Traditional project financial appraisal

Educational Project
design and
management

Financial Aspect appraisal
FINANCIAL PROJECT APPRAISAL
• It is an evaluation for capital budgeting, it entails
appraising project investment proposal and hence
guides the decision on whether to invest or not in a
particular project.
• It is all about determining the viability or profitability
of the project that one thinks to invest in.
• Various projects can be compared and then choose the
one that produces more benefits or profit than the
other(s).

Techniques of financial project appraisal
• The techniques are objective, quantified, and
based on economic costs and benefits
• They are divided into:
Traditional/Conventional investment appraisal
techniques (Non-discounted techniques)
Modern/ time adjusted investment appraisal
techniques (Discounted Cash Flo-DCF-
techniques)

Traditional techniques
• Traditional/Convectional techniques Is the kind of
techniques which does not consider the value of
money regarding to time.
• There four methods under traditional:
Payback period (PBP) method
Accounting rate of return (ARR)
Peak profit method
Urgency method

Payback Period (PBP) Method
• Payback period (pay-out period ) is generally defined as the
length of time or duration required to recover the initial
cash outlay (original investment) in the project.
• It is a period required to recover the original investment
cost through the income earned by the project. Normally
disregarding the salvage value
• The income earned is depreciation plus profits after taxation
• This method answers the question of how many years will it
take for the cash benefits to pay the original cost of an
investment
• The usual decision rule is to accept the project with the
shortest period.

PBP Method cont.…
Computing the payback period
• There are two ways of calculating the payback
period
The first method can be applied when the cash flow
stream is in the nature of annuity or uniform for all
years of the project’s life that involves dividing the
initial capital or investment by the constant cash
inflow.
𝑃𝐵𝑃 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐶𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤

PBP Method cont.…
• Example.
(a) Find the PBP where Mzumbe Secondary School
decides to invest Tsh. 40,000/= in a machine
which is expected to produce a constant cash
inflow of 8,000 each year.
(b) If the initial investment is Tsh. 10,000/= and
the annual earning is Tsh.2,500/=, calculate the
payback period

PBP Method cont.…
Solution (a)
𝑃𝐵𝑃 =
𝑃𝐵𝑃 =
40,000
8,000
𝑃𝐵𝑃=5 years
• Therefore, the payback period will be 5 years.
• It means that Mzumbe Secondary School will be able to
recover Tsh. 40,000/= after five years when the cash
inflow is Tsh. 8,000/= each year in the project life cycle.

PBP Method cont.…
Solution (b)
𝑃𝐵𝑃 =
𝑃𝐵𝑃 =
10,000
2,500
• Therefore, the payback period will be 4 years.
• Therefore, the payback period in respect of the above
investment outlay will be 4 years. It means, the Tsh.
10,000/= at the uniform annual income earning of Tsh.
2,500/= will be recovered after four years.

PBP Method cont.…
The second method is when the cash inflows or earned
incomes are not constant, that is there is mixed stream
Then the cash inflows (incomes) are accumulated or added
up until the initial investment is recovered in which the
cumulated amount is equivalent to the initial investment
outlay.
Example
1. Suppose Mzumbe University decides to invest in three
projects A, B, and C, with initial investment capital for
each project being Tsh. 1,000,000/=. Calculate their
payback periods of their cash inflows
2. Suggest which of the project would be chosen

PBP Method cont.…
Solution (1)

PBP Method cont.…
Solution (2)
By comparing the three projects, Project C will be
selected because it has the shortest payback
period, which is 4 years.

PBP Method cont.…
Calculate the payback periods of the following projects
each requiring a cash outlay of Tsh. 100,000/= with the
salvage value of zero (0). Suggest which of the projects
would be chosen whereby the life for each project is eight
years.

PBP Method cont.…
Solution (Project A)
𝑃𝐵𝑃 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝑠𝑐𝑟𝑎𝑝 (𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒)
𝑃𝐵𝑃 =
100,000 − 0
20,000
• Therefore, project A payback period will be 5 years.
Solution (Project B)

PBP Method cont.…
• Table shows that the payback period lies
between 3rd year and 4th year.
• At the end of 3rd year the table shows that the
cumulative cash inflows are Tsh. 80,000
requiring Tsh. 20,000 to be recovered during the
4th year.
• Hence, it is important to calculate time in
months it will take to get Tsh. 20,000 in the 4th
year and then add it to three years. Bear in mind
that the cash inflow in the 4th year is Tsh.
60,000. The calculation will be as follows:

PBP Method cont.…
𝑖𝑓 𝑇𝑠ℎ 60,000 → 12 𝑚𝑜𝑛𝑡ℎ𝑠
𝑡ℎ𝑒𝑛 20,000 → ? 𝑚𝑜𝑛𝑡ℎ𝑠
Cross multiply
=
20,000 × 12
60,000
= 4 𝑚𝑜𝑛𝑡ℎ𝑠
Therefore, the payback period of the Project B is
three years and 4 months.

