CHAPTER 5

Project Appraisal, Price-Level Changes, Social Cost–Benefit Analysis

After having gone through this chapter, you should be able to

Appreciate project appraisal in complex situations

Understand comparison of NPV and IRR

Overview situations of conflicting results of NPV and IRR and issue of multiple IRRs

Illustrate situations of independent projects and mutually exclusive projects

Appreciate the need for adjustment of price-level changes

Understand the concept of social cost–benefit analysis

Appreciate adjustment for risk in the project appraisal process

Overview examples of some projects and project management practices

Key Terms: Reinvestment Rate, Capital Rationing, Mutually Exclusive Project, Independent Project, Multiple IRR, Annualized Benefit, Sensitivity Analysis, Price-Level Changes, Social Cost–Benefit Analysis, Shadow Price

Having discussed project appraisal techniques in the previous chapter, the present this chapter discusses comparison of appraisal techniques and presents certain situations where these techniques give conflicting results or a situation of multiple IRR. Situations of independent projects and of mutually exclusive projects are also discussed. Further, issues relating to price-level changes, adjustment for risk, social cost–benefit, and qualitative factors for project management are illustrated.1

Comparison of Various Appraisal Techniques

Project appraisal techniques have common points in respect of information required and also of points of analysis (see Exhibits 4.4 and 4.5 of Chapter 4). Let us compare two techniques, NPV and IRR.

NPV and IRR Relationship

As discussed, both NPV and IRR take into consideration time value of money and adjust for differences in the timings of cash flows. Both the methods assume reinvestment of cash inflows during the life of the project and the reinvestment rate for NPV calculation is assumed to be the discount rate itself (i.e., 10% for Project A in Exhibit 5.1), while for IRR calculation the reinvestment rate assumed is the IRR itself. There are, of course, situations, where the assumption of the reinvestment rate being IRR itself does not hold true in reality. On the other hand, such assumption holds true for NPV as the discount rate followed is the cost of capital, and as such NPV is conceptually better.

Figure 5.1 illustrates the relationship between NPV and IRR. The figure plots NPV for Projects A and B, against the discount rates used to evaluate the cash flows. Note that for the Project A, at 10% discount rate, NPV is Rs. 12,900, while at 29.05% discount rate, NPV is 0 and that is the IRR. As against this, for Project B, at 10% discount rate, the NPV is Rs. 6,370, while NPV is 0 at 17.6% and that is the IRR (see Figure 5.1 and Exhibit 5.1).

There are situations where NPV and IRR give conflicting results. What can be those situations? When does it so happen? How to overcome such a problem? A situation of conflicting results is presented in Exhibit 5.2, with two projects P and Q.

As per Exhibit 5.2, NPV and PI (benefit–cost ratio) are higher for project P, as compared to those for project Q, accordingly project P appears to be preferable than project Q. As mentioned earlier, this is on the assumptions that the inflows during the intermittent period are reinvested at the rate of discount followed (i.e., 10%).

Figure 5.1 NPV and IRR relationship

On the other hand, IRR for project Q is higher as against that for project P and project Q should be preferred over project P. It is on the assumption that the inflows during the life of the project are reinvested at the IRR (i.e., 37.56% for project Q and 27.3% for project P). It raises a point: can cash inflows be reinvested at 27% in project P and at 37% in project Q?

The assumption for NPV that inflows would be reinvested at the discount rate of 10% for both the projects, being nearer to reality, makes NPV conceptually better.

Conditions where IRR and NPV may rank projects differently

Pattern of cash flows: The cash inflows for one project increase overtime while that of the other decrease, a situation similar to that in Exhibit 5.2.

Projects have different expected lives.

Different sizes: Cost of one project is higher than that of the other.

Exhibit 5.1

Two projects of equal size but having different inflows

Project A Project B
Project cost Rs. 25,000 Rs. 25,000
Inflows Uniform Rs. 10,000 pa Rs. 5,000 pa first 4 yrs and Rs. 25,000 in the fifth year
Project life 5 yrs 5 yrs
Discount rate 10% 10%

Outflows shown in ( ) Inflows shown without ( )

In Exhibit 5.2, the two projects are of equal size but have different patterns of inflows, increasing for project P and decreasing for project Q, but the analysis shows conflicting results for NPV and IRR. To iterate, it is primarily because of the assumption of reinvestment rate in IRR and NPV. In such cases, we should either modify assumptions of the IRR or use BCR which is conceptually sound. Such modification of IRR is beyond the scope of this book.

