Financial Analysis and Appraisal of Projects PDF

Chapter II. FINANCIAL ANALYSIS AND APPRAISAL OF PROJECTS PART I: Financial analysis of projects 2.1 What is Financial analysis and When is such analysis required? 2.1.1 What is commercial/financial analysis?  Financial analysis is all about the assessmen...

Chapter II. FINANCIAL ANALYSIS AND APPRAISAL OF PROJECTS PART I: Financial analysis of projects 2.1 What is Financial analysis and When is such analysis required? 2.1.1 What is commercial/financial analysis?  Financial analysis is all about the assessment, analysis and evaluation of the required project inputs, the outputs to be produced/generated/ and the future net benefits, (expressed in financial terms) with the aim of determining the viability of a project to the private investor or the executing entity public body.  The commercial analysis deals with two issues: Investment profitability analysis, with different methods of analysis; Simple methods of analysis of rate of return/static methods/ non-discounted techniques. i.e. simple rate of return and payback period Discounted-cash-flow methods/dynamic methods. i.e. NPV and IRR 1  Continued 2) Financial analysis/ratio analysis/ a) Liquidity analysis b) Capital structure analysis (debt-equity ratio) 3) The two types of analysis are complementary and not substitutable 4) In fact in the relevant literature commercial analysis and financial analysis are used interchangeably. 5) Whatever the terminology, the investment profitability analysis is the measurement and assessment of the profitability of the resources put into a project, more directly the return on the capital no matter what the sources of financing. 2  Continued  Thus, investment profitability analysis is an assessment of the potential earning power of the resources committed to a project without taking into account the financial transactions occurring during the project’s life.  On the other hand, financial analysis (ratio analysis) has to take into account the financial features of a project to ensure that the disposable finances shall permit the smooth implementation and operation of the project. 2.1.2 Why one undertakes Financial Analysis?/When to undertake financial analysis? Commercial/financial analysis applies to private and public investments. A private firm will primarily be interested in undertaking a financial analysis of any project it is considering and seldom will it undertake an economic analysis. 3  Continued  The issue of financial sustainability of a public project justifies the need for undertaking financial analysis.  But commercially oriented government authorities that are selling output such as railway, electricity, telecommunications, etc., will usually undertake a financial and an economic analysis.  Even non-commercially oriented government institutions may sometimes wish to choose between alternative facilities on the basis of essentially financial objectives.  Commercial profitability analysis is the first step in the economic appraisal of a project.  In fact economic analysis mainly involves of adjustments of the information used in financial analysis and of a few additional ones.  But, the procedure and methodology in financial analysis is basically the same with that of economic analysis. 4  2.2. Planning Horizon and Project Life  The project planning horizon of a decision maker may be defined as the period of time over which he/she decides to control and manage his/her project-related business activities, or for which he/she formulates his/her investment or business development plan.  The economic life, that is, the period over which the project would generate net gains, depends basically on; the technical or technological life cycle of the main plant items, on the life cycle of the product and of the industry involved, and on the flexibility of a firm in adapting its business activities to changes in the business environment. 5  Continued  When determining the economic life span of the project various factors have to be assessed, some of which are as follows: Duration of demand (position in the product life cycle); Duration of raw material deposits and supply; Rate of technical change; Life cycle of the industry; Duration of building and equipment; Opportunities for alternative investment; Administrative constraints (urban planning horizon).  Note that: Economic life of a project ≤ technical life/legal life of a project. 6  2.3 Identification and Analysis of the Estimates of Costs and Benefits  In project analysis, the identification of costs and benefits is the first step.  The costs and benefits of a project depend on the objectives the project wants to achieve.  So, the objectives of the analysis provide the standard against which cost and benefits are defined.  A cost is anything that reduces an objective, and a benefit is anything that contributes to an objective.  No formal analytical technique could possibly take into account all the various objectives of every participant in a project.  Most often the maximization of income is taken as the dominant objective of the firm because the single most important objective of an individual economic agent is to increase income and increased national income is the most important objective of national economic policy. 7  Continued  Quantification of costs: involves the quantitative assessment of both physical quantities and prices over the life span of the project.  The financial analysis of projects is typically based on accurate prediction of market prices, on top of quantity prediction.  It is worth thinking about the impact of the project itself on the level of prices; and the independent movement of prices due to other factors.  In economic analysis, the same principle can be applied but the price should be adjusted to reflect net efficiency benefits of the nations at large. 