Explain the importance of each of the steps in the capital expenditure process.
Outline the decision rules for each of the main methods of project evaluation.
Explain the advantages and disadvantages of the main project evaluation methods.

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Chapter 5 Project Evaluation:Principles and MethodsLearning ObjectivesExplain the importance of each of the steps in the capital expenditure process.Outline the decision rules for each of the main methods of project evaluation.Explain the advantages and disadvantages of the main project evaluation methods.Learning Objectives (cont.)Explain why the net present value method is preferred to all other methods.Understand the link between economic value added (EVA) and net present value (NPV).Capital Expenditure ProcessThe capital expenditure process involves:Generation of investment proposals.Evaluation and selection of those proposals.Approval and control of capital expenditures.Post-completion audit of investment projects.Generation of Investment ProposalsInvestment ideas can range from simple upgrades of equipment, replacing inefficient exiting equipment, through to plant expansions, new product development or corporate takeovers.Generation of good ideas for capital expenditure is better facilitated if a systematic means of searching for and developing them exists.This may be assisted by financial incentives and bonuses for those who propose successful projects.Evaluation and Selection of Investment ProposalsTo enable evaluation of a proposal, it should include the following data:Brief description of the proposal.Statement as to why it is desirable or necessary.Estimate of the amount and timing of the cash outlays.Estimate of the amount and timing of the cash inflows.Estimate of when the proposal will come into operation.Estimate of the proposal’s economic life.Approval and Control of Capital ExpendituresCapital expenditure budget (CEB) — maps out the estimated future capital expenditure on new and continuing projects.CEB has the important role of setting administrative procedures to implement the project (project timetable, procedures for controlling costs).Timing is important, project delays and cost over-runs will lower the NPV of a project, costing shareholder wealth.Post-completion Audit of Investment ProjectsHighlights any cash flows that have deviated significantly from the budget and provides explanations where possible.Benefits of conducting an audit:May improve quality of investment decisions.Provides information that will enable implementation of improvements in the project’s operating performance.May result in the re-evaluation and possible abandonment of an unsuccessful project.Methods of Project EvaluationMethods of project evaluation include:Net present value (NPV)Internal rate of return (IRR)Benefit–cost ratio (profitability index)Payback periodAccounting rate of returnProject Evaluation Methods Used by the Entities Surveyed(a) The aggregate percentage exceeds 100 per cent because most respondents used more than one method of project evaluation.Source: Graham, J.R. & C.R. Harvey (2001)Table 5.1: Selected project evaluation methods used by the CFOs surveyedMethodPercentageAccounting Rate of Return20.29Profitability Index11.87Internal Rate of Return75.61Net Present Value74.93Payback Period56.74Discounted Cash Flow MethodsDiscounted cash flow (DCF) methods involve the process of discounting a series of future net cash flows to their present values.DCF methods include:The net present value method (NPV).The internal rate of return method (IRR).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 project’s net cash flows:Forecast expected net profit from project, making an adjustment for non-cash flow items.Estimate net cash flows directly.Calculation of NPVThe standard NPV formula is given by: Net Cash FlowCash inflows:Receipts from sale of goods and servicesReceipts from sale of physical assetsCash outflows:Expenditure on materials, labour, and indirect expenses for manufacturingSelling and administrative Inventory and taxesEvaluation of NPVNPV method is consistent with the company’s objective of maximising shareholders’ wealth.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 company’s shares should increase.Decision rule for NPV method:Accept a project if its net present value is positive when the project’s net cash flows are discounted at the required rate of return.NPV ExampleExample 5.1Investment of $9000Net cash flows of $5090, $4500 and $4000 at the end of years 1, 2 and 3 respectively.Assume required rate of return is 10% p.a.What is the NPV of the project?NPV Example (cont.)Example 5.1:Apply the NPV formula given by (5.5).Thus, using a discount rate of 10%, the project has a NPV = +$2351 > 0, and is therefore acceptable.Internal Rate of Return (IRR)The internal rate of return is the discount rate that equates the present value of a project’s net cash flows with its initial cash outlay. 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 return (k). If IRR > k the project should be accepted.Calculation of InternalRate of ReturnBy setting the NPV formula to zero and treating the rate of return as the unknown, the IRR is given by: Multiple and Indeterminate Internal Rates of ReturnConventional projects have a unique rate of return.Multiple or no internal rates of return can occur for non-conventional projects with more than one sign change in the project’s series of cash flows.Thus, care must be taken when using the IRR evaluation technique.Under IRR: accept the project if it has a unique IRR > the required rate of return.Choosing Between the Discounted Cash Flow MethodsIndependent investmentsProjects that can be considered and evaluated in isolation from other projects.This means that the decision on one project will not affect the outcomes of another project.Mutually exclusive investmentsAlternative investment projects, only one of which can be accepted.For example, a piece of land is used to build a factory, which rules out an alternative project of building a warehouse on the same land.Choosing Between the Discounted Cash Flow Methods (cont.)Independent investments:For independent investments, both the IRR and NPV methods lead to the same accept/reject decision, except for those investments where the cash flow patterns result in either multiple or no internal rate(s) of return.In such cases, it doesn’t matter whether we use NPV or IRR.Choosing Between the Discounted Cash Flow Methods (cont.)Evaluating mutually exclusive projectsNPV and IRR methods can provide a different ranking order. The NPV method is the superior method for mutually exclusive projects. Ranking should be based on the magnitude of NPV.Benefit–Cost Ratio (Profitability Index)The profitability index is calculated by dividing the present value of the future net cash flows by the initial cash outlay: Decision rule:Accept if benefit–cost ratio > 1Reject if benefit–cost ratio 0, reject if NPV < 0.Summary (cont.)Mutually exclusive projects — accept project with the highest NPV.In practice, other valuation methods such as accounting rate of return, payback period and economic value added are used in conjunction with NPV, despite a preference for DCF methods.This may be to measure some other effect, like the effect of the project on liquidity — payback period.