Project Appraisal

By
Nalini Ranjan Kumar
Project
Project could be the purchase of a new water pump
for a hatchery unit, a new piece of equipment in a
Fishery farm, a whole new fish farm, etc

 Projects are:
 independent, if the cash flows of one are
unaffected by the acceptance of the
other.
 mutually exclusive, if the cash flows of
one can be adversely impacted by the
acceptance of the other.
 Project Appraisal

 A means of assessing whether an

investment project is worthwhile or
not
 Investment project could be the
purchase of a new PC for a small firm, a
new piece of equipment in a
manufacturing plant, a whole new
factory, etc
 Used in both public and private sector
Investment Appraisal

 Investment therefore assumes that

the investment will yield future
income streams
 Investment appraisal is all about
assessing these income streams
against the cost of the investment
 Not a precise science!
Undiscounted Method of
Project Appraisal
Ranking By Inspection

 With the same investment, two projects produce the

same net value of incremental production for a period ,
but one continues to earn longer than the other.

 For same investment, the total net value of return may

be same. However, one project has more inflow earlier
than the other.

6
Payback Period

 The length of time taken to repay the initial

capital cost
 Requires information on the returns the investment
generates
 e.g. A machine costs Rs.600,000
 It produces items that generate a profit of Rs.5 each
on a production run of 60,000 units per year
 Payback period will be 2 years
Payback Period
 Payback could occur during a year
 Can take account of this by reducing the cash
inflows from the investment to days, weeks or
years
Initial Investment
Payback period = --------------------------------------
Total Cash Received per/annum
 Payback Period

 Example
 Cost of machine = Rs.600,000 Year Income
 Annual income streams from
(Rs.)
investment = Rs.255,000 per 1 255,000
year
 Payback = 600,000/255,000 2 255,000
 =2.353 years

 = 2 yrs, 4 ¾ months
3 255,000
 = 28.23 months
 Strengths and Weaknesses of
Payback

 Strengths:
 Provides an indication of a project’s risk and

liquidity.
 Easy to calculate and understand.

 Weaknesses:
 Ignores the Time value of Money

 Ignores Cost and earning occurring after the

payback period.
Accounting/(Average) Rate of Return

 A comparison of the profit generated by the

investment with the cost of the investment
Average annual return or annual
profit
ARR = --------------------------------------------------
Initial cost of investment
 Accounting Rate of Return
 An investment is expected to yield cash flows of
Rs.10,000 annually for the next 5 years
 The initial cost of the investment is Rs.20,000
 Total profit therefore is: Rs.30,000
 Annual profit = Rs.30,000 / 5
= Rs.6,000
ARR = 6,000/20,000 x 100
= 30%

A worthwhile return?
Strengths and Weaknesses of ARR

 Strengths:
 Easy to calculate and understand.

 Can be used for comparing investment

whose time profiles of expenditure and

earnings are similar.
 Weaknesses:
 Ignores the Time Value of Money.
Discounted Measures of Project
Appraisal
 Present Value Concept

Time Value of Money Concept: = a rupee today is worth more than a

rupee tomorrow why:
 uncertainty: the future is unknown, will you be around to spend the
rupee.
 inflation: erodes the buying power of a rupee
 utility gain from consumption today versus future consumption,
 investment opportunities: invest today, earn interest, and have
more than a rupee to spend in the future.
 Basic idea is to get the present value of some future payment to be
received at time t.
 Present Value Concept

Discounting: = process to obtain the present value of future Euro

amounts:
 1 
PV FV *   where
 1  r t 
 

PV = present value, FV = future value, r = discount rate, and t is the

number of periods into the future.
0 t
time

present value future value

Rupees

idea of discounting
 Present Value Concept

Nominal versus Real: = nominal refers to the rupee value in

current terms (not discounted), whereas real refers to
the rupee value discounted to some base rupee value
(discounted values).
Discount Rate: indicates how you value present
consumption (utility) versus future consumption (utility)
- the higher the discount rate the more you value
present consumption relative to future consumption
- the lower the discount rate the more you value future
consumption relative to present consumption.
 Net Present Value (NPV)
 The NPV is the present worth of the incremental net
benefit or incremental cash flow stream.
 It may also be computed by finding the difference
between the present worth of the benefit stream less the
present worth of the cost stream.

