CATHOLIC UNIVERSITY INSTITUTE OF BUEA (CUIB)

SCHOOL OF BUSINESS

FIRST SEMESTER 2023/2024

Course Code/ Title BUS 405: Project Management

CHAPTER THREE

PROJECT APPRAISALS

3.1 Meaning

Project appraisal or investment appraisal has to do with collection of techniques used to identify
the attractiveness (viability) of a project or an investment. The purpose is to access the success of
a project or projects. Appraising a project means evaluating the proposed solution against its
ability to solve the identified problem or need.

Project appraisal is considered as the process of assessing, in a structured way, the case for
proceeding with a project or proposal, or the project's viability. It critically entails comparing
various options, using economic appraisal or some other decision analysis technique.

3.2 Importance of Investment Appraisal

-It permits the comparism of projects

-Larger resources are involved so it permits careful evaluation before decision

- Permits the estimation of future cash flows

- Helps in the allocation and optimal use of resources

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-Enables to know the time value of money

3.3 Techniques of Project Appraisal

3.3.1 Traditional Techniques

3.3.1.1 Simple Payback Period

This is the time taken to recover the initial amount invested in a project. It measures how fast
rather than how much. This requires that at the end of the payback period, usually expressed in
years; the cash inflows from a project should be equal to or greater than the cash outflows. This
is a rough measure of liquidity and not of profitability.

When deciding between two or more competing projects, the usual practice is to accept the one
with the shortest payback period.

In most situations, payback is always used as an initial screening method.

Payback Period with equal Annual Cash flows

In a simplified case of a project with equal cash inflows; payback period is readily obtained
from:

Payback period = Initial Cost of Capital/ Annual Cash inflow

However, if cash inflows are uneven, and this is a more likely happening; the payback period
computation changes.

Payback Period with Unequal Annual Cash flows

When cash flows are uneven, the payback period is calculated by working out the cumulative
cash flows over the project life. Where it recoups (recovers) its outflows gives the payback
period.

Advantages of the Simple Payback Period Technique.

1. Simplicity: As a concept, it is easily understood and is easily calculated.

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2. Rapidly changing Technology: If a new plant is likely to be scrapped in a short period
because of obsolescence, a quick payback is essential.

3. Improving Investment Conditions: When investment conditions are expected to improve in

4. It favours Projects with a Quick Return: It is often argued that these are to be preferred for
the following reasons;

-Rapid project payback leads to rapid company growth

-Rapid payback minimizes risk

-Rapid payback maximizes liquidity.

-It promotes a policy of caution in investment decisions.

Disadvantages or Criticisms of Simple Payback Period

1. Project returns may be ignored: In particular, cash flows arising after the payback period
are totally ignored.

2. Timing is ignored: Cash flows are effectively categorized as prepayback or post-payback; but
no more accurate measure is made.

3. Lack of Objectivity: Payback does not have clear decision criteria as to whether to accept or
reject an investment project. The cut-off point is ambiguous. For example, when is the
investment stage of a project considered to be finished: when the investment project begins to
generate cash flows or automatically after the first year?

4. Project Profitability is ignored: Payback takes no account of the effects on business profits
and periodic performance of the project as evidenced in the financial statements.

5. Favours short-term over long-term investments: Ideally, a company should have a range of
investment projects with differing time horizons, thus retaining a flexible approach to new

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opportunities while capitalizing on long-term projects which ensure that the company keeps pace
with technological or other research and development which affect its future viability.

6. The concept that payback is less risky may be misleading: The opportunity costs of capital
takes into account the increased risks associated with forecasting cash flows in future years
whereas payback just ignores these cash flows altogether. This is not “less risky” but just “more
inaccurate”.

3.3.1.2 Return on Capital Employes (ROCE)

3.3.1.3 Accounting Rate of Return (ARR)

3.3.2 Modern Techniques

Principle: There is a time preference for receiving the same sum of money sooner rather than
later. Conversely, there is a time preference for paying the same sum of money later rather than
sooner. A number of reasons can explain the time preference for money.

-Consumption Preference: Money received now can be spent on consumption.

-Risk Preference: Risk disappears once money is received.

-Investment Preference: Money received can be reinvested in the business or invested

-Inflation: Which reduces the real value of money over time.

