Project Ka Bazigaar

Project Appraisal By-Rahul Jain

Project Appraisal
y Overview and vocabulary y Methods y Payback, discounted payback y NPV y IRR y Sensitivity Analysis y Breakeven Analysis

What is Project Appraisal?

y Analysis of potential projects. y Long-term decisions; involve large expenditures. y Very important to firm s future.

Steps in Project Appraisal

y Estimate cash flows (inflows & outflows). y Determine r = WACC for project. y Evaluate cash flows.

Cash Flow Estimation Of Project

Initial outlay

Terminal Cash flow

...

Annual Cash Flows

Cash Flows Versus Profit

y Cash flow is not the same thing as profit, at least, for

two reasons:

y First, profit, as measured by an accountant, is based on

accrual concept. y Second, for computing profit, expenditures are arbitrarily divided into revenue and capital expenditures.

CF ! (REV  EXP  DEP)  DEP  CAPEX CF ! Profit  DEP  CAPEX

7

Components of Cash Flows

y Initial Investment y Net Cash Flows/Annual Cash Flows
y Revenues and Expenses y Depreciation and Taxes y Change in Net Working Capital

Change in accounts receivable y Change in inventory y Change in accounts payable y Change in Capital Expenditure y Free Cash Flows
y

Components of Cash Flows

y Terminal Cash Flows y Salvage Value
y y y y

Salvage value of the new asset Salvage value of the existing asset now Salvage value of the existing asset at the end of its normal Tax effect of salvage value

y Release of Net Working Capital

Depreciation for Tax Purposes

y Two most popular methods of charging depreciation are: y Straight-line y Diminishing balance or written-down value (WDV) methods. y For reporting to the shareholders, companies in India could charge depreciation either on the straight-line or the written-down value basis. y For the tax purposes, depreciation is computed on the written down value (WDV) of the block of assets.

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Terminal Value for a New Business

y The terminal value included the salvage value of the asset and the release of the working capital. y Managers make assumption of horizon period because detailed calculations for a long period become quite intricate. The financial analysis of such projects should incorporate an estimate of the value of cash flows after the horizon period without involving detailed calculations. y A simple method of estimating the terminal value at the end of the horizon period is to employ the following formula, which is a variation of the dividend growth model:
T
!

1  g

kg

N n 1 ! kg
11

Additional Aspects of Cash Flow Analysis

y Opportunity Costs of Resources y Sunk Costs y Tax Incentives
y y

Investment allowance Other tax incentives

12

Case Study
y Warehouse Case

There is nothing like

FREE LUNCH

Cost of Capital
y The project s cost of capital is the minimum

required rate of return on funds committed to the project, which depends on the riskiness of its cash flows. y The firm s cost of capital will be the overall, or average, required rate of return on the aggregate of investment projects.

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The Concept of the Opportunity Cost of Capital

y The opportunity cost is the rate of return foregone on

the next best alternative investment opportunity of comparable risk.

O

. . . .
Government bonds isk-free security

.
Preference shares

Equity shares

orporate bonds

isk

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The Weighted Average Cost of Capital

y The following steps are involved for calculating the

firm s WACC: y Calculate the cost of specific sources of funds y Multiply the cost of each source by its proportion in the capital structure. y Add the weighted component costs to get the WACC.
WACC is in fact the weighted marginal cost of capital (WMCC); that is, the weighted average cost of new capital given the firm s target capital structure.

Cost of Equity Capital

y Cost of Equity: The Dividend
ke ! DIV1 g P0

Growth Model

Cost of Debt
y Tax adjustment

y Debt Issued at Par

kd ! i ! I B0

After-tax cost of debt ! kd (1  T )

WACC
y Cost of capital (WACC)=

(Cost of Equity x Proportion of equity from capital)+ (Cost of debt x Proportion of debt from capital)+

What is the payback period?

The number of years required to recover a projects cost, or how long does it take to get the businesss money back?

Payback for Franchise L (Long: Most CFs in out years)

0 CFt -100 Cumulative -100 PaybackL = 2 + 1 10 -90 30/80 2

2.4

3 80 50

60 100 -30 0

= 2.375 years

Franchise S (Short: CFs come quickly)

0 CFt -100 1

1.6 2

3 20 40

70 100 50 -30 0 20

Cumulative -100 PaybackS

= 1 + 30/50 = 1.6 years

Strengths of Payback: 1. Provides an indication of a projects risk and liquidity. 2. Easy to calculate and understand. Weaknesses of Payback: 1. Ignores the VM. 2. Ignores CFs occurring after the payback period.

Discounted Payback: Uses discounted rather than raw CFs.

0 CFt PVCFt -100 -100 10% 1 10 9.09 -90.91 2 60 49.59 -41.32 3 80 60.11 18.79

Cumulative -100 Discounted = 2 payback

+ 41.32/60.11 = 2.7 yrs

Recover invest. + cap. costs in 2.7 yrs.

NPV: Sum of the PVs of inflows and outflows.

CFt . NPV ! t 1 t!   r
Cost often is CF0 and is negative.
CFt NPV !  CF0 . t 1 t !1   r
n

What s Franchise L s NPV?

Project L: 0 -100.00 10% 1 10 2 60 3 80

9.09 49.59 60.11 18.79 = NPVL

NPVS = $19.98.

Rationale for the NPV Method

NPV = PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value.

Using NPV method, which franchise(s) should be accepted?

y If Franchise S and L are mutually exclusive,

accept S because NPVs > NPVL . y If S & L are independent, accept both; NPV > 0.

Internal Rate of Return: IRR

0 CF0 Cost 1 CF1 2 CF2 Inflows 3 CF3

IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.

NPV: Enter r, solve for NPV.

CFt 1  r t ! NPV . t !0
n

IRR: Enter NPV = 0, solve for IRR.

CFt t ! 0. t ! 0 1  IRR
n

What s Franchise L s IRR?

0
IRR = ?

1 10

2 60

3 80

-100.00 PV1 PV2 PV3 0 = NPV

Enter CFs in CFLO, then press IRR: IRRL = 18.13%. IRRS = 23.56%.

Rationale for the IRR Method

If IRR > WACC, then the projects rate of return is greater than its cost-- some return is left over to boost stockholders returns. Example: WACC = 10%, IRR = 15%. Profitable.

Normal Cash Flow Project:

Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal Cash Flow Project: Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine.

Inflow (+) or Outflow (-) in Year

0 + 1 + + + + 2 + + + + 3 + + + 4 + + + + 5 + + N N NN N N NN NN

Individual Assignment
y Complete All the questions