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Project Evaluation

Fundamentals

I.S.M.- Dhanbad 18.09.2010

Sanjay Singh

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Corporate Finance

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Corporate finance

Invest in projects that yield a return greater than the requiredrate of return (cost of capital). Returns on projects should bemeasured based on cash flows generated and the timing ofthese cash flows.

Choose a financing mix that minimizes the hurdle rate andmatches the assets being financed.

If there are not enough investments that earn the cost ofcapital, return the cash to the shareholders in the form ofdividends and stock buybacks

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Complexity in decision making, why?

Uncertainty

Possible course of action unidentifiable

Outcome/payoff of the course of action

Complexities/ many variables

Limited access of information

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Before selection of a project

Risk involved with the project

Rough estimate of the project cost

Capability to mobilise the necessary resources

Study about the market size & growthpotential

Availability of input and market for output

Costs involved in production, administration &marketing.

Access to the technology

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During the project

Time & Cost trade-off

PERT/CPM

Monitoring ofCapital expenditure Capital budgeting

Variance & performance analysis

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Incentive to the projects

Govt. subsidy

Solar

Food processing etc.

Incentive for EOUs/SEZ

Incentive for Backward Areas

Incentive for Small Scale Units

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Project Evaluation Techniques

Discounted Cash flow method

Marginal costing

Cost benefit analysis

Risk analysis

Probability estimates

Simulation

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Discounted Cash flow

Value (intrinsic) of asset is a function ofexpected cash flow of an asset.

Assets with high & predictable cash flow havehigh values.

Cash flow is discounted with the discount ratereflecting the riskiness of the cash flow.

Intrinsic value means value attached to anasset by an well informed analyst withseamless access to all information available.

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Discount Cash Flow (NPV)

ows

As per present value method, where the Value of any asset isthe present value of expected future cash flows generated byassets.

t=n

Value =C

Ft

t=1 (1+r)t

If the discounted cash flow is more than the cost of project thenproject is acceptable.

where, n = Life of the asset

CFt = Cash flow in period t

r = Discount rate reflecting the riskiness of the estimated cashflows

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Discount Cash Flow (NPV)

Care must be taken for projecting

Cash flow

Growth

Discounting rate (Cost of capital)

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Discount Cash Flow (NPV)

Growth

Growth depends on return on assets and

retention ratio.

Stable or high growth?

For a firm which have growth rate more than the

growth rate of economy then two stage DCF model

should be adopted

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Growth rate

Growth i.e. g= b*ROE

Where b= retention ratio

ROE=return on equityor g=b* [ROA+D/E{ROA-i(1-t)}]

Where ROA is return on assets.

D/E is debt equity ratio.Nominal growth rate=(1+Real growth rate)(1+inflation rate)-1

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Discount Cash Flow (NPV)

Discounting rate

Cash flow is discounted with Cost ofCapital

Cost of capital or

W

ACC

WACC=Ke*E + Kd*D

E+D

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Cost of Equity: Ke

The cost of equity is the rate of return that

shareholders expect to get on equity

investment. There are two approaches to

estimating the cost of equity.

risk and return model (CAPM,APM).

dividend-growth model.

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Cost of Equity: Ke

As per CAPM

Ke= Rf+ (Rm-Rf)

Where Rf = risk free rate of interest(The long-term government discount bond rate is the appropriate risk free rate)

= risk (non diversifiable)

Rm= expected market return.

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Cost of Equity:

Beta is a non-diversifiable risk and it depends

on

Type of business.

Operating leverage.

Financial leverage.

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eta (Risk)

Unlevered beta is also called as firms beta.

Levered beta is called as equity beta.

Beta levered = Beta unlevered [1+ (1-t) D/E]

As per equation of a straight line :

Firms return= a + slope(risk)* (market return)

= xy- n * mean of x * mean of y

X2

n * (mean of x)

2

Beta =Cov (x,m)

Var m

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Firm with same cash flow but lower standard

deviation or coefficient of variation will be

preferred.

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