CHAPTER 4

Project Appraisal

Key Terms: Appraisal techniques, Cash flows, Discounting, Payback Period, NPV, Benefit Cost Ratio, IRR, Modified Payback period, Modified IRR, Cost of Capital

Having formulated the project proposal giving all details of the project as discussed in the previous chapter, let us examine the viability of the project, that is, its financial viability. This is a two-step exercise:

Various techniques¹ for project appraisal techniques include

First three techniques are termed as traditional techniques, while the others are called modern techniques. The last one is a technique for economic appraisal for macro-level projects.

The above techniques are illustrated in the following pages.

Ranking by Inspection

Projects are ranked by looking at the inflows and outflows for various projects. Such ranking is merely by personal judgment and is not a systematic one. To illustrate, of the four projects in Exhibit 4.1, ranking is by comparing the inflows and outflows and as such between the two projects A and B, rankings are 2,1 and between projects C and D rankings are 2, 1.

Such ranking is crude one, is on personal judgment, and is not systematic and not followed by banks and financial institutions.

Accounting Rate of Return (ARR)

Accounting profits are used as the basis of appraisal. Profits of a project are related with the investment of the project and a project with higher profit rate is selected. It is calculated as

where profit = PAT;

investment is average (Avg.) investment, that is, investment adjusted for annual depreciation.

So,

where Avg. profit is the average of profits at the beginning and end of the yearly profit for the project and Avg. investment is investment adjusted for depreciation for the year.

ARR for a project is compared with the cost of capital or the borrowing rate to ascertain whether the project is acceptable. If the ARR is more than cost of capital, the project is considered feasible.

ARR has the following positive points:

ARR has the following negative points:

ARR is a good accounting measure but not a technique for project appraisal.

For illustrations in the previous chapter, ARR will be as under:

Payback Period (PBP)

Payback period represents period within which annual inflows from the project are sufficient to recover investment.

So,

Where inflows are not uniform over the years, cumulative cash flows are calculated to see the years within which cumulative inflows are adequate to recover investment.

PBP has the following strong points:

PBP suffers from the following shortcomings:

As mentioned earlier, ARR and PBP are also known as traditional methods of appraisal

(refer illustrations in Chapter 5).

Discounted Cash Flows Methods

These are methods which discount inflows and outflows for time as they occur at different time intervals. These methods are

The above methods are also known as modern methods of project appraisal.

Before we discuss the modern methods of appraisal, let us discuss, in brief, the concept of discounting and time value of money.

Discounted Cash Flows: Principles

Time Value of Money

Having discussed the concept of discounting because of time, let us discuss the discounting methods of project appraisal.

Net Present Value (NPV)

NPV == PV of inflows less PV of outflows, in rupee terms, that is,

(See Illustrations IV and V in the next chapter.)

Benefit–Cost Ratio (BCR) or Profitability Index (PI)

In computation,

Computation of NPV and BCR is illustrated for two projects A and B in Exhibit 4.2.

Of the two projects A and B, at discount rate of 10% Project A has positive NPV greater than that of Project B so accept Project A.

Similarly Project A has greater BCR so accept Project A.

NPV and BCR—Comparison—illustrated below

From the comparison of NPV and BCR for the four projects in Exhibit 4.3, one finds that

Comparison of NPV and BCR when projects are of different sizes, that is, projects A, B, C, and D have size of Rs. 25,000 each while project E has a size of Rs. 75,000, is illustrated in Exhibit 4.4.

Internal Rate of Return (IRR)

Internal rate of return (IRR) is the rate of return from the project after discounting of cash flows, where present value of cash inflows equals the present value of cash outflows.

To calculate IRR:

IRR Computation: IRR can be calculated by

where ∑PV(I) = ∑ PV(O), a cumbersome process

IRR—Interpolation Formula

IRR lies between two rates, that is, between a low rate (L) and a high rate (H), such that

at “L” discount rate, NPV is Positive (+) and

at “H” discount rate, NPV is Negative (–)

Comparison of NPV, BCR, and IRR is illustrated in Exhibit 4.5.

NPV/BCR/IRR—Limitations:

The discounting methods discussed above although commonly used have some limitations as these are based on certain assumptions. These include:

Adjusted Payback Period (PBP Adj.)

PBP discussed above does not discount cash flows for time; to overcome this weak point, PBP is calculated for cash flows adjusted for time and this is known as adjusted payback period (PBP Adj.).

Modified Internal Rate of Return (MIRR)

Discounted cash flow methods (discussed above) namely, NPV, BCR, and IRR have several limitations, one such limitation being the reinvestment rate, that is, inflows during the intermittent period are reinvested at the rate of discount. MIRR is a discounted cash flow method which takes care of this limitation. It calculates rate of discount at the terminal date equating discounted inflows and outflows and is called MIRR.

Illustrations

Illustration 4.1: Computation of IRR

Johnson Watch Co. is considering an investment proposal as under:

NPV 10% = PV (I)10% 2 PV (O)10% == 138,280 – 136,000 = Rs. 2,280

NPV 12% = PV (I)12% 2 PV (O)12% == 131,810 – 136,000 = Rs. 26,410

So IRR lies between 10% and 12%

By interpolation

IRR == 10% + {2,280/(138,280 – 131,810)} × (12 –10) =10.711%

MIRR calculation for Illustration 4.1:

Illustration 4.2

For Anderson Sons, given outflows in the first 2 years and inflows in the subsequent years are given as:

So IRR lies between 10% and 20%

 

 

MIRR calculations:

Step 1.	PV of outflows at 15% = 120 + 80 (0.870) = 189.6
Step 2.	Compounded value of inflows at terminal year 6 at 15%

Step 3	MIRR is obtained as
	189.6 == 467/(1 + MIRR)
	189/467 == 0.4059957 which lies between 19% and 20% in PV
	Table for interest factor at 5 years

So MIRR is 19.5%

Case Studies

Water Supply Project of a City Municipality—Part I

Municipal Corporation of a Western State in India is planning to set up fully automatic water works for its newly developed colonies. Order for the plant and equipment costing Rs. 170 crores plus sales tax 5% was placed on June 20, 2000. Freight and insurance in transit was likely to cost Rs. 2 crores. The land was provided by the local government at a concessional price and construction together with land costed Rs. 25 crores. The plant was received on December 12, 2000, and was operational after installation on April 1, 2001, the installation charges being Rs. 18 crores.

Funds for the project were arranged through government grant of Rs. 200 crores and 12% Rs. 100 crores bank borrowings.

The commissioner of the Municipal Corporation is in charge of the project and is responsible for its planning, commissioning, and operations, with monthly expenses of Rs. 8 lakhs. In addition, a group of employees were provided training in project operations and the training cost was Rs. 25 lakhs.

A consultant, expert in water treatment plant, was hired with a consultation fee of 5 percent of the equipment cost.

Ascertain project cost from the above information.

Water Supply Project of a City Municipality—Part II

The project was expected to provide water services to households with a monthly billing of Rs. 20 crores. As per normal practice, 1 month billing was estimated to remain outstanding. In addition, to ensure regular supplies, stock of raw materials and supplies was to be maintained for 4-week requirements. Raw materials and supplies accounted for 30 percent of the billing.

Will the above information affect the project cost estimated in Part I above?

Water Supply Project of a City Municipality—Part III

Operational details of the project for the first 20 years were as under:

Requirements:

 

¹ Refer to Chapter 4, pp. 44–46 of Information Systems Project Management by David Olson, Business Expert Press, LLC (2015).