WOLLEGA UNIVERSITY
SCHOOL OF GRADUATE STUDIES
AGRICULTURAL ECONOMICS
AGRICULTURAL PROJECT PLANNING AND
ANALYSIS (AGEC 522)
BY ADMASSU T (PHD FELLOW)
1
AND
DEREJE F (MSC)
CHAPTER 4: INVESTMENT DECISION CRITERIA
In chapter 3, we have discussed detail feasibility
studies of:
1. Market and demand analysis.
2. Technical analysis.
3. Location and site selection.
4. Organization and management
5. Environmental analysis.
6. Financial analysis.
7. Net Cash Flows calculation
2
CHAPTER 4: INVESTMENT DECISION …
In this chapter, we will discuss:
The concept of time value of money,
Applications of Time Value of Money:
1. Discounted Criteria (refined criteria):
i. Net Present Value (NPV)
ii. Net Benefit Cost Ratio (NBCR)
iii. Internal Rate of Return (IRR)
2. Non Discounted Criteria (crude criteria):
i. Urgency
ii. Payback period
iii. Accounting Rate of Return (ARR) 3
THE CONCEPT OF TIME VALUES OF MONEY
‘A bird in hand is worth two in the bush’.
Implications:
A Birr today is more valuable than a Birr a year to
come.
Present values are better than the same values in the
future,
Earlier returns are better than later.
Why preference to present values:
Naturally, individuals prefer present earnings to
future earnings.
Inflation may decrease the purchasing power of the
future earnings.
One can invest the money to earn a positive level of 4
return, say r, and get 100 (1+ r) in one year.
THE CONCEPT OF TIME VALUES ….
Simple versus compound interest
Simple interest is computed on a fixed principal
for a specific period of time.
I =PRT
..........
..........
..........
..........
..........
..........
..........
..........
..........
..........
..........
.(1)
FV=P+PRT
Where, I = Interest earned during time t
P = Principal money involved,
R = rate of interest used,
T = Time period during which the principal was used.
Where FV = Future Values of money
5
THE CONCEPT OF TIME VALUES ….
Compound interest is computed on the sum of an
original principal plus the periodically accrued
interest.
When interest is compounded, the interest of one
period becomes principal in the next.
FV n
= PV(1 + r )n
......................................................................................................(3)
Where, FV = Future Value of Money
PV = Present Values of money
r = rate of interest used in the decimal form,
n = Time period during which the money was used.
This formula is used to calculate future value of single deposit.
6
THE CONCEPT OF TIME VALUES ….
Interest rate, in compound interest, may be
compounded daily, monthly, quarterly, semi-
annually, or annually.
n is equal to the number of years, if interest is
compounded annually , and (r ÷1);
n = 2 times number of years, if interest is
compounded semi-annually , and (r ÷ 2);
n = 4 times number of years, if interest is
compounded quarterly , and (r ÷ 4);
n = 12 times number of year, if interest is
compounded monthly , and (r ÷ 12)
n = 365 times number of years, if interest is 7
compounded daily , and (r ÷ 365).
THE CONCEPT OF TIME VALUES ….
Discounting (Present Values)
is a technique by which one can ‘reduce’ future
benefit and cost streams to their corresponding
present value.
Costs and benefits of agricultural projects occur
at different times.
Unless we discount all benefits and costs
occurring at different times we can’t add and
arrive at a decision.
Generally benefits appear latter than costs.
By discounting, we are bringing all costs and 8
benefits to year 0.
DISCOUNTING (PRESENT VALUES)…
The process of discounting is simply the reverse of
compounding as the following formula shows:
Pv= FV/(1+r) ..........
n
..........
..........
..........
..........
..........
..........
..........
...(4)
This when the cash flow stream is supposed to be a single sum of
money at the end of the period.
In practice, project cash inflows may continue for many years in varying
amounts. In such cases, we use the following formula:
n
= A1 + A2 .....+ An =
PVn (1r) ((1+r) 2 ∑ At ................................................(5)
(1+ r) t =1 (1+ r)
n t
Where, PV = present value of cash flow stream
At = cash flow at the end of year t
R = discount rate 9
n = duration of cash flow stream
DISCOUNTING (PRESENT VALUES)…
Example 1:
Suppose that you are considering investing Birr 15
million in Jitu Horticultural project which is
supposed to generate net cash inflows at the end of each
year (all in millions):
Year 0 1 2 3 4 5 6 7 8 9 10
Net inflows 0 1 1.5 2.5 3 3 4 3 2 1.5 0.5
Assume that book value at the end is zero and
applicable discount rate is 10 %.
