Methods of Project AppraisalMethods of Project Appraisal

Meaning of Project AppraisalMeaning of Project Appraisal: - : -

Project AppraisalProject Appraisal is the analysis of costs and benefits of a proposed project with a is the analysis of costs and benefits of a proposed project with a

goal of assuring a rational allocation of limited financial resources amongst alternategoal of assuring a rational allocation of limited financial resources amongst alternate

Investment opportunities with the objective of achieving specific goals.Investment opportunities with the objective of achieving specific goals.

Project AppraisalProject Appraisal is mainly the process of transmitting information accumulated is mainly the process of transmitting information accumulated through feasibility studies into a comprehensive form in order to enable the through feasibility studies into a comprehensive form in order to enable the decision maker undertake a comprehensive appraisal of various projects and decision maker undertake a comprehensive appraisal of various projects and embark on a specific project or projects by allocating resources.embark on a specific project or projects by allocating resources.

The various Factors considered by Financial Institutions while appraising a The various Factors considered by Financial Institutions while appraising a project are: -project are: -

Technical, Financial, Economic, Commercial, Social and Technical, Financial, Economic, Commercial, Social and

Managerial Factors.Managerial Factors.

Objectives & ScopeObjectives & Scope: - : -

To extract relevant information for determining the success or To extract relevant information for determining the success or failure of a project.failure of a project.

To apply standard yardsticks for determining the rate of success or To apply standard yardsticks for determining the rate of success or failure of a project.failure of a project.

To determine the expected costs and benefits of the project.To determine the expected costs and benefits of the project.

To arrive at specific conclusions regarding the project.To arrive at specific conclusions regarding the project.

SignificanceSignificance: - : -

It helps in arriving at specific and predicted results.It helps in arriving at specific and predicted results.

It evaluates the desirability of the project.It evaluates the desirability of the project.

It provides information to determine the success or failure of a It provides information to determine the success or failure of a project.project.

It employs existing norms to predict the rate of success or failure It employs existing norms to predict the rate of success or failure of the project.of the project.

It verifies the hypothesis framed for the project.It verifies the hypothesis framed for the project.

Factors Considered while Appraising a Project Factors Considered while Appraising a Project : -: -

Technical FactorsTechnical Factors Financial FactorsFinancial Factors Economic FactorsEconomic Factors Social FactorsSocial Factors Commercial FactorsCommercial Factors Managerial Factors Managerial Factors

Methods of Project AppraisalMethods of Project Appraisal

METHODS OF PROJECT APPRAISAL

DISCOUNTING CRITERIA

NON -DISCOUNTING CRITERIA

NET PRES ENT

VALUE

PROFIT-ABILITY

INDEX

INTERNAL RATE OF RETURN

PAYBACK PERIOD

ACCOUNTING RATE OF RETURN

Pay-Back Period MethodPay-Back Period Method: -: -

The The Pay-Back PeriodPay-Back Period is the length of time required to recover the initial outlay on 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 the project Or It is the time required to recover the original investment through income generated from the project.income generated from the project.

Pay-Back PeriodPay-Back Period = = Original Cost of Investment____Original Cost of Investment____

Annual Cash Inflows or SavingsAnnual Cash Inflows or Savings

ProsPros: - : - a) It is easy to operate and simple to understand. a) It is easy to operate and simple to understand.

b) It is best suited where the project has shorter gestation period and b) It is best suited where the project has shorter gestation period and project cost is also less. project cost is also less.

c) It is best suited for high risk category projects. Which are prone to rapid c) It is best suited for high risk category projects. Which are prone to rapid

technological changes.technological changes.

d) It enables entrepreneur to select an investment which yields quick d) It enables entrepreneur to select an investment which yields quick returnreturn

of funds.of funds.

ConsCons: - : - a) It Emphasizes more on liquidity rather than profitability.a) It Emphasizes more on liquidity rather than profitability.

b) It does not cover the earnings beyond the pay back period, which b) It does not cover the earnings beyond the pay back period, which maymay

result in wrong selection of investment projects.result in wrong selection of investment projects. c) It is suitable for only small projects requiring less investment and c) It is suitable for only small projects requiring less investment and

timetime d) This method ignores the cost of capital which is very important d) This method ignores the cost of capital which is very important

factorfactor in making sound investment decision.in making sound investment decision.

