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Project Appraisal The assessment of the viability of a project involving medium or long-term investments in terms of shareholder wealth may be termed as project appraisal. In our country the all-India level financial institutions have devised an in house policy of assessing the industrial projects to grant financial assistance based on their commercial, technical, economic and financial viability. The various aspects of Project Appraisal are: 1. 2. 3. 4. 5. 6. 7. Basic Eligibility for Financial Assistance Market Appraisal Technical Appraisal Financial Appraisal Economic Appraisal Entrepreneur/Promoter Appraisal Management/Organization Appraisal
1. Basic Eligibility for Financial Assistance Constitution of Firm/Company Priority/Government Policy Institutional Policy Decisions Acceptability of the Promoters Institutions.
2. Market Appraisal Assessment of Potential Demand (Demand-Supply Gap).
3. Imports. Exports. Technical Appraisal Location ad Site Plant Capacity and Product-Mix Technology and Technical Know-how Selection and Procurement of Plant and Machinery Civil and Structural Work Charts and Lay-Outs Raw Materials. Financial Appraisal Estimation of Cost of Project Means of Financing Profitability Projections and Assumptions thereof Cash Flow and Balance Sheet Projections Ratio Analysis Analysis of Past Working Results. Econometric Methods. Consumer Profile. Trend Projection. etc. Financial Position and Sources and Application of Funds 2 . Methods of Demand Forecasting viz. Methods of Forecasting and Environmental Changes. Consumables and Utilities Implementation Schedule 4. Competition. Government Policies. Price Trends. Supply. Distribution and Sales Promotion. Problems in Demand Forecasting in Collection of Data. End Use. Study on Trends of Production.
Management/Organization Appraisal Management Set-Up Organizational Set-Up Recruitment and Selection of Executives Training Project Appraisal Criteria (Capital Budgeting .) A company before selecting to implement a project gets the feasibility study carried out if the project is viable in financial terms.IRR & NPV etc. Obviously. the company must have carried out the technical and market analysis. Economic Appraisal Cost-Benefit Analysis Domestic Resource Cost Effective Rate of Protection Employment Potential Productivity and Investment per Worker 6. Past Track Record and Dealings with Institutions/Banks 7. What is the expected return? It is a subjective question and the figure has to be arrived at by the promoter of the project / 3 . Entrepreneur/Promoter Appraisal Background. Qualifications and Experience Financial Resourcefulness Managerial Competence.5. The prime objective of the capital budgeting is to see if the projected cash flows of the company yield a return which is higher than the expected return.
Cash Accruals Every company sells the product and earns some income from it. one should be conversant with the various provisions of the relevant sections of the Income Tax Act 1961. Thus. Gross Cash Accruals = P. – Dividend + Non Cash flow Items In case.A. The terms used for estimating/evaluating the cash flows are gross cash accruals and net cash accruals.T. this income is taxed after allowing the various permissible deductions. The capital budgeting employs the following four kinds of techniques: 4 .company. = Profit after Tax Non Cash flow Items = Depreciation & Preliminary expenses w/off Net Cash Accruals = P. what is the current lending rate of the banks. the company does not declare dividend during a particular year the gross cash flows and the net cash flows will be equal.A. the main objective of these deductions to reduce the effective rate of taxation of the company.T. Techniques and methods used for evaluation of projects: Once the relevant information about the project is gathered the techniques of capital budgeting are employed to judge the attractiveness of the proposals. He may take various parameters into considerations like.T. Many deductions which are permitted are of non-cash flow items like depreciation and the preliminary expense. and the financial institutions and what is the average return on the capital employed in that kind of industry? One can source the data from the various magazines and journals on economic and finance published by Government of India. + Non Cash flow Items P. However. it should be clear that there is a difference between the net profit and the cash flows.A. However. what are the expectations of the investors in equity. The end result will tell whether to accept or reject the proposals. and the financial institutions and what is the average lending rate of the banks. There are certain deductions which are permissible under the said Act.
Project having less than a pre-determined cut off rate of return. and. The two widely used methods of discounted cash flow techniques are: • Net Present Value (NPV) • Internal Rate of Return (IRR) • Benefit Cost Ratio (BCR) or Profitability Index (PI) Net Present Value (NPV) Method: Under the NPV Method. At refers to cash flow at the end of year ‘t’. 15% or 20%. higher would be the attractiveness of the project. n = Life of the project in number of years. 2. I = Initial Investment. the better is the project. Payback period method: The payback period is the method under which we find out the number of years required to recover the initial outlay. say. ------------n (1 +r) t where. 3. Thus lower the payback period. the cash flows are discounted at the rate which we call as the expected / required rate or cost of capital and the NPV is evaluated with the help of the following equation: n NPV = ∑ t=1 At ────── .• • • • • Accounting Rate of Return (ARR) Payback Period (PBP) Net Present Value (NPV) Internal Rate of Return(IRR) Benefit Cost Ratio (BCR) or Profitability Index (PI) Accounting Rate of Return or Average Rate of Return (ARR): ARR is defined as the ratio of Average Profit after Tax to the Average Book Value of the Investment. r = Discount rate.I. The higher the ARR. are rejected. 5 . t= 1.
