Chapter 4: PROJECT

APPRAISAL

The specific objectives of this topic is to:

1. Define Project Appraisal
2. Explain the features of capital budgeting
3. Discuss the steps in capital budgeting
4. Evaluate projects using both the discounted and the non-discounted methods
5. Explain the advantages and disadvantages of the discounted and the non-discounted
methods.
6. Understand multi-criteria decision making process
7. Discuss the uncertainty and Risks in Project Appraisal
8. Discuss participation in project appraisal.
9. Understand computer applications in project appraisal

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INTRODUCTION
Resources are limited. All organizations have to
make choices regarding the allocation of human and
financial resources for project investments. The
appraisal process covers four general situations.
First is where a single project is being proposed and
appraised. Development Banks and large companies
undertake this type of analysis all the time. The
investment funds are available. The appraisal simply
helps determine if the investment is viable, usually
according to quantitative financial criteria.

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A second case is where an organization has different
competing projects for investment and inadequate resources
to do them all. The projects are not mutually exclusive; if
sufficient funds were available, all the projects could be
completed. Investing in one project would not preclude
investing in others. An example would be a mining company
with a portfolio of 15 capital investment projects at the
beginning of the financial year and insufficient funds to invest
in all of them. The projects could include buying new drilling
machinery, setting up a new computer system, or pursuing
joint ventures with smaller mining companies to increase ore
reserves. Each project can be appraised and then compared
in terms of standard financial criteria. The projects can then
be ranked with investment funds allocated to the projects in
order of priority.
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A third case is where projects are mutually exclusive.
For example, with a given area of bare land, an
investor must choose between forestry, agriculture or
perhaps urban development. Selecting one option
precludes the other. Each project is appraised
individually and compared.

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A fourth case is where a project has already been
selected (for political reasons usually) and the appraisal
is used to help determine the best method of
implementation. This situation is very common in
developing countries. Six general steps are recognized
in analyzing an investment (or appraising a project)
using quantitative methods:
Ensure that clear project goals address broader
strategies and policies;
Identify, quantify and schedule inputs and outputs
(costs and benefits);
Assign values to them and prepare cash flows (- and +);
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Definition of Project Appraisal
Project Appraisal is a consistent process of reviewing a
given project and evaluating its content to approve or
reject this project, through analyzing the problem or
need to be addressed by the project, generating solution
options (alternatives) for solving the problem, selecting
the most feasible option, conducting a feasibility
analysis of that option, creating the solution statement,
and identifying all people and organizations concerned
with or affected by the project and its expected
outcomes.
It is an attempt to justify the project through analysis,
which is away to determine project feasibility and cost-
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Capital Budgeting
Capital budgeting involves commitment of current
funds / cash / capital in long-lived assets in order to
generate benefits over a series of years in future. It
also entails planning of capital expenditure in order
to achieve the long-term goals of a firm. The amount
of money committed to a long-term asset or project
is usually large and is called the initial cash / capital
outlay.

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 Features / Characteristics of Capital Budgeting
They involve significant or high amount of initial cash
outlay.
Investment decisions are irreversible. This is because of
the specialized nature of the assets, which are acquired.
Investment decisions involve a lot of uncertainty and risk
due to the unreliability of the estimates pertaining to the
future benefits.
There is significant time lag between commitment of
capital (initial cash outlay) and the receipt of the benefits
from an investment i.e. the benefits are not realized at
once.
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Investment decisions usually overstretch the ability of the
management since they demand awareness of all relevant
factors which are likely to affect long lived investments e.g.
economic conditions, political changes, social changes,
technological trends and competitive factors.
The limited financial resources available for investment
purposes require prioritization by the management.
Benefits / cash flows are received over a series of years.
There is need to have priorities in commitment of resources
in long term projects

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 Examples of types of capital budgeting decisions
(projects)
The different types of projects / investments can be classified
as follows:
Acquisition
This involves the purchase of a completely new asset where
none existed e.g. the purchase of a new machine, vehicle,
putting up of a new building etc for the first time.
Replacement and modernization
This involves replacing an old and inefficient asset with a
completely new one, which is more efficient. Replacement
can be identical or an unidentical.
Expansion and diversification
This involves addition of new investments to already existing
ones. This occurs due to inadequacy of the existing facilities,
e.g. putting up an additional ward in a hospital.
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Other classification of projects
Mutually exclusive projects
They are projects, which are substitute or alternative of each
other. They compete against each other. If one is undertaken,
the other is rejected e.g. a decision on whether to acquire a
minibus or a Nissan.
Contingent projects
These are projects, which depends on each other. If one is
undertaken, the other has to be undertaken.
Independent projects
These are projects, which serve different purposes. They do
not compete against each other. The benefits derived from
one project are not whatsoever affected by the benefits of the
other projects. Both projects can be undertaken subject to
availability of capital within the firm.

