

Corporate
Finance FIN 622
VU
Lesson
09
METHODS
OF PROJECT EVALUATIONS
The
following topics will be
discussed in this hand out.
Methods
of Project evaluations:
NPV
Associated
topics that will be covered
are:
Weighted
Average Cost of Capital
Opportunity
cost
Net
present value
(NPV)
There
are two aspects of NPV
method of project evaluation. First is the initial
investment or upfront cost
and
second, is the benefits (like cash
flow) emerging from the
project.
First
aspect is pretty simple. As it is
incurred in the current or present time, there
are no issues
associated
with
its measurement. On the other
side, benefits shall be reaped in
future and involves time
value of
money,
making the measurement complex and
difficult.
NPV
measures the NET benefit by which the
value of a firm would
increase in case the project
in
undertaken.
As on
overview of this method, the present
value of future cash flow is
calculated using a discount
rate.
And if
this PV of future cash flow is
greater than the initial investment, the
NPV is stated as "positive".
Alternatively,
this suggests that project is
worth undertaking and financially viable.
If the PV of future cash
flow
is less than initial investment,
then it is better to scrap the
project.
The
NPV method is used for evaluating the
desirability of investments or projects.
Net Present Value is
found
by subtracting the required investment:
NPV =
PV required investment
The
building worth Rs.
2,000,000, but this does not
mean that you are
Rs. 2,000,000 better off.
You
committed
Rs. 1,900,000, and therefore
your net present value is
calculated by using the above
formula:
NPV =
2,000,000 1,900,000 = Rs.
100,000
In
other words, your office
development is worth more than it costs,
it makes a net contribution to
value.
The
formula for calculating NPV
can be written as:
NPV = Co + C1
/ 1 + r
Where:
Co = the
cash flow at time o or investment and
therefore cash outflow
r = the discount
rate/the required minimum rate of
return on investment
The
discount factor r can be calculated
using:
Examples:
Decision
rule:
If NPV
is positive (+): accept the
project
If NPV
is negative (): reject the
project
Weighted
Average Cost of
Capital:
A calculation of a
firm's cost of capital in which
each category of capital is
proportionately weighted.
All
capital
sources  common stock, preferred stock,
bonds and any other
longterm debt  are included in
a
27
Corporate
Finance FIN 622
VU
WACC
calculation.
WACC
is calculated by multiplying the cost of
each capital component by its
proportional weight and
then
summing:
WACC =
E / V * Re + D / V * Rd * ( 1 Tc )
Where:
Re =
cost of equity
Rd =
cost of debt
E =
market value of the firm's equity
D =
market value of the firm's
debt
V=E+D
E/V =
percentage of financing that is
equity
D/V =
percentage of financing that is
debt
Tc = corporate tax
rate
Broadly
speaking, a company's assets
are financed by either debt or equity.
WACC is the average of the
costs
of these sources of financing, each of
which is weighted by its respective
use in the given situation. By
taking
a weighted average, we can see how
much interest the company
has to pay for every
dollar it
finances.
A firm's
WACC is the overall required return on
the firm as a whole and, as
such, it is often used
internally
by
company directors to determine the
economic feasibility of expansionary
opportunities and mergers. It
is
the appropriate
discount rate to use for
cash flows with risk that is
similar to that of the overall
firm.
Opportunity
Cost:
The
cost of an alternative that must be
forgone in order to pursue a certain
action is called opportunity
cost.
Put another
way, the benefits you could have
received by taking an alternative
action.
There is a
difference in return between a chosen
investment and one that is
necessarily passed up. Say
you
invest in a
stock and it returns a
paltry 2% over the year. In
placing your money in the
stock, you gave up
the
opportunity of another investment  say, a riskfree
government bond yielding 6%. In this
situation,
your
opportunity costs are 4%
(6%2%).
The
opportunity cost of going to
college is the money you
would have earned if you
worked instead. On the
one
hand, you lose four
years of salary while getting
your degree; on the other
hand, you hope to earn
more
during
your career, thanks to your
education, to offset the lost
wages.
Here's
another example: if a gardener decides to
grow carrots, his or her
opportunity cost is the
alternative
crop
that might have been
grown instead (potatoes,
tomatoes, pumpkins, etc.).
In
both cases, a choice between
two options must be made. It
would be an easy decision if
you knew the
end
outcome; however, the risk that you could
achieve greater "benefits"
(be they monetary or otherwise)
with
another option is the opportunity
cost.
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