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be noted that life cycle cost is a decision support tool that should match the purpose and not an external, financial reporting system that should obey rigid principles, such as Generally Accepted Accounting Practice (GAAP).

In addition to cost behaviour and the relevance of costs, long-term decisions require a consideration of the time value of money. The cost of money is an integral part of the analysis for determining profitability and establishing net present values and rates of return based on cash flows. These concepts will now be discussed.

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used. According to the NPV method, cash inflows are assumed to be reinvested at the discount rate used in the analysis, while according to the IRR method, cash flows are assumed to be reinvested at the internal rate of return of the original investment.

**3.3.1 ** **Net present value **

The net present value (NPV) method requires the choice of a discount rate to
be used in the analysis. Many companies use the cost of capital. **Cost of **
**capital **represents what a company would have to pay to borrow or raise funds
through equity in the financial marketplace. In NPV analysis, the discount rate
is the minimum required rate of return – the rate the company requires for any
investment to be profitable. The **discount rate **is adjusted to reflect the risk
and uncertainty of cash flows expected in the future. The present value of all
cash inflows is compared to the present value of all cash outflows. If the
present values of the inflows are greater than or equal to the present values of
the outflows (ie the NPV is greater than or equal to zero), the investment is
acceptable, because a return at least equal to the discount rate is provided. If
the present values of the outflows are greater than the present values of the
inflows, the NPV will be negative and the investment rejected. Table 3.4
summarises the results of NPV analyses.

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**Table 3.4 ** **Summary of net present value **

**If the net present value is … ** **Then the project is … **
Positive

Zero

Negative

Acceptable, since it promises a return greater than a required rate of return.

Acceptable, since it promises a return equal to the required rate of return.

Not acceptable, since it promises a return less than the required rate of return.

**Source: **

Adapted from Garrison et al* *(2003:364)

The net present value of a project can be calculated by using the following
equation (Drury 2008:295-297; Garrison et al* * 2006:654-660; Hilton et al* *
2003:587;* *Jackson & Sawyers* *2003:248):

## > @

### ∑

^{N}

^{}

^{}

10 n

Cn

NPV x 1 d ^{n}

where

Cn = the cash to be received or disbursed at the end of period *n*
d = the appropriate discount rate for the future cash flows
*n* = the time period during which the cash flow occurs
N = the life of the investment, in years

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**3.3.2 ** **Internal rate of return **

The internal rate of return (IRR) is an alternative technique for making capital
investment decisions. The IRR represents the true interest rate earned over
the course of an investment’s economic life. It is sometimes referred to as
**discounted rate of return.** The internal rate of return is the maximum cost of
capital that can be applied to finance a project without harming the
shareholders. If the IRR is greater than the opportunity cost of capital, the
investment will be profitable and yield a positive NPV. If the IRR is less than
the cost of capital, the investment will be unprofitable and result in a negative
NPV. The IRR is computed by finding the discount rate that equates the
present value of a project’s cash outflows with the present value of its cash
inflows. The IRR is therefore that discount rate that will cause the net present
value of a project to be equal to zero (Drury 2008:298; Garrison et al 2006:661;

Garrison et al* *2003:371).

The two methods will now be compared.

**3.3.3 ** **Comparison of the net present value and internal rate of return **
**methods **

The net present value method has several important advantages over the internal rate of return method. These include the following:

The NPV method is often simpler to use.

The assumption made by the IRR method concerning the rate of return earned on cash flows generated during its useful life is questionable.

The NPV method assumes that the rate of return is the discount rate, whereas the IRR method assumes the rate of return is the internal rate of return on the project.

Risk and uncertainty are taken into account by adjusting the discount rate using the net present value. When the IRR method is used, users have to adjust cash flows directly in order to adjust for risk.

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When the two methods do not concur about the attractiveness of a project, it is
preferable to opt for the net present value method, because it makes the more
realistic assumption about the rate of return that can be earned on a project’s
cash flows. (Garrison et al 2006:662-663; Jackson & Sawyers* *2003:252).

Unless there are qualitative reasons for rejecting the project, the investment will be acceptable if the IRR is equal to or greater than the minimum required rate of return (See Figure 3.6).

**Figure 3.6 Choosing the right investment evaluation method **

**Source: **

Adapted from Jackson and Sawyers* *(2003:253)

Future money is reduced (discounted) to its current money equivalent or present value. The rate at which future money is discounted, is referred to as the discount rate and is taken to represent the time value of money.

Decision on what method to

use Net present value

(NPV)

Invest in project

Reject project

Consider all qualitative (non-number) factors

in the decision NPV is

greater than or equal to 0

IRR is greater than or equal

to cost of capital Internal rate of

return (IRR)

Reject project NO

YES YES

NO

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**3.3.4 The main components of discounting **

The discount rate is the interest rate used to discount future cash flows to their present values. If a project has a positive NPV, it will earn a rate of return higher than its discount rate. The three main components of discounting are

(1) the time stream of costs and revenue (2) the discount rate

(3) project life

**(1) ** **The time stream of costs and revenues. **The objective of discounting
and discounted cash flows, when applied to life cycle cost, is to express future
flows of cash in their present value. The estimated time stream of expenditure
and receipts is therefore a vital component of the analysis. All costs and
revenues over the entire life cycle of the project should be identified. Taxation
and investment incentives should also be taken into account.

**(2) ** **The discount rate. **The choice of the discount rate is the second major
component of discounting. The choice whether to proceed with a specific
project is crucially affected by one’s choice of discount rate. The discount rate
should be the opportunity cost of capital - the real rate of return available on the
best alternative use of funds to be devoted to the project. The appropriate cost
of capital is a long-term cost in which the time period refers to the life cycle of a
project and cannot be expected to be financed by borrowing in the short-term
money markets.

**(3) ** **Project life. **The estimate of the probable life of a project is the third
component of discounting. Many factors will influence this estimate. Specialist
suppliers can give estimates, but the estimator will also have to rely on
historical data and professional judgment. The shorter the project life is, the
more important the estimate of the project life will be (Flanagan & Norman
1983:45-46).

In metallurgical research projects, it was observed during personal interviews that the majority of the respondents used NPV and IRR techniques for the

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evaluation of projects. However, it is crucial that the cost estimates used for the calculations are accurate.

Depending on the amount of time and resources available, the degree of accuracy and other factors such as data availability, there are different methods of cost estimation. The techniques used to estimate costs will now be discussed.

In this study, two of the research objectives relate to cost estimation, namely:

(1) to examine different methods that can be used to estimate and manage the total costs of a project during its life cycle

(2) to determine whether these cost estimation methods are being used in metallurgical research projects

The different methods of cost estimation will now be discussed, while section 5.6.10 indicates which of these methods are used for metallurgical research projects.