Chapter Four

Technical Analysis of Project

 Self-Evaluation
 Define what the technical analysis of a project means to you,
and outline your understanding of its significance in project
management.
 On a scale of 1 to 5, where 1 indicates limited understanding and
5 reflects a high level of comprehension, rate your familiarity with
the methods used for evaluating the technical aspects of a project.
 Provide a brief explanation of at least two methods you believe
are crucial for conducting a comprehensive technical analysis in
project management.
 Introduction

 In this chapter, you will get fundamental technical issues

in Project Analysis.

Practically applicable (Availability)

Most optimum formulation (best)

 What mean technical Analysis?

 The technical analysis of a project involves the systematic

examination and evaluation of the technical aspects and
requirements of a project.

 It seems to be a continuous process in the project management

system which determines the prerequisites for meaningful
commissioning and establishment of the project.
 Purpose of Technical Analysis
i. To ensure that the project is technically feasible in the sense
that all the inputs required to set up project are available
(Practically applicable).
ii. To facilitate the most optimal formulation (most suitable)
of the project in terms of technology, size, location,
machinery, equipment, etc.
iii. Deciding from all available alternatives which will be the
best option for the organization.
 Cont….
 The following are basic issues pertaining to technical analysis
using common sense and economic logic.
o Plant capacity
o Technology and engineering
o Raw materials and Supplies study
o Product mix
o Location and site
o Machineries and equipment
o Structures and civil works
o Environmental impact
o Human resource organization
o Project charts and layouts
o Project implementation schedule
 [Link] Capacity
Q) How do you understand Plant Capacity?

 Plant capacity (also referred to as production capacity) refers to the

volume or number of units that can be manufactured during a given
period.

 Plant capacity may be defined in two ways:

feasible normal capacity (FNC) and

nominal maximum capacity (NMC).

So, Plant capacity may be seen from two perspectives:

 Cont….
1. Feasibility normal capacity (FNC)
 Capacity of the plant under normal working conditions.
2. Nominal maximum capacity (NMC)
 A higher capacity – nominal maximum capacity
 Taking into account overtime, excessive consumption of
factory supplies, utilities, spare parts and wear – and tear parts,
as well as disproportionate production cost increases.
What could be the determinants of Plant Capacity?
 Technology requirement
 Input constraints
 Investment cost
 Market conditions
 Resources of the firm
 Govt. policy
 Cont….
Factors Determining Capacity Decision:
1. Technological requirement
2. Input constraints
There may be constraints on the availability of certain inputs:
 Power supply may be limited, Basic raw materials may be
scarce, Foreign exchange available for import may be
inadequate, etc.
3. Investment cost
4. Market conditions
 Very strong market = Higher capacity is preferable
 Uncertain market = start with small capacity
 If the market, starting from a small base, is expected to grow
rapidly, the initial capacity may be higher than the initial level of
demand and further additions to capacity may be effected with
the growth of the market
 Cont….
5. Resources of the firm
o The resources, managerial and financial available to a firm define a
limit on its capacity decision.
o Obviously, a firm cannot choose a scale of operations beyond its
financial resources and managerial capability.
6. Governmental policy

o The capacity level may be influenced by the policy of the

government.
 4.2. Technology and Engineering
 For manufacturing a product/service often two or more
alternative technologies are available.

 Some of integral parts of engineering at the feasibility stage are:

1. Technology Choice

2. Appropriateness of Technology
 Cont…
1. Choice of Technology:

 Selection of appropriate technology and know–how is a critical

element in any feasibility study.

 Selection of the most suitable alternative in relation to the project

to investment strategy chosen.

