METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital

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Corporate Finance FIN 622

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 long-term debt - are included in a

Corporate Finance FIN 622

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 risk-free 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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