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FEASIBILITY

CAPITAL BUDGETING-DISCOUNTED

CASH FLOWS and NON-DISCOUNTED

CASH FLOW METHOD.

SOCIAL COST BENEFIT ANALYSIS and

ECONOMIC RATE OF RETURN.

#) Financial techniques for

project appraisal and

feasibility:

Financial analysis assumed an increasingly

important role as a scientific tool for appraising

the real worth of an enterprise, its performance

during the period of time and its pitfalls.

Financial analysis is defined as the process of

discovering economic facts about an

entrepreneur and /or a project on the basis of

an interpretation of financial data.

Project Appraisal is mainly the process of

transmitting information accumulated

through feasibility studies into a

comprehensive form in order to enable

the decision maker undertake a

comprehensive appraisal of various

projects and embark on a specific project

or projects by allocating resources.

It helps in arriving at specific and predicted results.

It evaluates the desirability of the project.

It provides information to determine the success or

failure of a project.

It employs existing norms to predict the rate of success

or failure of the project.

It verifies the hypothesis framed for the

WHAT IS CAPITAL

BUDGETING?

Capital Budgeting is a project selection

exercise performed by the business enterprise.

Capital budgeting uses the concept of present

value to select the projects.

Capital budgeting uses tools such as pay back

period, net present value, internal rate of

return, profitability index to select projects.

Methods of project appraisal

Discounted cash flows Non-discounted cash flows

NET PRESENT VALUE PROFITABILITY INDEX INTERNAL RATE OF RETURN PAY BACK PERIOD ACCOUNTING RATE OF RETURN

The payback period is the length of time

required to recover the initial outlay on the

project Or It is the time required to recover the

original investment through income generated

from the project.

Payback = Initial Investment

____________________

Annual Average Cash Flows

Assume that a

project requires an

outlay of Rs 50,000

and yields annual

cash inflow of Rs

12,500 for 7 years.

The payback period

for the project is:

Rs 50,000

PB = = 4 years

Rs 12,000

a) It is easy to operate and simple to

understand.

b) It is best suited where the project

has shorter gestation period project cost is also

less.

c) It is best suited for high risk category

projects. Which are prone to rapid

technological changes.

d) It enables entrepreneur to select an

investment which yields quick return of funds.

a) It Emphasizes more on liquidity rather than

profitability.

b) It does not cover the earnings beyond the

pay back period, which may result in wrong

selection of investment projects.

c) It is suitable for only small projects requiring

less investment and time.

d) This method ignores the cost of capital

which is very important factor in making sound

investment decision.

This method is considered better than pay--back period method because it

considers earnings of the project during its full economic life.

This method is also known as Return On Investment Return On Investment (ROI).

It is mainly expressed in terms of percentage.

ARR = Average Income

_____________________________* 100

Average Investment

Where average investment = total investment divided by 2

Decision rule: In the ARR, A project is to be ACCEPTED when ( If Actual ARR is

higher or greater than the rate of return) otherwise it is Rejected and In case of

alternate projects, One with the highest ARR is to be selected.

DISCOUNTED CASH FLOWS:

NET PRESENT VALUE( NPV)

This method mainly considers the time

value of money. It is the sum of the

aggregate present values of all the cash

flows positive as well as that are

expected to occur over the operating life

of the project.

Net present value should be found out

by subtracting present value of cash

outflows from present value of cash

inflows. The formula for the net present

value can be written as follows

NPV= PV of net cash inflows Initial

outlay ( cash outflows)

LIKEWISE,

3 1 2

0

2 3

0

1

NPV

(1 ) (1 ) (1 ) (1 )

NPV

(1 )

n

n

n

t

t

t

C C C C

C

k k k k

C

C

k

=

(

= + + + +

(

+ + + +

=

+

forecasted based on realistic assumptions.

Appropriate discount rate should be identified

to discount the forecasted cash flows. The

appropriate discount rate is the projects

opportunity cost of capital.

Present value of cash flows should be

calculated using the opportunity cost of capital

as the discount rate.

The project should be accepted if NPV is

positive (i.e., NPV > 0).

Assume that Project X costs Rs 2,500

now and is expected to generate year-

end cash inflows of Rs 900, Rs 800, Rs

700, Rs 600 and Rs 500 in years 1

through 5. The opportunity cost of the

capital may be assumed to be 10 per

cent.

