or opportunity cost of capital.

It is called the opportunity cost because it is the return

forgone by investing in the project rather than investing in
securities

Example: If the expected FV, from one year now, is 400,000

birr and the opportunity cost (discount rate) is 7%, then
400,000 400,000
PV    373,832
1  .07 1.07
Note: Subtracting the required investment from the PV gives
the Net Present Value (NPV).

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 1. The Net Present Value (NPV)
Suppose the required investment is Birr 350,000 for the
above example, then
NPV = PV – (required investment)
= 373, 832 - 350, 000
= 23, 832
C1
Thus, NPV is written as NPV   C0
1 r

where C1 = cash flow at the end of year 1

Co = cash flow at period 0 (i.e. today) is a negative
quantity, b/se Co is an investment and it shows cash
outflow or initial investment cost
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 Considering several project years, NPV is the sum of present
values of all the cash flows that are expected to occur over
the life of the project.
The formula for calculating NPV is
n
Ct
NPV    C0
t 1 (1  r )
t

where, Co = initial investment

Ct = cash flow at d/t periods
t = life of the project
r = discount rate

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The general formula for NPV is:

where Bt= the project benefits in period t

Ct = the project costs in period t
n = number of project operational years
r = appropriate discount rate
Note: Bt-Ct represents annual net cash flows (NCF) of the project

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Decision rule associated with NPV
If NPV is positive (i.e. NPV>0), accept the project

If NPV is negative (i.e. NPV<0), reject the project

If NPV is zero, we are indifferent between accepting and

rejecting the project

If projects are independent, select all projects with positive

NPV; and if projects are mutually exclusive, select the
project with the highest positive NPV

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Example 1. Find the NPV of a project with the cash flow stream
given below. Assume the cost of capital (r) is 10%
Year: 0 1 2 3 4 5
Cash flow (‘000): 200 40 40 60 60 70

Solution:
5

C t
40,000 40,000 60,000 60,000 70,000
NPV  1
 C0       200,000
(1  r ) t
1  0.1 (1  0.1) (1  0.1) (1  0.1) (1  0.1)
2 3 4 5

40,000 40,000 60,000 60,000 70,000

  2
 3
 4
 5
 200,000
1 .1 (1.1) (1.1) (1.1) (1.1)
 36,363.64  33,057.85  45,078.89  40,980.81  43,464.49  200,000
 198,945.68  200,000
  1,054.32  0  Reject the project
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 Example 2: From the following project information
calculate the NPV with 8% discount rate
Year 0 1 2 3
Capital cost 10,000 - - -
Operating cost - 4,000 4,000 4,000
Revenue - 8,000 8,000 8,000

Solution:
Year 0 1 2 3
Capital cost 10,000 - - -
Operating cost - 4,000 4,000 4,000
Revenue - 8,000 8,000 8,000
Net Benefit (NCF) -10,000 4,000 4,000 4,000
DF @ 8% 1 0.9259 0.8573 0.7938

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 Therefore, the NPV= (-10000 x 1) + (4000 x 0.9259) + (4000
x 0.8573) + (4000 x 0.7938) = 308 Birr
 Our decision is accept the project since NPV is > 0.
Note that a project’s NPV clearly varies with the discount rate
used.
 Usually the higher the discount rate, the smaller the NPV
will be.
 When NPV=0 the project could be selected because at this
NPV the project is at least able to repay its loan
 So, even though the absolute return is zero it could be
possible to undertake the project as it pays the capital
outlay
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Advantages of NPV
 The cash flows from the beginning to the end of the project
are considered
 It gives a measure of the discounted absolute surplus from
an Investment
 It is particularly used for comparison and selection from
among mutually exclusive projects that are of the same size
 It discounts cash flows by the cost of capital which gives
explicit recognition to the returns required by investors

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 Since it is expressed in Birr (currency) the decision maker
can easily understand it than percentage and ratio

Disadvantages of NPV
 The NPV method can be employed in selecting from
mutually exclusive projects only when the projects are of
the same size
 If the levels of investment are different deciding the
acceptability of the project only on the basis of NPV is
misleading
 The discount rate needs to be obtained externally to the
method of calculation. That is r is determined exogenously.

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 The opportunity cost of capital (r) is assumed to remain
constant throughout the life of the project
 But usually the cost of capital changes over the lifespan of
the project
 It does not show the exact profitability rate of the project.