8  Continued  Cost classification: is all about categorization of costs in to: 1) Tangible and intangible costs 2) Total investment costs: including a) Initial investment costs; Fixed investment costs Pre-production expenditures b) Investment required during plant operation/rehabilitation and replacement investment costs c) Net working capital 3) Operational/running costs 9  Continued  Terminal value/end of life/salvage costs: they are costs associated with dismantling, disposal and land reclamation.  Those costs are associated with decommissioning of fixed assets at the end of the project life minus any revenues obtained from selling those assets.  Contingency allowances: Physical vs price contingencies  Price contingencies can be related to changes in relative prices or those related for general inflation.  Physical contingencies and relative price changes are common and expected, so they are part of the cost base.  But, inflation is not common, and in hence it is better to use constant prices instead of current prices to quantify costs.  Contingency allowances for inflation will not be included among the costs in project accounts other than the financing plan. 10  Continued  How taxes, debt services, subsidies and credit transactions are considered in projects financial and economic analysis?  Sunk costs: are those costs which are already incurred in the past and can not be used for another purpose or can not be recovered even if the project stops operation. 2.4. How to value project costs and benefits in financial analysis? This is all about the issue of pricing/valuing/of the project's inputs and outputs. The inputs and outputs of a project appear in physical form and prices are used to express them in value terms in order to obtain common denominator. 11  Continued  Ideally, for the purpose of the feasibility study, prices should reflect the real economic values of project inputs and outputs for the entire planning horizon of the decision makers.  In financial analysis all these receipts and expenditures are valued as they appear in the financial balance sheet of the project, and are therefore, measured in market prices.  Market prices are just the prices in the local economy, and include all applicable taxes, tariffs, trade mark-ups and commissions.  Generally, prices may be defined in various ways, depending on whether they are: Market/explicit price or shadow/imputed price Absolute or relative price Current or constant prices 12  Continued  Market/explicit prices: are prices available in the market no matter who determines.  Those prices are mostly used in financial analysis.  In economic analysis we raise the question whether market prices reflect real economic value of project inputs and outputs.  In economic analysis, if the market prices are distorted, then shadow or imputed prices will have to be used.  Shadow/imputed prices: are prices given to goods and services which have no market prices.  Such a kind of prices are mostly used in economic analysis of projects.  Absolute prices reflect the value of a single product in an absolute amount of money, while relative prices express the value of one product in terms of another. 13  Continued  The level of absolute prices may vary over the lifetime of the project because of inflation or productivity changes.  However, relative prices may sometimes remain unchanged despite variations in absolute prices.  Both absolute and relative prices can be used in financial analysis. Constant Vs Current prices  Wherever relative input and output prices remain stable, it is sufficiently accurate to compute the profitability or yield of an investment at constant prices.  Only when relative prices change and project input prices grow faster (or slower) than output prices, or vice versa, then the corresponding impacts on net cash flows and profits must be included in the financial analysis. 14  Continued  If inflation impacts are negligible, the problem of choosing between current and constant prices does not exist, since they are equal and the planner may use either. 2.5. The Treatment of Transfer Payments in Financial Analysis Some entries in financial accounts represent shifts in claims to goods and services from one entity in the society to another and do not reflect changes in national income. So the definition of costs and benefits might be confusing. These payments are called direct transfer payments and these payments include taxes, subsidies, loans, and debt services. 15  Continued  Taxes: taxes that are treated as a direct transfer payment are those representing a diversion of net benefit to the society.  A tax does not represent real resource flow; it represents only the transfer of a claim to real resource flows.  In financial analysis a tax is clearly a cost.  When a firm pays taxes its net income reduces.  But the payment of taxes does not reduce national income.  So, in economic analysis taxes will not be treated as a cost in project account. 16  Continued  Taxes: taxes that are treated as a direct transfer payment are those representing a diversion of net benefit to the society.  A tax does not represent real resource flow; it represents only the transfer of a claim to real resource flows.  In financial analysis a tax is clearly a cost.  When a firm pays taxes its net income reduces.  But the payment of taxes does not reduce national income.  So, in economic analysis taxes will not be treated as a cost in project account. 17 2.6. Cash Flows in Financial Analysis Reading Assignment 18  Part II: Financial Appraisal Criteria of Projects and Selection of Investments  It is to be reminded that the theme of project planning/study is to determine whether an investment is feasible or not.  This means to show whether the financial return on both the total capital invested and on the paid-in equity capital is sufficiently high or not.  Although sufficient returns are essential for a project to be implemented, investments must be justified usually within wider context, which for investors and financiers includes any gains, whether net profits or non-cash benefits, resulting directly or indirectly from an investment. 