• Project appraisal is the process of assessing and questioning proposals before resources are committed.
What can Project Appraisal Deliver?Project appraisal helps project initiators and designers to;• Be consistent and objective in choosing projects• Make sure their program benefits all sections of the community, including those from ethnic groups who have been left out in the past• Provide documentation to meet financial and audit requirements and to explain decisions to local people.
• Appraisal justifies spending money on a project.• Appraisal is an important decision making tool.• Appraisal lays the foundations for delivery.• Getting the system right
Key issues in appraising projects include the following.• Need, targeting and objectives• Context and connections• Consultation• Inputs• Outputs and outcomes• Value for money• Implementation• Risk and uncertainty• Forward strategies• Sustainability
STEPS FOLLOWED IN PROJECTAPPRAISAL• Economic• Technical• Organizational suitability• Managerial Aspects• Operational Aspects• Financial Aspects
Capital• Sources of funds• Capital Structure• Cost of Capital
What is capital budgeting?• A process for determining the profitability of a capital investment.• Long-term decisions; involve large expenditures.• Very important to firm’s future.
Steps in Capital Budgeting• Estimate cash flows (inflows & outflows).• Assess risk of cash flows.• Determine r = WACC for project.• Evaluate cash flows.
Discounting Method• What is discounting factor?• Difficulty/Problem
NPV (Net Present Value) Method: -This method mainly considers the time value of money. It is the sum of theaggregate present values of all the cash flows – positive as well as negative – thatare expected to occur over the operating life of the project. NPV = PV of Net Cash Inflows – Initial Outlay (Cash outflows)• Decision Rule: - • If NPV is positive, ACCEPT • If NPV is negative, REJECT • If NPV is 0, then apply Payback Period Method
For Example: - Initial Investment – 20,000 Estimated Life – 5 years Scrap Value – 1000 XYZ Enterprise’s Capital Project Year Cash flow Discount factor Present Value @10% 1 5.000 0.909 4545 2 10,000 0.826 8260 3 10,000 0.751 7510 4 3,000 0.683 2049 5 2,000 0.621 1242 5 1,000 0.621 621 PV of Net Cash Inflows = 24227 NPV = PV of Net Cash Inflows – Cash Outflows = 24227 – 20,000 NPV = 4227Here, NPV is Positive (+ ve) The Project is ACCEPTED.
PROS1. NPV gives important to the time value of money.2. Profitability and risk of the projects are given high priority.3. NPV helps in maximizing the firms value.
Cons1. NPV is difficult to use.2. It is difficult to calculate the appropriate discount rate.3. NPV may not give correct decision when the projects are of unequal life.
Profitability IndexIt is the ratio of present value of expected future cash inflows and Initial cash outflows or cash outlay. It is also used for ranking the projects in order of their profitability. PI = Present value of Future cash Inflows Initial Cash OutlayDecision Rule: - ACCEPT a Project If PI is greater ( > 1 ) and Reject it otherwise.
For Example: - In Case of Above Illustration: - Here PI = Present Value of Cash Inflows Present Value of cash Outflows = 24227 20000 PI = 1.21Here, The PI is greater than ONE ( > 1 ), so the project is accepted.
IRR (Internal Rate of Return) Method: - This method is known by various other names like Yield on Investment or Rate of Return Method. It is used when the cost of investment and the annual cash inflows are known and rate of return is to be calculated. It takes into account time value of Money by discounting inflows and cash flows. This is the Most alternative to NPV. It is the Discount rate that makes it NPV equal to zero.Decision criterion• If the IRR is greater than the cost of capital, accept the project.• If the IRR is less than the cost of capital, reject the project.
Pros1. It recognizes the time value of money and considers cashflows over entire life of the project.2.It provides for uniform ranking of various proposals dueto the percentage rate of return.3.It has a psychological appeal to the user. Since values areexpressed in percentages.
Cons1. It is most difficult method of evaluation of investment proposals.
Pay-Back Period Method: - The Pay-Back Period is the length of time required to recover the initial outlay on the project Or It is the time required to recover the original investment through income generated from the project. Pay-Back Period = Original Cost of Investment____ Annual Cash Inflows or SavingsPros: - a) It is easy to operate and simple to understand. b) It is best suited where the project has shorter gestation period and project cost is also less. c) It is best suited for high risk category projects. Which are prone to rapid technological changes. d) It enables entrepreneur to select an investment which yields quick return of funds.
Cons: - a) It Emphasizes more on liquidity rather than profitability. b) It does not cover the earnings beyond the pay back period, which may result in wrong selection of investment projects. d) This method ignores the cost of capital which is very important factor in making sound investment decision.Decision Rule: - A project which gives the shortest pay-back period, is considered to be the most ACCEPTABLEFor Example: - If a Project involves a cash outlay of Rs. 2,00,000 and the Annual Cash inflows are Rs. 50,000, 80,000, 60,000, and 40,000 during its economic life of 4 years. Here Pay-Back Period = 3 years + 10,000 40,000 Pay-Back Period = 3 years + 0.25 Or 3 years and 3 months.
Accounting Rate of Return Method: -This method is considered better than pay-back period method because it considers earnings of the project during its full economic life. This method is also known as Return On Investment (ROI). It is mainly expressed in terms of percentage. ARR or ROI = Average Annual Earnings After Tax_______ * 100 Average Book Investment After Depreciation Here, Average Investment = (Initial Cost – Salvage Value) * 1 / 2Decision Rule: - In the ARR, A project is to be ACCEPTED when ( If Actual ARR is higher or greater than the rate of return) otherwise it is Rejected and In case of alternate projects, One with the highest ARR is to be selected.
Pros: - a) It is simple to calculate and easy to understand. b) It considers earning of the project during the entire operative life. c) This method considers net earnings after depreciation and taxes.Cons: - a) It ignores time value of money. b) It lays more emphasis on profit and less on cash flows. c) It does not consider re-investment of profit over years.
Economic Analysis/Appraisal• Analysis from the economic aspect assesses the desirability of an investment proposal in terms of its effect on the economy• The question to be addressed here is1. Whether the investment proposal contributes to the developmental objective of the country?2. Whether the investment proposal is likely to use of scarce resources such as capital, skilled labour, managerial talents etc., that would be needed to implement and operate the project?• In economic analysis, input and output prices are adjusted to reflect true social or economic values. These adjusted prices are often termed as shadow or accounting prices• The taxes and duties are treated as transfer payments and are excluded from the capital and operating cost
Steps in Economic Analysis1. Pricing of Project Inputs and OutputsIn economic analysis, the valuation of inputs and outputs can be made keeping in view the following three rules:1. Most of the inputs in economic analysis are valued at opportunity cost or on the principle of willingness to pay or alternative uses2. For some final goods and services, usually non-traded ones, the concept of opportunity cost is not applicable because it is consumption value that sets the economic value. This criterion is called "willingness to pay" or "value in use".3. The third rule of pricing inputs and outputs is that the analysis is done at present, i.e. constant prices. This is because current price analysis entails the prediction of inflation rate which is difficult and unreliable
Steps in Economic Analysis2. Identifying Project Costs and Benefits•This is important step. An improper identification of costs and benefits wouldlead to under - estimation of costs or over-estimation of benefits or vice versaFor example:Most of the benefits from an expanded irrigation project may be offset by afall in fish production and reduce income for thousands of fishermen.Increased benefits due to the construction of a new highway may be equallymatched by a reduction in the income of the railways due to decrease inpassengers/goods.