2 3 4 5

1, 0.10 2, 0.10 3, 0.10

4, 0.10 5, 0.

Rs 900 Rs 800 Rs 700 Rs 600 Rs 500

NPV Rs 2,500

(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)

NPV [Rs 900(PVF ) + Rs 800(PVF ) + Rs 700(PVF )

+ Rs 600(PVF ) + Rs 500(PVF

(

= + + + +

(

=

10

)] Rs 2,500

NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683

+ Rs 500 0.620] Rs 2,500

NPV Rs 2,725 Rs 2,500 = + Rs 225

=

=

Accept the project when NPV is positive

NPV > 0

Reject the project when NPV is negative

NPV < 0

May accept the project when NPV is zero

NPV = 0

The NPV method can be used to select

between mutually exclusive projects; the one

with the higher NPV should be selected.

NPV is most acceptable investment rule for the

following reasons:

Time value

Measure of true profitability

Value-additivity

Shareholder value

Limitations:

Involved cash flow estimation

Discount rate difficult to determine

Mutually exclusive projects

Ranking of projects

The internal rate of return (IRR) is the rate that equates the

investment outlay with the present value of cash inflow received

after one period. This also implies that the rate of return is the

discount rate which makes NPV = 0.

This method is known by various other names like Yield on

Investment or or Rate of Rate of Return Method. It is used

when the cost of investment and the annual cash inflows are

known and rate of return is to be calculated.

It takes into account time value of Money by discounting inflows

and cash flows. This is the Most alternative to NPV. It is the

Discount rate that makes it NPV equal to zero.

IRR= smaller discount rate+ NPV@ smaller rate

_____________________x bigger discount rate smaler dis rate

sum of absolute values of NPV @

smaller and bigger discount rates.

Let us assume that

an investment would

cost Rs 20,000 and

provide annual cash

inflow of Rs 5,430 for

6 years.

The IRR of the

investment can be

found out as follows:

6,

6,

6,

NPV Rs 20,000 + Rs 5,430(PVAF ) = 0

Rs 20,000 Rs 5,430(PVAF )

Rs 20,000

PVAF 3.683

Rs 5,430

r

r

r

=

=

= =

A B C D E F G H

1 N P V P r o f i l e

2 C a s h F l o w

D i s c o u n t

r a t e N P V

3 - 2 0 0 0 0 0 % 1 2 , 5 8 0

4 5 4 3 0 5 % 7 , 5 6 1

5 5 4 3 0 1 0 % 3 , 6 4 9

6 5 4 3 0 1 5 % 5 5 0

7 5 4 3 0 1 6 % 0

8 5 4 3 0 2 0 % ( 1 , 9 4 2 )

9 5 4 3 0 2 5 % ( 3 , 9 7 4 )

F i g u r e 8 . 1 N P V P r o f i l e

I R

R

Accept the project when r > k.

Reject the project when r < k.

May accept the project when r = k.

In case of independent projects, IRR and

NPV rules will give the same results if the

firm has no shortage of funds.

IRR method has following merits:

Time value

Profitability measure

Acceptance rule

Shareholder value

IRR method may suffer from:

Multiple rates

Mutually exclusive projects

Value additivity

Profitability index is the ratio of the

present value of cash inflows, at the

required rate of return, to the initial cash

outflow of the investment

The initial cash outlay of

a project is Rs 100,000

and it can generate cash

inflow of Rs 40,000, Rs

30,000, Rs 50,000 and

Rs 20,000 in year 1

through 4. Assume a 10

per cent rate of discount.

The PV of cash inflows

at 10 per cent discount

rate is:

. 1235 . 1

1,00,000 Rs

1,12,350 Rs

PI

12,350 Rs = 100,000 Rs 112,350 Rs NPV

0.68 20,000 Rs + 0.751 50,000 Rs + 0.826 30,000 Rs + 0.909 40,000 Rs =

) 20,000(PVF Rs + ) 50,000(PVF Rs + ) 30,000(PVF Rs + ) 40,000(PVF Rs PV

0.10 4, 0.10 3, 0.10 2, 0.10 1,

= =

=

=

The following are the P

I

acceptance rules:

Accept the project when PI is greater than one. PI > 1

Reject the project when PI is less than one. PI < 1

May accept the project when PI is equal to one. PI = 1

The project with positive NPV will have PI

greater than one. PI less than means that the

projects NPV is negative.

