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Financial appraisal techniques

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Basically computation of Project Appraisal technique with a special reference to financial parameters - Payback, Discounted Cash flow, NPV, IRR etc are explained. The slides are used for educating …

Basically computation of Project Appraisal technique with a special reference to financial parameters - Payback, Discounted Cash flow, NPV, IRR etc are explained. The slides are used for educating those who have taken up Project Finance recently


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  • 1. Financial Appraisal, Sensitivity and Scenario Analysis R.Ganesh, Sr.faculty, SBSC, Hyd
  • 2. Capital Investment Process
    • TT
    Identification Evaluation Implementation & Follow up Selection
    • Type of Investment
    • Required Investment
    • Replacement Investment
    • Expansion Investment
    • Diversification investment
    • Input
    • Expected cashflow stream
    • Discount rate
    • Decision Rule
    • Net Present Value
    • Profitability Index
    • Internal rate of return
    • Payback period
    • Performance Evaluation
    • Monitor magnitude and timing of cash flows
    • Check project still meets selection criterion
    • Decide on continuation or abandonment
    • Review steps if failure rate is high
  • 3. Payback Period Payback period is the number of periods for the sum of project’s expected Cash Flows to equal its initial cash outlay. Payback period is the time it takes to recover its initial investment. A project is acceptable if the payback period is shorter than or equal to CUT-OFF period.
  • 4. Expected cashflow streams – alternative investment proposals – Initial outlay of ONE million rupees End of Year Investment A Investment B Investment C Investment D Invesrtment E Investment F 1 600,000 100,000 250,000 250,000 325,000 325,000 2 300,000 300,000 250,000 250,000 325,000 325,000 3 100,000 600,000 250,000 250,000 325,000 325,000 4 200,000 200,000 250,000 250,000 325,000 325,000 5 300,000 300,000 250,000 250,000 325,000 925,000 Total Cashflows 1,500,000 1,500,000 1,250,000 1,250,000 1,625,000 2,275,000 Payback period 3.00 3.00 4.00 4.00 3.08 3.08
  • 5. Drawbacks of Payback method
    • Strongest appeal !!
    Adjustment for timing of Cash Flows ? Adjustment for Risk ? Maximisation of the Firm’s Equity Value ? Its simplicity & ease of application Contributes to overall liquidity It is easy to employ when future events are difficult to quantify
  • 6. Discounted payback period Discounted payback is the number of periods required for the sum of present values of project’s expected cash flows to equal its initial cash outlay.
  • 7. Discounted Payback –calculations- Investment ‘A’ End of Year Expected cashflows Discount factor Present Value Cumulative Present value 1 600,000 0.9091 545,455 545,455 2 300,000 0.8264 247,934 793,389 3 100,000 0.7513 75,131 868,520 4 200,000 0.6830 136,603 1,005,123 5 300,000 0.6209 186,276 1,191,399
  • 8. Expected cashflow streams and cost of capital – alternative investment proposals – Initial outlay of ONE million rupees End of Year Investment A Investment B Investment C Investment D Invesrtment E Investment F 1 600,000 100,000 250,000 250,000 325,000 325,000 2 300,000 300,000 250,000 250,000 325,000 325,000 3 100,000 600,000 250,000 250,000 325,000 325,000 4 200,000 200,000 250,000 250,000 325,000 325,000 5 300,000 300,000 250,000 250,000 325,000 925,000 Total Cashflows 1,500,000 1,500,000 1,250,000 1,250,000 1,625,000 2,275,000 Cost of capital 10% 10% 5% 10% 10% 10% NPV 191,399 112,511 82,369 -52,303 232,006 635,605 Discounted Payback period 3.96 4.40 4.58 More than 5 3.86 3.86
  • 9. Internal Rate of Return(IRR) IRR is the discount rate that makes the Net Present Value (NPV) of the Project EQUAL to ZERO. An investment to be accepted if its IRR is higher than its Cost of Capital and should be rejected, if lower. IRR can be interpreted as a measure of profitability of its expected cashflows. IRR takes into account Time Value of money and risk of investment
  • 10. Expected cashflow streams and cost of capital – alternative investment proposals – Initial outlay of ONE million rupees End of Year Investment A Investment B Investment C Investment D Invesrtment E Investment F 1 600,000 100,000 250,000 250,000 325,000 325,000 2 300,000 300,000 250,000 250,000 325,000 325,000 3 100,000 600,000 250,000 250,000 325,000 325,000 4 200,000 200,000 250,000 250,000 325,000 325,000 5 300,000 300,000 250,000 250,000 325,000 925,000 Total Cashflows 1,500,000 1,500,000 1,250,000 1,250,000 1,625,000 2,275,000 Cost of capital 10% 10% 5% 10% 10% 10% IRR 19.05% 13.92% 7.93% 7.93% 18.72% 28.52%
  • 11. Net Present Value Discount factor is the inverse of compounding factor. NPV(k,N) = -CF0 + CF1 X DF1 + CF2 X DF2 + …………… …… .CFt X DFt + ………………………...CFN X DFN NPV = (-)Initial cash outlay + Present value of future cash flows at the cost of capital. Investment to be undertaken if its NPV is positive and should be rejected if NPV is negative
  • 12. Why NPV rule is a good investment rule ?
    • It is a measure of value creation – when NPV is positive, project creates value and when negative, destroys value.
    • It adjusts for the timing of project’s expected cash flows
    • It adjusts for the risk of project’s expected cash flows
    • It is additive.
  • 13. NPV Profile Expected Cash Flows – CF(0), CF(1), CF(2)…….CF(n) Risk of expected cashflow stream Cost of Capital (k) required rate of return NPV = --CF(o) + ∑CF(t)/(1+k) t t=1,n NPV>0 NPV<0 Accept Project Reject Project