19  Continued  Thus once, costs and benefits have been identified, priced and valued, the project analyst should work out to determine on which project (s) to invest.  To this effect, the project analyst should have ways and means to select more profitable from less profitable or unprofitable projects.  Projects, which are powerful means of development, have to be appraised by multiple criteria.  It should be noted that there might be no one best technique for estimating project worth although some may be better than others. 20  Continued  There are other non-quantifiable and non-economic criteria for making project decisions.  There are two types of measures of project worth i.e. undiscounted and discounted.  The basic underlying difference between these two lies in the consideration of time value of money in the project investment.  Undiscounted measures do not take into account the time value of money, while discounted measures do. 21  2. 1. Non-Discounted Measures of Project Worth 1) Ranking by Inspection: this method identifies the more desirable project from two or more investment projects by mere inspection.  Suppose two projects have the same investments and net value of production but are with different in economic life i.e. one continues to earn longer than the other, then the project with longer duration is preferred to the one with shorter lifetime.  This leads to bias in the choice obviously due to the absence of more elaborate and appropriate analysis.  This criterion is rough and simplistic.  It is based on the size of costs and the length of cash flow stream. 22  Continued However, it is possible in some cases to determine by mere inspection which of two or more investment projects is more desirable. There are two cases under which this might be true. I. When two investments have identical cash flows each year up to the final year of the short lived investment, but one continues to earn cash proceeds (financial results or profits) in subsequent years. The investment with the longer life would be more desirable. 23  Continued II. When two investments have the same initial outlay (the total net value of incremental production may be the same), the same earning life and earn the same total proceeds (profits), but one project has more of the cash inflow earlier in the time sequence, we should choose the one for which the total proceeds is greater than the other’s in the earlier period. 24  2) Urgency According to this criterion projects which are deemed to be more urgent get priority over projects which are regarded as less urgent. The problem with this criterion is: how can the degree of urgency be determined? In certain situations it may not be practically difficult to determine the urgency of a certain project proposal. For instance the project could be bottleneck alleviation of an ongoing operation/firm/ etc. Since it is not a systematic decision, this is not something that can be encouraged. Rather it is a practice that should be discouraged. 25  3) The Payback Period/Cutoff period/payoff period It is one of the simplest and most frequently used methods of measuring the economic value of an investment. It is defined as the length of time required for the stream of cash proceeds produced by the investment (project) to be equal to the original cash outlay required by the investment (capital investment). It is also defined as the number of years expected to be consumed until the sum of the project’s net earnings (receipts minus payments) equal the cost of the project’s initial capital investment. As the name suggests, the rule leads one to choose that project which recovers its capital costs in the shorter period (also called as the capital recovery criterion). 26  Continued When cash flow is in annuity form (even cash flows), the payback period of a project can be estimated by using the straight forward formula; P = I/E; where P is the payback period of the project in years, I is the investment cost of the project, and E is the annual net cash revenue. If the expected proceeds are not constant from year to year, then the payback period must be calculated by adding up the proceeds expected in successive years until the total receipt is equal to the original outlay. This criterion is most often used in the business enterprises. However, its use in agricultural projects is limited. 27  Limitations of pay-back period Generally, this criterion has two important limitations: 1) It fails to give any considerations to cash proceeds earned after the payback date. It simply emphasizes quick financial returns. 2) It fails to take into account differences in the timing of receipts earned prior to the payback date. For instance, if we have two projects with the same capital cost and if they have the same payback period then they are equally ranked. Yet we know by the inspection method that a project with more earlier benefits should be more desirable and should be preferred since the earlier benefits are received the earlier it can be reinvested or consumed. 28  4) Proceeds per Unit of Outlay Under this method, investments are ranked according to their total proceeds divided by the amount of the corresponding investments. In other words the total net value of incremental production divided by the total amount of the investment gives us the proceeds per unit of outlay. OR The proceeds per unit of outlay is worked out by dividing the total proceeds to the total amount of investment, and a given project is ranked based on the highest magnitude of the parameter. This method is again deficient because it still fails to consider the timing of proceeds. This is inconsistent with the generally accepted economic principle that 1 birr today is more valuable than 1 birr tomorrow. 