It recognises the time value of money.

It is consistent with the shareholder value maximisation

principle. A project with PI greater than one will have

positive NPV and if accepted, it will increase

shareholders wealth.

In the PI method, since the present value of cash

inflows is divided by the initial cash outflow, it is a

relative measure of a projects profitability.

Like NPV method, PI criterion also requires calculation

of cash flows and estimate of the discount rate. In

practice, estimation of cash flows and discount rate

pose problems.

CONVENTIONAL AND NON-

CONVENTIONAL CASH

FLOWS:

A conventional investment has cash flows the pattern

of an initial cash outlay followed by cash inflows.

Conventional projects have only one change in the sign

of cash flows; for example, the initial outflow followed

by inflows, i.e., + + +.

A non-conventional investment, on the other hand, has

cash outflows mingled with cash inflows throughout the

life of the project. Non-conventional investments have

more than one change in the signs of cash flows; for

example, + + + ++ +.

Time preference for money is an

individuals preference for possession of a

given amount of money now, rather than the

same amount at some future time.

Three reasons may be attributed to the

individuals time preference for money:

Risk

preference for consumption

investment opportunities

The time preference for money is generally

expressed by an interest rate. This rate will be

positive even in the absence of any risk. It

maybe therefore called the risk-free rate.

An investor requires compensation for

assuming risk, which is called risk premium.

The investors required rate of return is:

Risk-free rate + Risk premium

Two most common methods of adjusting

cash flows for time value of money:

Compoundingthe process of

calculating future values of cash flows

and

Discountingthe process of

calculating present values of cash flows

Compounding is the process of finding the

future values of cash flows by applying the

concept of compound interest.

Compound interest is the interest that is

received on the original amount (principal) as

well as on any interest earned but not

withdrawn during earlier periods.

Simple interest is the interest that is

calculated only on the original amount

(principal), and thus, no compounding of

interest takes place.

If you deposited Rs 55,650 in

a bank, which was paying a

15 per cent rate of interest on

a ten-year time deposit, how

much would the deposit grow

at the end of ten years?

We will first find out the

compound value factor at 15

per cent for 10 years which is

4.046. Multiplying 4.046 by Rs

55,650, we get Rs 225,159.90

as the compound value:

10, 0.12

FV 55,650 CVF 55,650 4.046 Rs 225,159.90 = = =

Present value of a future cash flow

(inflow or outflow) is the amount of

current cash that is of equivalent value to

the decision-maker.

Discounting is the process of

determining present value of a series of

future cash flows.

Suppose that an investor

wants to find out the present

value of Rs 50,000 to be

received after 15 years. Her

interest rate is 9 per cent.

First, we will find out the

present value factor, which is

0.275. Multiplying 0.275 by Rs

50,000, we obtain Rs 13,750

as the present value:

15, 0.09

PV = 50,000 PVF = 50,000 0.275 = Rs 13,750

Social cost benefit analysis( SCBA) ,also called

economic analysis, is a methodology

developed for evaluating investment projects

from the point of view of the society (or

economy ) as a whole.

In the context to planned economies, SCBA

aids in evaluating individual projects within the

planning framework which spells out national

economic objectives and broad allocation of

resources to various sectors.

The term social cost refers to all those

harmful a consequences and damages

which the community on the whole

sustains as a result of productive

processes, and for which the

Entrepreneurs are not held responsible

manifested.

In SCBA the focus is on the social costs and benefit of

the projects.

These often tend to differ from the monetary costs and

benefits of the projects.

The prinicipal sources of discrepancy are:

Market imperfections

Externalities

Taxes and subsidies

Concern for savings

Concern for redistribution

Merit wants.

Is to secure and achieve the value of

money in economic life by simply

evaluating the costs and benefits of

alternative economic choices and

selecting an alternative which offers the

largest net benfit.

i.e the highest margin of benefit over

cost.

The nature of social benefits and costs

are such that there cannot be any

standard method or technique applicable

to all types of investment projects.

For example: A bridge , a road , a

housing colony, or an industrial project

will each require a different approach

while identifying and measuring its social

benefit and costs.

At another level too , the problems of

qualification and measurement of social

costs and benefits are formidable.This is

because many of these costs and

benefits are intangible and their

evaluation in terms of money is bound to

be subjective.

