Engineering Economics

Financial evaluation of projects

One of the basic matters in studying new projects is to evaluate (evaluate) the project from a financial point of view to determine whether the project is worth investing in and whether it is better than other alternatives or not. This assessment is preceded by several steps that we discussed earlier, such as analyzing the market, competitors, our resources and capabilities, and analyzing the sector environment. There are several methods of evaluation. We review four of them in this article and discuss the advantages and disadvantages of each method. There are other methods that are not considered as good and so we will not go over them here. Let’s start with a simple example and then discuss the different evaluation methods

Suppose that you can put 1000 pounds in a bank that gives 10% interest, and you find a project that needs you to spend 1000 pounds now, so you get 1090 after a year, then the project ends. Is this a good project or not?

If you put your cash in the bank, you will get 1100 pounds after a year, and if you invest in the project, you will get 1090 pounds after a year. So putting money in the bank is the best investment. Why do we consider the alternative investment is the bank? Because most people either put their money in the bank or invest it. If we assume that you refuse to put your money in any bank, the result will change and the project will become profitable, because you will either find with you after the year 1090 pounds as a result of the investment project, or you will find with you 1000 pounds as a result of keeping your money as it is without any investment. If we assume that you put your money in a bank that gives Variable interest is usually between 8% and 10% so the example will change. We will consider that the expected interest is 9%, and therefore if you put your money in the bank, you will have 1090 pounds after a year, and if you invest, you will get 1090 pounds after a year. The two cases are the same. Some references consider the interest rate to be the interest rate for borrowing, given that you will borrow the capital, and therefore the rate of return must be higher than the interest rate. If you contemplate this matter, you will find that the matter is the same whether you will borrow the capital or invest your money, which if you did not invest it in this project, you would put it in a bank. In both cases, the return must be higher than the interest rate for borrowing or higher than the interest rate for saving in the bank. You can also To consider the lowest interest rate, if the project does not achieve a higher rate, then you will not invest in it. For example, you have some money to save anywhere and you are thinking of investing in a project, but you do not want to take the risk of investing unless the expected return is greater than 20%. In this case, you will use the 20% interest rate. Suppose another person borrows money from his relatives for a project and returns it as it is after a year or two. If this person invests in a project that gives a return less than the bank’s interest rate, he will have benefited, because the alternative here is not to borrow and not to do anything.

Note: We are not here discussing the religious aspect of banks, but we are discussing the evaluation of projects. The method of evaluation depends on the expected rate of return if we do not invest money in a project. This percentage may be zero in the case of putting money at home or in a safe, and it may be the percentage of a bank’s return. Here, I do not encourage you to put your money in the regular bank or anything else, and I do not encourage you to borrow from banks, as this is an issue that you should search for on well-known fatwa sites. The previous example is very simple.

Consider the following example: What if you had to spend 1,000 pounds on a project now and then spend 500 pounds every year with the expectation that you would get 300 pounds after one year and 600 pounds every year after the first year. Is this a profitable project? Of course, we cannot evaluate the project just by looking, and we need to use evaluation methods

All the methods that we are discussing here are based on cash flows and do not depend on accounting profits because accounting profits are a theoretical thing that is used so that we can evaluate the performance of companies year after year.

An example to clarify the meaning of cash flows: We will buy a machine worth 1,000 pounds today and operate it to produce food, so that the sales return in the year exceeds all costs from the price of food and workers’ wages by 500 pounds annually, and there are no taxes for several years. The cash flow in this case is a cash out flow which is 1000 pounds and a cash flow inside which is 500 pounds annually. Accounting profits will be considered that in the first year – in theory – we consumed a fifth of the value of the machine, for example, which is 200 pounds – according to the depreciation method used – and therefore our profits are 300 pounds. We will not use these profits in our accounts here because, as you can see, it is a theoretical thing that is not suitable for evaluating new projects, but it is useful in evaluating our annual performance.

First: Study the net present value of the project

Net Present Value NPV Since we will have to spend money at different times and there will be a return of money at different times, we need to evaluate the value of money at the present time. If the bank’s usual return was, for example, 10%, then the value of 1100 pounds that you get after a year is equal to 1,000 pounds that you get now. The present value of the \$1,100 you get after one year is \$1,000
In other words, if you put 1,000 pounds in the bank today, you will get 1,100 pounds after a year, so the value of 1,100 pounds that you get after a year will be equal to the 1,000 pounds you own now.