Alternative investment: invest the money in 10 years
bonds which yield 5.5 % simple interest rate per year
until the redemption time of the end of 10th year.
10
Which investment alternative is more viable? Why?
DISCOUNTING (PRESENT VALUES)…
Ans.
Discounted cash inflows of Jitu Horticultural project is:
Year 0 1 2 3 4 5 6 7 8 9 10
0.91 1.24 1.88 2.05 1.863 2.258 1.54 0.933 0.636 0.193
Discounted inflows
The sum is = 13.50 million is the only expected cash
inflow from the project in the
Cash inflows from the bonds
Year 0 1 2 3 4 5 6 7 8 9 10
Net cash inflow 0.825 0.825 0.825 0.825 0.825 0.825 0.825 0.825 0.825 0.825
1 − 1 n
PVOAn = A (1 + r )
r
. = 0.825 (6.1445) = 5.069 million.
the initial investment of Birr 15 million will be collected at the end of
tenth year. 11
Hence, a rational investor will invest in the bonds rather than in the
Jitu horticultural project.
ANNUITIES
When cash receipts or payments are made at
equal time interval with equal amounts of
money, it is called annuity.
If the cash receipts or payments are made at the
end of each time interval, the annuity is called
Ordinary Annuity.
Its future value formula is:
(1+r) −1
n
=
FVOAn r .....................................................................................(6)
A
Where FVOA = Future value of ordinary annuity
A = constant periodic cash flow
r = interest rate per period
n = duration of the annuity
12
ANNUITIES…
The present value of the Ordinary annuity is the
inverse of its future value as shown by the
following formula.
1 − ( 1 +1r ) n
PVOAn = A r .......... .......... ...( 7 )
Where PVOA = Present value of ordinary annuity
A = constant periodic cash flow
r = interest rate per period
n = duration of the annuity
Example 2: - What is the present worth of an annual sum of Birr
100,000 to be received at the end of each of the next ten years, using a
discount rate of 8%? The answer is Birr 100,000 (6.71) = Birr 671,000.00
13
ANNUITIES…
In practice, most investments do not begin to
repay the first year.
For instance, assume that we are thinking of
Apple production project, which begins to
generate returns at the end of about the sixth
year and continues to produce commercially for
about twenty years.
In this case, we are concerned only in the present
worth of a future income stream beginning in the
sixth year and continuing through the twenty-
fifth year.
14
ANNUITIES…
Example 3: Assume that an investor is
considering investing in Horticultural project
which generate net cash inflows of Birr 2 million
beginning from the end of fifth year till its year
10.
What would be the present worth of this income
stream using 10 percent discount rate? If the
investment cost of Birr 6 million is required at
the beginning of the year, is the investment
viable. Why?
15
ANNUITIES…
Ans.
From the present worth of an annuity factor for
an income stream received for the whole period,
we simply subtract the present worth of an
annuity factor for the income stream for the
period before the future income begins.
This means, the present worth of annuity factors
(10%) for years 10 and 4 are 6.1445 and 3.1699,
respectively.
Present worth of an annuity factor for fifth
through tenth year inclusive at 10 percent
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discount rate equals 6.1445 – 3.1699 = 2.9746.
ANNUITIES…
The present worth of the stream we have is Birr
2,000,000 X 2.9746 = Birr 5,949,200.
Hence, if the initial cost of investment exceeds
Birr 5,949,200, the project may not financially
viable.
17
NOMINAL VS. REAL INTEREST RATE
Nominal interest rate - when we use market
interest rate, without allowing for inflation.
If interest rate takes an allowance for inflation, it
is real interest rate.
Nominal interest rate is the rate that investors
pay to borrow money.
The real interest rate is the nominal interest rate
corrected for inflation.
18
NOMINAL VS. REAL INTEREST RATE…
If a private investor borrows money from a bank
at an interest rate of 10 percent and undertakes
a project, the nominal interest rate is 10 percent.
the amount the project owes to the bank grows by
10 percent per year.
If prices are rising, say by 7 percent per year, the
Birr with which the firm will repay the bank is
losing 7 percent of its value per year.
Each year the project owes 10 percent more Birr,
but the Birr is worth 7 percent less.
The real interest rate is, therefore, only 3
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percent.