The choice of technology is influenced by a variety of

considerations. Some of these are:
1. Plant Capacity. Q = f(inputs, Technology)
o To meet a given capacity requirement perhaps only a certain
production technology may be viable
 Cont…
2. Principal Inputs
o The choice of technology depends on the principal inputs available
for the project.
o In some cases, the raw materials available influence the technology
chosen.
3. Investment Outlay and Production Cost
4. Uses by Other Units
o The technology adopted must be proven by successful use by other
units.
 Cont…
5. Latest Developments
 The technology adopted must be based on the latest developments
in order to ensure that the likelihood of technological uselessness in
the near future, at least, is minimized. Confirmation
6. Ease of Adoption
 A technology that is difficult to adapt shall be rejected
7. Labor situation

 A shortage and expensive labor - capital intensive technology

 Excessive and cheap labor - labor intensive technology

 Cont…
2. Appropriateness of Technology:
 refers to those methods of production, which are suitable to local
economic, social, and cultural conditions.
– Whether the technology utilizes local raw materials?

– Whether the technology utilizes local manpower?

– Whether the technology protects ecological balance?

– Whether the technology is harmonious with social and cultural

conditions?

– Whether the goods and services produced cater to the basic needs?
 4.3. Material Inputs and Utilities
 An important aspect of technical analysis is concerned with
defining the materials and utilities required.
 Issues to be raised in relation to materials and parts include:
 What types of materials are needed?
 Where are the sources of the materials and supplies?
 How the materials and supplies are obtained?
How the materials and supplies will be provided such as
normal purchase, and the like
 What are the costs of each materials?
Both unit and total costs of materials.
 Environmental factors
 Cont…
 Material inputs and utilities may be classified into four broad
categories:
(i) Raw materials (for crop, livestock, mineral…..product)
(ii) Processed industrial materials and components
(iii) Auxiliary materials and factory supplies (chemicals, additives,
packaging materials, paint, varnishes, oils, grease, cleaning
materials, etc.)
(iv) Utilities (power, water, steam, fuel, etc.)

 In studying them the following questions need to be answered:

o What is the total requirement of the project?
o What are the sources of supply?
o What quantity would be available from domestic sources?
o What quantity can be procured from foreign sources?
o What are the likely shortages/ bottlenecks?
o What measures may be taken to enhance supplies?
 4.4. Product Mix
 known as product assortment or product portfolio, refers to the
complete set of products and/or services offered by a firm.
 A product mix consists of product lines, which are associated items
that consumers tend to use together or think of as similar products
or services
 The choice of product mix is guided by market requirements.
 In the production of most of the items, variations in size and quality
are aimed at satisfying a broad range of customers
 Distinguish by size, style, brand name, price, color, materials, or
any other features that makes one item different from another
 4.5. Location and Site
Location vs Site?
 Although most often the terms ‘location’ and ‘site‘ are used
synonymously, they should be distinguished.

 Location refers to a relatively broad area like a city, or an

industrial zone, or a coastal area,

 But site refers to a specific piece of land where the project

would be set up.

 From one location several alternative sites can be considered.