It is difficult to evaluate the social benefit

and costs whether any project would

yield better results from the social point

of view.It would costs high.

Towards the end of 1960s and in the

early 1970s two Principal approaches for

SCBA emerged:

The UNIDO APPROACH

The LITTLE-MIRRLEES APPROACH

The UNIDO approach was first articulated in

the GUIDELINES FOR PROJECT

EVALUATION which provides a

comprehensive framework for SCBA in a

developing countries.

The rigour and length of this work created

demand for a operational guide for project

evaluation in practice.

To fulfill this need, UNIDO came out with

another publication,GUIDE TO PRACTICAL

PROJECT APPRAISAL in 1978.

The UNIDO method of project appraisal involves 5 stages:

Calculation of the financial profitability of the project measured at

market prices.

Obtaining the net benefit of the project measured in terms of

economic prices.

Adjustment for the impact of the project on savings and

investment .

Adjustment for the impact of the project on income distribution.

Adjustment for the impact of the project on merit goods and

demerit goods whose social valves differ from their economic

valves.

Each stage of appraisal measures the

desirability of the project from a different

stage.

I.M.D LITTELE and J.A MIRELEES have

developed an approach to social- cost

benefit analysis expounded by them in

the following works:

MANUAL OF INDUSTRIAL PROJECT

ANALYSIS IN DEVELOPLING

COUNTRIES ,vol 2 and project appraisal

and planning for developing countries.

There is a considerable similarity between the

UNIDO approach and the L-M approach

Both the approaches call for :

Calculating the accounting( shadow ) price

particularly for foreign exchange saving and

unskilled labour.

Considering the factor of equity.

Using DCFanalysis.

Difference b/w UNIDO and L-

M approach

The UNIDO aproach measures costs and

benefits in terms of domestic rupees whereas

the L-M approach measures costs and benefits

in terms of international prices, also referred to

as border prices.

The UNIDO approach measures costs and

benefit in terms of consumption whereas the L-

M approach measures costs and benefit in

terms of uncommitted social income.

The stage by stage analysis

recommended by the UNIDO approach

focuses on efficency, savings, and

redistribution considerations in different

stage. But the L-M approach ,however,

tends to view these considerations

together.

SCBA by financial

institutions:

The all India term-lending financial

institutions IDBI, IFCI, AND ICICI etc

appraise projects proposals primarily

from the financial point of view.

ICICI was in fact the first financial

institution to introduce a system of

economic analysis as distinct from

financial profitability analysis.

IFCI also adopted a system of economic

appraisal in 1979.

Finally, IDBI also introduced a system of

economic appraisal of projects financed

by them.

IDBI in its economic appraisal of

industrial projects ,considers 3 aspects.

ECONOMIC RATE OF RETURN

EFFECTIVE RATE OF PRODUCTION

DOMESTIC RESOURCE COST.

This is the rate of return the project will earn if

there are no distortions.

For this indicator, the flow of costs and receipts

is revalued at their opportunity costs.

The tradable inputs and output are revalued at

their international prices , the non-tradables are

revalued at fixed conversion factors, while

labor is revalued at the shadow wage rate.

The flow of net receipts is then, discounted to

arrive at the ERR.

Normally, the ERR should be higher then

the prevailing rate of interest in the world

market.

According to a Planning Commission

study, the ERR should be atleast 12 %.

The ERR should be normally be higher

than the MRR( market rate of return).

This indicator measures the degree of

effective protection that a production

enjoys through its entire production cycle.

The ERP measures the margin of

protection on value added to the

impositions of tariffs and other protective

measures on the product and its input

over foreign or world market added.

The ERP will be negative if its tariff raise

the cot of material inputs by a larger

absolute amount than they raise the price

of the product.

The higher ERP , the greater this

inducement , leading to uneconomic

utilization of scarce resources.

This is the most crucial indicator of the viability

of a project especially from a macro-

perspective.

It is an indicator of the comparative advantage

in any product, as it refers to the real

opportunity cost in terms of domestic

resources.

It is useful in deciding whether the product in

question should be produced or imported.

For this purpose of calculation the total cost of

the project is divided into two categories:

Rupee and

foreign exchange expenditure

The DRC, thus calculated , is compared with

the exchange rate.

A DRC lower than the exchange rate indicates

that the product could be profitably

manufactured domestically.

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