Table of Contents1. INTRODUCTION12. FINANICAL ANALYSIS12.1 Cost of project22.2 Means of financing52.3 Estimates of sales and production62.4 Cost of production72.5 Working capital requirement and its financing72.6 Profitability projections92.7 Projected cash flow statements122.8 Projected balance sheet133. PROJECT INVESTMENT CRITERIA ANALYSIS153.1 Payback period analysis153.2 Net present value173.3 Internal rate of return193.4 Accounting rate of return213.5 Profitability index (PI)223.6 Benefit cost ratio224. SENSITIVITY ANALYSIS244.1 Scenario analysis265. CONCLUSION276. REFERENCE28

1. INTRODUCTION A project analysis is performed by a company when they want to know whether a project is possible given certain circumstances. Feasibility studies are undertaken under many circumstances - to find out whether a company has enough money for a project, to find out whether the product being created will sell, or to see if there are enough human resources for the project. A good project analysis study will show the strengths and deficits before the project is planned or budgeted for. By doing the research beforehand, companies can save money and resources in the long run by avoiding projects that are not feasible.Rather than just diving into a project and hoping for the best, a feasibility study allows project managers to investigate the possible negative and positive outcomes of a project before investing too much time and money. project analysis is a multi-step exercise. As the analysis progresses, the developer or sponsor will gradually acquire more information that will help determine whether or not to proceed further.27 The following four activities may be performed sequentially, although more often than not, they are done simultaneously:1. market analysis;2. Environmental analysis;3. Economic analysis4. Financial feasibility analysis.5. Ecological analysis In this paper we will address project financial and investment criteria analysis part. 2. FINANICAL ANALYSIS Financial analysis seeks to ascertain whether the proposed project will be financially viable in the sense of being able to meet the burden of serving debt and whether the proposed project will satisfy the return expectation of those who provide the capital. The aspects of which have to be looked into while conducting financial analysis are: Cost of a project Means of financing Estimates of sales and production Cost of production Working capital requirement and its financing Profitability projections Projected cash flow statements Projected balance sheets 2.1 Cost of project

The first logical step in the financial analysis is the estimation of how large the total investment cost will be. The investment outlays can be planned for several initial years and some non-routine maintenance or replacement costs in more distant years. Thus we need to define a time horizon.

By time horizon, we mean the maximum number of years for which forecasts are provided. Forecasts regarding the future of the project should be formulated for a period appropriate to its economically useful life and long enough to encompass its likely mid-to-long term impact.

Although the investment horizon is often indefinite, in project analysis it is convenient to assume reaching a point in the future when all the assets and all the liabilities are virtually liquidated simultaneously.Conceptually, it is at that point that one can cost up the accounts and verify whether the investment was a success. This procedure entails choosing a particular time horizon.For the majority of infrastructures the time horizon is at least 20 years; for productive investments, and again indicatively, it is about 10 years. Nevertheless, the time horizon should not be so long as to exceed the economically useful life of the project.

In practice, it is helpful to refer to a standard benchmark, differentiated by sector and based on some internationally accepted practices. An example is shown in Table 1. Each project proposer, however, can justify the adoption of a specific time horizon based on project-specific features.

