## Costbenefit evaluation techniques

We would consider proceeding w ith a project only where the benefits outweigh the costs. However, in order to choose among projects, we need to take into account the timing of the costs and benefits as well as the benefits relative to the size of the investment.

Consider the project cash flow estimates for four projects at 10E shown in Exercise 3.2 Table 3.2. Negative values represent expenditure and positive values income.

Rank the four projects in order of financial desirability and make a note of your reasons for ranking them in that way before reading further.

In the follow ing sections we w ill take a brief look at some common methods for comparing projects on the basis of their cash flow forecasts.

### Net profit

The net profit of a project is the difference between the total costs and the total income over the life of the project. Project 2 in Table 3.2 shows the greatest net profit but this is at the expense of a large investment. Indeed, if we had £lm to invest, we might undertake all of the other three projects and obtain an even greater net profit. Note also, that all projects contain an element of risk and we might not be prepared to risk £ I m. We shall look at the effects of risk and investment later in this chapter.

 Year Project 1 Project 2 Project 3 Project 4 0 -1 (X).(XX) -I.(XXMXX) -1 (X).(XX) -I20.CXX) 1 IO.(XX) 200.(XX) 30.CXX) 30.CXX) 2 lO.(XX) 200.(XX) 30.0(X) 30.0(X) 3 K).(XX) 200.(XX) 30.CXX) 30.CXX) 4 20.(XX) 200.(XX) 30.(XX) 30.(XX) 5 KX).(XX) 300.(XX) 30.(XX) 75 .(XX) Net profit 5().(XX) KX).(XX) 50.(XX) 75.(XX)

Cash flows take place at the end of each year. The year 0 figure represents the initial investment made at the start of the project.

Cash flows take place at the end of each year. The year 0 figure represents the initial investment made at the start of the project.

Moreover, the simple net profit takes no account of the timing of the cash flow s. Projects I and 3 each have a net profit of £50.(XX) and therefore, according to this selection criterion, would be equally preferable. The bulk of the income occurs late in the life of project I. whereas project 3 returns a steady income throughout its life. Having to wait for a return has the disadvantage that the investment must be funded for longer. Add to that the fact that, other things being equal, estimates in the more distant future are less reliable that short-term estimates and we can see that the two projects are not equally preferable.

### P.i yback period

The payback period is the time taken to break even or pay back the initial investment. Normally, the project w ith the shortest payback period w ill be chosen on the basis that an organization w ill wish to minimize the time that a project is 'in debt'.

Exercise 3.3 Consider the four project cash flow s given in Table 3.2 and calculate the payback period for each of them.

The advantage of the payback period is that it is simple to calculate and is not particularly sensitive to small forecasting errors. Its disadvantage as a selection technique is that it ignores the overall profitability of the project - in fact, it totally ignores any income (or expenditure) once the project has broken even. Thus the fact that projects 2 and 4 are. overall, more profitable than project 3 is ignored.

### Return on investment

The return on investment (ROI), also known as the accounting rate of return (ARK), provides a way of comparing the net profitability to the investment required. There are some variations on the formula used to calculate the return on investment but a straightforward common version is

ROI = average annual profit y |(X) total investment

Exercise 3.4 Calculating the ROI for project I. the net profit is £50.000 and the total investment is £ I (X).(XX). The return on investment is therefore calculated as

R0| _ average annual profit jc |()() total investment