Exhibit 5.2

Two projects of equal size but having different patterns of inflows are as:

 

Project P

Project Q

Project cost

Life

Inflows

Rs. 70,000

5yrs

Increasing over the years

Rs. 70,000

5yrs

Decreasing over the years

Year

Project P

Project Q

0

(70,000)

(70,000)

1

10,000

50,000

2

20,000

40,000

3

30,000

20,000

4

45,000

10,000

5

60,000

10,000

Total

165,000

130,000

Payback period

3.2 yrs

1.5 yrs

NPV 10%

46,135

36,550

BCR 10%

1.659

1.522

IRR

27.3%

37.56%

PBP Adj.

3.71 yrs

1.44 yrs

MIRR

22%

20%

Situation of Multiple IRR

Further, there are situations we may have two or more IRRs, where NPV is 0. (As mentioned earlier, IRR is the rate of discount where the present value of inflows equals the present value of outflows.) These are situations where there are some cash outflows on the abandonment of the project. For example, Exhibit 5.3 shows Projects A and B, where the initial outflows are followed by 1- or 2-year inflows, which are then followed by an outflow.

Such cases are found in natural resource projects. In mining, a bauxite firm is normally required as a part of the contract to restore the landscape after digging out the ore deposits. Similarly, an oil company, as a part of the lease agreement is required to inject water into the underground reservoir in order to make possible a secondary recovery at such time when the primary reserves are exhausted.

For Multiple IRR, the conditions required are

Sum of outflows exceeds or equals the sum of inflows. In other words, a situation of multiple IRR arises where the net present value is nonlinear as shown in Figure 5.2.

Number of IRRs will be the number of times there is change in algebraic signs.

Taking inflows as positive and outflows as negative, in Exhibit 5.3, for Project A algebraic signs have changed twice (from negative to positive and then to negative), so Project A has two IRRs of 25 percent and 400 percent.

Similarly, Project B has three IRRs of 0 percent, 100 percent, and 200 percent.

Though there are several approaches to deal with the situation of multiple IRR, these are considered beyond the purview of this book. However, the net present value method is adopted for decision making in such cases.

Figure 5.2 Situation of multiple IRR

Exhibit 5.3

Multiple IRR

Year

Project A

Project B

Project C

0

– (1,600)

– (1,000)

– (1,000)

1

+ 10,000

+ 6,000

+ 1,400

2

– (10,000)

– (11,000)

+ 100

3

+ 6,000

IRRs(%)

25 and 400

Two IRRs

0, 100,and 400

Three IRRs

32.5

Multiple IRR: conditions

Sum of outflows ≥ sum of inflows

No. of IRRs5

No. of times reversal of algebraic signs of inflows and outflows

In Exhibit 5.3, Projects A and B have multiple IRRs as

in Project A, sum of outflows are greater than sum of inflows

in Project B, sum of outflows are equal to sum of inflows

Further, number of IRRs = No. of times there is reversal of algebraic signs of inflows and outflows.

Multiple IRR,

where sum of outflows ≥ sum of inflows, and

Number of IRRs = No. of times there is reversal of algebraic signs of inflows and outflows

Accordingly, in Project A there are two IRRs as 25 percent and 400 percent, while in Project B there are three IRRs as 0 percent, 100 percent, and 400 percent. On the other hand, for Project C, sum of outflows being less than sum of inflows, IRR is 32.5 percent.

Independent Projects and Capital Rationing

As mentioned earlier, where acceptance of one project does not debar the inclusion of the other projects, the situation is one of independent projects. One or more projects can be taken at a time and the availability of funds is the critical factor and it is a situation of capital rationing.

In principle, more projects should be added as long as the marginal revenue is greater than the marginal cost, and to maximize profits they should operate up to a point where the marginal revenue equals the marginal cost. For this purpose marginal revenue is the rate of return earned on successive investments and marginal cost is the cost on successive increments of capital.

Figure 5.3 illustrates that investment up to point 0L2, the point where marginal revenue equals marginal cost, is optimal. For investment beyond this point or below this point (i.e., 0L1 and 0L3), the profit is not maximized.

An enterprise having a number of project proposals is constrained by scarce funds and this gives rise to a situation of capital rationing. The principle of capital rationing is to allocate funds to projects which have a higher return and to reject projects which are not viable. The various steps involved in the finalization of independent projects are summarized as follows:

Step 1 Calculate the Profitability Index (PI) for each of the project proposal.
Step 2 Rank the proposals according to their profitability indices (PIs or BC ratios) in a descending order (from the highest to the lowest).

Figure 5.3 Cost/revenue versus investment

Step 3 Reject project proposals having a PI less than unity.
Step 4 Of the remainder, begin with the proposal having the highest PI, proceed down through the list, and accept proposals until the entire available funds have been utilized

(see Exhibits 5.4 and 5.5).