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2. Benefit Cost Ratio (BCR)
 The second widely used discounted measure of project
worth is the benefit cost ratio
 BCR is obtained by dividing the present value of the benefit
stream by the present value of the cost stream.
 The formula for BCR is given as:

Pr esent Value of Benefits ( PVB) PVB

BCR  
Initial Investment (C0 ) C0

 If we are interested calculate Net benefit cost ratio (NBCR), then

PVB  C0 PVB
NBCR    1  BCR  1
C0 C0
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BCR=
Decision criteria:
i) If BCR > 1, we accept the project ⇒ NPV>0
ii) If BCR < 1, we reject the project ⇒ NPV<0
iii) If BCR = 1, indifferent ⇒NPV =0

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Advantages of BCR method
 BCR indicates a relative and not absolute measure of
surplus. Thus, it is considered superior to NPV method as it
indicates the relative measure of return
 It serves as a measure of efficiency to convert costs into
benefits (measures the value of benefit per Birr of
expenditure)
 Since BCR indicates the benefit per Birr of investment it can
be considered as better method for ranking projects

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Disadvantages of BCR
 As with NPV, it requires a discount rate to be determined
externally
 This method can not be employed when a package of
smaller projects is to be considered in relation to a large
projects

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3. The Internal Rate of Return (IRR)
The IRR for an investment proposal is the discount rate that
makes NPV of a project zero

For financial analysis it would be the maximum interest rate that

the project could afford to pay on its funds and still recover all its
investment and operating costs

We are forced to resort to a systematic procedure of trial and error

to find the discount rate which will make the net present worth of
the incremental net benefit stream equal to zero

Making the initial estimate is the most difficult aspect of the trial
and error procedure
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 Decision rule for projects
• We implement all projects that show an IRR greater than the
predetermined discount rate (opportunity cost of capital)
• That is, accept all independent projects having an IRR
greater than the opportunity cost of capital (cut off rate).
• The reference discount rate (also called the target rate) is
predetermined by the central bank
• All projects with an internal rate of return greater than some
target rate (cut off rate) of return r, should be accepted

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 The rule for interpolating the value of IRR lying between
two discount rates too high on the one side and too low
on the other is:
NPV1
IRR  r1  (r2  r1 )
NPV1  NPV2

Where, r1 = lower discount rate

r2 = higher discount rate
NPV1 = NPV at lower discount rate
NPV2 = NPV at higher discount rate

 Signs are ignored when taking the sum of NPVs at the

lower and higher discount rates.

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. Decision Rule :-The formal selection criteria of
independent projects based on IRR is to accept a project
having an IRR equal to or greater than the opportunity
cost of capital
i) If IRR > r, accept the project.
ii) If IRR < r, reject the project
iii) If IRR = r, we’re indifferent
Note:- When
 NPV > 0, IRR > r
 NPV = 0 , IRR = r
 NPV < 0, IRR < r where, r - is predetermined discount rate
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 How do we compute IRR?
The arithmetic rule for computing the IRR relies on using
two discount rates.
In the IRR calculation, we set the NPV equal to zero and
determine the discount rate that satisfies this condition.
Example: Consider a project with the following cash flows

Year 0 1 2 3 4

Cash flow (100,000) 30,000 30,000 40,000 45,000

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 The IRR is the value of r, which satisfies the ff equation

 100,000 30,000 30,000 40,000 45,000

0    
1 (1  r )1
(1  r ) 2
(1  r ) 3
(1  r ) 4

30,000 30,000 40,000 45,000

100,000    
(1  r )1
(1  r ) 2
(1  r ) 3
(1  r ) 4

 We try different values of r till we find that the right-hand

side of the above equation is equal to 100,000.
 Let us, to begin with, r = 12 percent.

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 30,000 30,000 40,000 45,000
107,773  1
 2
 3

(1.12) (1.12) (1.12) (1.12) 4

 Since this is more than 100,000, we have to try a higher

value of r. In general, a higher r lowers NPV and a lower r
increases NPV. Let try by making r = 14%

30,000 30,000 40,000 45,000

103,046  1
 2
 3

(1.14) (1.14) (1.14) (1.14) 4

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 Since this value is higher than the target value of 100,000, we
have to try still higher value of r. Let r = 15%

30,000 30,000 40,000 45,000

100,802    
(1.15)1 (1.15) 2 (1.15) 3 (1.15) 4

 This value is slightly higher than our target value, 100,000.

