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Chapter 13 – Project Appraisal

1. Internal Investment > Present Cost = Internal Development.

2. This chapter is about evaluation of investment “within” the business.

3. CBA and then conscious or subconscious evaluation of decision must be done.

4. Financing of Capital Expenditure is treated separately.

5. ORAGANISING INVESTMENT DECISION :-

a. Investment requirements according to the particular needs :-

i. Asset Replacements

ii. Cost Savings

iii. Expansion

iv. Reactive Investment

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6. Managerial Responsibility :

a. Flows top to bottom.

b. Each position has “cut-off” levels; amount corresponds to given levels of authority/seniority.

7. [pic]

8. Financial Variables of a Project :

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9. Important!! : Techniques for Project Appraisal are useless without “GOOD QUALITY DATA”.

10. Assessing the Quality of Data

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11. PROJECT APPRAISAL TECHNIQUES :

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a. Payback Period :

i. Calculated with reference to cash flow data.

ii. Time it takes for “Cash Savings” to equal “Capital Outlay”.

iii. Payback Period = Capital Outlay / Net Cash Flow = (x) years

iv. If Payback Period does not occur at the end of year, then you need to calculate the “Cumulative to Payback” process.

v. Example :

|Capital Outlay |-15000 |  |  |

|  |  |  |  |

|  |Annual |Annual to Payback |Cummulative to Payback |

|Year 1 |7000 |7000 |7000 |

|Year 2 |4000 |4000 |11000 |

|Year 3 |3000 |3000 |14000 |

|Year 4 |2000 |1000 |15000 |

|  |  |  |  |

|Payback Period |3 years in full |AND |  |

|  |0.5 |i.e. 1000/2000 for year 4 |  |

|  |  |  |  |

|So, Pay back period |3.5 years |  |  |

vi. Project Appraisal’s main aim is to find out which project should be selected from number of competing projects.

vii. Payback Period :

1. Positive: simple, easy to understand and implement.

2. CRITIC: does *not* take the “time value” for money i.e. inflation etc..

b. ACCOUNTING RATE OF RETURN : (ARR)

i. Calculated using the “Project’s Profit”

ii. Data relating to the whole life of project is required.

iii. Formula :

1. ARR : Avg. Annual Profit / Capital Outlay X 100

iv. Example :

|ARR |  |  |  |  |  |  |

|  |Project A |Project B |Project C |Project D |  |  |

|A - Total Net Cash |17000 |30000 |10000 |30000 |  |  |

|Inflow | | | | | | |

|B- LESS : Capital |15000 |18000 |10000 |18000 |  |  |

|Outlay | | | | | | |

|C- Total Profit :(A-B)|2000 |12000 |0 |12000 |  |  |

|Project Life |5 |5 |2 |5 |  |  |

|Avg annual Profit |400 |2400 |0 |2400 |  |  |

|(C/D) | | | | | | |

|  |  |  |  |  |  |  |

|  |  |  |  |  |  |  |

|ARR |Avg Annual Profit / Capital Outlay |  |  |  |  |  |

| |X 1000 | | | | | |

|  |  |  |  |  |  |  |

|  |2.666667 |(i.e. 0.4 million / 15 million X 100 for |  |  |  |  |

| | |Project A) | | | | |

|OR |2.7 |% |Project A |  |  |  |

|  |13.33333 |  |  |  |  |  |

|OR |13.4 |% |Project B |  |  |  |

|  |  |  |  |  |  |  |

|  |13.33333 |  |  |  |  |  |

|OR |13.4 |% |Project C |  |  |  |

v. ARR :

1. CRITIC :

a. Fails to take time value of money.

b. Ambiguity in accounting rate of return.

