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Lecture Business finance (9/e) - Chapter 6: The application of project evaluation methods

Chapter 6 - The application of project evaluation methods. After studying this chapter you will be able to: Explain the principles used in estimating project cash flows, compare mutually exclusive projects that have different lives, determine when to retire (abandon) or replace assets,. | Chapter 6 The Application of Project Evaluation Methods 2 2 2 2 2 2 Learning Objectives Explain the principles used in estimating project cash flows. Compare mutually exclusive projects that have different lives. Determine when to retire (abandon) or replace assets. 2 2 2 2 2 2 Learning Objectives (cont.) Use sensitivity analysis and break-even analysis to analyse project risk. Use decision trees to analyse sequential decisions. Explain the role of qualitative factors in project selection. Explain the effects of resource constraints on project selection. 3 3 3 3 3 3 Introduction Practical project evaluation has to accommodate: Uncertainty with respect to the cash flows. Uncertainty with respect to the estimation of the project’s required rate of return. The existence and implications of taxes. 4 4 4 4 4 4 Application of the Net Present Value Method Estimation of cash flows in project evaluation Exclude financing charges The required rate of return used to discount cash flows . | Chapter 6 The Application of Project Evaluation Methods 2 2 2 2 2 2 Learning Objectives Explain the principles used in estimating project cash flows. Compare mutually exclusive projects that have different lives. Determine when to retire (abandon) or replace assets. 2 2 2 2 2 2 Learning Objectives (cont.) Use sensitivity analysis and break-even analysis to analyse project risk. Use decision trees to analyse sequential decisions. Explain the role of qualitative factors in project selection. Explain the effects of resource constraints on project selection. 3 3 3 3 3 3 Introduction Practical project evaluation has to accommodate: Uncertainty with respect to the cash flows. Uncertainty with respect to the estimation of the project’s required rate of return. The existence and implications of taxes. 4 4 4 4 4 4 Application of the Net Present Value Method Estimation of cash flows in project evaluation Exclude financing charges The required rate of return used to discount cash flows incorporates the cost of equity and debt. Including financing charges in the cash flows would be double counting. Focus on incremental cash flows Is it a cash item? Will the amount of the item change if the project is undertaken? 5 5 5 5 5 5 Application of the Net Present Value Method (cont.) Estimation of cash flows in project evaluation (cont.) Exclude sunk costs Costs already incurred (sunk costs) are irrelevant to future decision making. Decisions on whether to continue a project should be based only on expected future costs and benefits. Beware of allocated costs Any costs that will not change as a result of the project should be excluded from the analysis. 6 6 6 6 6 6 Application of the Net Present Value Method (cont.) Estimation of cash flows in project evaluation (cont.) Include residual values This will provide a cash flow at end of project. Recognise the timing of the cash flows Just as in the valuation of debt securities such as bonds, the exact timing of cash flows can .