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 Factors to consider in capital budgeting decisions
The amount of initial cash outlay of each available
alternative project.
The economic life of the project.
Any additional operating or working capital requirements
due to acquisition of a new asset to replace the old one.
How the capital expenditure relating to a project will be
phased out e.g. how would the initial cash outlay be
incurred. Is it at once or in phases?
The effects of any project undertaken on the continuity of
the firm.
The amount and timing of the expected future benefits
from a project.
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 Problems encountered by managers when carrying out
investment decisions.
Managers are likely to face numerous problems when making
investment decisions.
These problems are:
i. Inadequate information
ii. Search for investment opportunity in the appropriate
environment e.g. use of the right technology for a particular
project and not another.
iii.Estimation of the future benefits or cash flows from the
project – investment decisions extend far into the future,
which is uncertain.
iv.Evaluation of projects using appropriate technique / method
which is acceptable
v. Selection of the project using an approach / method which
meets all the features of a sound investment appraisal
technique.
vi.Continuous evaluation and assessment of the project once
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it
 Steps in capital budgeting
The following steps are followed in capital budgeting:
 Generation of investment proposals
 Estimation of expected future cash flows
 Evaluation of the project
 Selection and implementation of the project
 Replacement decision

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 STEP 1: Generation of investment proposals

Investment proposals or ideas can be generated

from internal or external sources. Internal sources
might include the various departments while
external sources include competitors, suppliers,
customers, the government etc.

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 STEP 2: Estimation of expected future cash
flows

Profits refer to the earnings after tax of a project

(accounting profits). Profits do not distinguish
between cash and non-cash expenses e.g. provision
for depreciation and bad debts are non-cash items.
Therefore, once the accounting profits have been
determined, non-cash items have to be added back in
order to derive the cash flows of a project. The
following standard schedule is used to determine the
cash flows of a project.

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 Sales revenue XXX
Add Savings in operating expenses (if any) XX
Total revenue XXX
Less Operating expenses (if any) (XX)
Earnings before interest, depreciation and tax (EBIDT) XXX
Less Interest expense (if any) (XX)
EBDT XXX
Less Provision for depreciation (XX)
EBT XXX
Less Tax (XX)
EAT (accounting profits) XXX
Add back depreciation charges XX
Net cash flows XXX

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 NB: depreciation is a non-cash item which is tax deductible / allowable. It is thus deducted by
taxing the income and then added back to accounting profits for it to have zero effect on amount
of cash flows.

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 STEP 3: Evaluation of the project
The evaluation of the project involves carrying out
the cost benefit analysis using the various
evaluations or appraisal techniques or methods
available. The various investment alternatives
available are evaluated to determine whether to
accept or reject them. The various project evaluation
techniques are broadly classified into two:
 Non-discounted cash flow methods – do not
consider the time value of money.
 Discounted cash flow methods –considers the
time value of money

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 STEP 4: Selection and implementation of the
project
Once the various projects available have been
evaluated, the one with the highest net benefit is
selected / accepted and then implemented. The
acceptability of a project depends on the investment
appraisal technique used in evaluation.

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 STEP 5: Replacement decision
Once the economic life of a project has come to an
end, the investor has to replace it with a new project.
There are two types of replacements:
 Identical replacement: where an old asset is
replaced with a similar one.
 Non-identical replacement: where an old asset is
replaced with a completely dissimilar asset.
Identical replacement involves a decision on how
often an asset should be replaced while non
identical replacement involves a decision on when
an asset should be replaced.
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 Project Evaluation / Appraisal Methods /
Techniques
The various project evaluation techniques are broadly
classified into two:

Non-discounted cash flow methods

These methods ignore the concept of the time value of
money. They ignore the magnitude and timing of the cash
flows. They assume that the value of money does not
change over time. These methods include:
i. Pay-back period method
ii. Accounting rate of return

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Discounted cash flow methods

These methods consider the time value of money by

computing the present value (discounting) of the expected
future cash flows of a project.
They are usually consistent with the goal of shareholders
wealth maximization. They include:
i. Net present Value (NPV) method
ii. Profitability Index (PI) method
iii.Internal Rate of Return (IRR)
iv.Discounted pay back period.

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 Features of a sound investment appraisal method /
technique
The most appropriate evaluation technique or method should
have the following characteristics / features. It should:
 Use all the cash flows of the project in evaluating
 Consider the time value of money
 Be consistent with the goal of shareholder wealth
maximization.
 Distinguish between two or more mutually exclusive
projects and should rank them in order of their economic
viability.
 Distinguish between acceptable and unacceptable projects
to the firm.
 Applicable to any conceivable project independent of all
other projects.
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 Non-Discounted Cash Flow Methods

i. Pay back period method

This refers to the length of time it will take to recover or
recoup the initial cash or capital outlay committed to the
project. The recovery of initial cash outlay is from the cash
flows generated from the project. Pay back period indicates
the length of time, which 1 the net committed funds should not
Pay back reciprocal 
exceed. * 100
pay back period

The pay back reciprocal in percentage indicates the rate at

which the initial cash outlay is being recovered per annum.

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Example 1
•Mater hospital has a 5 year project with a zero salvage value
which is expected to generate the following cash flows:
The initial cash outlay of the project is Sh. 1,000,000.
Determine the period, which the net commitment of funds
should not exceed. Compute the payback reciprocal in
percentage.
Year 1 2 3 4 5

Cash flows (in Sh’ 000. 200 250 300 250 150

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 Solution
Year Cash flows
Accumulated cash flows
1 200,000
200,000
2 250,000
450,000
3 300,000
750,000
4
The payback reciprocal 250,000
1,000,000 1
5  * 100150,000
1,150,000 payback period
1
The payback period * 100
is 4 25
years
%
4

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Example 2
ABC Ltd has a 4-year project whose initial cash
outlay is Sh. 500,000. The project will generate the
following cash flows:

Compute the payback period and the payback

reciprocal
Year in percentage. 1 2 3 4

Cash flows (in Sh’ 000) 120 160 200 150

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