B1-C1 B2-C2 Bn-Cn S

NPV = + + ….. +
(1+r) (1+r)2 (1+r)n (1+r)n

Where
Bi=total benefit of year i r =discount rate
Ci= total cost of year i n= the number of year in operation ( 0,1,2,..n)
s= salvage value of assets at the end of year n
Ai= net benefit of year i
i= the ith year
 Example of NPV Estimation
Year Cash Flow (Rs.) Discount Factor Present Value
(4.75%) (Rs)
(CF x DF)

0 - 600,000 1.00 -600,000

1 +75,000 0.9546539 71,599.04
2 +100,000 0.9113641 91,136.41
3 +150,000 0.8700374 130,505.61
4 +200,000 0.8305846 166,116.92
5 +210,000 0.7929209 166,513.39
6 +150,000 0.7569650 113,544.75
Total 285,000 NPV =139,416
 The criterion for decision
 If NPV > 0, indicate rate of return more than the
discount rate used, the investment would be
economically feasible
 If NPV <0, indicate rate of return less than the discount
rate used, the investment would not be economically
feasible
 NPV= O, break even point
 Choose between mutually exclusive projects on basis of
higher NPV.
 In case of independent projects all the projects having
positive NPV can be selected.
Benefit –cost Ratio (B/C)
It is defined as the ratio of the total present
value of benefit to the cost

n Bi
∑
i=1 (1+r)i
Benefit-cost ratio =
n Ci
∑ Where,
r is discount rate.
i=1 (1+r)i n is number of years
and i=1,2,….n
B= Benefit and
C= Cost
The criterion for
decision

 If B/C>1, which means total PV of benefit is

greater than total PV of costs, investment
would be economically feasible.
 If B/C<1, investment would not be
economically feasible and
 If B/C=1, it would be a break-even situation.
Internal Rate of Return: IRR
 IRR is that discount rate for which NPV= O
 It is the discount rate that will equal the present
value the benefit stream to the present value of the
cost stream.

Thus

B1-C1 B2-C2 Bn-Cn S

NPV = + =0
+ ….. +
(1+r) (1+r)2 (1+r)n (1+r)n

Where, r=IRR, Bt-Ct= CFt

Process of estimating
IRR
Enter r, solve for NPV.

n CFt
= NPV .
∑ (1 + r)t
t=0

IRR: Enter NPV = 0, solve for IRR.

n CFt
= 0.
∑ (1 + IRR)t
t=0
Relationship among NPV, discount rate and IRR

NPV

IRR

Discount rate
 Internal Rate of Return (IRR)
Present worth of incremental net
benefit stream (cash flow) at the
Internal Lower Difference lower discount rate
Rate of discoun between the
return t rate discount
= + rates -------------------------------------------
Sum of the present worths of the
incremental net benefit streams
(cash flows) at the two discount
rates, (sign ignored)
Decisions on Projects

 In case of independent projects,

accept all having: IRR > r
 In case of mutually exclusive
projects, Which have highest IRR
Comparison of three discounting methods
Selection Ranking Mutually Discount
criteria Exclusive Rate
Projects
NPV Accept when No Project Accept with Must be
NPV>0 ranking largest NPV determined
B/C Accept when May be Can’t be used Must be
Ratio B/C>1 used to directly determined
(Net) rank
projects
B/C Accept when May give Can’t be used Must be
Ratio B/C>1 incorrect directly determined
(Gross) ranking
IRR Accept when May give Can’t be used Determined
IRR> incorrect directly internally
opportunity cost ranking
of capital