By: Adriana Espinosa Villeda

For the subject: Corporate Finance

Unit 2. Financial tools for the

project selection

Introduction
The evaluation of projects aims to assess using various tools.
financial if the projected cash flow allows the investor to obtain profitability
desired, in addition to recovering the investment.

In this topic, I will develop the most common tools for project evaluation:

1
 By: Adriana Espinosa Villeda

For the subject: Corporate Finance

Recovery period (PRI)

Time required for an investment to generate cash flows

sufficient to recover their initial cost.

According to Nassir (2011), the payback period (PRI) is the third

the most used criterion to evaluate a project and aims to measure how much time it takes
recovers the investment, including the cost of capital involved.
The importance of this indicator is that it complements the information, often hidden.
In the assumption that, if the cash flow does not reach, "it is owed" both from the NPV and the IRR.

Source: Ross (2010)

Payback period rule:

An investment is acceptable if its calculated payback period is shorter

that a predetermined number of time periods.

Formula for payback period of investment

( − )
= +

Where:
the immediate previous period before the investment is recovered
b = initial investment
c = sum of previous cash flows
d= Net Cash Flow (NCF)1of the year in which the investment is satisfied

1Remember that
= = −

2
 By: Adriana Espinosa Villeda

For the subject: Corporate Finance

Example 1
Approach
The transformer company Corvex, S.A. made an initial investment of 2,000,000 and is estimated to be
following cash flows for the first 6 years. What is the payback period?
How do you interpret the result if the shareholders desire a recovery of 3 years?

• Año 1: 700,000
• Year 2: 600,000
• Año 3: 550,000
• Año 4: 400,000
• Year 5: 300,000
• Year 6: 250,000

Data

a c
d

Procedure
( − ) ( , , − , , )
= + = + = .
,
For exact calculations, we take the decimal of the result 3.38.
For calculating months: 0.38*12 months = 4.5 months
For calculations of days= 0.5*30 days=15 days
Resultado:PRI=3 Años, 4 meses, 15 dí[Link] lo tanto, se rechaza el proyecto,
since the shareholders wanted a recovery of 3 years.

3
 By: Adriana Espinosa Villeda

For the subject: Corporate Finance

Net Present Value (NPV)

Difference between the market value of an investment and its cost.

According to Nassir (2011), the net present value is the most well-known and most
accepted by the project evaluators. It measures the resulting surplus after
obtain the desired or required profitability and after recovering the entire investment.
To do this, calculate the present value of all future cash flows projected from the
first operating period, and subtracts the total investment expressed at moment 0.

VPN Rule

An investment should be accepted if the net present value is positive and rejected if
it's negative.

If the result is equal to 0, it indicates that the project reports exactly the rate that is
I wanted to obtain after recovering the invested capital.

If the result is negative, show the amount needed to match the rate that is
I wanted to obtain after recovering the investment. If the NPV is negative, the project
it can have a high return, but it will be lower than required. In some cases, such as
it will be explained later, the negative NPV can even indicate that, in addition to
profit is not obtained, part or all of the investment is not recovered.

VPN Formula

=− + ∑
( + )
=

Where:
period life number
initial investment of the project
net cash flow of period t period or year
recovery rate

4
 By: Adriana Espinosa Villeda

For subject: Corporate Finance

Example 2 (Taken from Ross, J. (2010), page 263-4)

Approach
Suppose you are asked to decide whether or not to launch a new consumer product.
Based on projected sales and costs, cash flows are expected during
the five-year life of the project is $2,000 in the first two years, $4,000 in
the next two and 5,000 in the last year. It will cost around 10,000 dollars to start the
production. A discount rate of 10% is used to evaluate new products. What
What should be done in this case?

Data
= 4000 dollars
10,000 dollars 5000 dollars
2000 dollars =5
2000 dollars = 0.10 = 10%
4000 dollars

Procedure
Given the cash flows and the discount rate, it is possible to calculate the total value of
product by discounting cash flows retroactively to the present:

=− + ∑
( + )
=

=− , +[ ]+[ ][ ][ ][ ]
( +. ) ( +. ) ( +. ) ( +. ) ( +. )

=− , +[ . + . + . + . +] .

=− , +[ , .] = , .

Result and interpretation

The VPN is $2,312.99, so based on the net present value rule, it should be
undertake the project.

Note: Observe how the initial investment (S0) is placed with a negative sign, due to
that is subtracted from the updated cash flows.

5
 By: Adriana Espinosa Villeda

For the subject: Corporate Finance

Present value in Excel spreadsheet

6
 By: Adriana Espinosa Villeda

For subject: Corporate Finance

Internal Rate of Return (IRR)

The internal rate of return (IRR) of an investment is the return

required to produce a zero VPN when used as a rate of
discount.

The IRR is closely related to the NPV, as the IRR aims to find a single
rate of return that summarizes the merits of a project. Furthermore, it is desirable that it be
an 'internal' rate in the sense that it only depends on the cash flows of a
private investment, not the rates offered elsewhere.