 Cont…
 The choice of location and site follows an assessment of demand,
size, and input requirement.
 The choice of location is influenced by a variety of considerations:
proximity to raw materials and markets, availability of
infrastructure, labor situation, governmental polices, and other
factors.
1. Proximity to Raw Materials and Markets
 An important consideration for location is the proximity to the
sources of raw materials and nearness to the market for the final
products.
 Raw materials (resource)based project – Located near resource
 A perishable based project – Located near consumption centre
 Imported material based project – located near a port
 Cont…
2. Availability of Infrastructure
 Availability of power, transportation, water, and communications should
be carefully assessed before a location decision is made.
o Adequate supply of power is a very important condition for location-
insufficient power can be a major constraint, particularly in the case
of an electricity-intensive project
o The availability, reliability, and cost of transportation for various
alternative locations should be assessed.
o Given the plant capacity and the type of technology, the water
requirement for the project can be assessed.
o In addition to power, transport, and water, the project should have
adequate communication facilities like telephone and Internet.
 Cont…
3. Government Policies
 Government policies have bearing on location. In the case of public
sector projects, location is directly decided by the government.
 In the case of private sector projects, location is influenced by
certain governmental restrictions and inducements.
 For example: in some area, the government may offers
inducements for establishing industries in backward areas.
– These inducements consist of subsidies, concessional finance, tax,
loans, power subsidy, income tax benefits, lower promoter
contribution, and so on.
 Cont…
4. Climate Conditions
 The climatic conditions like temperature, humidity, wind, sunshine,
rainfall, snowfall, dust, flooding, and earthquakes have an important
influence on location decision.
o Means of transport may becomes less reliable in the case of heavy
snow or rainfall, causing interrupted supplies of perishable
products to distant market.
o Fluctuating quantities and qualities of raw materials owing and
Output selling to extreme weather conditions.
 Cont…
5. Proximity to Ancillary Units
 Most firms depend on ancillary units for components and parts.
• If the ancillary units are located nearby, coordination becomes easy,
transportation costs are lower, and inventory requirements become
considerably less.
6. Ease in Coping with Environmental Pollution
 A project may cause environmental pollution in various ways: it
may throw gaseous emissions; it may produce liquid and solid
discharges; it may cause noise, heat, and vibrations. So,
o The location study should analyze the cost of mitigating
environmental pollution to tolerable levels at alternative locations.
 Site Selection

 Once the broad location is chosen, attention needs to be focused on

the selection of a specific site.

 Two or three alternative sites must be considered and evaluated with

respect to cost of land and cost of site preparation and development.
 4.6. Machineries and Equipment
 The requirement of machineries and equipment is dependent on
production technology and plant capacity.
 It is also influenced by the type of project.
 To determine the kinds of machinery and equipment required for a
manufacturing industry, the following procedure may be followed:
(i) Define the various machining and other operations
(ii) Estimate the likely levels of production over time
(iii) Calculate the machine hours required for each type of
operation
(iv) Select machineries and equipment required for each function.
 4.7. Structure and Civil Works
 Structure and civil works may be divided into three categories:
(i) site preparation and development like: grading and leveling of
the site; demolition and removal of existing structures; site
preparation etc. ..
(ii) buildings and structures like: factory or process buildings;
buildings required for stores, warehouses, laboratories, cafeteria,
medical service buildings etc…
(iii) outdoor works like: supply and distribution utilities (water,
electric power, communication), landscaping, transportation and
traffic signals etc.
 4.8. Environmental Impact
 A project may cause environmental pollution in various ways: it
may throw gaseous emissions; it may produce liquid and solid
discharges; it may cause noise, heat, and vibrations.
 Hence, the environmental aspects of the projects have to be
properly examined. The key issues that need to be considered in this
respect are:
 What are the types of wastes and emissions generated?
 What needs to be done for proper disposal of wastes and
treatment of emissions?
 Will the project be able to secure all environmental clearances
and fulfill with all legislative requirements?
 4.9. Human Resource Organization
 Once the production program, plant capacity, raw materials and
supplies, location and site, environmental, technological
processes to be employed and plant organization have been
determined, the human resource requirements at various levels and
during different stages of the project must be defined, as well as
their availability and costs.
 Human resources categories:
o General management
o Production management and supervision
o Administration (finance, purchasing, marketing etc.)
o Production control, etc.
 4.10. Project Charts and Layouts
 refers to the scope of the project which provide the basis for
detailed project engineering and estimation of the investment and
production costs.
 The important charts and layout drawings are as follows:
• General functional layout
• Material flow diagram
• Production line diagrams
• Transport layout
• Utility consumption layout
• Communication layout
• Organizational layout
• Plant layout
 4.11. Schedule of Project Implementation
 In order to prepare the project implementation schedule, the
following information is required:
 List of all possible activities from project planning to start
production.
 The sequence in which various activities have to be performed.
 The time required for performing the various activities.
 The resources normally required for performing the various
activities
 The implications of putting more resources or less resources
than are normally required
 Exercise
i. Identify project ideas/problems of your own and
select the one from alternative ideas,
ii. Set your general and specific objective,
iii. Specify the type and number/amount of input utilized
and also specify the project location and site located?
iv. Develop your Scheduling to achieve the objective of the
selected idea

