Faculty Development Programme on Project Financing

Session II :

Financial Appraisal of Projects

Dr. Manvinder Singh Pahwa
Associate Professor and Head, Department of Accounting and Finance, College of Management Studies, University of Petroleum and Energy Studies, Dehradun mspahwacs@gmail.com

Project Appraisal
Market Appraisal

Technical Appraisal

Project Appraisal

Management Appraisal

Financial Appraisal

Project Appraisal
Market Appraisal

Technical Appraisal

Project Appraisal

Management Appraisal

Financial Appraisal

Financial Appraisal
Financial appraisal of a project is to work out the financial feasibility. In other words, financial appraisal of a project means assessing whether a project is profitable for the business concern or not.

Financial Appraisal : Certain Aspects

The following aspects are considered to understand the financial health of a project proposal.

Past working results. (B/S, Income statement, CFS, Ratio Analysis) Cost of Project (Initial Investment) Sources of funds (Financing and Costs) Future projections of cash flow to be generated.

B/S: The past financial statements are a useful source of assessment of financial performance of companies. The Balance sheet reveals the Assets, Liabilities of the firm. P/L: The Income statement reflects the revenue expenses and income of the company. The difference between the total expenses and total income gives the net profit/loss for the firm. CFS : Cash flow statement reveals the cash generation capacity of the firm. Ratio analysis : Different ratios like leverage ratios, liquidity, activity ratios and profitability ratios help in assessment of the performance, efficiency and productivity of the company.

Capital Cost of Project

Land and site development Buildings Plant and Machinery Imported Indigenous Technical know-how fees Expenses on foreign technicians and training of India technicians abroad. Miscellaneous fixed assets Preliminary and preoperative expenses Provision for contingencies Margin money for working capital

Sources of Project Financing

Capital/Equity Term loans/Institutional loans Issue of Debentures Unsecured loans from promoters Retained earnings Government support and subsidy.

Cost of Capital of Project

The Cost of Capital of a Project is the Weighted Average Cost of various sources of finances associated with it. This is important because this provides for the cut off rate of a project. In other words, it means the minimum required rare of return which a project must generate in order to be feasible.

Future Cash Flows

The estimation of future cash flows for a project is one of the most important and difficult steps in financial appraisal of a project. If future cash flows are not determined and estimated correctly then the profitability of the project proposal(s) cannot be estimated correctly. Therefore it is required that the future cash flows be estimated considering the risk and uncertainty associated with it.

Future Cash Flows

The estimation of future cash flows for a project is one of the most important and difficult steps in financial appraisal of a project. If future cash flows are not determined and estimated correctly then the profitability of the project proposal(s) cannot be estimated correctly. Therefore it is required that the future cash flows be estimated considering the risk and uncertainty associated with it.

Features of Investment Decisions

Exchange of current funds for future benefits. Investment in Long Term assets. Future benefits will occur to firm over series of years. Irreversible decision. Involvement of huge risk. Large amount of funds are required

Determination of Cash Inflows

PBT (After Dep.) Less Tax PAT Add: Depreciation CASH INFLOWS ----------------

Techniques of Investment Appraisal

Non Discounted Cash Flow Techniques Discounted Cash Flow Techniques

Pay Back Period

Accounting Rate of Return

Net Present Value (NPV)

Profitability Index (PI)

Internal Rate of Return (IRR)

Non Discounted Techniques of Financial Appraisal

Pay Back Period (PBP)

PBP is the period in which the investment (cash out flow) made on a project or a machine is paid back in the form of cash inflows generated by that project. PBP = Initial Investment Annual Cash Inflow

Decision Criterion : Less the PBP better it is.

Example
The cash inflows of two projects having equal initial cash outflow of Rs. 1,00,000 are given as follows: Yr.
1.

2.
3. 4. 5.

Project X (Rs.) Project Y(Rs.) 20,000 25,000 20,000 25,000 30,000 50,000 30,000 20,000 50,000 10,000 Calculate Pay Back Period and evaluate the project which is better.

Answer

Project Y will be selected as it is having less payback period being 3 years as compared to Project X having 4 years payback.

Post Pay Back Period Profitability

The profitability of a project after the pay back period is called post pay back period profitability. Calculate PBP profitability in the previous question

Calculate PBP profitability in the previous question

Answer

Project X: Rs. 50,000

Project Y: Rs. 30,000

Average Rate of Return (ARR)

This is also called return on investment or return on capital employed. This method employs normal accounting technique to measure the increase in profit expected to result from an investment.
ARR = Average Annual Profit After tax and Dep. Average Investment

Decision Criterion : Accept if ARR more than minimum rate otherwise reject

Non Discounted Techniques of Financial Appraisal

Net Present Value Method (NPV)

The cash generated in future are not equivalent to the initial cash invested by a firm at present. The reason for this is nothing but the interest factor. NPV method over-comes this defect and makes the initial cash outflow and subsequent cash inflows comparable. NPV is obtained by discounting all cash inflows attributable to a capital investment project by a rate i.e., WACC.

NPV Continued.
R1 R2 R3 Rn + + + NPV = (1+I)1 (1+I)2 (1+I)3 (1+I)n
MINUS
Where,
R = Cash Inflows at different preiods I = Cost of Capital or Cut Off Rate

Initial Investment

n = No. of Years of Cash inflows

Decision Criterion : Accept if NPV is Positive, Reject if NPV is Negative

Profitability Index
PI = Present Value of Future Cash Inflows Present Value of Cash Outflows
This method makes two projects comparable in which there is difference in the amounts of initial investment.

Problem
From the following estimate which machine is better for the company:
Machine Cost Yr.1 Yr.2 Yr.3 Yr.4 Yr.5 A 25 L -5L 20L 14L 6L B 40 L 10L 14L 16L 17L 8L Cost of Capital = 16%. Life of both machines = 5 Years. Evaluate the proposal using (i) PBP (ii) NPV (iii) PI

Answers
S.No. Particulars
1. 2. 3.

Machine 1 3 Years Rs. 2.119L 1.085

Machine 2 3 Years Rs. 2.47L 1.062

PBP NPV PI

Internal Rate of Return (IRR)

IRR of a project is defined as the discount rate which produces a zero NPV. In other words, IRR is the discount rate which will equate PV of Cash Inflows to PV of Cash Outflows. In this technique, the time schedule of occurrence of the future cash flows is known but the rate of discount is to be calculated, which can be done by trial and error method.

Thanks
Manvinder Singh Pahwa
Mobile: 093525 01090 (Rajasthan) Mobile: 099868 73977 (Karnataka) email: mspahwacs@gmail.com