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

1. Financial Appraisal, Sensitivity and Scenario Analysis R.Ganesh, Sr.faculty, SBSC, Hyd

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

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

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.

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