 So we will increase the value of r from 15 percent to 16
percent. When r = 16%

30,000 30,000 40,000 45,000

98,641    
(1.16)1 (1.16) 2 (1.16) 3 (1.16) 4

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 Now we have higher and lower discount rate (r2 & r1) with their
respective NPVs (NPV2 & NPV1)
 r2 = 16% and NPV2 (98,641-100,000) = -1,359
 r1 = 15% and NPV1 (100,802-100,000) = 802
 By using the formula, we can find IRR as

NPV1
IRR  r1  (r2  r1 )
NPV1  NPV2

802
IRR  15%  (16  15%)
802  (1359)
Thus, IRR = 15.37%

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Decision
 If IRR > r, accept the project (i.e. if r < 15.37%)
 If IRR < r, reject the project (i.e. if r >15.37%)
 If IRR= r, indifferent (i.e. if r = 15.37%)

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Advantages of IRR

 It is closely related to NPV, often leads to the same

decision
 It is easy to understand and communicate.
Disadvantages of IRR
 May result in multiple answers or does not deal with the
conventional cash flows
 May lead to incorrect decisions in comparison of
mutually exclusive projects

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 2.6. Sensitivity Analysis
Projects are implemented within a constantly changing
and complex environment.

Thus, all projects are subject to some degree of risk and

uncertainty

Risk refers to the probability of an event occurring and

can be quantified.

Uncertainty is inherently unpredictable and cannot be

quantified itself, although the effects of a specified
uncertain event can often be quantified.

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The first task of the planner is to gather information
sufficiently to enable some project uncertainties to be
quantified as risks. This is the process of risk
identification

These risks can then be subject to risk analysis

techniques

No matter how good the project’s information gathering

systems are, there will still be some uncertainties which
cannot be quantified.

These should be subject to sensitivity analysis in order to

assess their potential seriousness in disrupting project
implementation and operations.
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Sensitivity analysis:- is a technique applied to uncertainties.

Sensitivity analysis is the technique used to determine how

independent variable values will impact a dependent
variable under a given set of assumptions

It is also known as the what-if analysis

These uncertainties are factors affecting project outcomes

which cannot be quantified.

The purpose of sensitivity analysis is to tell us the factors

liable to have the greatest influence over project success and
failure. Once these factors have been identified it is then
possible to design appropriate mitigation measures
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 Sensitivity analysis shows how the NPV or other criteria of
merit changes with variations in the value of any variable.

A range of estimates can be made in this analysis

 In this approach, a variable might be tested using 3 different values: a
‘best estimate’, an ‘optimistic’ value and a ‘pessimistic’ value.
 These values could be determined by the likely order of variation of the
variable being tested
 Such an approach is useful in defining the possible impact of changes in
a parameter of interest but, without further analysis, such tests do not
provide any additional information; and

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 It is difficult to make comparisons of sensitivity changes in different
variables if the percentage variations are different

A second approach is to choose a fixed percentage variation

and to test each important variable for the percentage
change.
This approach has the advantage that it is possible to
compare the sensitivity of the project to changes in different
variables and hence to determine which variables are most
important in determining project profitability

But, it method has the disadvantage that it says noting about

the likelihood of the assumed change or the size of potential
variations.

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Some changes in variables have a linear relationship to the
NPV while others do not.

To apply these tests the following points have to be

considered:
 Set up the relationship between the basic underlying factors
and NPV (or other criteria).

 Estimate the range of variation and the most likely value of

each of the basic underlying factors.

 Study the effect on NPV of variations in the basic variables.

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 Where a linear relationship exists between the variable
concerned and the NPV, the following formula can be
used to calculate a switching value,

i.e. the change in value for the variable concerned required

to reduce the NPV of the project to zero.

This can be done for both economic and financial analysis,

but care must be taken to ensure that the test being
undertaken is relevant to the type of analysis being done.
e.g. a change in the actual wage rate for unskilled labour
affects the financial analysis, but it is a change in the
shadow wage rate that affects the economic analysis.

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When, NPV1 is the base value for the project and NPV 2 is the
new value resulting from an assumed change in prices (or
quantity) from P1 to P2, the switching value (SV) for the item
being tested is given by:

 NPV1  P2  P1 
SV      100%

 NPV2  NPV1  P1 

Sensitivity analysis allows for the identification of those

critical areas that will influence the success or failure of the
project.

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This should provide those who are planning and managing
projects with ideas about the areas that need to be studied
in more depth or where actions may be required to protect
the project.

Two major limitations of sensitivity analysis

i. It is partial. The study of the impact of variation is normally
undertaken one factor at a time, holding other factors
constant. This may not be meaningful when the underlying
factors are likely to be interrelated.

ii. It says nothing about the likelihood of the tested changes

happening. Any judgments about likelihood will necessarily
be qualitative.

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