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FINANCIAL JUSTIFICATION

The present day economy is characterized by limited resources and

practically unlimited, competitive and mutually exclusive needs. Indian Railways (IR) is
no different and that the budgetary support is dwindling year after year, capital for
investment in IR has become scarce. Further, the future of a business organization
tomorrow is shaped by its decisions today to invest in projects, equipment and
property. As investment decisions involve sinking of very heavy amounts and often
commit the organization for years ahead, these decisions have far reaching effects upon
the future growth and profitability of the organization. As funds are limited, the
management must decide which project should be taken and which should not. A
detailed report after due analysis of various financial implications involved in the
proposed investment should therefore be made to the management to decide sound
and appropriate decision on investment. Such an analysis of financial implications of
various investment proposals is known as Financial Appraisal.

A review submitted by British Parliament in the sixties reads thus

“Investment projects must show a satisfactory return in commercial terms”. The
statement is absolutely valid even in the present status of Indian economy and IR
already facing severe financial crunch should make investment only in such projects,
which are financially viable.

NEED FOR FINANCIAL JUSTIFICATION

1. Capital is scarce; Investment decisions should be made prudently since it

involves dividend liability.
2. Money spent by IR is public money and care should be taken while deciding upon
investments.
3. Priorities should be on the dot and there should be returns after the completion
of a project i.e. earnings should be sufficient to take care of expenditure.

Projects where financial justification is not necessary:

1. Works on safety consideration.
2. Works for strategic importance and to cater to the defence of the country.
3. Employee welfare works.
4. Passenger welfare works.

FACTORS INFLUENCING FINANCIAL APPRAISAL/JUSTIFICATION

1. Right time for investment: The economy, market and other conditions should be
suitable for investment.
2. Period of Investment: Since gestation period is long in railway projects, the
period for which the investment will be required and the quantum of such investment
should be carefully addressed viz. period of construction, time for completion and the
cost of investment per year.
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3. Availability of Capital is the key factor since without capital no investment can be
made. Smooth inflow of capital should be ensured to avoid cost overrun and time
overrun.
4. Sufficient provision for Repairs and Maintenance of the project should be made.
5. Sufficient provision for capital expenditure for replacement of assets during
economic life of an asset should be made viz. Working Capital, cost of spares, tools and
plants etc.
6. The project should have considerable scrap value.
7. The project should generate sufficient earnings, saving in expenditure and the
same should be realistically assessed.
8. The ROR should be acceptable and it should be ensured that earnings and
expenditure are realistic and not inflated or deflated.
9. Proper evaluation of the various factors, both direct and indirect, merits and de-
merits, should be made. Where alternatives are available detailed evaluation of each of
the alternative should be made.

FINANCIAL JUSTIFICATION IN INDIAN RAILWAYS

The process of formulation and approval of a project on Indian Railways

deals with from well-defined stages viz. searching, forecasting, evaluating and deciding.
At the first stage of searching different alternatives, projects, schemes for a project are
studied in order to determine prima-facie technical and economical feasibility of a
particular alternative(s). This is done by conducting Reconnaissance Survey or
Preliminary Survey where detailed field surveys and investigations are not conducted
but the alternatives are analyzed in detail with the help of available parameters, data
with the Railways. This helps in avoiding unnecessary expenditure. The second and
third stages of forecasting and evaluating are the vital stages in project evaluation since
the final decision will be based on the outcome of these two stages. This report is
known as Techno Economic Survey or Engineering cum Traffic survey. The fourth and
last stage is evaluation. As discussed earlier evaluation of a project is of utmost
importance since the decisions are made on the basis of financial implication and have a
long lasting effect on the organization.

In IR financial appraisal/justification is done on stressing more emphasis on the

following three factors:

1. Cost of the Project: That the cost of the project is realistic and is as per current
market rates.
2. Earnings estimated are realistic and are based on the data available in the traffic
survey (wherever applicable).
3. Avoidance of detention/saving in expenditure are realistically provided and not
inflated. Any inflation will project a favorable ROR.
4. Assessment of working expenditure is realistic.

As per the general practice the project appraisal is done in three methods i.e.

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(i) Accounting Rate of Return Method,
(ii) Payback period Method and
(iii) Discounted Cash Flow Method.

(i) Accounting Rate of Return Method.

This is an age-old method used for evaluating capital projects. The most widely used
formulae for ascertaining the rate of return is given below:
ROR = Average Profit per annum x 100
Average Amount invested
The main merit of ROR technique is that it is simple and can be understood easily. It is
this simplicity of this method, which accounts for its popularity. But the most important
draw back of this technique is that it does not take into account the timing of the profit
and the return is being calculated on average basis.

(ii) Pay Back Period Method.

