The concept of Project Evaluation
"Continuous and Discrete Time Discounting" from the Wolfram Demonstrations Project
Explore the effect of discounting by visiting the Wolfram demonstration (click on the graph to the left).


   Basics:

  • A project is an investment activity where labour and/or capital is spent to create producing asset from which we can expect future benefits. A project is characterised by

    • Specific starting and ending points
    • Its major costs and returns are measurable
    • It should have a specific geographic location
    • It should have a specific clientele group
    • It should have a well defined time sequence of investment and production activities

  • IMPORTANT

A project overview is often presented by Gantt charts, as in the figure below, where the different activities are planned in time.


Project budgeting is done by one (or more) of the following methods:

Capital budgeting methods

  • Payback period: which measures the time required for the cash inflows to equal the original outlay. It measures risk, not return.
  • Cost-benefit analysis: which includes issues other than cash, such as time savings.
  • Real option method: which attempts to value managerial flexibility that is assumed away in NPV.
  • Internal rate of return: which calculates the rate of return of a project without making assumptions about the reinvestment of the cash flows (hence internal).
  • modified internal rate of return (MIRR): similar to IRR, but it makes explicit assumptions about the reinvestment of the cash flows. Sometimes it is called Growth Rate of Return.

Three principles

Of the five alternatives above there are really only three different principles of project evaluation:
  • Payback
  • Cost-Benefit (including real option)
  • Internal Rate of Return (including MIRR)

Payback

does not include discounting, it purely a matter of time when the initial investment is covered. When a cash amount of C is received every year (t) after an investment I, the payback is (t I)/C. Payback is one (all investment covered) after t years, t = C/I.

Key cost-benefit indicators:

    • PVB (present value of benefits);
    • PVC (present value of costs);
    • NPV (PVB less PVC);
    • NPV/k (where k is the level of funds available) and
    • BCR (benefit cost ratio, PVB divided by PVC).

Internal rate of return (IRR)

IRR is similar to NPV, but solved for the discount rate rather than the present (or future) value. See also the table below.

Economic Evaluation factors

 Name  Formula  Solves for
 Given
 Single-payment, present worth
 
 Present worth
 Future worth
 Single-payment, compound amount
 
 Future worth  Present worth
 Uniform-series, present worth
 

 Present worth  Annualised worth
 Capital-recovery
 
Annualised worth 
 Present worth
 Sinking fund
 
 Annualised worth  Future worth 
Uniform-series, compound amount 
 
 Future worth  Annualised worth 


From the  Guidelines for Project Evaluation (FAO), chapter 1:

Project choice and national planning

For a private commercial entrepreneur project choice is a rather simple exercise. If he knows his own objectives, which seems to be a reasonable assumption, all he has to do is to ascertain which projects satisfy his objectives best. For a planner the picture is somewhat more complex. In choosing projects he has to ascertain which ones best satisfy the interests and objectives of the nation. His personal objectives are fairly unimportant; he must choose the best thing for the society. This is complex not merely because the national interests are not easy to define, but also because the reading of these interests by different planners may well be different. If different planners pursue different national objectives, the result may be unsatisfactory and conceivably disastrous.

The main reason for doing social benefit-cost analysis in project choice is to subject project choice to a consistent set of general objectives of national policy. The choice of one project rather than another must be viewed in the context of their total national impact, and this total impact has to be evaluated in terms of a consistent and appropriate set of objectives. The avoidance of a complete dichotomy between project choice and national planning is one of the main reasons for doing social benefit-cost analysis. When one project is chosen rather than another, the choice has consequences for employment, output, consumption, savings, foreign exchange earning, income distribution and other things of relevance to national objectives. The purpose of social benefit-cost analysis is to see whether these consequences taken together are desirable in the light of the objectives of national planning.

Basic differences between commercial calculations and social benefit-cost analysis

A commercial firm faces specific prices (or demand and supply conditions) and does not need to go into the question of what these prices represent for the nation as a whole. If a specific soap costs 1 shilling a bar, or if a particular type of cigarette sells at 2 shillings a packet, the manufacturer of the soap or cigarettes gets some hard information from this. For a planner, however, this information is really very "soft", and he needs to go deeper to ascertain what these prices mean. Does the price of cigarettes take account of the smokers' higher probability of heart disease or cancer? Does the price of soap take note of the benefits that others receive from people's use of soap, e.g., the reduced risk of spread of disease, or the advantage of not having to travel with dirty fellow passengers? For the commercial entrepreneur these questions may be interesting as a pastime, but for a public-project planner they are crucial questions that should influence his decisions.

By the very nature of his work a commercial entrepreneur can confine his thoughts to a rather limited range of effects, but a planner on behalf of the country must, of necessity, take a wider view. This point is simple enough, but it is often overlooked when one contrasts the quick and clear-cut decisions of private entrepreneurs with the rather slow and cumbersome exercises of public-project evaluation. The two jobs are not really comparable. This is not to say that multiplicity of objectives is an exclusive characteristic of public-project evaluation. Most economic agents have many objectives. An entrepreneur may try to get more profits, but may also be interested in being big and having a large volume of sales. A worker may wish to earn more, but may also desire more leisure. While the reconciliation of these different objectives does involve problems, the job is likely to be much more complex for a planner who has to seek an appropriate compromise between the various divergent objectives and goals of national planning. These objectives may severely conflict with each other, since the nation is a collection of diverse groups with different interests. The problem cannot be casually dismissed, and social benefit-cost analysis must face the problem of multiple objectives of diverse types.

Even the choice of a rate of interest to discount future social benefits reflects a particular compromise of the conflicting interests of different generations. For a commercial firm the rates of interest may simply reflect the rates at which it can lend or borrow. But to a planner interest rates must be viewed as a method of apportioning benefits and costs to different time periods, and possibly between different generations. He has to compare the value of benefits today with that of benefits in the future. Thus, the contrast between commercial decision making and the planning of projects on behalf of the nation is simple but important. The latter would appear usually to be a much more complex exercise than the former, and the techniques used in the former exercise may be unhelpful in the latter. The approach of social benefit-cost analysis is aimed precisely at systematizing the complex problems of project planning from the point of view of the society or the nation.

Subpages (1): Calculations