Independent Project and Capital Rationing

M/S Lalbahi & Sons have 10 investment project proposals requiring funds amounting to Rs. 141 lakhs. They have Rs. 60 lakhs available with them. Which of the projects should be accepted? The fund requirement for each project with corresponding PI is given below.

The above case is a situation of capital rationing and would require the following steps:

1. Arrange projects in the descending order of their PI.

2. Reject projects having PI below 1, that is, projects no. 4, 3, and 6.

3. Accept projects with high PI as long as the available Rs. 60 lakhs is utilized.

Exhibit 5.4

Independent Projects and Capital Rationing

Project

Investment
(Rs. Lakhs)

Profitability Index
(PI)

1

20.00  

1.6  

2

12.00  

1.45

3

23.00  

0.78

4

2.00

0.97

5

5.00

1.08

6

2.00

0.63

7

3.00

1.14

8

36.00  

1.17

9

11.00  

1.25

10

17.00  

1.38

Exhibit 5.5

Independent Projects: PI and Fund Allocation

Fund allocated to various projects: A situation of Capital Rationing

So projects selected are 1, 2, 10, and 9. In case there is a tie, linear programming techniques can be used for allocation and that is beyond the scope of this book.

Mutually Exclusive Projects

These are alternate projects, that is, acceptance of one precludes the acceptance of other projects. Evaluation techniques like NPV, PI, and IRR are adopted to decide about the selection of one project. However, the use of these techniques would depend upon the characteristics of projects in view. For example, in Exhibit 5.1 we concluded that Project A should be preferred over Project B. However, Exhibit 5.2 indicated that NPV and IRR give conflicting results and in such cases, NPV is conceptually better. Situations of mutually exclusive projects could be analyzed under the following two categories:

A) Projects with equal lives, or

B) Projects with unequal lives

 

A) Projects with Equal Lives: These could be further categorized as

a) Projects of equal lives, having the same size and the same pattern of cash flows

Projects A and B in Exhibit 5.1 have equal lives, the same size and the same pattern of cash flows; NPV or IRR give similar results which are not conflicting.

b) Projects of equal lives, but having unequal size or having a different pattern of cash flows

Projects P and Q in Exhibit 5.2 are of equal lives but different pattern of cash flows and in such cases NPV and IRR give conflicting results, NPV is conceptually better, and NPV or PI can be used for decision making.

How to resolve the conflicting situation?

There are two alternatives to overcome such a situation. The alternatives are

 i. To use NPV if projects are of the same size. However, if the projects are of different sizes, PI should be used.

ii. From the cash flows of two projects, determine the difference of cash flows and thus create another project say “R” by subtracting the cash flows of one from that of another (see Exhibit 5.6).

Calculate IRR for the newly created project R. If IRR of the new project R is greater than cost of capital, select the project with the higher cash flows.

To illustrate, Exhibit 5.6 is an extension of Exhibit 5.2 and presents a new project R. This is created by subtracting cash flows for Q project from that of P project (given in Exhibit 5.2).

IRR by Interpolation Formula

IRR = [NPV(L)/Abs.(PV(I) – PV(I)H] × (H – L)])

IRR = 10% 1 {9,585/(62,465 – 30,250)} × (30 – 10) = 15.95%

Assuming that the cost of capital, called cut-off rate, is 15%.

So, Accept Project P.

Decision Rule

Accept P, if IRR for (P – Q) >cost of capital; since 15.95% > 15%, accept P.

Exhibit 5.6

Projects with Equal Lives with different flow pattern

(this is an extension of Exhibit 5.2)

B). Projects with Unequal Lives

In case the projects proposed have unequal lives, the following four alternative approaches of analysis are as under:

Approach a) Consider reinvestment opportunities for inflows during the intermittent period of the project and compare the expected reinvestment rate of the shorter duration project with IRR of longer duration project.

Decision Rule

 i. If the expected reinvestment rate > IRR of the longer project, prefer the shorter duration project, alternately

ii. If the expected reinvestment rate < IRR of the longer project, prefer the longer project.

Approach b) Add other similar projects so as to equalize the lives for the two projects. NPV can be calculated for the two alternative proposals of 30 years each.

This approach is theoretical one and assumes that opportunity for adding more projects exists and also there is a possibility of reinvestment during the intermittent period. Further the assumptions are nor realistic.

Approach c) Cut off the analysis for the two projects of unequal lives at terminal year that of shorter life project, estimate terminal value of longer project at that terminal date and appraise the two projects by various techniques. This approach though very common requires the estimation of value at the year of termination.