Decision RuleDecision Rule: - A project which gives the shortest pay-back period, is considered : - A project which gives the shortest pay-back period, is considered to be the most to be the most ACCEPTABLEACCEPTABLE

For ExampleFor Example: - If a Project involves a cash outlay of Rs. 2,00,000 and the Annual : - If a Project involves a cash outlay of Rs. 2,00,000 and the Annual Cash inflows are Rs. 50,000, 80,000, 60,000, and 40,000 during its Cash inflows are Rs. 50,000, 80,000, 60,000, and 40,000 during its economic life of 4 years. economic life of 4 years.

Here Here Pay-Back PeriodPay-Back Period = 3 years + = 3 years + 10,00010,000 40,00040,000

Pay-Back PeriodPay-Back Period = 3 years + 0.25 Or 3 years and 3 months. = 3 years + 0.25 Or 3 years and 3 months.

Accounting Rate of Return MethodAccounting Rate of Return Method: - : -

This method is considered better than pay-back period method because it considers 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 earnings of the project during its full economic life. This method is also known as Return On InvestmentReturn On Investment (ROI). It is mainly expressed in terms of percentage. (ROI). It is mainly expressed in terms of percentage.

ARR or ROIARR or ROI = = Average Annual Earnings After Tax_______Average Annual Earnings After Tax_______ * 100 * 100

Average Book Investment After DepreciationAverage Book Investment After Depreciation

Here, Average Investment = (Initial Cost – Salvage Value) * 1 / 2Here, Average Investment = (Initial Cost – Salvage Value) * 1 / 2

Decision RuleDecision Rule: - In the ARR, A project is to be : - In the ARR, A project is to be ACCEPTEDACCEPTED when ( If Actual ARR when ( If Actual ARR is higher or greater than the rate of return) otherwise it is Rejectedis higher or greater than the rate of return) otherwise it is Rejected

and In case of alternate projects, One with the highest ARR is toand In case of alternate projects, One with the highest ARR is to

be selected.be selected.

ProsPros: - : - a) It is simple to calculate and easy to understand. a) It is simple to calculate and easy to understand. b) It considers earning of the project during the entire operative life.b) It considers earning of the project during the entire operative life. c) It helps in comparing the projects which differ widely.c) It helps in comparing the projects which differ widely. d) This method considers net earnings after depreciation and taxes.d) This method considers net earnings after depreciation and taxes.

ConsCons: -: - a) It ignores time value of money.a) It ignores time value of money. b) It lays more emphasis on profit and less on cash flows.b) It lays more emphasis on profit and less on cash flows. c) It does not consider re-investment of profit over years.c) It does not consider re-investment of profit over years. d) It does not differentiate between the size of investments required ford) It does not differentiate between the size of investments required for

different projects.different projects.

For ExampleFor Example: - : - Project AProject A Project BProject BInvestmentInvestment 25,00025,000 37,00037,000Expected Life (In Yrs.)Expected Life (In Yrs.) 4 5 4 5

Net Earnings (After Dep. & Taxes)Net Earnings (After Dep. & Taxes)YearsYears 11 2500 2500 3750 3750 22 1875 1875 3750 3750 33 1875 1875 2500 2500 44 1250 1250 1250 1250

If the Desired rate of return is 12%, which project should be selected?If the Desired rate of return is 12%, which project should be selected?

NPV (Net Present Value) MethodNPV (Net Present Value) Method: - : -

This method mainly considers the time value of money. It is the sum of theThis method mainly considers the time value of money. It is the sum of theaggregate present values of all the cash flows – positive as well as negative – thataggregate present values of all the cash flows – positive as well as negative – thatare expected to occur over the operating life of the project.are expected to occur over the operating life of the project.