12. The principle of “DISCOUNTING”

a. Compounding

b. Discounting

c. Use the factor table to compound or discount the future cash flows.

d. In order to calculate NPV (Net Present Value), PI (Profitability Index) or Discounted Payback Period, the relevant DCF (Discounting Factor) must be known. (Refer to the Annuity Tables)

e. DCF must be company’s required rate of return. (HURDLE RATE)

f. HURDLE RATE = Company’s Cost of Capital OR Project’s Breakeven Point.

g. If HURDLE RATE > Return, then it will decrease the business value

h. If HURDLE RATE < Return, then it will increase the value of business.

i. Capital invested through DEBT, is always calculated “after Tax”.

j. Dividend Payments are paid using the “After Tax” profits.

13. NPV (Net Present Value)

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a. Example

|NPV | | | |

| | | | |

|Project Name |Project B | | |

| | | | |

|Year |Annual CF (10%) |DCF(refer annuity tables) |Present Value i.e. |

| | | |(Col 1 X Col 2) |

|1 |6000 |0.909 |5454 |

|2 |6000 |0.826 |4956 |

|3 |6000 |0.751 |4506 |

|4 |6000 |0.683 |4098 |

|5 |6000 |0.621 |3726 |

|Present Value of Cash | | |22740 |

|LESS : Capital Outlay | | |18000 |

|NPV | | |4740 |

14. Discounted Payback

a. Definition: The discounted annual flows are used and accumulated until their SUM equals the “Capital Outlay”.

b. Example :

|Discounted Payback | | | |

| | | | |

|Capital Outlay |-18000 | | |

| | | | |

|Year |Annual |Annual to Payback |Cumulative to Payback |

|1 |5454 |5454 |5454 |

|2 |4956 |4956 |10410 |

|3 |4506 |4506 |14916 |

|4 |4098 |3084 |18000 |

| |  | | |

| | | | |

|Discounted Payback |3.75 | | |

| | | | |

|Decimal calculation |0.752562225 |i.e. 3084/4098 | |

15. Profitability Index:

a. Is a ratio which relates the present value of the “cash inflows” from a project to its capital outlay,

b. Formula :

i. Cash Inflow (Present Value after discount) / Capital Outlay

c. Example :

|Profitability Index | | | | |

| |Project A |Project B |Project C |Project D |

| | | | | |

|Present Value (Cash Inflows) |13907 |22740 |8675 |22021 |

|Capital Outlay |15000 |18000 |10000 |18000 |

|P.I. |0.93 |1.26 |0.87 |1.22 |

| | | WINNER !! | | |

Project B covers the cost of project once and gives 26 % profit as a bonus !!

16. Internal Rate Of Return (IRR)

a. If IRR > Cost of Capital , then the project is acceptable

b. At IRR, the NVP is 0 (zero)

c. CRITIC : it may be impossible to provide a clear solution to projects that have irregular cash flows.

d. Formula : d1 + [(n1 + n2) X s]

i. S = (d2-d1) (higher DCF)

ii. D1 = lower dcf

iii. N1 = NVP at lower DCF

iv. N2 = NVP at higher DCF

e. Example :

|Year |Cash Inflow |DCF (18%) |Present Value |DCF (21%) |Present Value |

| | | | | | |

|1 |6000 |0.847 |5082 |0.826 |4956 |

|2 |6000 |0.718 |4308 |0.683 |4098 |

|3 |6000 |0.609 |3654 |0.564 |3384 |

|4 |6000 |0.516 |3096 |0.467 |2802 |

|5 |6000 |0.437 |2622 |0.386 |2316 |

|Present Net Cash Flow | |18762 | |17556 |

|Less : Capital Outlay | |18000 | |18000 |

| | | |762 | |-444 |

17. Annuity Tables

a. Instead of calculating “DCF” over the years, you can obtain arithmetical tables which give cumulative “DCF” over a specific period.

b. Example : To find out “total present value” of $100 over 10 years either we could take above mentioned road in prev. tables OR we can multiply $100 by the tables OR we can multiply $100 by the “Cumulative discount factor” from annuity tables.

c. CRITIC : only used when annual cash flows are equal.

18. Minimum Annual Savings:

a. Capital Outlay / cumulative discount factor

19. Maximum Capital outlay:

a. Annual Savings X CDF

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