PRESENTATION ON PROJECT APPRAISAL & Its FINANCIAL TECHNIQUES

Project appraisal Project appraisal is a generic

term that refers to the process of assessing, in a structured way, the case for proceeding with a project or proposal. In short, project appraisal is the effort of calculating a project's viability. It often involves comparing various options, using economic appraisal or some other decision analysis technique.

PROCESS OF PROJECT APPRAISAL

Initial AssessmentDefine problem and long-listConsult and short-listDevelop optionsCompare and select Project

appraisal

Financial techniques for project appraisal

Net present value (NPV)Internal rate of return (IRR)Average rate of return (ARR)Pay back periodDiscounted payback periodProfitability index

Net Present Value (NPV)

The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of a project. The following is the formula for calculating NPV:

where:Ct = net cash inflow during the periodCo= initial investmentr = discount rate, andt = number of time periods

Advantages Of NPV1. NPV gives important to the time

value of money.2. In the calculation of NPV, both after

cash flow and before cash flow over the life span of the project are considered.

3. Profitability and risk of the projects are given high priority.

4. NPV helps in maximizing the firm's value.

Disadvantages Of NPV1. NPV is difficult to use.

2. NPV can not give accurate decision if the amount of investment of mutually exclusive projects are not equal.

3. It is difficult to calculate the appropriate discount rate.

4. NPV may not give correct decision when the projects are of unequal life.

Internal Rate of Return

The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. The formula for IRR is:

0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . .

+Pn/(1+IRR)n

where, P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . .

n, respectively; andIRR equals the project's internal rate of return.

Advantages Of IRR1. IRR method considers the time

value of money.2. IRR method discloses the

maximum rate of return the project can give.

3. IRR method considers and analysis all cash flows of entire project.

4. IRR method ascertains the exact rate of return the project earns.

Disadvantages Of IRR1. IRR method is difficult to understand,

complications due to trial and error method.

2. The important drawback of IRR is that it recognizes the cash inflows generated by project is reinvested to internal rate of project, but NPV recognizes such cash inflows are reinvested to cost of capital of the organization.

3. Single discount rate ignores the varying future interpret rate.

Average Rate Of Return (ARR) Average rate of return (ARR) is also known as accounting

rate of return. ARR is based upon accounting information rather than on cash flow. In other words, Accounting rate of return (ARR) refers to the rate of earning or rate of net profit after tax on investment.ARR consider profitability rather than liquidity. Under ARR technique, the average annual expected book income is divided by the average book investment in the project.

ARR = (Average net income/Average investment) x 100

Where,Average net income= Total net income/No. of yearsAverage investment= Net investment/2

Illustration for ARRThe initial investment of the project is Rs.30,000. The net profit after tax is as follows:Year Net profit after tax($)1 250002 300003 200004 250005 40000

SolutionCalculation of ARR:ARR = (Average net income/Average investment) x 100= (28000/15000) x 100 = 18.67%.

Where,Average net income = Total net income/No, of years = 25000+30000+20000+25000+40000/5 = 28000

Average Investment = Net investment/2 = 30000/2 = 15000

Advantages Of ARR1. ARR is based on accounting

information, therefore, other special reports are not required for determining ARR.

2. ARR method is easy to calculate and simple to understand.

3. ARR method is based on accounting profit hence measures the profitability of investment.

Disadvantages Of ARR

1. ARR ignores the time value of money.

2. ARR method ignores the cash flow from investment

3. ARR method does not consider terminal value of the project.

Payback period Method

A company chooses the expected number of years required to recover an original investment. Projects will only be selected if initial outlay can be recovered within a predetermined period. This method is relatively easy since the cash flow doesn't need to be discounted. Its major weakness is that it ignores the cash inflows after the payback period, and does not consider the timing of cash flows.

Advantages Of Pay Back Period 1. Pay back period is simple and easy to

understand and compute.

2. Pay back period is universally used and easy to understand.

3. Pay back period gives more importance on liquidity for making decision about the investment proposals.

4. Pay back period deals with risk. The project with a shortest PBP has less risk than with the project with longest PBP.

Disadvantages Of Pay Back Period

1. In the calculation of pay back period, time value of money is not recognized.

2. Pay back period gives high emphasis on liquidity and ignores profitability.

3. Only cash flow before the pay back period is considered. Cash flow occurred after the PBP is not considered.

Discounted payback period

The discounted payback period is the amount of time that it takes to cover the cost of a project, by adding the net positive discounted cashflows arising from the project. It should never be the sole appraisal method used to assess a project but is a useful performance indicator to contextualise the project’s anticipated performance.

Advantages of Discounted Payback Period

owners and managers like regular payback period to know how long it will take them to recover their initial investment. Using discounted payback period simply gives them a more finely tuned estimate of that.

discounted payback period has an advantage over regular payback period for that very reason - cash flows are discounted and calculation gives a better estimate of payback period.

Disadvantages of Discounted Payback Period

Time value of money is not considered when you calculate payback period. In other words, no matter in what year you receive a cash flow, it is given the same weight as the first year. This flaw will cause managers to overstate the time to recovery for the initial investment.

A second flaw is the lack of consideration of cash flows beyond the payback period. If the capital project lasts longer than the payback period, then cash flows the project generates after the initial investment is recovered are not considered at all in the payback period calculation.

Profitability Index

This is the ratio of the present value of project cash inflow to the present value of initial cost. Projects with a Profitability Index of greater than 1.0 are acceptable. The major disadvantage in this method is that it requires cost of capital to calculate and it cannot be used when there are unequal cash flows. The advantage of this method is that it considers all cash flows of the project.

Advantages Of Profitability Index 1.Profitability index considers the

time value of money.2. Profitability index considers

analysis all cash flows of entire life.3. Profitability index makes the right

in the case of different amount of cash outlay of different project.

4. Profitability index ascertains the exact rate of return of the project.

Disadvantages Of Profitability Index

1. It is difficult to understand interest rate or discount rate.

2. It is difficult to calculate profitability index if two projects having different useful life.