NPVNPV = PV of Net Cash Inflows – Initial Outlay (Cash outflows) = PV of Net Cash Inflows – Initial Outlay (Cash outflows)

Decision RuleDecision Rule: - : - If NPV is positive, ACCEPTIf NPV is positive, ACCEPT If NPV is negative, REJECTIf NPV is negative, REJECT If NPV is 0, then apply Payback Period MethodIf NPV is 0, then apply Payback Period Method

The standard NPV method is based on the assumption that the intermediate The standard NPV method is based on the assumption that the intermediate cash flows are reinvested at a rate of return equal to the cost of capital. When cash flows are reinvested at a rate of return equal to the cost of capital. When this assumption is not valid, the investment rates applicable to the intermediate this assumption is not valid, the investment rates applicable to the intermediate cash flows need to be defined for calculating the modified NPV. cash flows need to be defined for calculating the modified NPV.

Pros and Cons of NPVPros and Cons of NPV: -: -

ProsPros: -: -

a) This method introduces the element of time value of money and as such is a a) This method introduces the element of time value of money and as such is a scientific method of evaluating the project.scientific method of evaluating the project.

b) It covers the whole project from start to finish and gives more accurate b) It covers the whole project from start to finish and gives more accurate figures figures

c) It Indicates all future flows in today’s value. This makes possible comparisons c) It Indicates all future flows in today’s value. This makes possible comparisons between two mutually exclusive projects.between two mutually exclusive projects.

d) It takes into account the objective of maximum profitabilityd) It takes into account the objective of maximum profitability

ConsCons: -: -

a) It is difficult method to calculate and use.a) It is difficult method to calculate and use.

b) It is biased towards shot run projects.b) It is biased towards shot run projects.

c) In this method profitability is not linked to capital employed.c) In this method profitability is not linked to capital employed.

d) It does not consider Non-Financial data like the marketability of a product. d) It does not consider Non-Financial data like the marketability of a product.

For ExampleFor Example: - : - Initial Investment – 20,000Initial Investment – 20,000

Estimated Life – 5 years

Scrap Value – 1000 XYZ Enterprise’s Capital Project

Year Cash flow Discount factor Present Value

@10%  

1 5.000 0.909 4545

2 10,000 0.826 8260

3 10,000 0.751 7510

4 3,000 0.683 2049

5 2,000 0.621 1242

5 1,000 0.621 621

PV of Net Cash Inflows = 24227

NPV = PV of Net Cash Inflows – Cash Outflows

= 24227 – 20,000

NPV = 4227

Here, NPV is Positive (+ ve) The Project is ACCEPTED.

Profitability Index MethodProfitability Index Method: - : -

Profitability IndexProfitability Index is the ratio of present value of expected future cash inflows and is the ratio of present value of expected future cash inflows and

Initial cash outflows or cash outlay. It is also used for ranking the projects in orderInitial cash outflows or cash outlay. It is also used for ranking the projects in order

of their profitability. It is also helpful in selecting projects in a situation of capitalof their profitability. It is also helpful in selecting projects in a situation of capital

rationing. It is also know as Benefit / Cost Ratio (BCR).rationing. It is also know as Benefit / Cost Ratio (BCR).

PI = PI = Present value of Future cash InflowsPresent value of Future cash Inflows

Initial Cash OutlayInitial Cash Outlay

Decision RuleDecision Rule: - In Case of Independent Investments, : - In Case of Independent Investments, ACCEPTACCEPT a Project If a PI is a Project If a PI is

greater ( > 1 ) and Reject it otherwise.greater ( > 1 ) and Reject it otherwise.

In Case of Alternative Investments, In Case of Alternative Investments, ACCEPTACCEPT the project with the project with the the

largest PI, provided it is greater than ( > 1 ) and Reject others. largest PI, provided it is greater than ( > 1 ) and Reject others.

ProsPros: - : - a) It is conceptually sound.a) It is conceptually sound.

b) It considers time value of money.b) It considers time value of money.

c) It Facilitates ranking of projects which help in the selection of c) It Facilitates ranking of projects which help in the selection of projects.projects.

ConsCons: - : - a) It is vulnerable to different interpretations.a) It is vulnerable to different interpretations.

b) Its computation Process is complex.b) Its computation Process is complex.