Rule of IRR

If the IRR is greater than the cost of

it is recommended to accept the capital
project

If the IRR is less than the cost of

it is recommended to reject the
project

How to calculate the IRR?

Generally, the calculation of the IRR was done through trial and error due to the
complexity of its calculation. Likewise, there are ways to calculate it using rearrangements of
the unknown of the discount rate with quadratic formulas or iterations. Here I leave
an example:[Link]

Given the complexity of the calculation and the objectives of the course, we will carry out the calculations.
through Excel spreadsheet.

7
 By: Adriana Espinosa Villeda

For the subject: Corporate Finance

Example 3 (Taken from Ross, J. (2010), page 263-4)

Approach
A project has a total cost of 435.44 dollars. The cash flows are 100.
dollars in the first year, 200 in the second, and 300 in the third. What is the IRR? If so
It requires a return of 18%, should this investment be accepted?
Describe the VPN profile and find the IRR by calculating some VPN.
with different discount rates.

Data
=3
= 435.44 dollars =?
100 dollars
200 dollars
300 dollars
Procedure
Alternative 1: trial and error in Excel using the NPV (net present value) formula
That is, -initial investment plus the sum of the present values.

Alternative 2:
With the function IRR=(valores, [estimación]): The link provided does not contain translatable text.
function-tir-64925eaa-9988-495b-b290-3ad0c163c1bc
In most cases, you do not need to provide the estimate argument for the
calculation of IRR. If you omit the estimate argument, it is assumed to be 0.1 (10%).
For example:

8
 By: Adriana Espinosa Villeda

For the subject: Corporate Finance

Result and interpretation

The VPN is zero to 15%, so the IRR is 15%. If an 18% return is needed, it is not
You should take the investment. The reason is that the NPV is negative at 18% (it is -24.47 dollars).
The IRR rule indicates the same thing in this case. This investment should not be accepted because
its yield of 15% is lower than the required yield of 18%.

Problems of the IRR

Problems arise with the IRR when
cash flows are not
conventional or when it comes to
compare two or more investments to see
which is the best. In the first case, and of
surprisingly, the question: what
Is it the performance? It's very difficult to
respond. In the second case, the IRR
it can be a confusing guide.
For example, in the image on the right
it is appreciated how the IRR equals zero
with two VPN values.
How is this possible? Through the flows
non-conventional.

9
 By: Adriana Espinosa Villeda

For the subject: Corporate Finance

Profitability Index (PI)

Also known as the benefit/cost ratio, it measures the present value of the
benefits per unit of investment.

VPN Rule

• If the IR >1 accept the project

• If the IR = 1 indifferent
• If the IR <1 reject the project

If there is a capital limitation, projects with the highest IR are chosen.

VPN Formula

=
ó
Where: Present value of cash flows

=∑
( + )
=

Important note: "Do not confuse the present value (PV) with the present value
net (VPN), the latter takes into account the discount of the investment
Where:
period or year
net cash flow of period t
recovery rate
project lifetime period number

10
 By: Adriana Espinosa Villeda

For the subject: Corporate Finance

Example 4
Approach
A project costs 3,000 dollars and has the following cash flows: for year 1 of 2000 dollars and for
Year 2 of 4000 dollars (a recovery rate of 35% is considered).

What is the profitability index? And what would be recommended in this case.
Data
=Inversión inicial= 3,000 dólares
2,000 dollars
4,000 dollars
0.35
Procedure
, ,
∑ [ + ]
=
( + ) ( + . ) ( + . )
= = =
ó

[ , . + , ]. , .
= = = .
, ,
Result and interpretation
According to the IR rule, if it is greater than one it is accepted. The result 1.22 indicates
that for every dollar invested, a result of 1.22 dollars in value or 0.22 is obtained
dollars in VPN. Thus, the profitability index measures 'the noise of the coins', that is,
the value created by each monetary unit invested

11
 By: Adriana Espinosa Villeda

For the subject: Corporate Finance

Net present value versus internal rate of return

In project evaluation, the NPV and IRR parameters are valuation tools.
for decision-making, however, both parameters do not always match.

The first difference is the way to study the profitability of a project. The NPV does it.
in absolute net terms, that is, in monetary units, it indicates the value of
project today; while the IRR gives us a relative measure, in percentage.

The IRR can be very attractive but may not generate a flow that allows, among other things,
facing the payment of a debt.

In an investment flow (initial outlay and positive cash flows in the future), several can occur
situations in the relationship between NPV and IRR:

Source: Nassir (2011)

Bibliography

Nassir, S. (2011). Investment projects. Formulation and evaluation. Chile: Pearson.

Available in Corporate Finance Bibliography [Virtual Classroom]

Review Chapter 9. Calculation and analysis of profitability

Ross, J. (2010). Fundamentals of corporate finance. Mexico: McGraw Hill.

Available in Corporate Finance Bibliography [Virtual Classroom]

Review Chapter 9. Net present value and other investment criteria

12