v. Develop the expected output of the selected projected

idea
Financial Analysis
of Project
 Financial Appraisal
 Projects can be appraised from the view point of their
beneficiaries or losers (financial analysis) or from the
viewpoint of the entire society (economic analysis).
 Financial analysis answers the question “is the project
financially profitable to a given individual, group or
business? In financial analysis costs and benefits are
valued at market prices
 Economic analysis answers the question- “is the project
profitable to the society or to a target population as a
whole? what is its impact (in terms of job creation and
linkages with the other sectors) on the whole economy?
In economic analysis costs and benefits are valued at
shadow prices
 Financial Analysis
 Financial analysis consists determination of the following:

1. Cost of project

2. Means-off financing

3. Estimates of sales and production

4. Cost of production

5. Working capital requirement and its financing

6. Breakeven point

7. Projected cash flow statements

 Pricing Project Costs and Benefits
 Once costs and benefits have been identified, they must be valued.
 The only practical way to compare differing goods and services directly
is to give each a money value.
 Therefore, we must find the proper prices for the costs and benefits in
our analysis.
Finding Market Prices:
 Project analysis characteristically are built
 first by identifying the technical inputs and output for a proposed
investment,
 then by valuing the inputs and outputs at market prices to construct the
financial accounts,
 and finally by adjusting the financial prices so they better reflect
economic values.
 Cont…
 Thus, the first step in valuing costs and benefits is finding the
market prices for the inputs and outputs.

Point of first sale and farm-gate price:

 In project analysis, a good rule for determining a market price for

agricultural commodities produced in the project is to seek the
price at the “point of first sale”.

 The increased value of the product as it goes to higher markets in

the channel arises as a payment for marketing services.

 Even in this case, the analyst must analyze the marketing service
component independently of the production component.
 Project Appraisal methods
 When costs and benefits have been identified,
quantified and priced (valued), the analyst is
trying to determine which among various
projects to accept, which to reject.
 The most common methods analysing the
financial feasibility of a project are:
Return on investment
 Payback period

 Net present value

 Internal Rate of Return

 Benefit cost ratio

 Discounted pay back period

 Measures of Project Worth for Financial Analysis
 There are two methods for measuring the worthiness of projects:
1. Undiscounted and
2. Discounted methods.
NB: there is no one best technique for estimating project worth; each
has its own strength & weakness.

 These tools of decision making are important for analyze the

financial and economic measures of investment worth but

o they are necessary conditions but not sufficient condition for final
decision
 Undiscounted Methods
 The most used non-discounted measures of project worth are:
1. Ranking by inspection (Return on Investment (RoI))
2. Payback period
1. Ranking by inspection (RoI)

 The analyst can sometimes simply choose one project among

alternative projects by examining the following:

 Total cost of investment and investment period;

 The structure, & amount of costs and benefits;

 Total amount of the net incremental benefit;

 The lifetime of the project, etc.

 Cont…
 If two projects have the same initial investment, and different lifespan,
the same proceeds throughout the period of the short-lived investment,
but
 if the long lived investment to earn income after the end of the short-
lived one then, the long-lived one is more desirable.
 Suppose two projects have the same life period, identical initial
investment outlay, and the net proceeds throughout the life period is
identical and the total net proceeds is identical,
 the project that earns more income early than the other is more
desirable.
 The problem with ranking by inspection method is that the selection
lacks objectivity.
 Cont…
 Rate of return is the ratio of average annual
profits, to the capital invested. It is the
measure of profitability which relates income
to investment.
 The formula for computing the ROI is:

ROI = Average annual net income X 100%

Total Investment
 Decision criterion: the higher the ROI, the better the
project is.
 2. Payback period
It is the length of time from the beginning of the project
until the sum of net incremental benefits of the project
equal to total capital investment.

