Professional Documents
Culture Documents
Part-II
FINANCIAL APPRAISAL
TECHNIQUES
Introduction
After a project has been prepared, it is generally
appropriate for a critical review or an independent
appraisal to be conducted.
4. Complementary Projects:
The investment in one enhances the cash flows of one or
more other projects. Consider a manufacturer of personal
computer equipment and software.
8
If it develops new software that enhances the abilities of a
computer mouse, the introduction of this new software may
Financial appraisal techniques:
There are several techniques that have been
suggested by accountants, economists and
others to judge the worthwhileness of capital
projects.
2. Discounting techniques
1. Non-discounted techniques:
Simplicity is the main benefit, i.e. Theses techniques
are simple to understand and easy to compute, but
suffers from drawbacks.
They don’t recognize the time value of money and
not consistent with wealth maximization.
The common non-discounted techniques are
(a) Pay back period
(b) Accounting Rate of Return
A) Pay back period :
The amount of time needed to recover the initial
investment is called Payback period.
If this is “n” years, projects with pay back period of “n”
years or less are deemed worthwhile and projects with a
pay back period exceeding “n” years are considered as
unworthy.
How to calculate pay back period?
1. When the cash inflows are constant , the pay back period
is simply the initial out lay divided by the annual cash
inflows.
That is:
Example:
A project which costs cash outlay of Birr 1,000,000 is
expected to generate a constant annual cash inflow of
Birr 300,000 for five years. Compute its pay back period.
=
Example:
Year Cash flow
0 Birr 600,000
1 50,000
2 150,000
3 150,000
4 200,000
5 150,000
Compute the payback period
The decision rule is:
A project is accepted if the computed payback period
is less than or equal to the pay back period set by
management.
A project is rejected if the computed payback period is
greater than the pay back period set by management
Advantages of Pay back period
It is simple both in concept and application
It is based on cash flows
Focuses on earlier cash flows and liquidity
Disadvantages:
Does not consider the time value of money
It is a measure of the project’s capital recovery, not
profitability
It ignores cash flows beyond the pay back period-this
leads to discrimination against projects which generate
substantial cash inflows in latter years.
Difficulty in setting the standard pay back period
B) Accounting Rate of return (ARR)
Also called average rate of return on investment.
It measures profitability, which relates income to investment.
This method provides a percentage return of the investment.
Since income and investment can be measured in various
ways, but the common one is:
That is:
Recognize the time value of money
NPV= -5,273
Advantage
Considers the time value of money
Considers the project in totality
Based on cash flows
Does not require the estimation of decision standard
Shortcomings
Relatively complex
B) Benefit-Cost ratio: is the ratio of the present value of
cash flows (PVCF) to the initial investment of the project.
It is also called profitability Index (PI)
Is the ratio of benefits to costs
If once the NPV is computed, it can be automatically
calculated.
Consider the above example and find PI
Decision rule:
Accept if PI > 1 (NPV is positive)
Reject if PI < 1 (NPV is negative)
Indifferent if PI=1 (NPV is zero)
CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback = 2 + 41.32/60.1= 2.7 yrs