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Methods of Project Appraisal

The document discusses various methods used to appraise capital investment projects, including: 1) Payback period - the time taken for cash inflows to repay initial cash outflows. Shorter payback periods are preferred. 2) Accounting rate of return (ARR) - expresses profit as a percentage of average investment. Higher ARRs are preferred. 3) Discounted cash flow methods - consider time value of money. These include net present value (NPV), profitability index (PI), and internal rate of return (IRR). Projects with positive NPV, PI>1, and IRR>cost of capital are preferred.

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Mîñåk Şhïï
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97 views28 pages

Methods of Project Appraisal

The document discusses various methods used to appraise capital investment projects, including: 1) Payback period - the time taken for cash inflows to repay initial cash outflows. Shorter payback periods are preferred. 2) Accounting rate of return (ARR) - expresses profit as a percentage of average investment. Higher ARRs are preferred. 3) Discounted cash flow methods - consider time value of money. These include net present value (NPV), profitability index (PI), and internal rate of return (IRR). Projects with positive NPV, PI>1, and IRR>cost of capital are preferred.

Uploaded by

Mîñåk Şhïï
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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METHODS OF PROJECT

APPRAISAL
Introduction
 When taking capital expenditure decisions, a long
term view of costs and benefits must be taken into
account.
 It is important to understand how major investment
projects are assessed.
 Organisations need to apply both non-discounted
and discounted cash flow techniques to compare
costs and benefits of long term investment projects.
RELEVANT AND NON-RELEVANT
COSTS
 A relevant cost is a future cash flow arising as a direct
consequence of a decision.
 Relevant costs are future incremental cash flows.
 Examples include:
- Avoidable costs which would not be incurred if the
activity to which they relate did not exist.
- Differential costs is the difference in relevant cost
between alternatives.
- Opportunity cost is the benefit which has been given up,
by choosing one option instead of another.
RELEVANT AND NON-RELEVANT
COSTS
 Non-relevant costs are those costs which are
irrelevant for decision-making.
 Examples include:
- A committed cost : a future cash flow that will be
incurred anyway, whatever decision is taken now.
- A sunk cost: a cost which has already been incurred
and therefore not taken into account.
- A notional cost: a hypothetical accounting cost to
reflect the use of a benefit for which there is no
actual cash outflow.
RELEVANT AND NON-RELEVANT
COSTS
 Usually, variable costs are relevant costs while fixed
costs are non-relevant to a decision.
 However, fixed costs have to be identified as being
either ‘specific’ or ‘general’.
 Usually, specific or directly attributable fixed costs
are relevant.
 General fixed overheads are non-relevant.
Example: Relevant and non-relevant
costs
 Which of the following should be treated as relevant cash flows?
a. A reduction in the sales of a company’s other products caused by the
investment
b. An expenditure on plant and equipment that has not yet been made
and will be made only if the project is accepted
c. Costs of research and development undertaken in connection with the
product during the past three years
d. Annual depreciation expense from the investment
e. Dividend payments by the firm
f. The resale value of plant and equipment at the end of the project’s
life
g. Salary and medical costs for production personnel who will be
employed only if the project is accepted
Methods of project appraisal
 Accounting rate of return
 Payback period
 Discounted payback period
 Net present value
 Internal rate of return (IRR)
Payback period
 Time taken for the cash flows generated by a
project to pay back the initial cash flows
 Calculation is based on cash flows and not profit
 Decision rule:
- accept the project with the shortest payback
- if an organisation has a target payback, it will
reject a capital project unless the payback period is
less than the target payback
Payback-Constant Cash Flows
 Example 1:
- A project requires an initial outlay of Rs5,000,000
and generates cash inflows of Rs1,250,000 for six
years. Calculate the payback period for the
project.
Payback-unequal Cash Flows
 Payback period found by adding up the cash
inflows until the total is equal to the initial cash
outlay
 Example 2:
A project requires an initial cash outlay of
Rs20,000,000. Forecast cash inflows for years 1-4
are as follows: Rs8,000,000, Rs7,000,000,
Rs4,000,000 and Rs3,000,000. Calculate the
payback period for the project.
Advantages and Disadvantages of
Payback
 Advantages
- It is simple to understand and easy to calculate.
- It considers cash flows and not profit (therefore
more objective)
- Useful when businesses are facing liquidity
problems and need cash
- Appropriate for risky projects
Advantages and Disadvantages of
Payback
 Disadvantages
- Unable to distinguish between projects having the
same payback.
- It ignores cash flows after the payback period
- The choice of a target payback period is arbitrary

- It does not consider the time value of money.