It is the length of time that the project requires to recover

the investment cost.
 Cont…
Alternative projects Year Investment cost Net incremental
benefits
I 1 20000 __
2 2000
3 8000
4 12000
5 9000
II 1 20000 __
2 200
3 12000
4 8000
5 12000
III 1 20000 __
2 1000
3 5000
4 6000
5 8000
6 10000
7 5000
8 2000
 Cont…
 Project I & II have a payback period of 4 year but project III has a
payback period of 5 years.
 Thus, project I & II have equal higher rank than project III.
 Therefore, the method fails to consider the time and amount of net
incremental benefit after the payback period (project III).
 In addition, the method results equal rank for both project I and II.
 Yet, we know by inspection that we would choose project II over
project I because more of the returns to project II are realized
earlier.
 Payback Period method is a measure of cash recovery, not
profitability.
 Cont…
 The formula to calculate the PBP of an investment depends on
whether the periodic cash inflows from the project are even or
uneven.
 If the cash inflows are even (if the expected cash inflow is a
constant sum), the formula to calculate PBP is:
𝐶𝑎𝑠ℎ 𝑜𝑢𝑡𝑙𝑎𝑦 (𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡)
PBP =
𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑
Example1: If Birr 2 million is invested to earn Birr 500,000 per
annum for 7 years, the PBP is computed as follows:
𝐶𝑎𝑠ℎ 𝑜𝑢𝑡𝑙𝑎𝑦 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 2𝑚𝑖𝑙𝑙𝑖𝑜𝑛
PBP = = = 𝟒 𝐲𝐞𝐚𝐫𝐬
𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑 500000
 Cont…
 When cash inflows are uneven, the formula to calculate PBP is:
𝐵
PBP = A +
𝐶

 A is the last period with a negative cumulative cash flow;

 B is the absolute value of cumulative net cash flow at the end of

the period A; and

 C is the total cash inflow during the period following period A.

Note: Cumulative net-cash flow is the sum of inflows to date, minus

the initial outflow.
 Cont…
 Example: Company C is planning to undertake one project
requiring initial investment of ETB 50 million and is expected to
generate ETB 10 million net cash flow in Year 1, ETB13 million in
Year 2, ETB16 million in year 3, ETB 19 million in Year 4 and
ETB 22 million in Year 5. Calculate the payback value of the
project.
 Cont…
 According to the payback criterion, the shorter the payback
period, the more desirable the project is
 Since cash flow estimates are quite accurate for periods in the near
future and relatively inaccurate for periods in distant future due to
economic and operational uncertainties, PBP is an indicator of risk
inherent in a project.
 The longer the PBP of a project, the higher the risk and the less
desirable the project is.

 Projects having larger cash inflows in the earlier periods are

generally ranked higher when appraised with PBP, compared to
similar projects having larger cash inflows in the later periods.
 PBP Example
Alternative projects Year Investment cost Net incremental
benefits
I 1 20000 __
2 2000
3 8000
4 12000
5 9000
II 1 20000 __
2 200
3 12000
4 8000
5 12000
III 1 20000 __
2 1000
3 5000
4 6000
5 8000
6 10000
7 5000
8 2000
 Cont…
 Project I & II have a payback period of 4 year but project III has a
payback period of 5 years.
 Thus, project I & II have equal higher rank than project III.
 Therefore, the method fails to consider the time and amount of net
incremental benefit after the payback period (project III).
 In addition, the method results equal rank for both project I and II.
 Yet, we know by inspection that we would choose project II over
project I because more of the returns to project II are realized
earlier.
 Payback Period method is a measure of cash recovery, not
profitability.
 Cont…
 PBP method has two weaknesses:

It fails to consider the time & amount of net benefits after the
payback period.

It does not adequately take into account the time value of money
even in the payable periods.
 Net Present Value (NPV)
 NPV: is the difference between the present values of the future net
cash inflows and the initial investment outlay.

