Certified Expert in Credit Management (CECM)

(4th Intake_On-Campus)

Assignment-II
On
Project Appraisal for the Purpose of Financing by a Bank

Name of Participant : Tanvir Ahmed

Serial No. of the Participant : 5
Name of Affiliated Institute : Citibank N.A.
Cell Phone Number : 01674799407
Email Address : tanvir9870@gmail.com

Date of Submission : 30-Mar-2020

Bangladesh Institute of Bank Management (BIBM)

Mirpur-2, Dhaka
1. Which one of the capital budgeting techniques is preferable to you?
Explain with logic.
Different capital budgeting techniques are being used by the companies to evaluate potential
projects including Payback Period, Discounted Payback Period, Profitability Index, Net Present
Value, Internal Rate of Return etc. Among these the techniques that incorporate time value of
money concept or use discounted cash flow are clearly better than the others as these consider
the expected future cash flows adjusted for cost of capital. Of the techniques that take into
account discounted cash flows, NPV and IRR are clearly two superior methods. But NPV is
better than IRR because of the following reasons:
1. IRR inherently assumes that any cash flows can be reinvested at the internal rate of
return. This assumption is problematic because there is no guarantee that equally profitable
opportunities will be available as soon as cash flows occur. The risk of receiving cash flows
and not having good enough opportunities for reinvestment is called reinvestment risk. NPV,
on the other hand, does not suffer from such a problematic assumption because it assumes
that reinvestment occurs at the cost of capital, which is conservative and realistic.

2. In case of mutually-exclusive projects, an NPV and IRR conflict may arise in which one
project has a higher NPV but the other has higher IRR. Mutually exclusive projects are
projects in which acceptance of one project excludes the others from consideration. The
conflict either arises due to relative size of the project or due to the different cash flow
distribution of the projects. Since NPV is an absolute measure, it will rank a project adding
more Taka value higher regardless of the initial investment required. IRR is a relative
measure, and it will rank projects offering best investment return higher regardless of the
total value added.

3. Another particularly important feature of NPV analysis is its ability to notch the
discount rate up and down to allow for different risk level of projects. NPV is
theoretically sound because it has realistic reinvestment assumption. It considers the cost of
capital and provides a Taka value estimate of value added, which is easier to understand.

4. IRR’s assumption of reinvestment at IRR is unrealistic and could result in inaccurate ranking
of projects. Another, quite serious weakness is the multiple IRR problem. In case of non-
normal cash flows, i.e. where a project has positive cash flows followed by negative cash
flows, IRR has multiple values. Because of this weakness of IRR NPV is preferred over IRR.
5.

CECM 4th Intake, Assignment-2

2. Solution of the Capital Budgeting problem:
Problem:
The Khaleque Group is contemplating the purchase of a new milling machine. The machine will
cost Tk.6,00,000. The machine is expected to generate earnings before depreciation and taxes of
Tk.2,00,000 each year over its 5-year economic life. Mr. Khaleque is aware that the tax law will
most probably be changed before acquisition of the new machine. Proposed changes would
necessitate using five-year straight-line depreciation rather than the three-year MACRS schedule.
Khaleque's tax rates would increase to 40% instead of current 34%. Khaleque's cost of capital is
12%.
Compute the NPV and IRR of the new machine under existing depreciation and tax laws.
Solution:
Assumptions:
1. Since new tax law is going to be introduced we are taking tax rate as 40%.
2. Considering straight line method depreciation per year would be (Taka 6,00,000÷5) =
Taka 1,20,000/-
Calculation of Net Cash Flow/Cash flow after tax:

Year 1 2 3 4 5
Earnings before depreciation and
tax 200,000 200,000 200,000 200,000 200,000

Less: Depreciation 120,000 120,000 120,000 120,000 120,000

Earning before tax 80,000 80,000 80,000 80,000 80,000

Less: Tax (@40%) 32,000 32,000 32,000 32,000 32,000

Earning after tax 48,000 48,000 48,000 48,000 48,000

Add: Depreciation 120,000 120,000 120,000 120,000 120,000

Net cash flow 168,000 168,000 168,000 168,000 168,000

NPV:
168,000 168,000 168,000 168,000 168,000
= + + + + −600,000
1.12 (1.12 )2 (1.12)3 (1.12)4 (1.12)5
= 605,602.40 – 600,000