Approach d) Another approach is to annualize the respective cash flows pattern of the alternate projects and select a project having the minimum annualized cost or the maximum annualized gain.

The formula for annualization is

Annualized cost = (Present value of cash flows)/
(present value factor for the given year as ascertained from the Annuity Table)

Decision Rule:

Select a project with minimum annualized cost or

Select a project with maximum annualized benefit.

The present value factor is a factor which when applied to the present value amount gives the yearly installment. In other words, present value factor is reciprocal of the PV of the rupee one received over the life of the project at a given rate of interest.

Annualized cost for the Projects A and B is illustrated in Exhibit 5.7.

Project Investment and Risk

Project investment proposals relate to future which is always uncertain. Accordingly estimates of cash flows for a project are not certain. In addition, return from a project is directly related to anticipated risk; greater the risk, higher the return and vice-versa. Different investment proposals have different levels of risks. Risk refers to the potential variability of returns from investment proposals and the more variable these returns, the greater is the risk. It raises the need to make an adjustment for risk in investment appraisal. A brief description of approaches for the adjustment of risk is given below.

Exhibit 5.7

Annualized Cost of two projects

A company has two alternate proposals requiring initial investment of Rs. 100 lakhs and Rs. 80 lakhs, respectively. They have lives of 10 years and 6 years, respectively.

Their operating cash costs are as under:

 

Project A

Project B

Life

10 yrs

6 yrs

Initial investment (Rs. 000)

10,000

8,000

Operating costs (Rs. 000)

in years

1

2

3

4

5

6

7

8

9

10

 

2,000

2,000

2,000

2,500

2,500

2,500

3,000

3,000

3,000

3,000

 

2,500

2,500

2,500

3,800

3,800

3,800

Salvage value (Rs. 000)

1,500 end of tenth year

1,000 end of sixth year

The Annualized Cost is Calculated as under:

 

Project A

Project B

Present value of original cost and annual operating costs at 10% (Rs. 000)

Less present value of salvage

25,014

(578)

21,316

(565)

Total cost (PV)

24,436

20,750

Annualized cost

(PV of cash flows)/PV of annuity

24,436/6.1446 5 3,976.83

20,750/4.3553 5 4,764.54

Decision rule

Accept project with lowest annualized cost

SO ACCEPT PROJECT A

(More illustrations of mutually exclusive projects are given at the end of the chapter.)

Swings and Roundabout Principle

One method of dealing with risk is to ignore it altogether. It would seem odd to regard this as a method of dealing with risk, but would be sensible if seen from the point that risk is random in its incidence and is likely to cause better than expected results as it is to cause worse than expected. When we aim at a rate of return of say 15 percent, we discover that, on an average, this is what occurs on the “swings and roundabout” principle. In such circumstances, risk can safely be ignored. However, unfortunately, this happy averaging out does not always happen in practice. In most cases we are likely to find that the nature of the risk is such that we may find a project doing substantially worse than expected, but rarely substantially better than expected. Two clear reasons for this are the project manager’s enthusiasm to push the project through and the difference between the anticipated capacity utilization and the actual.

Expected Values

Another approach to adjust for risk is that the project manager estimates not one set of cash flows, rather several possible sets of cash flows are estimated with probabilities for each estimate. This method of probability estimate of cash flows for risk adjustment is beyond the scope of this book.

If a man will begin with certainties he will end in doubts

Sir Francis Bacon

Risk-Adjusted Discount Rate

The philosophy of this method is that a project involving risk will be expected to offer a premium in excess of that of a risk-free project. The greater the risk involved in a project, the greater the required premium in return and higher the discount rate used in the project evaluation. Conversely, a lower discount rate is used for less risky projects.

In other words, as risk increases, higher expected returns are required to compensate for the additional risk, and investors trade-off between risk and return. For example, an investor may be indifferent to a risk-free project having a sure return of 5 percent, or to a moderately risky project with a 7 percent return, or to a very risky project with a 15 percent return.

The trade-off between risk and return is made clear in Figure 5.4. The investor is expected to have a 5 percent risk-free return; with risk, the investor would expect a higher rate of return of 16 percent, the risk measured in terms of coefficient of variance of 1.5. In other words, he is indifferent between risky investment projects of B, C, and D and the risk-free return of 5 percent from project A.

The risk factor under this method is usually judged by the cash flow pattern of a particular project and thus will remain to be a subjective decision. Second, this method applies a constant risk-adjusted discount rate, which fails to take into account fluctuating degrees of risk throughout the life of the project. Third, it assumes that the cash flows can be reinvested at the risk-adjusted discount rate.