 It is the difference between the present value of cash inflows or

benefits (PVB) and the present value of cash outflows (PVC = CO).
 Given Rt =Benefits, NBt =yearly net cash flow, r = discount rate and CO = Initial
cost of project or investment cost,
 Cont…
 Where; PVB PVC and NPV are present value (PV) of benefits or
cash inflows, PV of cost or cash outflows, and Net present value
(PV of net cash inflows), respectively.

 Decision Rules:

 If NPV is positive, accept the project.

 If NPV is negative, reject the project.

 If NPV is zero, be indifferent.

 If we are comparing two or more projects, the higher the NPV,

the better the project is.
 Example of NPV
 The initial investment of a project is ETB 60,000. Find the NPV of
the project if the discount rate is 10%, and the yearly cash flow is
given below.
 Internal Rate of Return (IRR)
 IRR: Is the rate of discount or cost of capital that equates the PV of
future net cash flows equal to the initial investment cost of the
project.
 It is the discount rate that makes the NPV of all cash flows equal to zero.

 It is the value of r in the following equation.

Given Rt =Returns (benefis), n =Life of the project, r = IRR and C0 =

Initial cost of project,
 Internal Rate of Return (IRR)
• Find IRR of a project with 20000 initial investments, cost of capital
of 12% and with cash flows in the following Table.
𝑌𝑒𝑎𝑟 1 2 3 4
•
𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 6000 6000 8000 9000
• Compute the NPV with 12% discount rate.
6000 6000 8000 9000
NPV = (1.12) + (1.12)2 + (1.12)3
+ (1.12)4 − 20000 = 1603
• Since the NPV is still positive, (1603), try again with a higher
discount rate: 15%.
6000 6000 8000 9000
NPV = (1.15) + (1.15)2 + (1.15)3
+ (1.15)4 − 20000 = 167
• Still the NPV is positive. Try again with a higher discount rate i.e.
16%.
6000 6000 8000 9000
NPV = (1.16) + (1.16)2 + (1.16)3
+ (1.16)4 − 20000 = −344
• Thus, it can be concluded that the IRR is between 15% and 16%.
 Cont….
• Draw Back: The calculation of r consists of a process of trial &
error by assuming various values of r.
• If a more refined estimate of r is needed, we use the following
procedure:
 Determine the NPV of the two closest rates of return
 Present value at 15% = 167.
 Present value at 16% = -344.
Find the sum of the absolute values of the NPVs
obtained in Step 1.
 167+344 = 511.
Calculate the ratio of the NPV of the smaller discount rate,
identified in Step 1, to the sum obtained in Step 2.
 167/511 = 0.33.
Add the number in Step 3 to the smallest discount rate.
 15+0.33 = 15.33.
 Cont…
 When using the IRR, the investment criterion is that the IRR should
be greater than the discount rate.

 IRR can be interpreted as:

the highest rate of interest an investor could afford to pay,

without loosing money, if all the funds to finance the investment
are borrowed, and if the debt service ( loan and accrued interest)
was repaid by use of cash proceeds from the investment.
 Cont…
 When the NPV is positive, then

the IRR is greater than the rate of discount, and the discounted
benefits are greater than the discounted costs;

 When NPV is equal to zero, then

the IRR is equal to the rate of discount, and discounted benefits

are equal to the discounted costs; and

 When NPV is negative, then

the IRR is smaller than the discount rate, and the discounted
benefits are smaller than the discounted costs
 Profitability Index (PI) or Benefit Cost Ratio
 PI: is the ratio of present value of future net cash flows to the initial
cost of the project.

Given Rt =Return (yearly net cash flow) k =Risk-adjusted discount

rate and C0 = Initial cost of project,

or

 Decision Rule for PI:

When PI > 1, accept the project.

When PI < 1, reject the project.

When PI = 1, be indifferent.