1. Discounted Payback Period (Payback Period in Practice)

In practice and recently, the payback technique has been restructured to take into consideration
the time value of money.

This method takes the basic structure of the payback method, and then deals with one of the
major weaknesses of by discounting the future cash flows at an appropriate discount rate –
usually the cost of capital. Thus, the initial investment is compared with future cash flows given
in today’s money.

2. The Net Present Value (NPV) Technique

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When the sum of all the present values of the future cash flows is calculated and added to the
initial investment cost, the resulting figure is the Net Present Value.

Formula

Decision Rule: Accept Projects with positive NPV. Preference should be given to projects with
higher NPVs.

NPV can be calculated in a number of ways;

Formula above with a calculator.

Use of the PV factor tables

Use of a financial calculator

A simple computer model can be developed.

Advantages of NPV

1. It takes into account the time value of money.

2. Profit and the difficulties of profit measurement are excluded. ➢Using cash flows emphasises
the importance of liquidity.

3. It is easy to compare the NPV of different projects.

4. It takes into account the scale of the investment

5. Has a precise decision rule – objectivity in this case

Disadvantages of NPV

1. It is not as easily understood as the payback and accounting rate of return.

2. It requires knowledge of the company’s cost of capital, which may be difficult to calculate
although prevailing interest rate could be used.

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3. The Internal Rate of Return (IRR)

-Accountants also call it the Discounted Cash flow Yield or Internal Yield.

-Economists also call this the Economic Rate of Return or the marginal efficiency of capital.

-The NPV model takes the discount rate; the initial cash outflow and resulting cash inflows, and
then assesses whether, at the opportunity cost of capital, the cash inflows measured in today’s
money outweigh the cash outflows.

-The IRR method approaches the problem in a different way. It takes the cash outflow and the
forecasted cash inflows, it calculates what the rate of return would have to be to make the NPV
of the investment zero, i.e. at what rate of return will the NPV equal to zero; implying that IRR is
the rate at which NPV = 0.

-The rate of return (IRR) is then compared with the cost of capital.

-The IRR is the maximum cost of capital that a company could use to finance an investment
without harming the shareholders.

Formula

IRR of Even Annual Cash flows

A simpler approach can be used to find the IRR of simple projects in which the annual cash
inflows are equal. This is from

IRR = Annual Cash Inflow/ Initial Cost of Capital x 100%

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It follows from the above that the IRR of perpetuities can be computed in a similar way.

Advantages of IRR

1. It takes into consideration the time value of money

2. It considers cash flows and not profit flows

3. The information it provides is more easily understood by managers, especially non-financial

4. It gives a precise decision rule

Demerits or Disadvantages of IRR

1. The trial and error process of calculating the IRR can be time consuming, but this
disadvantage can easily be overcome with the use of computer software.

2. It is possible to have more than one IRR’s for a project. This occurs where the cash flows over
the life of the project are a combination of positive and negative values. Under these
circumstances it is not easy to identify the true IRR and the method should be avoided.

3. In certain circumstances the IRR and the NPV can give conflicting results. This occurs
because the IRR ignores the relative size of investments as it is based on a percentage return
rather than the absolute cash value of the return.

Which Should be Preferred - NPV or IRR?

NPV should be preferred for the following Reasons

1. The NPV leads to the maximization of shareholder’s wealth

2. It takes into consideration the scale of the project

3. It is measured in the units of cash flows i.e. in monetary units

4. There exist a unique NPV for any project irrespective of the nature of cash flows whether
conventional or not

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5. NPV is adaptable to changes in the discount rates unlike IRR that may give same rate even
when discount rates are changing

6. The above makes NPV more adequate for long term planning than IRR

7. NPV is better understood since it deals with absolute gain, etc.

4. Profitability Index

This is the ratio of the present values of the future cash inflows of a project to the initial
investment in the project. This index helps in cost benefit analysis of investment and helps them
rank in order of the best return on initial investment. It is calculated as follows;

Profitability Index (PI) = Sum of Present Values/Initial Investment.

PI >1 = Profitable so should be accepted

PI =1 = Break-Even

PI < 1 = Not profitable so should be rejected

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