Table 1 reference time horizon (years) recommended for a period

Conceptually, the cost of project represents the total of all items of outlay associated with a project which is supported by long-term funds. It is the sum of the outlays on the following. Land and Site Development: The costs of land site development are- - Cost of leveling and development - Cost of compound wall and gates - Cost of tube wells Buildings and Civil Works: Building and civil works covers the following- - Buildings for the main plants and equipments - Warehouse and open yard facilities - Garage - Sewers, drainage Plant and Machinery: The plant and machinery consists the following costs- i) Cost of Imported Machinery: This is the sum of a) FOB Value (Free on board) b) Imported duty c) Clearing, loading and unloading charges. ii) Cost of Indigenous Machinery: This consists of a) FOR (Free On Rail) cost b) Sales tax and other taxes iii) Cost of Stores and Spares: Provision of Escalation = (Latest rate of annual inflation to the plant and machinery X (Length of the delivery period) Technical know-how and Engineering Fees: The technical know-how and engineering fees for setting up the project is a component of the project cost which is taken into account as cost of capital. Expenses on Foreign Technicians and Training of Technicians Abroad: Expenses on foreign technicians like traveling, boarding and lodging are considered as a cost of project. Miscellaneous Fixed Assets: Fixed assets and machinery which are not part of the direct manufacturing process may be referred to as miscellaneous fixed assets. Like furniture, office machinery and equipment. Preliminary and Capital Issue Expenses: Preliminary expenses are- - Identifying the project - Market survey - Articles of association Capital Issue Expenses are- - Underwriting commission - Brokerage - Stamp duty Pre-operative Expenses: These types of expenses are the following- i) Establishment expenses ii) Traveling expenses iii) Insurance charges iv) Mortgage expenses v) Miscellaneous expenses Provision for Contingencies: There are 2 procedures that are followed for provision for contingencies. These are- i) Divide the cost items into 2 categories - Firm cost items - Non-firm cost items ii) Set the provision for contingencies at 5% to 10%. Margin Money for Working Capital: Margin money for working capital is an important element of the project cost which is provided by commercial banks and trade creditors. Initial cash Losses: Most of the projects incur cash losses in the initial years. Failure to make a provision for such cash losses in the project cost affects the liquidity position and impairs the operations.2.2 Means of financingTo meet the cost of the project, the following means of finance are available- Share Capital: Two types of share capitals are- i) Equity capital represents the contribution made by the owners of the business and equity shareholders. ii) Preference capital represents the contribution made by preference shareholders. Term Loans: Term loans provided by financial institutions and commercial banks, term loans represent secured borrowings which are a very important source (and sometimes the major source) for financing new projects. There are 2 types of term loans. - Native Term Loans - Foreign Currency Term Loans Debenture Capital: Akin to promissory notes, debentures are instruments for rising debt capital. There are 2 types of debenture capital. This are- i) Non- convertible debentures: are straight debt instruments which have maturity period of 5 to 9 years. ii) Convertible debentures: are debentures which are convertible wholly or partly into equity shares. Deferred Credit: Many times the suppliers of the plant and machinery offer a deferred credit facility under which payment for the purchase of the plant of the plant and machinery can be made over a period of time. Incentive Source: Government provides different types of incentives for financing. These includes- - Tax exemption - Capital subsidy Miscellaneous Sources: Miscellaneous sources are- - Unsecured loans: are typically provided by the promoters to bridge the gap between the promoters contribution and (as required by the financial institutions) and the equity capital the promoters can subscribe to. - Public deposits: represents unsecure borrowing from the public at large. - Leasing and hire purchase finance: represents a form of borrowing different from the conventional term loans and debenture capitals. We have described the various means of finance that can be tapped for a project. The guidelines and considerations that should be borne in mind for planning the means of finance as follows:i) Norms of regulatory bodies and financial institutionsIn some countries, the proposed means of finance for a project must either be approved by a regulatory agency or conform to certain norms laid down by the government or financial institutions in this regard. The primary purpose of such regulation is to impart prudence to project financing decisions and provide a measure of protection to investors. In addition, the norms of financial institutions, which often provides substantial assistance to projects significantly shape and circumscribe project financing decisions. ii) Key business considerations: Key business considerations which are relevant for project financing decision are: - Risk (Business risk and financial risk) - Cost (Lower than cost of equity) - Control - Flexibility2.3 Estimates of sales and productionIn estimating sales revenues, the following considerations should be kept in mind:1. It is not advisable to assume a high capacity utilization level in the first year of operation. It is sensible to assume that capacity utilization would be somewhat low in the first year and rise there after gradually to reach the maximum level in the third or fourth year of operation.2. It is not necessary to make adjustments for stocks of finished goods. For practical purposes, it may be assumed that production would be equal to sales. 3. The selling price considered should be the price realizable by the company net of excise duty.4. The selling price used may b the present selling price- it is generally assumed that changes in selling price will be matched by proportionate changes in cost of production. If a portion of production is salable at a controlled price, take the controlled price for that portion. 2.4 Cost of production After production is estimated the cost of production may be worked out.The major components of cost of production are: Material cost Utilities cost Labor cost Factory overhead costMaterials: The most important element of cost, the material cost comprises of the cost of raw materials, chemicals, components and consumable stores required for production. It is a function of the quantities in which these materials are required and the prices payable for them. Utilities: Utilities consist of power, water, and fuel. The requirements of power, water, and fuel may be determined on the basis of norms specified by the collaborators, consultants, etc or the consumption standards in the industry, whichever is higher.Labor: Labor cost is the cost of all manpower employed in the factory. Labor cost naturally is a function of the number of employees and the rate of remuneration.Factory Overhead: The expenses on repairs and maintenance, rent, taxes, insurance on factory assets, and so on are collectively referred as factory overhead. 2.5 Working capital requirement and its financing The capital used for performing day to day activities i.e. purchases of Raw material, making payment of direct and indirect expenses, carrying out of production of goods and services, investment in stocks, stores, etc is called as working capital. All assets consisting of working capital revolve around cash. Firstly, cash is used to purchase of raw materials, which when certain expenses are in carried on it gets itself converted into semi finished goods and finally into inventory of finished products. Inventory (finished goods), after adding certain profit margin to it, is sold to the customers, which may take the form of cash or receivables or debtors. Receivables or debtors when realized again take the form of cash and the cycle goes on. The revolving nature of current assets consisting of working capital has been cleared with the help of following chart:

ReceivablesSales

Finished goodsCash

Work in progressRaw materials

Because of this revolving nature of the assets consisting working capital, later is also known as 'fluctuating' or 'floating' or ' circulating' capital.In estimating the working capital requirement and planning for its financing, the following pints have to be kept in mind: The working capital requirement consists of the following: raw materials stocks of goods in process stocks of finished goods debtors operating expenses consumable stores The principal sources of working capital finance are: working capital advances trade credit accruals and provisions long term sources of financing. The margin requirement varies with the type of current assets as follows: Current Assets Margin Raw materials 10-25 percent Work-in-process 20-40 percent Finished Goods 30-50 percent Debtors 30-50 percent2.6 Profitability projections The profitability projections or estimates of working results (as they are referred to by term-lending financial institutions) are prepared along the following lines:A. Cost of production B. Total administrative expensesC. Total sales expensesD. Royalty and know-how payableE. Total cost production ( A+B+C+D)F. Expected salesG. Gross profit before interestH. Total financial expenses I. DepreciationJ. Operating profit ( G-H-I)K. Other incomeL. Preliminary expenses written offM. Profit/loss before taxation ( J+K-L)N. Provision for taxes O. Profit after tax (M-N) Less, dividend on: - Preference capital - Equity capital P. Rental profit Q. Net cash accrual (P+I+L)Cost of Production:Represent the cost of materials, labor, utilities and factory overheads as calculated earlier.Total Administrative Expenses:Consist of Administrative salaries, remuneration to directors, professionals fees, light, postage, telegrams and telephones and office supplies (stationary, printing etc)

Total Sales Expense:Consist of commission payable to dealers, packing and forwarding charges, salary of sales staff, sales promotion and advertising expense and other miscellaneous expenses.Royalty and Know-how Payable:Rate is usually 2-5 % of sales and generally payable for a limited numbers f years i.e. 5 to 10 years Total cost of productionThis is simply the sum of cost of Production, royalty and Know-how Payable, total Sales Expense and total Administrative Expenses.Cost of Production + Royalty and Know-how Payable + Total Sales Expense + Total Administrative Expenses = Total cost of production Expected salesThe figures of expected sales are drawn from the estimates of sales and production prepared earlier. Gross profit before interest This represents the difference between expected sales and total cost of production. Expected sales + Total cost of production = Gross profit before interest Total Financial ExpenseConsist of interest on term loans, interest on bank borrowings, commitment charge on term loans and commission for bank guarantee. In estimating the interest on term loans, two points should be borne in mind: Interest on term loans is based on the present rate of interest charged by the term lending financial institutions and commercial banks. Interest amount would decrease according to repayment schedule of the term loan. The interest on working capital borrowings from banks may be estimated as follows:i. Determine the total requirement of the working capitalii. Find out the quantum of bank borrowing that would be available against the total working capital requirement iii. Calculate the interest charge on the basis of the prevailing interest rates