CECM 4th Intake, Assignment-2

= 5,602.40

IRR:
IRR is computed here by trial and error method. From the above NPV calculation we have found
a positive NPV at 12% cost of capital. Now, recalculating the NPV considering higher cost of
capital 14% gives us the following result.
NPV @ 14% cost of capital:
168,000 168,000 168,000 168,000 168,000
= + + + + −600,000
1.14 ( 1.14 )2 (1.14)3 (1.1 4 )4 (1.14)5
= 576,757.60 – 600,000

= -23,242.40

So, the IRR would be: 12%+{5,602.40÷(5,602.40+23,242.40)}×(14%-12%) = 12.38%

CECM 4th Intake, Assignment-2

3. What aspects should be considered by a banker before finalizing a project
for financing?
Project financing is the most crucial type of financing where banks get involved. Profitability of
a bank largely depends on successful identification of profitable and sustainable projects and
making investment therein. Project financing is the process of financing a specific economic unit
that the sponsors create, in which banks or creditors share much of the venture's business risk
and funding is obtained strictly for the project itself. Project finance creates value by reducing
the costs of funding, maintaining the sponsors financial flexibility, increasing the leverage ratios,
avoiding contamination risk, reducing corporate taxes, improving risk management, and
reducing the costs associated with market imperfections. However, project finance transactions
are complex undertakings hence banks need to consider various aspects of the proposed project
before finalizing it for financing. Amongst the various aspects the most crucial ones are
discussed below:
1. Managerial Aspect: This the starting point of project evaluation. At this stage bank needs to
check the background of the sponsors of the project. Bank should check the sincerity,
honesty & integrity of the sponsors by analyzing data about their market reputation as
borrower. Educational Background of the sponsors is another vital element which should be
checked, although it is not mandatory that sponsors must have excellent academic
background in case the sponsors possess outstanding technical knowledge. Experience of the
borrower needs to be considered very carefully as future success relies mostly on their
experience of managing the venture. Succession plan and Team Work/ Ability of the
management of the venture/project to run the project efficiently are other important
determinants.
2. Organizational Aspect: Organizational structure should be carefully analyzed by the bank
before financing a project. Because risk factors of a project vary as per its organizational
structure hence it should be carefully checked whether a project is Sole Proprietorship or
Partnership or Private limited company or Public Limited Company/Listed with Stock
Exchanges.
3. Technical Aspect: Number of technical considerations to be made before financing a
project. For example; location of the business needs to be checked and it’s land, building and
machineries to be valued by a responsible officer along with an independent surveyor. Bank
should check availability of power, fuel, water, materials etc. in the project location. Along
with that name, brand, origin of the machineries and critical equipment needs to be checked.
Few more technical aspects that need checking are training of the vital employees,
availability of spare parts and machines, production capacity, building code compliance,
labor intensive and capital intensive nature, availability of generator and substation,
availability of solar system and finally but most importantly availability and source of raw
materials.

CECM 4th Intake, Assignment-2

4. Marketing Aspect: Marketing aspect includes analysis of aggregate demand of proposed
product/service in the future, marketing mix, possible market share of the project under
appraisal, business outlook along with industry growth and entry-exit barrier, projected sales
volume, scope of market expansion, cross selling capability and cross border risk,
identification of dominant player/ possible threat of competition etc.
5. Financial Aspect: This is the most important part of the project evaluation. Bank should
carefully conducts assessment of working capital finance requirement, potential utilization of
limit, business cycle, cyclical effect, credit risk grading score sheet etc. It would not be wise
to involve in a project which is already cash rich and potential of limit utilization is low. On
the other hand bank should be careful about financing a project which is highly levered.
6. Economic & Industry Aspect: Bank should take a top down approach before financing a
project which starts with economy analysis. Expected GDP growth of the country to be
checked at first along with per capita GDP. Availability of foreign exchange reserve also
needs to be carefully evaluated which might impact the project in future during the time of
importing capital machineries and raw materials or during the time of profit repatriation (if
the project is a JV). Industry growth trend should also be checked along with industry
penetration to determine potential growth of industry. Industry risk factors need to be
considered carefully as well before financing a project.

CECM 4th Intake, Assignment-2