Methods of Project Appraisal

Meaning of Project Appraisal: -

Project Appraisal is the analysis of costs and benefits of a proposed project with a
goal of assuring a rational allocation of limited financial resources amongst alternate
Investment opportunities with the objective of achieving specific goals.

Project Appraisal is mainly the process of transmitting information accumulated

through feasibility studies into a comprehensive form in order to enable the
decision maker undertake a comprehensive appraisal of various projects and
embark on a specific project or projects by allocating resources.

The various Factors considered by Financial Institutions while appraising a

project are: -
Technical, Financial, Economic, Commercial, Social and
Managerial Factors.
 Objectives & Scope: -

 To extract relevant information for determining the success or

failure of a project.

 To apply standard yardsticks for determining the rate of success or

failure of a project.

 To determine the expected costs and benefits of the project.

 To arrive at specific conclusions regarding the project.

 Significance: -

 It helps in arriving at specific and predicted results.

 It evaluates the desirability of the project.

 It provides information to determine the success or failure of a

project.

 It employs existing norms to predict the rate of success or failure

of the project.

 It verifies the hypothesis framed for the project.

Factors Considered while Appraising a Project : -

 Technical Factors
 Financial Factors
 Economic Factors
 Social Factors
 Commercial Factors
 Managerial Factors
Methods of Project Appraisal

METHODS OF
PROJ ECT APPRAISAL

DISCOUNTING NON -DISCOUNTING

CRITERIA CRITERIA

NET PROFIT- INTERNAL ACCOUNTING

PAYB ACK
PRES ENT AB ILITY RATE OF RATE OF
PERIOD
VALUE INDEX RETURN RETURN
 Pay-Back Period Method: -

The Pay-Back Period is the length of time required to recover the initial outlay on
the project Or It is the time required to recover the original investment through
income generated from the project.

Pay-Back Period = Original Cost of Investment____

Annual Cash Inflows or Savings

Pros: - a) It is easy to operate and simple to understand.

b) It is best suited where the project has shorter gestation period and
project cost is also less.
c) It is best suited for high risk category projects. Which are prone to rapid
technological changes.
d) It enables entrepreneur to select an investment which yields quick return
of funds.
Cons: - a) It Emphasizes more on liquidity rather than profitability.
b) It does not cover the earnings beyond the pay back period, which may
result in wrong selection of investment projects.
c) It is suitable for only small projects requiring less investment and time
d) This method ignores the cost of capital which is very important factor
in making sound investment decision.

Decision Rule: - A project which gives the shortest pay-back period, is considered
to be the most ACCEPTABLE

For Example: - If a Project involves a cash outlay of Rs. 2,00,000 and the Annual
Cash inflows are Rs. 50,000, 80,000, 60,000, and 40,000 during its
economic life of 4 years.

Here Pay-Back Period = 3 years + 10,000

40,000

Pay-Back Period = 3 years + 0.25 Or 3 years and 3 months.

 Accounting Rate of Return Method: -
This method is considered better than pay-back period method because it considers
earnings of the project during its full economic life. This method is also known
as Return On Investment (ROI). It is mainly expressed in terms of percentage.

ARR or ROI = Average Annual Earnings After Tax_______ * 100

Average Book Investment After Depreciation

Here, Average Investment = (Initial Cost – Salvage Value) * 1 / 2

Decision Rule: - In the ARR, A project is to be ACCEPTED when ( If Actual ARR

is higher or greater than the rate of return) otherwise it is Rejected
and In case of alternate projects, One with the highest ARR is to
be selected.
Pros: - a) It is simple to calculate and easy to understand.
b) It considers earning of the project during the entire operative life.
c) It helps in comparing the projects which differ widely.
d) This method considers net earnings after depreciation and taxes.
Cons: - a) It ignores time value of money.
b) It lays more emphasis on profit and less on cash flows.
c) It does not consider re-investment of profit over years.
d) It does not differentiate between the size of investments required for
different projects.

For Example: - Project A Project B

Investment 25,000 37,000
Expected Life (In Yrs.) 4 5
Net Earnings (After Dep. & Taxes)
Years
1 2500 3750
2 1875 3750
3 1875 2500
4 1250 1250

If the Desired rate of return is 12%, which project should be selected?

 NPV (Net Present Value) Method: -
This method mainly considers the time value of money. It is the sum of the
aggregate present values of all the cash flows – positive as well as negative – that
are expected to occur over the operating life of the project.