29  5) Output-Capital Ratio This is another crude index of investment efficiency. It is defined as the average value added per unit of capital expenditure. Under this criterion, we select the project with the highest output-capital ratio or the lowest capital-output ratio (Capital coefficient). The main problem with this approach is that it ignores other factors of production such as labor and land and concentrates only on the productivity of capital. Accordingly the criterion favors those projects that use large quantities of labor and land in place of capital. Further it does not consider the timely spread of costs and proceeds. 30  6) The average annual proceeds per unit of outlay This is similar to the proceeds per unit of outlay criterion except that the average proceeds per year is expressed as a ratio of the original investment. The total proceeds are first divided by the number of years during which they are received, and this figure (the average proceeds per year) is then expressed as a ratio of the original outlay. This method fails to take properly into considerations the timing of proceeds and exhibits a built in bias for short lived investment with high cash proceeds. 31  7) Average Income on the Book Value of Investment This is the ratio of the income to the book value of its assets. The value of assets as recorded in the operation’s financial account books. N.B. Book value of assets is the difference between initial cost of the assets and the accumulated depreciation. 32  2.2 Discounted project assessment criteria and discounting future income flows in project analysis Time Preference: The undiscounted measures discussed so far share a common weakness. They fail to take into account adequately the timing of benefits and costs. It is not possible to just add all the benefits of the project and to subtract all the costs, irrespective of when they occur. The bulk of the project's costs will be incurred during extended period of implementation stage and its benefits will be realized after operation commences, rising to some plateau when the project reaches full capacity. 33  Continued For a whole range of reasons, people, enterprises and governments will not be indifferent about whether they receive income (or incur expenditure) now or in some future period. They are said to have time preference in that they will prefer to receive income sooner rather than later, and to pay for expenditures later rather than sooner. Some of the reasons are;  There is an expectation that society and individuals will be better off in the future than they are now  Expectation of inflation  Marginal return on capital  Uncertainty about the future  Pure time preference 34  2.2.1 Discounting future income flows in project analysis The undiscounted measures are naive methods for choosing among alternative projects. They often mislead the analyst in ranking the project ideas. The major drawback of these measures is that for the same data of the projects, we get different rankings, hence, the choice process becomes inconsistent and incompatible. Besides, the undiscounted measures fail to take account of the timing of benefits and costs. It is an accepted principle in Economics that inter-temporal variations of costs and benefits influence their values and a time adjustment is necessary before aggregation. 35  Continued Therefore, time, as one parameter, should be included in project appraisal. Generally speaking, there is a positive rate of discount, which leads us to place a lower present value on a given sum of money the further in the future one expects it to accrue. The accepted method for such an adjustment is called discounting. Discounting is a technique or a process by which one can reduce future benefits and costs to their present worth or present value. This is a method used to revalue future cost and benefit flows of a project into present day values so that they become comparable and be added together. 36  Continued Costs and benefits are discounted by a factor that reflects the rate at which today's value of monetary unit of benefit/cost decreases with the passage of time. Any cost/benefit of a project that is received in a future period is discounted, or deflated by some factor, r, to reflect its lower value to the individual (society) [than today’s available resource]. The factor used to discount future costs and benefits is called the discounting factor. In order to clearly understand the principles of discounting, it will be helpful to have a clear understanding of the principle of compounding. 37 Continued 38  Continued It is possible to consider the value people will put on income in different periods, by working back in time from the future. The discount rate and the interest rate are very similar. The only difference is that the interest rate used for compounding assumes a viewpoint from here to the future, while the discount rate used for discounting looks backward from the future to the present. Exercise: 1) Distinguish the difference between the concepts of annuity factor and the discounting factor? 2) The difference between discount rate and interest rate? 39 2.2.2 Discounted measures of project worth 40  Continued Stylized Facts about NPV: 1)The discounted rate should be equal either to the actual rate of interest on long term loans in the capital market or to the interest rate paid by the borrower. However, since capital markets do not usually exist in developing countries, the discount rate should reflect the opportunity cost of capital- This being the minimum rate of return below which the project analyst considers that does not pay for him to invest. 2)The discounting period should normally be equal to the life time of the project. 3)During the implementation period the net benefits are usually negative because investments costs may be greater than benefits. However, the interest should be on the present value of net benefits over the entire life of the project. 