Figure 5.4 Indifferent curve or risk return trade-off

Due to the limitations mentioned above, some suggest adjustment of the cash flows rather than the discount rate. Estimated cash flows are converted into certain cash flows by applying what is known as a “certainty equivalent coefficient,” depending on the degree of risk inherent in cash flows. For evaluation purposes, all project cash flows are discounted by a risk-free discount rate.

Certain statistical methods or techniques like standard deviation (called Hillier’s model), simulation (called Hertz’s model), discrete probabilistic analysis (DPA), and continuous probabilistic analysis (CPA) are used to measure risk; these are beyond the scope of the book.

Sensitivity Analysis

Sensitivity analysis is a way of showing effects of uncertainty by varying the value of the key factors, say sales, price, and costs, and showing the resulting effect on the project. It is a procedure to study the responsiveness of net present values or IRR to variations in one of the cash flow elements like price, sales, and cost and to determine how sensitive a project’s return to a change is in a particular value.

Since estimates of cash flows are generally based on a single estimate of factors like selling price, sales volume, and cost of production, sensitivity analysis shows how sensitive is NPV or IRR estimate with the variation in the estimates of various variables.

Sensitivity analysis is derived from the simulation approach and requires the definition of all relevant variables which influence NPV and IRR of the project.

Steps involved in sensitivity analysis are

 I. Identifying the critical or sensitive elements of inflows and outflows and

II. Analyzing the effect of variation of such elements on the expected NPV or IRR.

For example, if raw material costs increase by 10 percent or sales fall by 10 percent, or selling price increases by 10 percent, how sensitive would be the return from the project? Thus sensitivity analysis tests the viability of the project under the worst circumstance.

Project Planning and Price-Level Changes

A point can be raised that during inflation when prices are increasing, how to adjust for inflation while planning a project?

Inflation reflects increasing price level and a fall in money value. Inflationary conditions are those where too much money will be chasing too few goods and services, and thus cause a general increase in the prices of goods and services. Inflation distorts cash flow estimates and thus the results of project appraisals. Project appraisal techniques do not automatically take into account the inflationary factor. This necessitates specific inclusion of inflation in project planning and analysis.

Need for adjustment for price-level changes arises, when there is time gap between inflows and outflows and there is inflation during the period. As in a project, investment is made at the beginning and inflows occur over the years in future; and during this period there may have been increase in prices.

Inflation adjustment would depend upon whether cash flows are estimated at constant prices or current prices. If constant prices are used to estimate project cash flows, no separate adjustment needs to be made as constant prices imply that inflation has been taken care of. On the other hand, if cash flows are estimated in terms of current prices, inflationary adjustment becomes necessary. The real difference is the difference between money cash flows and real cash flows. Money cash flows are the actual amounts of money changing hands, whereas real cash flows are the purchasing power equivalents of the actual cash flows. In a world of zero inflation, there would be no need to distinguish between money and real cash flows as they would be identical. Where inflation does exist, there arises a difference between money and real cash flows which necessitates adjustments while evaluating projects.

There are two approaches for adjustment for price-level changes:

a) Adjust discount rate—so as to include for inflation, that is, add a factor for inflation in the discount rate used. So discount rate would be say, 12 percent (10% without inflation plus 2% for inflation) or
b) Adjust estimated cash flows for price-level changes. Steps required are as follows:
  i. Forecast inflation rates for the coming years
 ii. Adjust annual cash flows on account of inflation estimated above
iii. Evaluate adjusted cash flows and calculate NPV, BCR, IRR, or PBP Adj.

Illustration: For Project B in Exhibit 5.1 above, cash inflows are adjusted for the estimated inflation rate. These are shown in Exhibit 5.8. These adjusted inflows are appraised by using various techniques, namely, NPV, BCR, and IRR. This is shown in Exhibit 5.9.

Exhibit 5.8

Adjusted Cash flows for Price-Level Changes

(for Project B shown in Exhibit 5.1)

Yr

Inflows

Expected Inflation rate %

Adjusted Inflows

Inflows adjusted

1

5,000

10

5,000 × (100/110) =

4,345

2

5,000

11

5,000 × (100/110)(100/111) =

4,095

3

5,000

19

5,000 × (100/110)(100/111)(100/119) =

3,441

4

5,000

14

5,000 × (100/110)(100/111)(100/119)(100/114) =

3,019

5

25,000

16

25,000 × (100/110)(100/111)(100/119)(100/114)(100/116) =

13,010

Social Cost–Benefit Analysis for Project Appraisal

Social cost–benefit analysis is essentially an approach to evaluate public investments or investment in social projects. Steps involved in using social cost–benefit analysis while evaluating a project are

Exhibit 5.9

Appraisal of Cash flows adjusted for Price-Level Changes

(for Project B shown in Exhibit 5.1)

 

Inflows adjusted for inflation

Discount Factor 10%

Present value of cash flows

0

(25,000)   

1.00   

(25,000)   

1

4,345

0.909

3,950

2

4,095

0.826

3,282

3

3,441

0.751

2,584

4

3,019

0.683

2,062

5

13,010   

0.621

8,079

PBP Adj.