If we compare two or more projects, the higher the PI, the better the
project is.
 Cont…
 Example: Consider a project with initial investment of Birr 50,000,
discounting rate of 12% and the following Cash inflows.

 Decision: Accept.
 Net benefit – Investment ratio
 This criterion is suitable and convenient for ranking projects especially
when sufficient budget is not available to implement all projects that
satisfy other criteria.
 That is, two or more projects may all have:
 a positive NPV,
 IRR that exceeds the discount rate, both financial and economic
discount rates, and
 a benefit-cost ratio of greater than one. In this case, ranking could be
made using Net Benefit - investment ratio.
𝐵𝑡−𝐶𝑡
Net benefit – investment ratio = σ𝑛𝑡=1
1+𝑟 𝑡
𝑛
𝐼
෍
1+𝑟 𝑡
𝑡=1

 The formal selection criterion for the Net Benefit-Investment ratio

measure of project worth is to accept all projects with a ratio of 1 or
greater
 Cont…
Simple PBP and Discounted PBP
𝐶𝑎𝑠ℎ 𝑜𝑢𝑡𝑙𝑎𝑦 (𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡)
SPBP = or
𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑

= year before the payback period occure (-ve cumulative cash flow)
Cumulative cash flow in year before recovery
+
Cash flow in year after recovery

𝐃𝐏𝐁𝐏 = year before the discounted payback period occures

Cumulative cash flow in year before recovery
+
Discounted cash flow in year after recovery
 Cont…
Example: Mr. Yaregal would like to invest $150,000 into a project as
an initial investment. The firm expects to generate $70,000 in the first
year, $60,000 in the second year, and $60,000 in the third year.
Calculate discounted payback period of Yaregal project if the
discounted cost becomes 10% and 15%.
Year Cash flow Discount factor Present value Cumulative cash flow
DF = 1/(1+r)n (10%)
0 -150,000 1 -150,000 -150,000
1 70,000 0.909 63,636.36 -86,363.64
2 60,000 0.826 49,586.78 -36,776.86
3 60,000 0.751 45,078.89 8,302.03

Discounted Payback Period = Year before the discounted payback

period occurs + (Cumulative cash flow in year before recovery /
Discounted cash flow in year after recovery)
= 2 + ($36.776.86 / $45,078.89) = 2 + 0.82 = 2.82 years.
 Cont…
Exercise 1:

A project is having a cash outflow of $ 30,000 with annual cash

inflows of $ 6,000, so let us

i. calculate the discounted payback period and simple payback

period, in this case, assuming companies of working capital cost
is 15% and the life of the project is 10 years. And

ii. What will be the relationship between the simple rate of return
and discounted payback period when discount rate is increase and
decrease?
 Cont…
Exercise 2:

Required:
1. Calculate the payback period of Project S and Project L, and make
your decision.
2. Calculate the discounted payback period of Project S and Project
L with 10% cost of capital, and make your decision
 Capital Rationing
 If a firm has a number of proposals which have NPV>0 (IRR>K)
but cannot undertake all these projects because of the limited
availability of funds at present.

 Since the objective of investment decision making is to maximize

the NPV, then the selection procedure should follow:

1. Consider all combinations which can be accommodated with in

capital budget constraint and

2. Choose the feasible combination which has the highest NPV

Example: A firm has a capital budget constraint of Birr 100,000 and

six proposals with the following characteristics.
 5.5. Capital Rationing
Proposal Outlay required NPV IRR
1 60000 25000 14
2 50000 20000 14.5
3 40000 18000 15.0
4 25000 10000 13.0
5 20000 10000 12.0
6 5000 6000 25.0
Set Outlay required NPV
1,3 100,000 43000
1,4,6 90,000 41000
1,5,6 85,000 41000
2,3,6 95,000 44000
2,4,5,6 100,000 46000
3,4,5,6 90,000 44000
 The set consisting of proposals 2,4,5 and 6 is the most desirable set as it
has the largest NPV.
THANK
YOU!!!