A certain program is to be evaluated for economic efficiency

A certain program is to be evaluated for economic efficiency. The investments (costs) and returns are given in Table 4.9 below. Evaluate B-C ratio, NPW, Payback Period, and IRR for discount rates of 5%, 10%, and 20%. Comment on the attractiveness of this program.

Solution

Net present value

r = 5%

-10000 + 5000/1.05 + 5000/1.05^2 + ...... - 35000/1.05^10

= 4052.14

In a similar way

when r = 10%, NPV = 5301.10

when r = 20%, NPV = 4502.14

Internal Rate of Return

10000 = 5000/(1+r) + 5000 / (1+r)^2 + ...... -35000 / (1+r)^10

r = 0%

Note :

In certain cases where there is a cash outflow in the duration of the project, it might lead to multiple IRRs. In such cases calculating modified rate of return is more viable.

Payback Period : 2 years. In 2 years the initial investment will be recovered. The demerit of this method is that it does not include npv and does not take the slavage cost into consideration.

B-C Ratio :

When r = 5%

PV of all the future benefit = 14052.14

Benefit/cost = 14052.14/10000 = 1.405

When r = 10%

PV of all the future benefit = 15301.10

Benefit/cost = 15301.10/10000 = 1.53

When r = 20%

PV of all the future benefit = 14502.14

Benefit/cost = 14502.14/10000 = 1.450

The programme is most attractive when the dicount rate is 10% as given by NPW. We choose this method because it takes into cosideration the TV of money.