APPLICATIONS OF TIME VALUE OF MONEY TO
THE PROJECT EVALUATION
The distinctive characteristics of investment
decisions:
They have long term consequences,
They often involves substantial outlays,
They may be difficult, expensive and virtually
impossible to reverse.
Costs and benefits of the project should be
carefully identified and assessed in order to
ensure that the expected streams of the
benefits exceeds the costs.
A wide range of investment decision criterion 20
have been in use.
APPLICATIONS OF TIME VALUE OF MONEY
In all cases, there are key steps to be followed in
determining an investment decisions:
i. Estimate the costs and benefits of the project,
ii. Assess the riskiness of the project,
iii. Calculate the cost of capital,
iv. Compute the criterion of investment decision.
There are several criteria that have been
suggested by Economists, Accountants and other
to judge the worthless of capital project.
21
APPLICATIONS OF TIME VALUE OF MONEY
Investment criteria
Discounting Criteria
Non-Discounting Criteria
Net Present Benefit Internal Rate Pay Back Accounting
Cost Ratio of Return Period Rate of
Value
criteria Return
22
DISCOUNTED CRITERIA
1. Net Present Value (NPV)
The NPV of project is the sum of present values
of all the cash flow both positive and negative
that are expected to occur over the life of the
project.
the discount rate used is normally the interest
rate at which bank loans are available, or where
the enterprise’s own funds are being used, the
rate which banks would pay on the deposit of
such funds - their ‘opportunity cost’.
The NPV represent the net benefit over and
above the compensation for time and risk
assumed. 23
NET PRESENT VALUE (NPV)…
Alternatives:
1. discounting Costs & Benefits separately.
the rule becomes that the discounted benefits should
exceed the discounted costs .
The sum of the discounted benefits > sum of the
discounted costs.
[Link] the net benefits (Costs –Benefits)
accept all independent projects with a positive NPV.
Independent projects are those projects which are not
mutually exclusive.
Mutually exclusive projects are of a kind that
implementing one project necessarily precludes
implementing another. 24
NET PRESENT VALUE (NPV)…
Example: Assume that the following data pertains to an
investment proposal in one hectare of mango production (all
data in 1,000 Birr).
Years 0 1 2 3 4 5
Costs 140 65 95 95 75 55
Benefits 0 100 150 200 150 100
Required?Using 12 percent discount rate,
determine the financial viability of the project
by using NPV criteria (use both methods).
25
NET PRESENT VALUE (NPV)…
Alternative one: Discounting Costs &
Benefits separately.
years 0 1 2 3 4 5
Cost 140 65 95 95 75 55
Benefits 0 100 150 200 150 100
PV costs 140.00 58.04 75.73 67.62 47.66 31.21
PV benefits 0.00 89.29 119.58 142.36 95.33 56.74
NPV -140.00 31.25 43.85 74.74 47.66 25.53
n n
PV = ∑PVB− ∑PVC = 83.03 26
t =1 t =1
NET PRESENT VALUE (NPV)…
Alternative two: discounting the
net benefits (Costs –Benefits)
years 0 1 2 3 4 5
Cost 140 65 95 95 75 55
Benefits 0 100 150 200 150 100
Net benefit -140.00 35.00 55.00 105.00 75.00 45.00
NPV -140.00 31.25 43.85 74.74 47.66 25.53
n 27
PV = ∑ PV(B − C) = 83.03
t =1
NET PRESENT VALUE (NPV)…
The NPV as one of the discounting criteria of
measuring project worth has the following
advantages.
It takes into account the value of resources
overtime.
It considers the net benefit stream in its entirety
(no exclusion of some years benefits).
For commercial projects it corresponds with the
financial objective of maximization of the wealth
of shareholders.
The NPV has additive property.
The concept is clear and the solution is always 28
determined.
2. BENEFIT COST RATIO
The benefit-cost ratio is defined as the ratio of
the discounted values of benefits to the
discounted value of costs.
There are two ways of defining the relationship
between benefits and cost:
BCR = PVB/PVC
Net Benefit cost ratio (NBCR) = BCR-1
BCR= PVB− PVC/ PVC
Where PVB = Present Value of Benefit
PVC = Present Value of Costs
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2. BENEFIT COST RATIO…
Benefit cost Ratio Net Benefit Ration Rule
Greater than one Greater than zero Accept
Equal to one Equal to zero Indifferent
Less than one Less than zero Reject
The B/C ratio measures the value of
benefits per Birr of expenditure; it is
therefore a measure of efficiency of 30
converting costs into benefits.