4.7 yrs

NPV 10%

25,000 – 19,957 = (–) 5,043

BCR 10%

0.798

a) Listing of the costs (capital, revenue, internal, external, etc.) and benefits of the project over its life span.

b) Quantification of costs and benefits in terms of market value.

c) Applying shadow prices to obtain the social value of each item.

d) Obtaining the net social benefit after discounting the benefit stream with an appropriate social discounting rate. (Basically, either the interest rate prevailing in the market or social opportunity cost of capital as decided by the value judgment of the policy maker. In fact, it needs consideration of how a project will affect the economy and to whom the costs and benefits will accrue. This is often a subject of controversy.)

e) Accepting if the project gives either zero or positive present social value and rejecting if the present social value is negative.

It would be clear from the above steps that it is not that simple to make use of this concept of social cost–benefit analysis. The specific difficulties are

  i. In listing all the benefits that are likely to accrue because of a particular project

 ii. In measuring some of the benefits in economic terms

iii. In deciding the life of the project

iv. In choosing the appropriate social discount rate

 v. In determining the shadow prices

It should also be noted that social cost–benefit analysis is not meant to substitute financial analysis based on market prices. In fact, financial analysis is always the first essential step toward project appraisal. It helps in identifying the micro aspects of costs and benefits associated with a project. However, basing a judgment about the acceptability of a project on financial analysis alone may result in misallocation of economic resources. Hence, financial analysis must be complemented with social cost–benefit analysis, so that the potential acceptability of a project is tied up with economy-wide macro considerations and repercussions.

In short, there are projects which have social implications resulting in certain social benefits or social costs which are not necessarily in financial terms. For example, construction of a road or a bridge may, in addition to monetary costs and benefits, lead to increase in passenger traffic and also commodity traffic which in turn would increase GDP. On the other hand, it may adversely affect the existing employment or add to pollution level. Similarly, automation may increase production and may affect the society by affecting the people employed. These are very common in national-level or macro-level projects and require adjustment while appraising the project for the society or the government.

Social cost–benefit analysis is illustrated for the construction of bridge across River Ganga in Case Exercise and also for State Electricity Board case study at the end of the chapter.

Case Exercises

Case Exercise 5.1: Two projects with unequal lives—Annualized Cost

Asean Co. has two alternate proposals with details as under:

 

Project X

Project Y

Project cost (Rs. 000)

Project lives

Salvage value (Rs. 000)

Discount factor

20,000

8 years

2,000

10%

20,000

10 years

2,000

10%

Find annualized cost of both the projects and which project should be selected?

 

Project X

Project Y

Present value (PV) factor at the end of project

PV of salvage value (Rs. 000)

0.467

20,000 × 0.467 = 934

0.386

2,000 × 0.386 = 772

Remaining cost (Rs. 000)

20,000 – 934 = 19,066

20,000 – 772 = 19,228

USPVF

5.335

6.145

Annualized cost (Rs. 000)

PV of total cost/USPVF

19,066/.5.335 = 3,573

19,228/6.145 = 3,129

Since annualized benefit of Project X is higher, select that project.

Case Exercise 5.2: A Manufacturing Project Situation

Given details:

Outlay or project cost Rs. 1000,000; life 10 years

Annual output 20,000 units

SP per unit Rs. 25

Cash cost per unit 17.50

Cash inflows Rs. 150,000 pa (i.e., Rs. 7.5 × 20,000)

Project Appraisal

Payback period = 6.67 years

NPV 10% = 10 lakhs – [(6.1446)(150,000)] = Rs. – 78,310

NPV 8% = 10 lakhs – [(6.7101) (150,000)] = Rs. 6,515

IRR = 8% – [(6,515)/(1,006,515 – 921,675)] × (10—8)

= 8% + (6,515/84,840) × 2 = 8.15%

PBP Adj. 8% = 9.89 years

Case Exercise 5.3: Project to Construct a bridge across River Ganga—Social Cost–Benefit Analysis

The project was to construct a bridge across River Ganga in Eastern Bihar.

Three alternative modes of transport, road, rail, and direct ferry, already existed.

The road route was quite circuitous; the rail route involved transshipment between broad gauge and meter gauge; a ferry or the LCT (loading craft terminal) involved delays, or extra handlings and the nonavailability of the ferry except at fixed hours and that too during day light hours.