is equivalent to the initial outlay or the net present value is zero. Thus both the methods give us similar results so far 6 . I =∑ t=1 (1 +r) t t= 1. ------------n. Likewise. This can be represented as: n At ────── . Benefit Cost Ratio (BCR)/ Profitability Index (PI): It is the ratio of the present value of the future cash flows and the initial outlay. 3. where. Hence under both the methods we would not accept the project. k = Discount Rate I In case the required rate of return exceeds IRR. we would get negative NPV. It is a relative method and not an absolute method. where r = IRR I = Initial Investment/Outlay This method has the following distinct advantages: • • It takes into account the quantum of the cash outflows It takes into account the total amounts of the cash inflows and the timings. 2. when discounted. Mathematically it is expressed as: n At ∑ ────── t=1 (1 +k) t BCR = PI = ─────────── . hence the project will again be rejected on the NPV basis.The IRR Method: The Internal Rate of Return (IRR) can be defined as the rate of return at which the sum of future cash inflows. the proposal would be rejected under IRR method. if the expected return exceeds the IRR. It is useful for comparing two or more projects in terms of their acceptability or profitability.
is investing in a project with an outlay of Rs. CASE STUDY Caselet: X Ltd.as the appraisal criterion for the investment in a project is concerned. The expected cash in flows before tax are: Years Cash Inflows before tax (Rs. It follows straight line method of depreciation. except when the initial cash outlays are different and the timings of the cash flows also differ. The tax rate is 55%.5 4 4 5 4 Find: (a) Payback Period(PB) (b) Average Rate of Return(ARR) (c) NPV at 10% of cost of capital (d)IRR (e) Profitability Index at 10% cost of capital (f) The acceptability or otherwise of the project based on NPV and IRR ***** 7 .10 lakhs estimated to last for 5 years. with no salvage value.lakhs) 1 2 2 3 3 3.
751 4 2.000 x 100 = 26% 5.100 0.450 7.900 2. = 3 + 0.900 2.000 2.000 1.000 2.675 4 4.683 5 2.991years = 4 years (approx) (B).991 = 3.000 2 3.000 2.900 5 4.550 0.000 0.825 0. 2.621 Cumulative CFATBD 2.450 2.500 0.925 8 .90.Solution to the Case Study on NPV. Lakh) Year CFBT DEPN Net Tax EAT EAT + Earnings DEPN= CFATBD 1 2.675 2.900 0.87.000.125 10.000 1.675 P.000 4.025 12.450 3 3. IRR.500 out of 4th year cash flow of Rs.50. Pay Back Period = 3 years + Time required for recovering Rs.450 2.826 0. etc.000 (C).000 2.000 2. Net Present Value (at a given rate of 10%) 1 2 3 CFAT 2.900 0.909 0.V at 0.000 2.000 2.100 0.000 2. : First let us find the cash inflows:(Rs. 2. ARR =Average Income = 6.500 2.000/5 Average Investment 10000/2 = 1.000 1.30.000 1.900 EAT = Earning After Tax CFATBD= Cash flow After Tax but Before Depreciation CFBT= Cash flow Before Tax (A).00.
794 0.735 0.691 1.981 1.900 (0.926 0.024 2.182 +0.063 2.10.450 2.675 2. which is less than the cut off rate of 10%.645% (E).857 0.10% Total P.0. hence project is not acceptable.1 +0. NPV is Negative.Rs.182 IRR = 8% + 0.V 1.100) Total PV at 8% 1.V of Cash Outflows = Rs. Hence the project is not acceptable 9 .000 2.000 (F).90 PV at 9% 0.917 0.90 2.772 0.099 2.834 2.182)% = 8% + 0.009 at 10% P.645% = 8.053 1.810 2.132 1.00 = . IRR CFAT 1 2 3 4 5 2.70 8 0.975 10.801 Total PV at 9% 1.645%.632 = 0.963 = 96. IRR is 8.885 9.182/(0.32% 10.124 2.366 lakhs (D).065 2. Profitability Index = PV of Cash Inflows PV of Cash Outflows = 9.650 NPV PV at 8% 0.852 2.842 0.00 lakhs NPV = 9.634 – 10.
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