For ExampleFor Example: - In Case of Above Illustration: - : - In Case of Above Illustration: -

Here PI = Here PI = Present Value of Cash InflowsPresent Value of Cash Inflows

Present Value of cash OutflowsPresent Value of cash Outflows

= = 2422724227

2000020000

PI = 1.21PI = 1.21

Here, The PI is greater than ONE ( > 1 ), so the project is accepted. Here, The PI is greater than ONE ( > 1 ), so the project is accepted.

IRR (Internal Rate of Return) MethodIRR (Internal Rate of Return) Method: -: -This method is known by various other names like This method is known by various other names like Yield on InvestmentYield on Investment or or Rate ofRate of

Return MethodReturn Method. It is used when the cost of investment and the annual cash inflows. 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 ofare 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.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.It is the Discount rate that makes it NPV equal to zero.

In this Method, the IRR can be ascertained by the In this Method, the IRR can be ascertained by the Trial & Error Yield MethodTrial & Error Yield Method,,

Whose the objective is to find out the expected yield from the investment.Whose the objective is to find out the expected yield from the investment.

= Smaller discount rate + NPV @ Smaller rate Sum of the absolute values of the NPV @ smaller and the bigger Discount rates

Bigger Smaller X discount – discount rate rate

Decision Rule: - In the Case of an Independent Investment, ACCEPT the project ifIts IRR is greater than the required rate of return and if it is lower, Then Reject it. In Case of Mutually Exclusive Projects, ACCEPT the project with the largest IRR, provided it is greater than the required rate of return & Reject others.

Pros: - a) It considers the profitability of the project for its entire economic life and hence enables evaluation of true profitability. b) It recognizes the time value of money and considers cash flows over

entire life of the project. c) It provides for uniform ranking of various proposals due to the percentage rate of return. d) It has a psychological appeal to the user. Since values are expressed in percentages.

Cons: - a) It is most difficult method of evaluation of investment proposals. b) It is based upon the assumption that the earnings are reinvested at the

Internal Rate of Return for the remaining life of the project. c) It may result in Incorrect decisions in comparing the Mutually Exclusive Projects.

NPV Vs IRRNPV Vs IRR It is calculated in terms of It is calculated in terms of

currency.currency. It recognizes the importance of It recognizes the importance of

market rate of interest or cost of market rate of interest or cost of capital.capital.

The PV is determined by The PV is determined by discounting the future cash flows discounting the future cash flows of a project at a predetermined of a project at a predetermined rate called cut off rate based on rate called cut off rate based on cost of capital.cost of capital.

In this, intermediate cash flows In this, intermediate cash flows are reinvested at a cutoff rate. are reinvested at a cutoff rate.

Project is accepted, If NPV is + Project is accepted, If NPV is +

ve ve

It is expresses in terms of the It is expresses in terms of the percentage return.percentage return.

It does not consider the market It does not consider the market rate of interest.rate of interest.

The PV of cash flow are The PV of cash flow are discounted at a suitable rate by hit discounted at a suitable rate by hit & trial method which equates the & trial method which equates the present value so calculated the present value so calculated the amount of investment.amount of investment.

In this, intermediate cash inflows In this, intermediate cash inflows are presumed to be reinvested at are presumed to be reinvested at the internal rate of return. the internal rate of return.

Project is accepted, if r > k. Project is accepted, if r > k.

Assessment of NPV & IRR MethodAssessment of NPV & IRR Method

NPVNPV IRRIRRTheoretical ConsiderationsTheoretical Considerations: - : -

a) Does the method discount all casha) Does the method discount all cash Yes Yes Yes Yes

flows?flows?

b) Does the method discount cash flowsb) Does the method discount cash flows Yes Yes No No

at the opportunity cost of funds?at the opportunity cost of funds?

c) From a set of M.E. Projects, does the c) From a set of M.E. Projects, does the

method choose the project whichmethod choose the project which

maximizes shareholder wealth?maximizes shareholder wealth? Yes Yes No No

Practical ConsiderationsPractical Considerations: -: -

a) Is the Method Simple?a) Is the Method Simple? Yes Yes Yes Yes

b) Can the method be used with limitedb) Can the method be used with limited

information?information? No No No No

c) Does the method give a relative measure? Noc) Does the method give a relative measure? No No No