Project proposal analysis involved estimation of financial inflows and outflows.

Analysis of the expected social costs–benefits involved the assessment of the following:

Total annual movement of traffic and cargo—South to North and North to South—both goods and traffic. Commodity-wise traffic was forecast till the 11th year after the opening of the bridge and beyond that benefits were assumed to be constant.

Projection of unsatisfied demand, that is, increase in the movement of goods and service.

Estimation of benefits and costs, that is, inflows and outflows for the expected traffic and also for projected unsatisfied demand.

Estimation of social benefits and costs.

Social benefits were revenues in terms of

Savings in costs resulting from reduction in vehicle operating costs and saving of fuel and road maintenance costs, or

Increase in revenue arising from movement of goods and services like vegetables or milk which earlier were not transported due to their perishable nature.

Social costs arose from increase in unemployment or increase in the level of pollution. For example, bridge constructed reduced the number of ferry plying both ways and that lead to unemployment of certain persons.

Thus IRR on investment was worked out, computing benefits in terms of quantifiable saving in costs to economy by using the proposed bridge.

IRR was calculated for the construction of the bridge at two different locations. Further, for each location, there were four alternatives, namely, for moderate and pessimistic traffic with “no cost overrun” and 10% “cost overrun,” respectively.

In addition, a sensitivity analysis was also carried out taking the existence of another bridge.

Case Studies

Case Study: Tata and AirAsia Airways Project

Tata Group planned to join AirAsia Bhd., Asia’s largest low-fare carrier and a local investor to enter the aviation market. It was 13 years after the Tata’s bid to buy 40 percent stake in Air India in partnership with Singapore Airlines Ltd which collapsed in the face of political and corporate intrigue; Air India originally was founded by Tata Group as Tata Airlines in the 1930s which was nationalized in 1953.

AirAsia is Asia’s largest low-fare carrier with 118 planes and more than 350 on order. Tony Fernandes, founder and group chief executive of AirAsia, an Indian extraction on his father side, evaluated developments in India over the last few years and was of the view that “the current environment is perfect to introduce AirAsia’s low fares, which stimulate travel and grow the market.” Further, AirAsia believed that, “India aviation has enormous long-term growth potential and is expected to produce tremendous upside for first movers.” AirAsia planned to replicate its success in Malaysia, Thailand, and Indonesia and focused on big Asian markets such as India through joint ventures (JVs).

The proposed airlines would be a JV between three parties, namely, Malaysia-based AirAsia, Tata Sons, and Telestra Tradeplace Pvt Ltd. AirAsia would hold 49 percent share, Tata Sons would have 30 percent, and the remaining 21 percent by the third partner. The initial investment in the project is estimated to be $30 to $60 million (Rs. 185–330 crores).

The airline would be managed by AirAsia, and Tata Sons would not have any operating role in the proposed venture. It would be proper to mention that Tata Group owned nearly 6 percent stake in SpiceJet Ltd, India’s second largest low-fare carrier and it was just a financial investment.

Telestra Tradeplace Pvt Ltd headed by Arun Bhatia was associated with AirAsia founder Tony Fernandes at the football club of which Fernandes was the club chairman.

Tata Sons was entering into the proposed venture given the reputed business model of AirAsia and that AirAsia could be a relevant and successful service provider in the domestic market. The domestic market was expected to draw benefits which included (a) AirAsia’s reputed service, which would further grow aviation as a mode of transport in what was a relatively underserved market, and (b) employment generation.

Telestra Tradeplace, the third partner, had a presence in aerospace with a group company called Hindustan Aerosystems Pvt Ltd, which manufactures and supplies precision components for the industry. Arun Bhatia’s son Amit Bhatia served on the board of directors at Queens Park Rangers Football Club in the United Kingdom alongside Fernandes, who was the majority owner of the club.

AirAsia had submitted an application to the Foreign Investment Promotion Board (FIPB) seeking approval to invest 49 percent in the venture. Thereafter, an application would be made by the proposed JV company to the Indian aviation regulators for the air operations permit.

As such, the AirAsia application was the first seeking approval to form a new airline after the liberalization of India’s overseas investment rules in aviation in September 2012 under which overseas airlines were allowed to pick up a stake up to 49 percent in domestic carriers. As per that liberalization policy, United Arab Emirates carrier Etihad Airways PISC was planning to buy a 24 percent stake in Jet Airways (India) Ltd.