DepreciationDepreciation is an important item, particularly for capital-incentive projects. In figuring out the depreciation charge, the following points should be borne in mind:1. Contingency margin and pre-operative expenses provided in estimating the cost of project should be added to the fixed assets proportionately to ascertain the value of fixed assets for determining the depreciation charge.2. Preliminary expenses in excess of 5.0% of the project cost is included under pre-operative expenses which is subsequently allocated to fixed assets for determining the depreciation charge.3. The income tax specifies that the written down value method should be used for tax purpose. If further specifies the rate of depreciation applicable to different kinds of assets. 4. For company law (Financial reporting) purpose, the method of depreciation may be either written down value (WDV) or straight line (SL) method. Other IncomeIncome arising from transactions is not part of the normal operations of the firm. i.e. sale of machinery, disposal of scrap etc.Write off Preliminary Expenses5% of the cost of project or capital employed, whichever is higher, can be amortized in five equal annual installments.Profit or Loss before TaxationThis is equal to: operating Profit + other income write off preliminary expense. Provision of TaxationTo figure out the tax burden, a second understanding of the income tax acta complicated legislationand relevant case laws is required. While calculating the taxable income, a variety of incentives and concessions have to be taken in to account. Once the taxable income, as per the income tax act, is calculated, the tax burden can be figured our fairly easily by applying the appropriate tax rates. Profit after TaxationThis is simply profit/loss before taxation minus provision for taxation. A part of profit after tax usually paid out as dividend- dividend on preference capital and dividend on equity capital.Retained ProfitThe difference between profit after tax and dividend payment is referred to as retained profit. It is also called ploughed back earnings.Net Cash AccrualThe net cash accruals form operations are equal to: retained profit + depreciation + Write-off preliminary expenses + other non-cash charges. 2.7 Projected cash flow statements The cash flow statement shows the movement of cash into and out of the firm and its net impact on the cash balance within the firm. A format for preparing the cash flow statement, which is really a cash flow budget.Cash Flow StatementSources of fund1. Share issue2. Profit before taxation with interest added back3. Depreciation provision for the year4. Development rebate reserve5. Increase in secured medium and long-term borrowings for the project6. Other medium/longterm loans7. Increase in unsecured loans and deposits8. Increase in bank borrowings for working capital9. Increase in liabilities for deferred payment to machinery suppliers10. Sale of fixed assets11. Sale of investments12. Other income (indicate details)Total (A) Disposition of Funds1. Capital expenditure for the project2. Other normal capital expenditure3. Increase in working capital4. Decrease in secured medium and long-term borrowings All Bangladesh institutions SFCs- Banks5. Decrease in unsecured loans and deposits6. Decrease in bank borrowings for working capital7 . Decrease in liabilities for deferred payments to machinery suppliers8. Increase in investments in other companies9. Interest on term loans10. Interest on bank borrowings for working capital11. Taxation12. Dividends - Equity - Preference13. Other expenditure Total (B) Opening balance of cash in hand and at bank Net surplus/deficit (A-B) Closing balance of cash in hand and at bank2.8 Projected balance sheet The balance sheet, showing the balances in various asset and liability accounts, reflects the financial condition of the firm at a given point of time. The horizontal format of balance sheet as prescribed by the Companies Act is given below

Liabilities side of the balance sheet represents the following: Share capital consists of paid-up equity and preferences capital. Reserves and surplus represent mainly the accumulated retained earnings like debenture redemption reserve, dividend equalization reserve, and the general reserve. Secured loans represent the borrowings of the firm against which security has been provided. The important components are debentures, term loans from financial institutions, and loans from commercial banks. Unsecured loans represent borrowings against which no specific security has been provided. Examples; fixed deposits from public and unsecured loans from promoters. Current liabilities are obligations which mature in the near future, usually within a year. Payables from acquiring materials and supplies used in production, provision for provident fund, provision for pension and gratuity, and provision for proposed dividends. The assets side of the balance sheet shows how funds have been used in the business. The major asset components may be described briefly. Fixed assets are tangible long-lived resources ordinarily used for producing goods and services. They are shown at original cost less accumulated depreciation. Investments represent financial securities owned by the firm. Current assets, loans, and advances consist of cash, debtors, inventories of different kinds, and loans and advances made by the firm. Miscellaneous expenditures and losses represent outlays not covered by the previously described asset accounts and accumulated losses, if any.

For preparing the projected balance sheet at the end of year n+1, we need information about following: the balance sheet at the end of year n; the projected income statement and the distribution of earnings for year n+1; the sources of external financing proposed to be tapped in year n+1; the proposed repayment of debt capital (long-term, intermediate term, and short-term) during year n+1; the outlays and the disposal of fixed assets during year n+1; the changes in the level of current assets during year n+1; the changes in other assets and certain outlays like preoperative and preliminary expenses (which are capitalized) during year n+1; the cash balance at the end of year n+1; 3. PROJECT INVESTMENT CRITERIA ANALYSISAt the simplest level of analysis, you'll want to make sure that the total costs of any major project you undertake are less than the total benefits resulting from the project. You could simply add up the costs, and then add up your expected revenue increases and cost savings over the next few years, and compare the two.However, if we did that, we'd be ignoring the fact that many of the costs will be incurred at the beginning of the project, while many of the revenues or cost savings will occur later, over a period of months or, more likely, years.We've reviewed a number of more formal ways to evaluate the costs or benefits that a major project will bring to your company. The most commonly used include: Payback period analysis Net present value Internal rate of return Accounting rate of return profitability index Benefit cost ratio Each of these methods has its advantages and drawbacks, so generally more than one is used for any given project. And no financial formula, or combination of formulas, should be used to the exclusion of common sense.3.1 Payback period analysisThe payback method is the simplest way of looking at one or more major project ideas. It tells you how long it will take to earn back the money you'll spend on the project. The formula is:Cost of Project