What is the present value of 2,000 pounds after two years if the interest rate is 10%? Value of 2000 pounds after one year = 2000 + (2000 * 10%) = 2200 Value of 2200 pounds after two years = 2200 + (2200 * 10%) = 2420

This can be calculated using the following law: Value after n years = Present value *(1 + interest rate) The value of 2000 pounds after two years = 2000 * (1 + 10%) 2 = 2420 What is the present value of 5000 you get after three years if The interest rate was 7%? Present value = future value / (1 + interest rate) nThe present value of 5000 pounds that you get after three years = 5000 / (1 + 7%) 3 = 4081.1 pounds Studying projects at the present value depends on evaluating all cash flows (incoming and outgoing, i.e. spent and acquired ) at its current value, so if the sum of the current values is positive, i.e. greater than zero, then the project is good. But before we go on explaining this method, we will look at it

Using Microsoft Excel to make these calculations Open Microsoft Excel

Click Insert…..Function
The following window will appear. Choose Financial
Then choose NPV as shown
Then press OK
The following window will appear
Type the annual interest amount in the first field
Then place the cursor inside the third field so that the computer displays a fourth field. Type the value of 5000 in the fourth field. Note that the second field is the value of the money you get after a year (of course, in our example, we will not get anything until the end of the third year), the third field is the value of what you will get after two years, the fourth field is the value of what you will get after three years, and so on
Choose OK
Read the result in the cell where it stands and it is 4081.1

General notes on using Excel to calculate present value:

Values written on the basis that they are earned or spent are considered earned or spent at the end of the period or the end of the year.
The amounts spent are preceded by a negative sign in order to be included in the accounts as amounts spent
You cannot use more than one interest rate. It may be expected that the interest will be low after two years, so we must take this into account, but the present value calculation in Excel does not allow you to do that. If necessary you will have to use the present value formula and variable interest rate calculation

Example Suppose we are studying a project that needs to spend 1,000 pounds now and it is expected that we will get a return (cash flow) of 500 pounds for three years, then 300 pounds in the fourth year, then the project ends. We want to calculate the present value of all these cash flows. Using Excel, as in the example above, taking into account that the interest rate is 6%, and entering the cash flows for the five years, except for the amount that will be disbursed at the beginning of the project. Since Excel considers any cash flow that takes place at the end of the period or the end of the year, we cannot enter the amount that will be disbursed at the beginning of the project in present value calculations using this automatic method in Excel. So what do we do? We will add the negative amount spent to the result of the present value of cash flows in the five years. We can calculate this directly in any cell as follows: -1000 + NPV (6%,500,500,500,30) and the result appears to be 574 pounds. Since the result is positive, this project is considered a financially successful project compared to putting money in a bank

We can write the values of cash flows and interest rate in cells in excel and make present value calculations reading the values from these cells because

This will enable us to study the effect of changing any of these values on the current value of the project.

We calculate the present value as follows: + B2 + NPV (B8, B3, B4, B5, B6) Now we can try to calculate the present value if the cash flows decreased from 500 pounds to 400 pounds, with the last year remaining 300 pounds. By changing the values in the cells, the current value will automatically change to 307 pounds. What if the cash flow becomes 300 pounds in all years? The net present value becomes only 40 pounds, meaning that the return of the project exceeds the return of putting money in the bank by only forty pounds. What if the return remains 300 pounds annually and the interest rate is 8%? The present value becomes less than zero 6 – Therefore, the project becomes unacceptable. For example, suppose we have two projects, one of which has a net present value of 1000 pounds and the second whose net present value is 1200 pounds. Of course, the project that has a greater net present value is considered better financially, and therefore we choose the project whose value is The net current is 1200 pounds. Example: Suppose I own 1000 pounds and I can invest them for a year with a return of 18%, then after that I can invest them in another project with a return of 8% and get back the original amount at the end of the fourth year. There is another project, if I invest in it now, it will give me a return of 300 pounds, 400 pounds, 400 pounds, 100 pounds. Which of the two methods should I choose if the interest rate is 8 percent? The first project: Return after one year (1000 * 0.18) = 180 Return after 2 years (1180 * 0.08) = 94 Return after 3 years (1274 * 0.08) = 102 Return after 4 years (1376 * 0.08) = 110 Note that you will recover the thousand pounds after the end of the fourth year. The net present value of the first project is 110 pounds. The net present value of the second project is 11.75 pounds. The present value method is characterized by being based on cash flows, not accounting profits. Thus, it takes into account the cash flows over the life of the project, as well as the change in the value of money with time. The net present value is greatly affected by the value of the interest on the basis of which the calculation is based, and therefore the error in its estimation greatly affects the evaluation result.