Discounted Payback
 To take into account the time value of money, a
discounted payback can be calculated.
 Example 3:
A company invests in a project costing $210,000. the
project will yield annual profits of $80,000 for the
next 3 years after providing annual depreciation of
$10,000. What is the discounted payback using a
cost of capital of 10%?
Accounting Rate of Return (ARR)
 Measure of the profitability of an investment
 Expresses profit from investment as a percentage of
the total investment (or alternatively, average
investment)
 Profit is the accounting profit taken from the income
statement
 Decision rule:

- Projects are accepted or rejected depending on


whether they meet the minimum return set by the
company
Advantages and Disadvantages of
ARR
 Advantages
- Easy to understand and can readily be ascertained

from information available from financial


statements.
- Considers profits for the entire life of the project.

- Produces a percentage figure, which is readily


understood by managers
Advantages and Disadvantages of
ARR
 Disadvantages
- It is based on accounting information and not cash
flows.
- Does not take into account the time value of money.
- There are several formulae for calculating ARR
which can lead to problems during comparison.
Example ARR
 XYZ Company is considering investing in a project
that requires an initial investment of $100,000 for
some machinery. There will be net inflows of
$20,000 for the first two years, $10,000 in years
three and four, and $30,000 in year five. Finally,
the machine has a salvage value of $25,000. Find
the ARR assuming straight line depreciation method
is applied.
Discounted Cash Flow Techniques
 Classified into the following methods:

- Net Present Value (NPV)

- Profitability Index (PI)

- Internal Rate of Return (IRR)


Net Present Value (NPV)
 considers all cash inflows and outflows associated
with a project over its full life
 reflects the time value of money
 net cash flows are discounted using the cost of
capital to arrive at the net present value
 decision rule
- accept a project if it produces a positive NPV
- reject a project having negative NPV
Advantages and Disadvantages of
(NPV)
 Advantages

- It is based on cash flows.


- It considers the time value of money.
- It considers cash flows for the whole project.
- The criteria for accepting a project is objective.
Advantages and Disadvantages of
(NPV)
 Disadvantages

- The choice of the discount rate is subjective.


- Transactions are assumed to occur at the end of
each year.
- It gives results in absolute terms without relating to
the size of the investment.
Example NPV
CDC Ltd. is considering a capital investment. The estimated cash flows are
given. The company’s cost of capital is 15%.
Required: (a) Calculate the NPV of the project, and assess whether it
should be undertaken
(b) Find the Profitability Index (PI).

Year Cash flow


(Rs)
0 (now) (120,000)
1 60,000
2 80,000
3 40,000
4 30,000
Profitability Index (PI)
 NPV gives values in absolute terms, without
comparing it to the size of the investment.
 When amount of investment varies in 2 projects it is
inappropriate to use NPV

 Profitability index (PI) can be used


 Also called the benefit/cost ratio
Profitability Index (PI)
 calculated as follows:

PI = Present value of inflows


Present value of initial investment outflows

 Decision rule:
- Project with PI > 1 should be accepted
- Project with PI < 1 and must be rejected
- In case of competing projects, the highest over 1 will
generally be accepted.
Internal Rate of Return (IRR)
 The cost of capital/discount rate that makes NPV of
the project zero
 IRR is therefore the maximum discount rate that will
be used to finance a project without making a loss
from it
 Decision rule
- accept a project where IRR > cost of capital
- For mutually exclusive projects, the project which has
the higher IRR should be recommended
Internal Rate of Return (IRR)
 IRR =

 Steps
- Step1: Calculate NPV of project using the cost of
capital.
- Step 2: If NPV is positive try a higher rate or, try a
lower rate if negative.
- Step 3: Use interpolation formula above to find IRR
of the project.
Advantages and disadvantages of
IRR
 Advantages
- It is easily understood by managers, especially non-
financial managers.
- It indicates how sensitive decisions are to a change in
interest rates.

 Disadvantages
- IRR ignores the relative size of investments.
- Projects with unconventional cash flows can have either
negative or multiple IRRs. This can be confusing to the
manager.
Example IRR
ABC Ltd. is considering a capital investment. The
estimated cash flows are as follows:
The company’s cost of capital is 10%.
Required: Calculate the IRR of the project.
Year Cash flow
(Rs)
0 (20,000)
1 6,000
2 8,000
3 10,000

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