As capital projects have a long gestation period during which time many uncertainties
may creep in. The degree of the risk assumed by a company when planning capital
expenditure is directly related to the length of time required to recover the investment
from the cash flow generated by the project. The pay back period takes care of the
important aspect of risk in the investment decisions. The pay back period means how
much time it was taken to recover the investment and the shorter the time for
recoupement of capital better the investment is. Generally this method is applied (i)
due to political instability of a country where the investment is made, (ii) due to the
expected frequent technological changes where the product will loose its market after a
limited period (iii) the yield is limited to for a limited period. Example: mines & mineral
deposits etc.

(iii) DCF Method

The Discounted Cash Flow method is divided into three parts –
(a) Internal Rate of Return Method,
(b) Net Present Value/Net Present Worth Method and
(c) Equivalent Annual Cost Method.

The concept of DCF technique is that the money has got time value and the money
receivable today is worth more than the same amount of money receivable after some
period. For an example if today an investment is made for Rs.100/- at a simple interest
of 10% the same will be Rs.110/- after one year or Rs.121/- after second year or Rs.133/-
after third year or Rs.146/- after fourth year. It means that the money which is worth
Rs.146/- at the end of fourth year is worth Rs.100/- today. In the compound interest
rate we are ascertaining the future value of present money whereas in discounting we
are calculating the present value of future money. The discounting means is just
opposite of compounding.

DCF technique is widely accepted methodology all over the world for project evaluation
and it helps the management in investment decisions. This is a unique method, which
takes into consideration the time value of money and the residual value of the assets.

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The reliability of a project evaluation is depends on several factors such as realistic
assessment of traffic projections, cost estimation etc. This method provides for
sensitivity analysis to assess the extent of permissible variations in the factors governing
the projects remunerativeness. Hence it is considered superior to other methods.

(a) Internal rate of return method (IRR)

The IRR is also known as trial and error method. There are two streams of cash flows
i.e. the investment is out flow and the returns are inflow. It is possible to equate both of
them when they are discounted at a particular rate in terms of present value. The trial
and error method seeks to find out a particular rate of discount which equals the cash
flow both inflows and outflows in terms of their present value. Cash outflow is negative
and the cash inflow is positive. The life of the project is taken as 30 years while
evaluating under DCF method. A number of trial calculations are made to establish the
exact rate of discount and finally the same will be settled to a particular rate without
insisting for a cut off rate.

(b) Net Present Value Method.

The net present value method assumes a particular rate of discount operates as a cut off
rate instead of working out by the rate by trial and error method. Usually this assumed
discount rate should be equal to the company’s rated averaged capital project. In other
words this assumed rate of discount is the minimum acceptable rate of return and the
proposed project does not give a positive NPV of cash flows and this minimum ROR
should not be accepted. As per the latest directives of Railway Board the cut off limit
under DCF method is 14%.
(c) Equivalent Annual Cost Method.
The concept of this method is that when we have to choose from two or more
alternative proposals where the income is same and the cost are to be considered the
selection would be in favour of one of which will cost us the least. Only outflows are
considered for this. The procedure to working out this method is known as equivalent
annual cost method.

Investments in the projects are often decided based on the financial appraisals by
choosing the best one along the alternatives. Or the one, which gives the desired level
of return or saving in expenditure or both. Capital-intensive investments like major
projects, other costly works and procurement of costly machinery etc. are thoroughly
investigated and the financial economic gains are assessed and after satisfying all these
requirements the investment decisions are taken.
A general list of points, which affects almost all proposals are:
1. Quantum of Investment.
2. Period of completion.
3. Involvement of Interest Burden (If allocated to Capital).
4. Return on Investment.
5. Scope for flexibility.

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Operating ratio –
 “Operating Ratio” is the ratio which the Working Expenses of Railway bear to its
Gross Earnings.
 In other words its represents the % of Working Expenses to Gross Earnings.
 The working expenses include the Approriation to D.R.F. and Appropriation to
Pension Fund.
 Operating Ratio has been regarded as one of the most important financial
indices to measure the operating efficiency of a Zonal Railway vis-a-vis the Gross
Earnings.
 It indicates how much we are spending to earn one rupee.
 While calculating the operating ratio, the traffic suspense balances and balances
under working expenses are excluded.
 The following factors are taken into consideration :
1. Capital at charge of zonal railway
2. Traffic earnings realized during the year
3. Working expenses of the year
4. Appropriation to DRF and pension fund
5. Miscellaneous receipts and misc expenses
6. Payment to general revenue towards dividend.

Gross Working Expenses

 O.R = _______________________ x 100
Gross Earnings

 If O.R. is less than 100 = Organisation is in profits.

 If O.R. is more than 100 = Organisation is in losses.

 There is no ideal Operating Ratio for Indian Railways.  In rail road sector, an
operating ratio of 80 or lower is considered desirable. However lower O.R. helps
in generating internal resources for meeting requirement of Plan Expenditure on
Safety (RSF), Amenities to Passengers & Staff (D.F) and other Capital investments
such as laying of new lines, acquisition of Rolling Stock etc (Capital Fund).