41  Continued Having set the discount rate, an investment project is deemed acceptable if the discounted net benefits (i.e. benefits minus costs) are positive. The economic criterion of project appraisal is to accept all projects that show positive or zero NPV at the predetermined discount rate and reject all projects that show negative NPV. Because of lack of funds or administrative resources, if we cannot undertake a number of projects, the implication is that the opportunity cost of capital has been estimated to be too high and we have to reduce and re-estimate NPV. On top of this, if one of several alternative projects has to be chosen, the project with the largest positive NPV has to be selected. 42 Continued 43  Decision Rule for Independent Projects Independent projects are projects that are not substitutes for each other. Here the decision rule is to accept the project if NPV is greater than or equal to zero. If two projects have positive NPV and there is no budget constraint, both should be accepted and we do not need to choose the one with the higher NPV. Decision Rule for Mutually Exclusive Projects A mutually exclusive project is a one that can only be implemented at the expense of the alternative project. Mutually exclusive projects are substitutes of each other because each of them produces technically the same product [compared to that of the other project/s]. 44  Continued Example of mutually exclusive projects includes two versions of the same project, say with different technology, scale or time. The decision rule for such projects is to accept the project with the highest NPVR. But, if there is substantial difference in the value of NPV of the two mutually exclusive projects, one will have to go for the project with the highest NPV. Practical Application for the Present Value Method The practical application of Net Present Value criterion as a means of evaluating investment proposals for project planning implies the following assumptions. I. Annual outlays and receipts from each investment are known for the entire life of the project. II. The project life span is known. 45  Continued III. There is a rate of discount, which can be applied to every proposal and during each time period. However, the above assumptions are not always satisfied for each and every project. This means that the NPV criterion may be applicable only to a limited number of project proposals. Advantages of the NPV Criterion III. The major advantage of the NPV selection criteria is that it’s simplicity in usage. Besides, this criterion does not rely on complex conventions about where costs and benefits shall be netted out. IV. In addition, it is the only selection criteria that can correctly be used to choose between mutually exclusive projects. 46  Disadvantages of the NPV Criterion 1) NPV is an absolute measure. A small but highly attractive project will have a small NPV than a large but less impressive project. (The problem is- it does not scale down those kinds of disparities in size!) 2) Like all discounted measures except the IRR, the use of the NPV criterion relies on a prior selection of an appropriate discount rate. 3) Although it is simple to use, its meaning may not be intuitively clear to non- economists. 4) Although it can be used when there is budget constraint, it is not suitable method, especially for a large and complex investment budget. If the budget constraint is a long term one, it will be necessary to raise the discount rate used, so that only projects with a positive NPV will be selected. 47  Continued 5) Some projects could be deferred from implementation although they show positive NPVs, due to scarcity of funds. Thus, passing the NPV test is not a sufficient condition for implementation. 6) It does not show the exact profitability of the project. 48  2. The Internal Rate of Return (IRR) This is a second measure of profitability. Sometimes it is also called marginal efficiency of capital or yield on investment. IRR is defined as the rate of discount at which the total present value of costs incurred during the life of the project is equal to the total present value of benefits accruing during the life of the project. The IRR of a project is probably the most commonly used assessment criterion in project appraisal. This is because the concept of an IRR is in some way comparable to the profit rate of the project. It is easy for non- economists to understand. Furthermore, it doesn’t rely on selection of a predetermined discount rate. 49 Continued 50  Continued IRR is the maximum discount rate that a project could pay for the resources used if the project is to recover its investment and operating costs and still be at break even. The IRR is the return to the entity’s own capital. It is the weighted average return to the entity’s own capital engaged over the life span of the project. Unfortunately, there is no formula for finding the internal rate of return. There are three alternative secondary approaches to calculate the IRR. 51  Continued Iteration: - using iterations (trial and error method), it is possible to determine the discount rate that makes the project's NPV equal to zero. This rate is the IRR of the project. The iteration begins with the preparation of a cash flow table. A randomly estimated discount rate is used to discount the net cash flow to the present value. If the NPV is positive, a higher discount rate is applied; if the NPV is negative at this higher rate, the IRR must be between these two rates. 52 Continued 53 Continued 54  Decision rule for Independent Projects According to the IRR version of economic criterion we implement all projects that show an IRR greater than the predetermined discount rate (opportunity cost of capital), i.e., accept all independent projects having an IRR ≥ the opportunity cost of capital (cutoff rate). The reference discount rate which is also called the target rate, is predetermined by the Central Bank. Once the IRR is identified, the decision rule is accept the project if the IRR is greater than the cost of capital, say r. Note also that:  When NPV > 0 then R > r  NPV = 0 then R = r  NPV < 0 then R < r 55  Continued Note the following: 1) All projects with an internal rate of return greater than some target rate of return, r*, should be accepted. 