2. BENEFIT COST RATIO…
Example : Assume that the following data pertains to an
investment proposal in one hectare of mango production (all
data in 1,000 Birr).
Years 0 1 2 3 4 5
Costs 140 65 95 95 75 55
Benefits 0 100 150 200 150 100
Required? Using 12 percent discount rate, determine the
financial viability of the project by using B/C ratio criteria.
31
2. BENEFIT COST RATIO…
years 0 1 2 3 4 5
Cost 140 65 95 95 75 55
Benefits 0 100 150 200 150 100
PV costs 140.00 58.04 75.73 67.62 47.66 31.21
PV benefits 0.00 89.29 119.58 142.36 95.33 56.74
NPV -140.00 31.25 43.85 74.74 47.66 25.53
Solution
The sum of PV cost = Birr 420.26
The sum of PV benefits =Birr 503.3
Benefit/ Cost = Birr 503.3/420.26 = 1.20
this shows that the project will contribute 0.2 cents towards 32
profit maximization per one Birr of costs incurred on it and hence
it is financially viable.
3. INTERNAL RATE OF RETURN
IRR is defined as the rate of discount at which
the total present value of costs incurred during
the life of the project is equal to the total present
value of benefits accruing during the life of the
project.
Formally, it is the solution to the following
expression where the IRR is denoted by r:
n
Ct
∑
t =1
(1 + r ) t
= Investment cos t
IRR is a discount rate which equates the present value of
future cash flow with the initial investment.
33
3. INTERNAL RATE OF RETURN
In IRR calculation, we set the NPV equal to zero
and determine the discount rate that satisfies
this condition.
IRR is the maximum interest that a project could
pay for the resources used if the project is to
recover its investment and operating costs and
still break even.
It measures opportunity cost of capital tied up in
the investment.
It is the weighted average return to the entity’s
own capital engaged over the life of the project.
34
3. INTERNAL RATE OF RETURN…
calculating the IR involves try and error.
we use interpolation (the process of finding a
desired value between two other values).
The rule for interpolating the value of the
internal rate of return lying between discount
rates too high on the one side and too low on the
other is:
IRR = + ( D 2 − D1) * PVF 1
D
1
PVF 1 + PVF 2
Where:
D1 is the lower discount rate (resulting in +PVF sum),
D2 is the higher discount rate (resulting in –PVF sum),
PVF1 is the sum of the net present value of the cash 35
flows at D1,
PVF2 is the net present value of the cash flows at D2.
3. INTERNAL RATE OF RETURN….
Steps involved:
1. Determine the net present value of the two
closest rates of return.
2. Find the sum of the absolute value of the NPV
obtained in Step 1.
3. Calculate the ratio of the NPV of the smaller
discount rate identified in step 1 to the sum
obtained in step 2
4. Add the number obtained in Step 3 to the
smaller discount rate.
5. The result is the approximated IRR. 36
3. INTERNAL RATE OF RETURN…
Example1: Consider the cash flows of hypothetical project
of having initial investment cost of 1 million birr:
Year s 1 2 3 4
Net cash flow 30,000 30,000 40,000 45,000
Required? Assuming 16% of cost of capital, evaluate the
financial viability of the project by determining its IRR.
Try substituting r = 15%, PVB = Birr 100,802
Try substituting r = 16%, PVB = Birr 98,641.
we conclude that the value of “r” lies between 15% and 16%
To find exact number, interpolation method is used.
At the end, you will find IRR close to 15.37%
Conclusion: The project is not financially viable since its
37
cost of capital 16% > its IRR of 15.37%.
3. INTERNAL RATE OF RETURN…
Decision rule of IRR
Accept the project if the IRR is greater than the
discount rate. For competing projects choose the
one with the higher IRR.
If IRR is equal to the discount rate, it indicates
the project has no net return but will recover the
cost to be incurred. In other word the project is
marginal.
Reject the project with IRR less than the discount
rate because it will not recover its cost after
allowing for the cost of capital.
38
NON- DISCOUNTED CRITERIA
1. URGENCY criteria:
project that is deemed to be more urgent
get priority over projects that are
regarded as less urgent.
The problem: how can the degree of
urgency be determined?
In certain situation, it may not difficult
to identify really urgent investments.
Eg.
