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Project Appraisal Techniques

Project Appraisal

The assessment of the viability of a project involving medium or


long-term investments in terms of shareholder wealth may be
termed as project appraisal. In our country the all-India level
financial institutions have devised an in house policy of assessing
the industrial projects to grant financial assistance based on their
commercial, technical, economic and financial viability.

The various aspects of Project Appraisal are:

1. Basic Eligibility for Financial Assistance


2. Market Appraisal
3. Technical Appraisal
4. Financial Appraisal
5. Economic Appraisal
6. Entrepreneur/Promoter Appraisal
7. Management/Organization Appraisal

1. Basic Eligibility for Financial Assistance

 Constitution of Firm/Company
 Priority/Government Policy
 Institutional Policy Decisions
 Acceptability of the Promoters by the Financial
Institutions.

2. Market Appraisal

 Assessment of Potential Demand (Demand-Supply Gap).

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 Study on Trends of Production, Supply, Imports,
Exports, Price Trends, Distribution and Sales Promotion,
Government Policies, Competition, Consumer Profile, etc.

 Methods of Demand Forecasting viz. Trend Projection,


End Use, Econometric Methods.
 Problems in Demand Forecasting in Collection of Data,
Methods of Forecasting and Environmental Changes.

3. Technical Appraisal

 Location ad Site
 Plant Capacity and Product-Mix
 Technology and Technical Know-how
 Selection and Procurement of Plant and Machinery
 Civil and Structural Work
 Charts and Lay-Outs
 Raw Materials, Consumables and Utilities
 Implementation Schedule

4. Financial Appraisal

 Estimation of Cost of Project


 Means of Financing
 Profitability Projections and Assumptions thereof
 Cash Flow and Balance Sheet Projections
 Ratio Analysis
 Analysis of Past Working Results, Financial
Position and Sources and Application of Funds

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5. Economic Appraisal

 Cost-Benefit Analysis
 Domestic Resource Cost
 Effective Rate of Protection
 Employment Potential
 Productivity and Investment per Worker

6. Entrepreneur/Promoter Appraisal

 Background, Qualifications and Experience


 Financial Resourcefulness
 Managerial Competence, Past Track Record and
Dealings with Institutions/Banks

7. Management/Organization Appraisal

 Management Set-Up
 Organizational Set-Up
 Recruitment and Selection of Executives
 Training
Project Appraisal Criteria (Capital Budgeting - IRR & NPV etc.)

A company before selecting to implement a project gets the feasibility


study carried out if the project is viable in financial terms. Obviously,
the company must have carried out the technical and market analysis.
The prime objective of the capital budgeting is to see if the projected
cash flows of the company yield a return which is higher than the
expected return. What is the expected return? It is a subjective question
and the figure has to be arrived at by the promoter of the project /

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company. He may take various parameters into considerations like;
what are the expectations of the investors in equity, what is the current
lending rate of the banks, and the financial institutions and what is the
average lending rate of the banks, and the financial institutions and
what is the average return on the capital employed in that kind of
industry? One can source the data from the various magazines and
journals on economic and finance published by Government of India.

Cash Accruals

Every company sells the product and earns some income from it.
However, this income is taxed after allowing the various permissible
deductions. Many deductions which are permitted are of non-cash flow
items like depreciation and the preliminary expense. Thus, one should
be conversant with the various provisions of the relevant sections of the
Income Tax Act 1961. There are certain deductions which are
permissible under the said Act, the main objective of these deductions to
reduce the effective rate of taxation of the company. However, it should
be clear that there is a difference between the net profit and the cash
flows. The terms used for estimating/evaluating the cash flows are gross
cash accruals and net cash accruals.

Gross Cash Accruals = P.A.T. + Non Cash flow Items

P.A.T. = Profit after Tax

Non Cash flow Items = Depreciation & Preliminary expenses w/off

Net Cash Accruals = P.A.T. – Dividend + Non Cash flow Items

In case, the company does not declare dividend during a particular year
the gross cash flows and the net cash flows will be equal.

Techniques and methods used for evaluation of projects:

Once the relevant information about the project is gathered the


techniques of capital budgeting are employed to judge the attractiveness
of the proposals. The end result will tell whether to accept or reject the
proposals. The capital budgeting employs the following four kinds of
techniques:

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• Accounting Rate of Return (ARR)
• Payback Period (PBP)
• Net Present Value (NPV)
• Internal Rate of Return(IRR)
• Benefit Cost Ratio (BCR) or Profitability Index (PI)

Accounting Rate of Return or Average Rate of Return (ARR):

ARR is defined as the ratio of Average Profit after Tax to the Average
Book Value of the Investment. The higher the ARR, the better is the
project. Project having less than a pre-determined cut off rate of return,
say, 15% or 20%, are rejected.

Payback period method:

The payback period is the method under which we find out the number
of years required to recover the initial outlay. Thus lower the payback
period, higher would be the attractiveness of the project.