  • 14. Cost of capital The Project is going to be financed entirely with Debt, so its relevant cost of capital is the INTEREST Rate of Debt – or – Project is going to be financed entirely with Equity, so its cost of capital is Cost of Equity Although project does not have same risk as the Co, its relevant cost of capital should be equal to firm’s WACC because firm’s shareholders and debtors are paid with cash from firm’s cash flows, NOT from the Project’s cash flows When Project’s risk is different from the risk of the Firm, the Project’s cost of capital should be lowered to account for the risk reduction that diversification brings to the firm.
  • 15.  
  • 16. Summary Evaluation Method Inputs Required Decision Rule Does the Rule Adjust cash flows for For Calculation For Decision Accept Reject Time ? Risk ? Net present Value(NPV)
    • Cash flows
    • Cost of Capital(k)
    NPV NPV > 0 NPV < 0 Yes yes Profitability Index (PI)
    • Cash flows
    • Cost of capital(k)
    PI PI > 1 PI < 1 Yes Yes Internal Rate of return(IRR)
    • Cash flows
    • IRR
    • Cost of capital(k)
    IRR > k IRR < k Yes Yes Discounted Payback period(DPP)
    • Cash flows
    • Cost of capital (k)
    • DPP cut off period
    DPP < cutoff period DPP > cutoff period Only within DPP Only within DPP Payback period(PP)
    • Cash flows
    • PP
    • Cutoff period
    PP < cutoff period PP > cutoff period No No
  • 17. Financing Operation in India Equity/Risk Capital Public Equity Issue Debt/Borrowed Capital Foreign direct Investment Project Finance Term loans & Working capital finance External Commercial Borrowings Corporate Loan Market Corporate Debt Market
  • 18. Equity Capital
    • Various means of raising equity capital
      • Bringing foreign funds
        • Foreign direct Investment including ADRs/GDRs and FCCBs
        • Preference share capital (not included in ECBs or FDI sectoral caps)
      • Raising domestic funds
        • Private placements
        • Public issue of equity
  • 19. Raising Domestic equity
    • Private Placement
    • To raise funds and dilute equity in favor of Indian shareholders (as per FDI sectoral caps) while limiting the no. of shareholders.
    • Private equity/venture capital investors to provide funding from ideation stage as well as help nurture the growth.
    • Public Issue
    • Well developed Equity markets with total market cap in excess of Rs 60 lakh Crores as of Dec,2010
    • Liquidity mainly in large cap and some mid cap companies
    • Main participants – Mutual funds, Insurance companies, FIIs and retail investors
  • 20. Private Equity
    • Can be used to raise funds and dilute equity in favor of Indian shareholders (as per FDI sectoral caps) while limiting the no. of shareholders.
    • Private equity/venture capital investors provide funding for Sunrise industries – Biotech, Hightech, etc.
      • Many US based funds invest in Indian companies or US companies with focus on India
      • Funding for startups and small scale units hard to come by, funding mainly for second stage or later
      • Typically look for the management team, their speed of execution, ability to scale, managing customer expectation, infrastructure, client relationships and dependence, order book/ pipeline and profitability.
  • 21. Corporate debt market in India
    • Less deep than Equity markets contrary to world markets
    • Liquidity mainly in Govt. securities and highly rated corporate papers (AAA and AA)
    • Primarily an OTC Market
    • Listed corporate debt market
      • Listed market underdeveloped
      • Listed debt markets are also regulated by SEBI
      • Listing requirements
        • Rating must for listing of debt
        • Credit Rating Agencies – Crisil (alliance with S&P), ICRA (alliance with Moody’s), CARE and Fitch India.
    • Banks investment in unlisted non SLR securities restricted to 10% of the total investments in non SLR securities.
  • 22. Corporate debt market in India
    • Market players:
    • Qualified Institutional Investors (QIB)
      • Public financial institution
      • Scheduled commercial banks
      • Mutual funds
      • Foreign institutional investor registered with SEBI
      • Multilateral and bilateral development financial institutions
  • 23. Project finance
    • Project Finance
      • Rupee project loans to fund Land & Buildings, Plant & Machinery, pre-operative and preliminary expenses (including interest for the construction and installation period) and margin money for working capital
      • Foreign currency project loans to fund imported capital equipment, services incidental to the equipment such as technology transfer and servicing fees, and domestic project expenditure.
      • Syndication of domestic/international debt
      • Use of EXIM bank US/Developed countries- funding for import of capital equipment from those countries
  • 24. Project Finance (contd.)
    • Rupee assistance by way of subscription to debentures and shares
    • Assistance by way of underwriting shares and debentures
    • Guarantees for
        • Foreign currency loans
        • Export credits.
        • Suppliers of equipment
        • Foreign lenders
        • Bond guarantees and confirming guarantees
    • Equity
        • Mezzanine finance
        • Equity
        • Take-out finance
    • Assistance for a project loan would typically be for a longer tenure than for a corporate loan
  • 25. Term loans and working capital finance Fund based working capital services
    • Cash credit facility
    • Working capital demand loan
    • Export packing credit / Pre-shipment credit
    • Packing credit & foreign currency
    • Short term loan
    • MIBOR linked loans
    • Commercial paper
    • Invoice bill discounting (Clean & LC backed)
    • Foreign currency non resident (bank) loan
    • Buyers & suppliers credit
    • Over draft
    Securitization
    • Receivables (present and future)
    • Off balance sheet funding
    • Plain vanilla corporate loans
    • Structured finance
    Long term loans

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