Second: Study the recovery period
Pay Back Period This method answers the following question: What is the period after which we recover the invested capital. Suppose you start a project that costs 9,000 pounds and expects a return (cash flow) of 4,000 pounds within a year, then profits of 5,000 pounds during another year. This means that you recover the capital within two years, so we say that the recovery period for this project is two years. As you can see, this method is easy to use and to understand its meaning. Knowing the payback period helps large companies evaluate their managers and evaluate their investment decisions. Due to its ease of use, studying the payback period is considered a good method in simple investment decisions for the investor. It is used in large companies to evaluate projects that are considered small in relation to the company’s investments and sales, such as establishing a small store, purchasing photocopiers, or the like. Studying the payback period is an important method in projects that are not expected to have a long life span or for which there is a threat of the emergence of alternatives in a short period, and therefore it is very important to ensure the recovery of capital

In a short time. This method is defective in that it does not take into account the change in the value of money with time. It considers the present value equal to the future value. In the previous example, we considered that we recovered the capital after two years, while the profits that we obtained after two years have a current value less than their value after two years. Also, this method looks at the recovery period and does not look at the value of cash flows after the recovery period. The payback period may be long, but the project is very profitable in the long run. Also, when comparing two projects, the project that is less profitable in the long run may have a shorter payback period than the other. The selection of the payback period is optional, which may affect the exclusion of good projects without proper basis.
Third: Study the internal rate of return
Internal Rate of Return IRR How easy it is to express the success of a project by saying that this project gives an average return of 17% annually. Studying the internal rate of return means calculating the interest rate that gives you a present value of all cash flows equal to zero. Example: Suppose you are studying a simple project that will cost you 1,000 pounds now and get 1,200 pounds after a year. What is the internal rate of return? Since this example is simple, the value of the internal rate of return can be known by looking at 20%. The internal rate of return does not depend on estimating the interest rate, as is the case in estimating the net present value, and therefore it is called the internal rate of return. Another example: Suppose you are studying a project that needs investments worth 1000 pounds now and gives you returns of 500 pounds, 400 pounds, 300 pounds in the years from the first to Third, then the project ends. To solve this example using the calculator, we will have to make several attempts until we reach the value of the internal rate of return by solving the equation 0 = -1000 + 500/(1+IRR) + 400 / (1+IRR)2 + 300 / (1 +IRR3) We can solve this problem using Microsoft Excel program easily as follows. Write the numbers in consecutive cells as shown below

Click Insert…..Function
Choose Financial
Then choose IRR
Then press OK

Type the names of the cells that contain the cash flows, and then press OK

You get the internal rate of return in the cell you’re standing on and it’s 10.7 percent

You can write the value of the cash flows inside the window above instead of the cell names, but writing the cell names gives you the ability to study the effect of the cash flow change in any year on the internal rate of return. internal rate of return. Also, this method avoids several problems in the method of calculating the payback period. A conflict may occur between the result of the internal rate of return and the net present value method in the case of studying two or more projects to choose only one of them. In this case, we neglect the value of the internal rate of return, and the basis for choosing is the net present value. There are several reasons for this discrepancy, including that the internal rate of return determines the rate of return, not its size, but the present value is compared to the total added value of the investors’ wealth. In a few cases, there may be more than one internal rate of return or no internal rate of return. This may only happen if there is more than one change in the sign (negative and positive) of the cash flow. Either if all the flows are positive or there is only one negative flow at the beginning or there is only one positive flow at the beginning then we get one internal rate of return.

Fourth: Profitability Guide
Profitability Index PI Profitability index depends on calculating the present value of cash flows, but instead of calculating the net present value, we calculate the ratio of cash flows during the life of the project, excluding the initial cost, to the value of the initial investment cost. The profitability index is equal to one. This means that we get one pound for every pound we put in the investment. Therefore, if the profitability index is less than one, the project will be rejected. But if the profitability index is more than one, then the project is acceptable, and the greater the value of the profitability index, the better the project will be from a financial point of view. Example: Suppose we will invest 1000 pounds in purchasing equipment and we expect a cash flow during the first three years of 400 pounds, 400 pounds, 400 EGP What is the evidence of profitability if the interest rate is 8%? Using Excel, we calculate the present value of cash flows during the life of the project: 400 pounds for three years, so we get 1031 pounds. Note that the initial investment cost of 1000 pounds will not be included in the calculation of the present value. We divide the product of the present value by the value of the initial investment cost, so we get the profitability index 1.03. Since the profitability index is greater than the correct one, the project is considered acceptable. The profitability index takes into account the time value of money and gives fairly understandable indicator. However, it is flawed that it does not take into account the volume of investments in the case of differentiating between several projects. A small project that gives greater profitability evidence will be better than a large project that gives a lower profitability return, and this may not be true. In these cases NPV is the best approach.

General Comment and Application Examples Although there are drawbacks to each of the four methods mentioned, each has its own advantages. Therefore, he may use two methods of analysis, such as the internal rate of return and the net present value or the net present value, the payback period, and so on. And the use of the computer makes the use of more than one method is easy.

You can see the attached examples, the same examples as an excel file, which illustrate some of the points we discussed from the attachments

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