The proposed JV planned to operate from Chennai, Tamil Nadu, and would provide domestic tier II/tier III city connectivity to Indian travelers. The focus will be on smaller cities that could handle Airbus SAS A320 operations and not to fly to high-cost airports. The single-plane model would allow the company to keep the costs low. The company won’t consider using smaller 70-seater planes and planned to start with three—four planes and scale up in the future. The company was hiring an all-Indian senior management and would start with about 300 employees. Currently, AirAsia, through its operations based in Thailand and Malaysia, already connects Chennai, Bengaluru, Tiruchirappalli, Kochi, and Kolkata to ASEAN; ASEAN stands for the Association of Southeast Asian Nations. AirAsia already operated 45 flights weekly from India to Kuala Lumpur.

Such associations with foreign airlines were at a time when India’s airline industry was laden with heavy debt and years of accumulated losses, rising costs, and intense competition. It was viewed that “India with its low flyer base, regulatory challenges and high cost structure, cannot afford more than four strong national airlines” and consolidation was expected like that happening in the United States and the European Union.

It was also viewed that the new venture would develop new markets between India and Southeast Asia. To quote, Craige Jenks, president of Airline/Aircraft Projects Inc., a leading New York-based air transport consulting and advisory services firm, “Up to now, Indian private airlines have followed Air India’s footsteps. They see goldmines in Dubai or Singapore, and their strategy is then to get into that already existing gold mine. The mind-set of AirAsia has been 100 percent opposite, and to develop a market where none previously existed. So I don’t think it is primarily an ultra-low-cost attack on what is already there, I think it is probably about creating new markets.”

Though the entry of AirAsia would change the landscape of competition in India, it was not going to be smooth for AirAsia as it enjoyed significant infrastructure advantage, including separate low-cost terminals. Indian market was different as it was facing huge infrastructure shortage and Indian conditions will not be as friendly as those in Malaysia. Further, AirAsia won’t be able to rely just on secondary Indian airports as the airline may not get sufficient passenger traffic.

In this regard, said Prof. Nawal Taneja, professor emeritus at the department of aviation at Ohio State University, “‘One brand, multiple production units is the new trend.’ It started with Lan Airlines in Latin America and then spread to Asia with Air Asia and in Australia with Jetstar. It is the way of the future.” (Source: P.R. Sanjai, Mint February 21, 2013)

Case Study: State Electricity Board Expansion Proposal Project

State Electricity Board, taking advantage of the government economic reforms and the liberalization measures announced, is planning to expand by setting up a gas-based power-generating unit.

The management of SEB has worked out a proposal to expand by adding a gas-based power-generating plant. Building for expansion would cost Rs. 600 lakhs; plant costing Rs. 1,200 lakhs is to be purchased from Bangalore requiring transportation, insurance, and installation expenses of Rs. 50 lakhs each. Working capital requirements are estimated at Rs. 200 lakhs. It is estimated that the pretests and trial run would cost another Rs.500 lakhs; the trial run would yield an output valued at Rs. 150 lakhs.

The unit is likely to operate at 50% in the first 2 years and at 70% thereafter for the remaining life of 3 years. The unit would be operational in the first year and there would be no gestation period. Thus the unit is estimated to have a life of 5 years at the expiry of which it would realize Rs. 800 lakhs.

The plant has an installed capacity to generate 10 lakh units a day which could be sold at an administered price of Rs. 2.00 per unit (assume 300 working days a year).

Estimates for operating cost for the 5 years are as under:

Assignment:

A: Financial Analysis

Estimate project cost

Estimate annual operating costs

Estimate annual operating revenue

Estimate annual inflows and outflows

Suggest possible alternative sources of funds

Evaluate the project and advise on the economic viability of the project

B: Social Cost–Benefit Analysis

For construction of building, the company is getting $6,000 to import cement and steel at control rate. The open market price is 25 percent higher.

The administered price per unit of electricity is Rs. 2 while the market price is Rs. 3 per unit.

The manpower cost at the minimum wage rate is 160 percent of international price.

Sustainability of the Project Over Its Lifetime

Given the future orientation of any project, it would be logical to consider the full lifetime of any project, from its conception to its disposal. It can be argued that when considering sustainability in project management the total life of the project and not just the life-cycle of the project is relevant; for example, if we take a city metro rail project, then we should consider not just the cumulative costs of activities/tasks that form part of launching this project but also the periodic costs of rebuilding/repairing the worn out parts of this asset, namely, stations and escalators. Most developed nations, not having considered this all important dimension before setting up large infrastructure projects in the mid-early twentieth century, are now facing the challenge, funds crunch for replacing/renovating/upgrading their aged infrastructure.

 

1 Based on Chapter 11 of The Practice of Management Accounting by Sastry K S and Dhameja Nand, (Wheeler Publishing 1995).

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