Financial Techniques for Project Appraisal and Feasibility

[Link] cash flow (modern) methods

The time adjusted or discounted cash flow methods take into account the time value of money
for evaluating the profitability of investment proposals.
[Link] Present Value Method
Net present value is the difference between present value of cash inflows and present value of
cash out flows. The following are the important steps involved in the computation and ranking of
investment proposals.
[Link] an appropriate rate of return that should be selected as minimum required rate of
return called cut off rate or discount rate.
B. Compute present value of cash outflows. If the investment is made in the initial years, the
present value of cash outflow is equal to the cost of investment.
[Link] present value of cash inflows. For computing present value of cash inflows the cash
flow concept of profit is (net profit after tax but before depreciation) is taken into account.
[Link] NPV is positive or zero, project is accepted and if NPV is negative, project is rejected.
[Link] Net present value by deducting present value of cash outflows from present value of
cash inflows
[Link] case of mutually exclusive projects, investment proposals having higher NPV preferred than
other
Advantages
[Link] method considers time value of money.
[Link] computing NPV earnings of entire life period is considered.
[Link] method matches with the objective of wealth maximisation.
Limitations
1 It is difficult to use.
[Link] is not easy to determine an appropriate discount rate.
[Link] may not give good results while comparing projects with unequal lives.
ii. Internal Rate of Return
Internal rate of return is a modern technique of capital budgeting which takes into account the
time value of money. This method is popularly known as Time Adjusted Rate of Return Method
or Discount Rate of Return Method. Internal Rate of Return is defined as that rate which
equates discounted cash inflows with discounted cash outflows.
Merits
[Link] recognises the time value of money and considers cash flows over the entire life of the
project.
2. The calculation of cost of capital is not a pre condition for the use of this method.
[Link] is also consistent with the firm's objective of maximising owner's welfare.
[Link] Considers the profitability of the project for its entire life
[Link] provides for uniform ranking of various proposals due to the percentage rate of return.
Limitation Pay
[Link] method is time consuming as the computation involves complicated steps.
[Link] is difficult to understand and is the most difficult method of evaluation of investment
proposals.
[Link] may yield multiple rates when cash outflows take place at different time periods. This will
make decision making more complicated.
[Link] may yield inconsistent results with NPV if the projects differ in their expected lives, or cash
flows or timing of cash flows.
iii. Profitability Index Method (Benefit Cost Method)
Profitability index method is also a time adjusted method for evaluating investment proposals.
Profitability index is also known as benefit cost method or desirability factor. This is a variant of
the net present value method. Profitability Index is the relationship between present value of
cash inflows and present value of cash outflows.
[Link]-discounted Cash Flow (Traditional) Methods
Non-discounted cash flow methods are methods which are employed for evaluating project in
which various proposed projects are ranked without considering the time value of money. The
various methods used under non-discounted cash flow methods are:
Pay Back Period
Pay back period is otherwise called as payout period or pay off period. Pay back period is the
time period required to recover or recoup the initial investment in a project. It refers to the time
required for generating sufficient cash inflows for the recovery of investment made in a project.
Advantages
[Link] method is simple to apply and easy to understand.
[Link] concept is particularly useful where liquidity is an important consideration.
[Link] terms of risk and uncertainties, pay back period method gives better results.
[Link] saves cost, it requires lesser time and labour as compared to other methods.
[Link] is an adequate measure for firms with very profitable internal investment opportunities.
[Link] method is very useful in evaluating those projects which involve high uncertainty.
Limitations
[Link] method does not consider the earnings of the entire life period for computing pay back
period.
2. It does not consider the time value of money
[Link] overemphasises liquidity.
4. The method is delicate and rigid.
[Link] treats each asset individually in isolation with the other assets.
[Link] ignores capital wastage and economic life by restricting consideration to the project' gross
earnings.
[Link] overlooks the cost of capital
Improvement to Pay Back Period
Posts Pay back Profitability Index
One of the serious limitations of pay back period method is that it does not take int account the
cash inflows earned after pay back period ad hence true profitability of the project cannot be
assessed.
Posts pay back Reciprocal Method
Posts pay back Reciprocal Method is employed to estimate the internal rate of return generated
by the project.
Post Pay back Period Method
Post pay back period method takes into account the period beyond the pay back period. This
method is otherwise termed as Surplus life over pay back period. According to this method,
project having longer pay back period is given preference.
Discounted Pay back Period
One of the serious limitations of pay back period method is that it does not consider the time
value of money. Hence, to overcome this limitation discounted pay back period method was
developed.
Rate of Return Method
Rate of return method is a traditional method used for evaluating long term investment
proposals. In this method the entire earnings expected from the investment over their lifetime is
taken into consideration and the proposals are ranked according to their expected return on
investments.
Average Rate of Return Method
In this method, a project is evaluated on the basis of profits computed as per accounting
concept. A rate of return based on investment is computed which is called Average Rate of
return of Return or ARR.
Advantages
1. The method is more simple and easy to understand.
2. Earnings of the entire life period is considered.
3. As this method is based on accounting concept of profit,
Limitations
1. The method does not consider time value of money.
2. This method is not suitable for ranking the projects with different life spans.
3. Adoption of different conceptual methods for computing accounting profits and investment
make this method more ambiguous.
4. It does not take into consideration the cash flows which are more important than the
accounting profits.
Return on Investment Method
This method is small variation of average rate of return. In this return on investmen is calculated
by dividing total profit by total investment.
Return on Average Investment Method
In this method, return on average investment is calculated for evaluating investmen proposals.
It establishes the relationship between total profits and average investment.
Average Return on Average Investment Method
This is the most appropriate method of rate of return method used for evaluating investment
proposal. In this method rate of return is calculated by dividing average profits by average
investment.
Economic Rates of Return
Economic Rates of Return (ERR) is a measure of the economic benefits from a project
compared to its economic costs. It is a rate calculated from the cash flow of an investment that
measures the profitability of the investment. ERR takes into account the effects of factors.
Non-financial Justification of Project Appraisal
Project Justification is a process that starts at the Project Initiation phase to explain why an
organization needs to implement a particular solution to a problem and how it can be
implemented.
Steps in Project Justification
1. Proposing a solution to the problem related to the business environment.
2. Determining alternatives or options to the proposed solution.
3. Analyzing costs, benefits, impacts, and risks of the proposed solution.
4. Validating the solution.
5. Getting the project ready for feasibility study.
Steps Factors to Justify the Non-financial Aspects of Project Appraisal
1. Social Cost Benefit Analysis (SCBA): Social Cost Benefit Analysis is the assessment and
analysis of the indirect effects resulting from the implementation of a project Such analysis is
different from the normal financial justification of the project.
2. Environmental Analysis: When a project initiator plans for project justification, he needs to
perform an environmental analysis that aims to examine the business environment.
[Link] Proposal: The project initiator uses the results of the environmental analysis to
determine areas requiring improvement. It actually means generating a solution that can resolve
the current issues and address future possible difficulties.
[Link] Analysis: The initiator should review all possible alternative options to the
proposed solution and prove the appropriateness of the selected solution.
[Link] Analysis: Impact analysis is done to explain how the proposed solution can affect the
business environment. The analysis aims to identify all significant and relevant impacts-
positive, negative or neutral and measures them in concrete. operational terms.
[Link] Analysis: It is an assessment of threats and uncertainties that have a negative impact to
the business organization and its environment, as a result of the project and solution
implementation.