The two widely used methods of discounted cash flow techniques are:
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Benefit Cost Ratio (BCR) or Profitability Index (PI)

Net Present Value (NPV) Method:

Under the NPV Method, the cash flows are discounted at the rate which
we call as the expected / required rate or cost of capital and the NPV is
evaluated with the help of the following equation:

n At
NPV = ∑ ────── - I, t= 1, 2, 3, ------------n
t=1 (1 +r) t

where, At refers to cash flow at the end of year ‘t’, r = Discount rate, n =
Life of the project in number of years, and, I = Initial Investment.

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The IRR Method:

The Internal Rate of Return (IRR) can be defined as the rate of return
at which the sum of future cash inflows, when discounted, is equivalent
to the initial outlay or the net present value is zero.

This can be represented as:


n At
I =∑ ────── , t= 1, 2, 3, ------------n, where r = IRR
t
t=1 (1 +r) I = Initial Investment/Outlay

This method has the following distinct advantages:

• It takes into account the quantum of the cash outflows


• It takes into account the total amounts of the cash inflows and the
timings.

Benefit Cost Ratio (BCR)/ Profitability Index (PI):

It is the ratio of the present value of the future cash flows and the initial
outlay. It is a relative method and not an absolute method. It is useful
for comparing two or more projects in terms of their acceptability or
profitability. Mathematically it is expressed as:

n At
∑ ──────
t=1 (1 +k) t
BCR = PI = ─────────── , where, k = Discount Rate
I

In case the required rate of return exceeds IRR, the proposal would be
rejected under IRR method. Likewise, if the expected return exceeds the
IRR, we would get negative NPV, hence the project will again be
rejected on the NPV basis. Hence under both the methods we would not
accept the project. Thus both the methods give us similar results so far

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as the appraisal criterion for the investment in a project is concerned,
except when the initial cash outlays are different and the timings of the
cash flows also differ.
CASE STUDY
Caselet:

X Ltd. is investing in a project with an outlay of Rs.10 lakhs estimated


to last for 5 years, with no salvage value. It follows straight line method
of depreciation. The tax rate is 55%. The expected cash in flows before
tax are:

Years 1 2 3 4 5
Cash
Inflows
2 3 3.5 4 4
before tax
(Rs.lakhs)

Find:
(a) Payback Period(PB)
(b) Average Rate of Return(ARR)
(c) NPV at 10% of cost of capital
(d)IRR
(e) Profitability Index at 10% cost of capital
(f) The acceptability or otherwise of the project based on NPV and
IRR
*****

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Solution to the Case Study on NPV, IRR, etc. :

First let us find the cash inflows:-


(Rs. Lakh)
Year CFBT DEPN Net Tax EAT EAT + Cumulative
Earnings DEPN= CFATBD
CFATBD
1 2.000 2.000 - - - 2.000 2.000
2 3.000 2.000 1.000 0.550 0.450 2.450 4.450
3 3.500 2.000 1.500 0.825 0.675 2.675 7.125
4 4.000 2.000 2.000 1.100 0.900 2.900 10.025
5 4.000 2.000 2.000 1.100 0.900 2.900 12.925

EAT = Earning After Tax


CFATBD= Cash flow After Tax but Before Depreciation
CFBT= Cash flow Before Tax

(A). Pay Back Period = 3 years + Time required for recovering


Rs. 2,87,500 out of 4th year cash flow of
Rs. 2,90,000.

= 3 + 0.991 = 3.991years

= 4 years (approx)

(B). ARR =Average Income = 6,50,000/5


Average Investment 10000/2

= 1,30,000 x 100 = 26%


5,00,000

(C). Net Present Value (at a given rate of 10%)


1 2 3 4 5
CFAT 2.000 2.450 2.675 2.900 2.900
P.V at 0.909 0.826 0.751 0.683 0.621

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10%
Total P.V
1.810 2.024 2.009 1.981 1.801
at 10%
P.V of Cash Outflows = Rs.10.00 lakhs
NPV = 9.634 – 10.00 = - Rs.0.366 lakhs

(D). IRR

Total PV Total PV
CFAT PV at 9% PV at 8%
at 9% at 8%
1 2.000 0.917 0.926 1.834 1.852
2 2.450 0.842 0.857 2.063 2.099
3 2.675 0.772 0.794 2.065 2.124
4 2.90 0.70 8 0.735 2.053 2.132
5 2.90 0.650 0.691 1.885 1.975
9.900 10.182
NPV (0.100) +0.182

IRR = 8% + 0.182/(0.1 +0.182)% = 8% + 0.645% = 8.645%

(E). Profitability Index = PV of Cash Inflows


PV of Cash Outflows

= 9.632 = 0.963 = 96.32%


10.000

(F). NPV is Negative, hence project is not acceptable.


IRR is 8.645%, which is less than the cut off rate of 10%.
Hence the project is not acceptable