NPV = PV of Net Cash Inflows – Initial Outlay (Cash outflows)

 Decision Rule: -
 If NPV is positive, ACCEPT

 If NPV is negative, REJECT

 If NPV is 0, then apply Payback Period Method

 The standard NPV method is based on the assumption that the intermediate
cash flows are reinvested at a rate of return equal to the cost of capital. When
this assumption is not valid, the investment rates applicable to the intermediate
cash flows need to be defined for calculating the modified NPV.
 Pros and Cons of NPV: -

Pros: -
a) This method introduces the element of time value of money and as such is a
scientific method of evaluating the project.
b) It covers the whole project from start to finish and gives more accurate
figures
c) It Indicates all future flows in today’s value. This makes possible comparisons
between two mutually exclusive projects.
d) It takes into account the objective of maximum profitability

Cons: -
a) It is difficult method to calculate and use.
b) It is biased towards shot run projects.
c) In this method profitability is not linked to capital employed.
d) It does not consider Non-Financial data like the marketability of a product.
For Example: -
Initial Investment – 20,000
Estimated Life – 5 years
Scrap Value – 1000 XYZ Enterprise’s Capital Project
Year Cash flow Discount factor Present Value
@10%  
1 5.000 0.909 4545
2 10,000 0.826 8260
3 10,000 0.751 7510
4 3,000 0.683 2049
5 2,000 0.621 1242
5 1,000 0.621 621
PV of Net Cash Inflows = 24227
NPV = PV of Net Cash Inflows – Cash Outflows
= 24227 – 20,000
NPV = 4227
Here, NPV is Positive (+ ve) The Project is ACCEPTED.
 Profitability Index Method: -
Profitability Index is the ratio of present value of expected future cash inflows
and
Initial cash outflows or cash outlay. It is also used for ranking the projects in order
of their profitability. It is also helpful in selecting projects in a situation of capital
rationing. It is also know as Benefit / Cost Ratio (BCR).

PI = Present value of Future cash Inflows

Initial Cash Outlay

Decision Rule: - In Case of Independent Investments, ACCEPT a Project If a PI is

greater ( > 1 ) and Reject it otherwise.
In Case of Alternative Investments, ACCEPT the project with
the
largest PI, provided it is greater than ( > 1 ) and Reject others.
Pros: - a) It is conceptually sound.
b) It considers time value of money.
c) It Facilitates ranking of projects which help in the selection of projects.

Cons: - a) It is vulnerable to different interpretations.

b) Its computation Process is complex.

For Example: - In Case of Above Illustration: -

Here PI = Present Value of Cash Inflows

Present Value of cash Outflows
= 24227
20000
PI = 1.21
Here, The PI is greater than ONE ( > 1 ), so the project is accepted.
IRR (Internal Rate of Return) Method: -
This method is known by various other names like Yield on Investment or Rate of
Return Method. It is used when the cost of investment and the annual cash inflows
are known and rate of return is to be calculated. It takes into account time value of
Money by discounting inflows and cash flows. This is the Most alternative to NPV.
It is the Discount rate that makes it NPV equal to zero.

In this Method, the IRR can be ascertained by the Trial & Error Yield Method,
Whose the objective is to find out the expected yield from the investment.

Bigger Smaller
= Smaller discount rate + NPV @ Smaller rate X discount – discount
Sum of the absolute values of the rate rate
NPV @ smaller and the bigger
Discount rates
Decision Rule: - In the Case of an Independent Investment, ACCEPT the project if
Its IRR is greater than the required rate of return and if it is lower, Then
Reject it. In Case of Mutually Exclusive Projects, ACCEPT the project with the
largest IRR, provided it is greater than the required rate of return &
Reject others.

Pros: - a) It considers the profitability of the project for its entire economic life and
hence enables evaluation of true profitability.
b) It recognizes the time value of money and considers cash flows over
entire life of the project.
c) It provides for uniform ranking of various proposals due to the
percentage rate of return.
d) It has a psychological appeal to the user. Since values are expressed in
percentages.

Cons: - a) It is most difficult method of evaluation of investment proposals.

b) It is based upon the assumption that the earnings are reinvested at the
Internal Rate of Return for the remaining life of the project.
c) It may result in Incorrect decisions in comparing the Mutually Exclusive
Projects.
 NPV Vs IRR
 It is calculated in terms of  It is expresses in terms of the
currency. percentage return.
 It recognizes the importance of  It does not consider the market
market rate of interest or cost of rate of interest.
capital.  The PV of cash flow are
 The PV is determined by discounted at a suitable rate by hit
discounting the future cash flows & trial method which equates the
of a project at a predetermined present value so calculated the
rate called cut off rate based on amount of investment.
cost of capital.  In this, intermediate cash inflows
 In this, intermediate cash flows are presumed to be reinvested at
are reinvested at a cutoff rate. the internal rate of return.
 Project is accepted, If NPV is +  Project is accepted, if r > k.
ve
 Assessment of NPV & IRR Method
NPV IRR
Theoretical Considerations: -
a) Does the method discount all cash Yes Yes
flows?
b) Does the method discount cash flows Yes No
at the opportunity cost of funds?
c) From a set of M.E. Projects, does the
method choose the project which
maximizes shareholder wealth? Yes No
Practical Considerations: -
a) Is the Method Simple? Yes Yes
b) Can the method be used with limited
information? No No
c) Does the method give a relative measure? No No