2) Note that the use of IRR does not avoid the need for discount rate, as sometimes claimed, but merely delays the need to use it until the IRR has been computed. 3) In the case of our example, if the discount rate is 10% both the NPV and IRR will suggest to accept the project if the cost of capital is 10% and both suggest to reject the project when the discount rate and the cost of capital is 20%. As will be demonstrated later, however, the two methods may not give identical signals. 56  The IRR and Mutually Exclusive Projects While the IRR cannot be directly used to choose between mutually exclusive projects, it can be employed for further manipulation. This manipulation entails subtracting the cash flow of the smaller project from the cash flow of the larger one and calculating the internal rate of return of the residual cash flow. If the residual cash flow's internal rate of return exceeds the target discount rate, which could only occur if the larger project has a higher NPV, then the larger project should be chosen. 57  Comparison of the NPV and IRR From the foregoing discussions it is clear that both the NPV and the IRR methods can and do rank investment projects in more rational manner than the non discounted methods. Thus, it is advisable to calculate these measures so that easily understandable information is provided to the decision makers. IRR is more useful in allowing projects of different size to be compared directly, because it eliminates the need for choosing a discount rate. In general it can be said that the NPV method is simpler, easier, and more direct and more reliable. In some situations both the NPV and the IRR criteria give the same accept - reject decision. 58  Continued However, there are two probable reasons why all acceptable projects cannot be implemented. 1. When investible funds (capital funds) are very limited in size; 2. The other and more severe problem is when the discount rate is not set correctly. 3. When the capital requirements of all acceptable projects exceed the available funds, the central authorities (The National Bank or the Ministry of Finance) should raise the discount rate up to that level where projects passing the test are just enough to exhaust the available funds. 4. But if too few projects are acceptable, then the discount rate should be reduced. 59  Continued Hence as long as capital funds are 'unlimited' it is argued that the NPV should be the relevant criterion. But if the function of the discount rate is to ration capital available at hand, IRR is considered to be more suitable than the NPV criterion. 60  Advantages of the IRR 1) It is the only measure of project worth that takes account of the opportunity cost of capital and does not depend on predetermined discount rate. 2) It is commonly used by international institutions like the World Bank since they cannot design projects of same kind with different discount rates for different countries. 3) This measure is easily understood by non economists, because it is closely related to the concept of return on investment (profitability). 4) It is a pure number and hence allows projects of different size to be compared directly. 61  Disadvantages of the IRR 1) The IRR is inappropriate to use for mutually exclusive projects and independent projects when there is a single period budget constraint. 2) A project must have at least one negative cash flow period before it is possible to calculate its internal rate of return. This is related to the algebraic definition of the IRR. 3) Sometimes it is possible to compute more than one IRR for a project. If a project has more than one IRR, then neither can reliably be used and another decision rule such as the NPV must be used as an alternative. 62  Continued 4) Prior to the advent of business calculators and computers software programs like lotus and excel, estimation of the IRR was a tedious process involving interpolations. (But these days this not a problem). 63 3. The Net Benefit Investment Ratio (NBIR) 64  Continued Where – Oct -operating costs in period t; ICt- investment costs in period t; and r - the appropriate discount rate, The NBIR shows the value of the projects discounted benefits net of operating costs, per unit of discounted investment cost. The decision rule in NBIR criterion is to accept projects when the ratio is greater than 1. This criterion is especially important for ranking independent projects since it shows the benefit per unit of investment. When we have a single period budget constraint projects with the highest NBIR should be selected up to the point where the budget is exhausted. 65  Advantages and dis-advantages of NBIR The main advantage of the NBIR is its capacity to determine the group of priority projects if there is a single period budget and/or investment constraint. Its basic limitation is that it is not suitable for comparison of mutually exclusive projects, because a project with the highest NBIR could have the lowest absolute net present value. The other disadvantage of NBIR is that the convention used for dividing costs (for example maintenance) into operating and investment costs varies from institution to institution and may render problems of comparability. 66 4. The Benefit Cost Ratio (BCR) 67  Continued The decision rule for BCR: A project should be accepted if its BCR is greater than or equal to 1 (i.e. if its discounted benefits exceed its discounted costs). The BCR will be less than, equal to, and greater than one when the discount rate used is greater, equal to, and less than the IRR. One possible advantage of the BCR, on top of being easy to show to non- economists, it is easy to show the impact of a percentage change in cost or benefits on the projects viability. Its major disadvantage is the need to specify and adhere to conventions regarding the designation of expenditures as costs and benefits. 68 THANK YOU !!! 69