Annual Cash Inflow= Payback Period

Thus, if a project cost $50,000 and was expected to return $12,000 annually, the payback period would be $50,000 $12,000, or 4.16 years.If the return from the project is expected to vary from year to year, you can simply add up the expected returns for each succeeding year, until you arrive at the total cost of the project.For example, in our previous cash flow example, the project costs $100,000 and the expected returns were as follows:Year 1$18,059

Year 2$25,513

Year 3$27,951

Year 4$32,021

Year 5$40,072

The project would be completely paid for about 10 1/2 months into the fourth year, because $100,000 (cost of project) is equal to all of the first three years' revenues, plus $28,477. $28,477 is equal to about 10.7/12 of the fourth year's revenues.Under the payback method of analysis, projects or purchases with shorter payback periods rank higher than those with longer paybacks. The theory is that projects with shorter paybacks are more liquid and thus less riskythey allow you to recoup your investment sooner, so you can reinvest the money elsewhere. With any project, the variables grow increasingly fuzzy as you look out into the future. With a shorter payback period, there's less of a chance that market conditions, interest rates, the economy or other factors affecting your project will drastically change.Generally, a payback period of three years or less is preferred. Some advisers say that if the payback period is less than a year, the project should be considered essential.Payback period has advantages like it measure of risk and liquidity and it useful for evaluating small projects. But don't forget the drawbacks of the payback period method. Chiefly, it ignores any benefits that occur after the payback period, so a project that returns $1 million after a six-year payback period is ranked lower than a project that returns zero after a five-year payback. In addition it is not consistent with investors wealth maximization. But probably the major criticism is that a straight payback method ignores the time value of money. To get around this problem, you should also consider the net present value of the project, as well as its internal rate of return.3.2 Net present valueThe net present value method (NPV) of evaluating a major project allows you to consider the time value of money. Essentially, it helps you find the present value in "today's dollars" of the future net cash flow of a project. Then, you can compare that amount with the amount of money needed to implement the project.If the NPV is greater than the cost, the project will be profitable for you (assuming, of course, that your estimated cash flow is reasonably close to reality). If you have more than one project on the table, you can compute the NPV of both, and choose the one with the greatest difference between NPV and cost. In order to calculate net present value the formula is:

Procedure:NPV is the present value of all cash flows generated by a project.1) Find the PV of each cash flow (both inflows and outflows)2) Add up all the PVs to get NPV.3) Accept the project if NPV > 0. If two projects are mutually exclusive, pick the one with the higher positive NPV. Bear in mind, though, that NPV analysis is generally used to evaluate the project's cash flows, rather than the income from the project that would be shown on an income statement. Why? Because the income statement factors in depreciation, but depreciation is not an out-of-pocket expense. For instance, if revenue of $10,000 is reduced to $7,000 of income because of a $3,000 depreciation deduction, you still have the use of the full $10,000. So, the cash flow figure of $10,000 is the more instructive one to look at. However, if you are very concerned about the appearance of your income statement (for example, if you anticipate putting the business up for sale or seeking major financing in the future, or if you're under stockholder pressure to show more income) you may decide that the income figure is more appropriate to use.Net present value is Consistent with shareholder wealth maximization, Consider both magnitude and timing of cash flows and Indicates whether a proposed project will yield the investors required rate of return. However many people find it difficult to work with a dollar return rather than a percentage return.3.3 Internal rate of returnThe internal rate of return is a discount rate that is commonly used to determine how much of a return an investor can expect to realize from a particular project. Strictly defined, the internal rate of return is the discount rate that occurs when a project is break even, or when the NPV equals 0. Here, the decision rule is simple: choose the project where the IRR is higher than the cost of financing. In other words, if your cost of capital is 5%, you don't accept projects unless the IRR is greater than 5%. The greater the difference between the financing cost and the IRR, the more attractive the project becomes. ExampleTo illustrate the calculation of IRR, lets consider the cash flow belowYear 0 1 2 3 4Cash flow(100,000) 30,000 30,000 40,000 45,000The IRR is the value of r which satisfies the following equation:r = Internal rate of return

