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Project Appraisal

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.

2. Market Appraisal

3. Technical Appraisal

4. Financial Appraisal

5. Economic Appraisal

6. Entrepreneur/Promoter Appraisal

7. Management/Organization Appraisal

Constitution of Firm/Company

Priority/Government Policy

Institutional Policy Decisions

Acceptability of the Promoters by the Financial

Institutions.

2. Market Appraisal

1

Study on Trends of Production, Supply, Imports,

Exports, Price Trends, Distribution and Sales Promotion,

Government Policies, Competition, Consumer Profile, etc.

End Use, Econometric Methods.

Problems in Demand Forecasting in Collection of Data,

Methods of Forecasting and Environmental Changes.

3. 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, Consumables and Utilities

Implementation Schedule

4. Financial Appraisal

Means of Financing

Profitability Projections and Assumptions thereof

Cash Flow and Balance Sheet Projections

Ratio Analysis

Analysis of Past Working Results, Financial

Position and Sources and Application of Funds

2

5. Economic Appraisal

Cost-Benefit Analysis

Domestic Resource Cost

Effective Rate of Protection

Employment Potential

Productivity and Investment per Worker

6. Entrepreneur/Promoter Appraisal

Financial Resourcefulness

Managerial Competence, Past Track Record and

Dealings with Institutions/Banks

7. Management/Organization Appraisal

Management Set-Up

Organizational Set-Up

Recruitment and Selection of Executives

Training

Project Appraisal Criteria (Capital Budgeting - IRR & NPV etc.)

study carried out if the project is viable in financial terms. Obviously,

the company must have carried out the technical and market analysis.

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. 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

company. He may take various parameters into considerations like;

what are the expectations of the investors in equity, what is the current

lending rate of the banks, and the financial institutions and what is the

average lending rate of the banks, 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.

Cash Accruals

Every company sells the product and earns some income from it.

However, this income is taxed after allowing the various permissible

deductions. Many deductions which are permitted are of non-cash flow

items like depreciation and the preliminary expense. Thus, one should

be conversant with the various provisions of the relevant sections of the

Income Tax Act 1961. There are certain deductions which are

permissible under the said Act, the main objective of these deductions to

reduce the effective rate of taxation of the company. However, it should

be clear that there is a difference between the net profit and the cash

flows. The terms used for estimating/evaluating the cash flows are gross

cash accruals and net cash accruals.

In case, the company does not declare dividend during a particular year

the gross cash flows and the net cash flows will be equal.

techniques of capital budgeting are employed to judge the attractiveness

of the proposals. The end result will tell whether to accept or reject the

proposals. The capital budgeting employs the following four kinds of

techniques:

4

• 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)

ARR is defined as the ratio of Average Profit after Tax to the Average

Book Value of the Investment. The higher the ARR, the better is the

project. Project having less than a pre-determined cut off rate of return,

say, 15% or 20%, are rejected.

The payback period is the method under which we find out the number

of years required to recover the initial outlay. Thus lower the payback

period, higher would be the attractiveness of the project.

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)

Under the NPV Method, 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 At

NPV = ∑ ────── - I, t= 1, 2, 3, ------------n

t=1 (1 +r) t

where, At refers to cash flow at the end of year ‘t’, r = Discount rate, n =

Life of the project in number of years, and, I = Initial Investment.

5

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, when discounted, is equivalent

to the initial outlay or the net present value is zero.

n At

I =∑ ────── , t= 1, 2, 3, ------------n, where r = IRR

t

t=1 (1 +r) I = Initial Investment/Outlay

• It takes into account the total amounts of the cash inflows and the

timings.

It is the ratio of the present value of the future cash flows and the initial

outlay. It is a relative method and not an absolute method. It is useful

for comparing two or more projects in terms of their acceptability or

profitability. Mathematically it is expressed as:

n At

∑ ──────

t=1 (1 +k) t

BCR = PI = ─────────── , where, k = Discount Rate

I

In case the required rate of return exceeds IRR, the proposal would be

rejected under IRR method. Likewise, if the expected return exceeds the

IRR, we would get negative NPV, hence the project will again be

rejected on the NPV basis. Hence under both the methods we would not

accept the project. Thus both the methods give us similar results so far

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as the appraisal criterion for the investment in a project is concerned,

except when the initial cash outlays are different and the timings of the

cash flows also differ.

CASE STUDY

Caselet:

to last for 5 years, with no salvage value. It follows straight line method

of depreciation. The tax rate is 55%. The expected cash in flows before

tax are:

Years 1 2 3 4 5

Cash

Inflows

2 3 3.5 4 4

before tax

(Rs.lakhs)

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

Solution to the Case Study on NPV, IRR, etc. :

(Rs. Lakh)

Year CFBT DEPN Net Tax EAT EAT + Cumulative

Earnings DEPN= CFATBD

CFATBD

1 2.000 2.000 - - - 2.000 2.000

2 3.000 2.000 1.000 0.550 0.450 2.450 4.450

3 3.500 2.000 1.500 0.825 0.675 2.675 7.125

4 4.000 2.000 2.000 1.100 0.900 2.900 10.025

5 4.000 2.000 2.000 1.100 0.900 2.900 12.925

CFATBD= Cash flow After Tax but Before Depreciation

CFBT= Cash flow Before Tax

Rs. 2,87,500 out of 4th year cash flow of

Rs. 2,90,000.

= 3 + 0.991 = 3.991years

= 4 years (approx)

Average Investment 10000/2

5,00,000

1 2 3 4 5

CFAT 2.000 2.450 2.675 2.900 2.900

P.V at 0.909 0.826 0.751 0.683 0.621

8

10%

Total P.V

1.810 2.024 2.009 1.981 1.801

at 10%

P.V of Cash Outflows = Rs.10.00 lakhs

NPV = 9.634 – 10.00 = - Rs.0.366 lakhs

(D). IRR

Total PV Total PV

CFAT PV at 9% PV at 8%

at 9% at 8%

1 2.000 0.917 0.926 1.834 1.852

2 2.450 0.842 0.857 2.063 2.099

3 2.675 0.772 0.794 2.065 2.124

4 2.90 0.70 8 0.735 2.053 2.132

5 2.90 0.650 0.691 1.885 1.975

9.900 10.182

NPV (0.100) +0.182

PV of Cash Outflows

10.000

IRR is 8.645%, which is less than the cut off rate of 10%.

Hence the project is not acceptable

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