39
NON- DISCOUNTED CRITERIA…
2. Payback Period
It is the number of years required to return the
original investment from the net cash flows (net
operating income after taxes plus depreciation).
The shorter the period, the more attractive the project
will be.
Paybackperiod = CummulativeInvestment cos t
Cummulativ enetcash inf lows
Decision Rule
If payback period < acceptable time limit, accept
project
If payback period > acceptable time limit, reject
project 40
NON- DISCOUNTED CRITERIA…
Advantages of PB method
Put more emphasis to quick return of the
invested fund so that they may be put to use in
other places or in meeting other needs.
Easy to apply (Simple to understand)
Problems with the Payback Method
Does not consider post-payback cash flows
Does not consider time value of money.
Does not explicitly consider risk
41
NON- DISCOUNTED CRITERIA
Example1 Assume that the firm is considering two projects; project A
and project B, each requires an investment of $100 millions. Below is
the summary of expected net cash flows in thousands.
years 1 2 3 4 5 6
Project A 50 40 30 10 1 1
Project b 10 20 30 40 50 60
Required? Determine the undiscounted pay back period of each
project and decide on the project with the shorter pay back period
assuming the two projects are not mutually exclusive.
42
NON- DISCOUNTED CRITERIA…
Solutions
Paybackper iod = Cummulativ eInvestmen t cos t
Cummulativ enetcash inf lows
Years 1 2 3 4 5 6
Project A annual cash inflows in
50 40 30 10 1 1
(1,000)
Cumulative cash flows of
Project A in (1,000)
50 90 120 130 131 132
Project B cash flows in (1,000) 10 20 30 40 50 60
Cumulative cash flows of
Project B in (1,000)
10 30 60 100 150 210
Uncovered cost up to the beginning of the period ÷
Cash inflows during the period
43
NON- DISCOUNTED CRITERIA
the payback period for the project A is: $100-
$90/$30= $10/$30=1/3.
Thus, the payback period for Project A will be 2
full years and1/3 a year (2.33 years).
Project B has exactly 4 years payback period.
If the firm has the policy of employing three
years payback period, project A will be accepted
but project B will be rejected.
44
NON- DISCOUNTED CRITERIA…
Example2 Assume that the firm is considering
two projects; project A and project B, each
requires an investment of $100 millions. Below
is the summary of expected net cash flows in
thousands.
years 1 2 3 4 5 6
Project A 50 40 30 10 1 1
Project b 10 20 30 40 50 60
Required? Determine the discounted pay back
period of each project using 12 % discount rate
and decide on the project with the shorter pay 45
back period assuming the two projects are not
mutually exclusive.
NON- DISCOUNTED CRITERIA…
Years 1 2 3 4 5 6
Project A discounted cash
45.45 33.06 22.54 6.83 0.62 0.56
inflows in (1,000)
Discounted Cumulative cash
45.45 78.51 101.05 107.88 108.5 109.06
inflows of Project A in (1,000)
Project B discounted cash
9.09 16.53 22.54 27.32 31.05 33.87
inflows in (1,000)
Discounted Cumulative cash
9.09 25.62 48.16 75.48 106.53 140.4
inflows of Project B in (1,000)
Uncovered cost up to the beginning of the period ÷ Cash inflows during
the period
the payback period for Project A: 2.716 years.
Note that the 2.716 years is longer than the 2.33 years it took without
discounting the net cash inflows above.
46
NON- DISCOUNTED CRITERIA…
3. Accounting Rate of Return (ARR)
It helps to make quick assessment of investment
profitability, (not liquidity!)
There are many methods of calculating it depending
on the underlying philosophies leading to different
results.
But, the most common methods of calculating (ARR)
is:
ARR = E−D
I
where
E is annual net benefits after maintenance and
operating costs expected from the investment,
D is annual average depreciation,
I is initial capital investment. 47
The higher the ARR, the better the project will be.
NON- DISCOUNTED CRITERIA…
Example: Years Net benefit Depreciation
0 -2,000 0
1 300 50
2 400 100
3 600 150
4 700 200
average depreciation is (50+100+150+200)/4 = 500/4 = 125,
average annual net benefits is (300+400+600+700)/4 = 2,000/4 = 500
D = 125, E = 500, and I = 2000. Thus:
ARR = ( 500−125
2 , 000 ) *100 = 18.75%.
If the firm uses cost of capital of 20%, this project
48
may be decided as non viable from the financial
point of view.
THE END OF
CHAPTER 4
49