PBP Method cont.…
• Decision: As the payback period for Project B is
shorter than that of Project A, project B is
acceptable and hence will be selected for
investment.

PBP Method cont.…
Exercise
1. Suppose Mzumbe University SACCOS decides to
invest in a milling machine using the initial capital of
Tsh. 3,000,000/= and expects to have a uniform
annual income of Tsh.500,000/=. Calculate the
payback period.
2. A photocopy machine costs Tsh. 40,000/= and is
expected to generate the following benefits over its
10-year life. Compute the payback period.

PBP Method cont.…
3. Calculate the payback periods of the following projects
each requiring a cash outlay of Tsh. 100,000/=. Suggest
which of the projects would be chosen where by the life
for each project is eight years.

Average/Accounting rate of return (ARR)
• ARR is a measure of profitability which relates the ratio of
annual accounting profit (net of depreciation) to the cost of the
investment.
• The alternative terms for Accounting Rate of Return are Return
on Capital Employed (ROCE) or Return on Investment (ROI).
• ARR is frequently used with Payback method to assess the
profitability of investment in a particular project or projects
• There are a number of alternative methods for calculating the
ARR
Accounting rate of return on Initial capital/investment
𝐴𝑅𝑅 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡𝑠/𝑖𝑛𝑐𝑜𝑚𝑒 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 (𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑎𝑝𝑖𝑡𝑎𝑙)
× 100%

ARR Method cont.…
Accounting rate of return on Average Capital/Investment
𝐴𝑅𝑅 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑜𝑣𝑒𝑟 𝑡ℎ𝑒 𝑙𝑖𝑓𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡
× 100%
• The average capital or investment is determined by dividing the net or
initial investment by two.
• This averaging process assumes that that the firm is using straight
line depreciation, in which case the book value of the asset declines at
a constant rate from its purchase price to zero at the end of its
depreciation life.
• This means that, on the average , firms will have one-half of the initial
purchase price in the books
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 =
2

ARR Method cont.…
ARR Decision criteria
The actual ARR would be compared with a
predetermined or a minimum required rate of
return or cut-off rate. A project would qualify to be
accepted if the actual ARR is higher than the
minimum desired ARR. Otherwise, it is liable to be
rejected
Alternatively, the ranking method can be used to
select or reject proposals. Obviously, projects having
higher ARR would be preferred to projects with
lower ARR.

ARR Method cont.…
Example
1. A firm is considering to invest in three projects each with an initial
investment (initial capital) of Tsh. 1,000 and a life span of 5 years. The
profits generated after tax and depreciation by the projects are estimated as
follows:
Calculate the accounting rate of return (ARR) on:
(a) Initial capital (initial investment)
(b) Average capital (Average investment)
Year Project 1 Tsh. Project 2 Tsh. Project 3 Tsh.
1 200 350 150
2 200 400 150
3 200 150 150
4 200 150 200
5 200 150 350

ARR Method cont.…
Solution (a)
ARR on Initial capital/investment
𝐴𝑅𝑅 =
× 100
The average profits after taxes are determined by adding the
after-tax-profits expected for each year of the project’s life and
dividing the result by the number of years.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 1 =
1000
5
= 200
1200
5
= 240
1000
5
= 200

ARR Method cont.…
𝐴𝑅𝑅 =
× 100
𝐴𝑅𝑅 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 1 =
200
1000
× 100% = 20%
240
1000
× 100% = 24%
200
1000
× 100% = 20%
Therefore, based on the ARR of the three projects, project
2 will be selected because of having higher ARR of 24%
compared to other two projects.

ARR Method cont.…
Solution (b)
ARR on average capital/investment
𝐴𝑅𝑅 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑜𝑣𝑒𝑟 𝑡ℎ𝑒 𝑙𝑖𝑓𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡
× 100%
• Then
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 =
2
=
1000
2
= 500
200
500
× 100% = 40%
240
500
× 100% = 48%
200
500
× 100% = 40%
Therefore, project 2 will be selected because of having higher ARR of
48%

The Peak-Profit method
• Peak-profit refers to the highest profit earned at a
particular time in the life cycle of a project.
• The peak-profit method involves taking the level of
profit in the best year and express it as a rate of return
on the sum invested
• In some projects profits build up slowly to peak, in
others a peak is reached early and then declines.
• A project with low peak profit but reaching the peak
early may be better than the one reaching the peak
later in its life though with higher profit. The reason for
this is that the high early profits may be reinvested.

Urgency criterion technique
• Under this technique, investment is made on projects
that are deemed to address urgent needs.
• Less urgent projects are put off or postponed first and
hence priority is given to urgent projects that require
immediate implementation so as to solve a prevailing
problem or issue
• For example, if the school has received so many pupils
following the implementation of the Free Education
Policy 2014, then classroom construction project will be
urgently initiated to address dire shortage of
classrooms.

Traditional project financial appraisal

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