The calculation of r involves a process of trial and error. We try different value of r till we find the right hand side of the above equation which is equal to 100,000. Lets begin to try r = 15 %. This makes the right hand side equal to:

This value is slightly higher than our target value, 100,000. So we increase the value of r to 16 %. Then the right hand becomes:

Since the value is now less than 100,000. We consider that value of r lies between 15 percent and 16 percent. If more refined estimate of r is needed, use we the following procedure: 1. Determin the net percent value of two closest rate of return.(NPV when IRR is at 15 percent) = 802(NPV when IRR is at 16 percent) = 1,3592. Find the sum of absolute value of net present values obtain in step 1. 802 + 1,359 = 2,1613. Calculate the ratio of the net present value of the smaller discount rate identified in step 1 to the sum obtained in step 2.

4. Add the number obtained in step three to the smaller discount rate. 15 + 0.37 = 15.37 percentThe IRR decision rule is straightforward when it comes to independent projects; however, the IRR rule in mutually-exclusive projects can be tricky. It's possible that two mutually exclusive projects can have conflicting IRRs and NPVs, meaning that one project has lower IRR but higher NPV than another project. These issues can arise when initial investments between two projects are not equal. Despite the issues with IRR, it is still a very useful metric utilized by businesses. Businesses often tend to value percentages more than numbers (i.e., an IRR of 30% versus an NPV of $1,000,000 intuitively sounds much more meaningful and effective), as percentages are more impactful in measuring investment success. Advantages of IRR are People feel more comfortable with IRR and consider both the magnitude and the timing of cash flows. However it has disadvantages such as multiple internal rates of return with unconventional cash flows that is any change in sign (+,-) in period cash flows produces as many IRRs as there are changes in the cash flow directions of the investment and IRR does not consider cost of capital; it should not be used to compare projects of different duration.3.4 Accounting rate of returnA fairly simple way of gauging your return on an investment in a major project or purchase is the accounting rate of return (ARR). The formula is:Accounting Rate of Return =Annual Cash Inflows - Depreciation

Initial Investment

For purposes of this formula, depreciation is calculated very simply, using the straight-line method:Depreciation =Cost - Salvage Value

Useful Life

As an example of how ARR works, let's say you're looking at equipment costing $7,500 that is expected to return roughly $2,000 per year for five years. After five years you'll sell the equipment for $500. The depreciation would be ($7,500 - $500) 5, or $1,400.ARR =$2,000 - $1,400

$7,500= 8%

Using ARR can give you a quick estimate of the project's net profits, and can provide a basis for comparing several different projects. Under this method of analysis, returns for the project's entire useful life are considered (unlike the payback period method, which considers only the period it takes to recoup the original investment). However, the ARR method uses income data rather than cash flow and it completely ignores the time value of money. To get around this problem, you should also consider the net present value of the project, as well as its internal rate of return.3.5 Profitability index (PI) The profitability index or present value index (PVI) indicates how the project offers to return for each Birr or Dollar invested. The profitability index is the ratio of the sum of present values of the project divided by the initial cost of the investment. It is a relative measure of the value (present value) of a project compared to its cost. The higher profitability index projects have higher PVs relative to the scarce capital invested.PI = NPV /InvestmentProfitability Index Decision RuleMutually exclusive investments with capital rationingChoose the project with the highest PI.Capital rationing exists if there is a limit on the amount of funds available for investment. There are two forms of capital rationing: soft rationing and hard rationing.Only use PI if there is capital rationing.3.6 Benefit cost ratioThere are two ways of defining the relationship between benefits and costs. Benefit cost ratio: BCR=PVB/INet benefit cost ratio: NBCR=PVB-I/1 = BCR-1Where PBV=Present value of benefits I=Initial investment (cost) To illustrate the calculation of these measures, let us consider a project which is being evaluated that has a cost of capital of 12 %.

Initial investment $100,000Benefits Year 1 25,000 Year 2 40,000 Year 3 40,000 Year 4 50,000

The benefit cost ratio measures for this project are: BCR= 25,000/ (1.12) + 40,000/ (1.12)2 + 40,000/ (1.12)3 +50,000/ (1.12)4100,000 BCR = 1.145 NBCR = BCR-1= 0.145

The two benefit cost measure, because the difference between them is simply unity, give the same signals. The following decisions rules are associated with them: When BCR or NBCR Rule >1 > 0 Accept =1 = 0 indifferent