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FINANCIAL TECHNIQUES FOR

PROJECT APPRAISAL AND


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
=
(
= + + + +
(
+ + + +

=
+

Cash flows of the investment project should be


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.