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Project Evaluation
Fundamentals
I.S.M.- Dhanbad 18.09.2010
Sanjay Singh
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Corporate Finance
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Corporate finance
Invest in projects that yield a return greater than the requiredrate of return (cost of capital). Returns on projects should bemeasured based on cash flows generated and the timing ofthese cash flows.
Choose a financing mix that minimizes the hurdle rate andmatches the assets being financed.
If there are not enough investments that earn the cost ofcapital, return the cash to the shareholders in the form ofdividends and stock buybacks
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Complexity in decision making, why?
Uncertainty
Possible course of action unidentifiable
Outcome/payoff of the course of action
Complexities/ many variables
Limited access of information
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Before selection of a project
Risk involved with the project
Rough estimate of the project cost
Capability to mobilise the necessary resources
Study about the market size & growthpotential
Availability of input and market for output
Costs involved in production, administration &marketing.
Access to the technology
Risk involved with the projectsks/18.09.2010
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During the project
Time & Cost trade-off
PERT/CPM
Monitoring ofCapital expenditure Capital budgeting
Variance & performance analysis
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Incentive to the projects
Govt. subsidy
Solar
Food processing etc.
Incentive for EOUs/SEZ
Incentive for Backward Areas
Incentive for Small Scale Units
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Project Evaluation Techniques
Discounted Cash flow method
Marginal costing
Cost benefit analysis
Risk analysis
Probability estimates
Simulation
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Discounted Cash flow
Value (intrinsic) of asset is a function ofexpected cash flow of an asset.
Assets with high & predictable cash flow havehigh values.
Cash flow is discounted with the discount ratereflecting the riskiness of the cash flow.
Intrinsic value means value attached to anasset by an well informed analyst withseamless access to all information available.
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Discount Cash Flow (NPV)
ows
As per present value method, where the Value of any asset isthe present value of expected future cash flows generated byassets.
t=n
Value =C
Ft
t=1 (1+r)t
If the discounted cash flow is more than the cost of project thenproject is acceptable.
where, n = Life of the asset
CFt = Cash flow in period t
r = Discount rate reflecting the riskiness of the estimated cashflows
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Discount Cash Flow (NPV)
Care must be taken for projecting
Cash flow
Growth
Discounting rate (Cost of capital)
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Discount Cash Flow (NPV)
Growth
Growth depends on return on assets and
retention ratio.
Stable or high growth?
For a firm which have growth rate more than the
growth rate of economy then two stage DCF model
should be adopted
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Growth rate
Growth i.e. g= b*ROE
Where b= retention ratio
ROE=return on equityor g=b* [ROA+D/E{ROA-i(1-t)}]
Where ROA is return on assets.
D/E is debt equity ratio.Nominal growth rate=(1+Real growth rate)(1+inflation rate)-1
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Discount Cash Flow (NPV)
Discounting rate
Cash flow is discounted with Cost ofCapital
Cost of capital or
W
ACC
WACC=Ke*E + Kd*D
E+D
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Cost of Equity: Ke
The cost of equity is the rate of return that
shareholders expect to get on equity
investment. There are two approaches to
estimating the cost of equity.
risk and return model (CAPM,APM).
dividend-growth model.
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Cost of Equity: Ke
As per CAPM
Ke= Rf+ (Rm-Rf)
Where Rf = risk free rate of interest(The long-term government discount bond rate is the appropriate risk free rate)
= risk (non diversifiable)
Rm= expected market return.
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Cost of Equity:
Beta is a non-diversifiable risk and it depends
on
Type of business.
Operating leverage.
Financial leverage.
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eta (Risk)
Unlevered beta is also called as firms beta.
Levered beta is called as equity beta.
Beta levered = Beta unlevered [1+ (1-t) D/E]
As per equation of a straight line :
Firms return= a + slope(risk)* (market return)
= xy- n * mean of x * mean of y
X2
n * (mean of x)
2
Beta =Cov (x,m)
Var m
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Firm with same cash flow but lower standard
deviation or coefficient of variation will be
preferred.
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