04.

ProjectAppraisal

Theprimeobjectiveofcapitalinvestmentistomakeprofitbywayofinvestingin
variouscapitalassets.

Similarlytheprimeobjectiveofthefinanciertofinanceforcapitalinvestmentisto
seethathisfinancegetsproperreturnandatendofthecontractedperiodtheloan
amountisrepaid.

Therearevarioustechniques,whichcanbeemployedtocarryoutprojectappraisal.

TraditionalMethods:
Paybackperiod.
Profitabilityindex(postpayback)
Rateofreturnmethod.

TimeAdjustedmethods:
Netpresentvaluemethod
Internalrateofreturnmethod.
ProfitabilityIndexmethod.

PaybackPeriod

Thisindicatestheperiodduringwhichtheentirecapitalinvestmentisrecovered.
Yearlycashinflowshouldbeaddeduptillthetotalisequaltoinitialcapital
investment/projectcost.

Financierprefersaunithavinglowerpaybackperiod.
Limitations:

Itdoesnotconsidertimevalueofmoney.

Itignoresallcashflowsafterthepaybackperiod.

Merits:
Itiseasytocalculate.
Itemphasizesshortandmediumtermliquidity.
Ittendstoeliminatehighriskprojects.

PostPaybackProfitabilityIndex

Postpaybackcashinflowsx100dividedbycapitalinvestment=Postpayback
profitabilityindex.

Cashinflowsafterreachingpaybackperiodareconsideredtoascertainsafety
margininrecoveryofcapitaloutlay.

RateofReturnMethod.

Returnperinvestment=
Totalcashinflowx100dividedbycapitalinvestment.

Averagerateofreturn=
Averagecashinflowsx100dividedbycapitalinvestment.

NetPresentValue(NPV)

Abirdinhandisequaltotwobirdsinbush.
Timevalueofmoneyisconsidered.
Anyproject,whichgivesbigreturnintheshortestpossibletime,ismoreimportant.
StepsinvolvedincomputingNPV:
Deciderateofreturnexpectedfromtheproject.Itshouldbeatleastequalto

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costofcapital.

Findoutpresentvalueofcapitaloutlay.
Findoutpresentvalueofcashinflows.
IfNPVis0orpositive,theprojectshouldbeaccepted.
Incaseofmultipleprojects,theonewithmaximumNPVshouldbeaccepted.

Internalratereturn(IRR)

IncaseofNPVmethod,thenetpresentvalueisfoundoutbydiscountingcash
flowsatpredeterminedrate.i.e.Costofcapital.

UnderIRRmethod,thecashflowisdiscountedatasuitablerate,whichequatesthe
presentvalue.

If IRR is > Cost of Capital, the project may be accepted. In case of

multiple projects, the one with maximum IRR should be accepted.
ProfitabilityIndexmethod

ProfitabilityIndex=Presentvalueofcashinflowsdividedbypresentvalueofcash
outflow.

NetProfitabilityIndex=Netpresentvaluedividedbyinitialcapital
investment/projectcost.

Ifprofitabilityindexis>1,theprojectshouldbeaccepted.
Refer Chapter 05- Financial Concepts for explanation of Internal Generation,
Cost of Capital etc.

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ProjectAppraisalExamples.

Cashinflows=PATlessdividend+depreciationRs000

Year
ProjectA
ProjectB

P.A.
Cum.
P.A.
Cum.
Cashoutflow
Cashoutflow
0
1000
2000
1
200
200
400
400
2
300
500
400
800
3
300
800
400
1200
1200
4
400
500
1700
2300
5
400
1600
600
Totaloutflow
1000
2000
TotalInflow
1600
2300
Net
600
300

ProjectA
ProjectB
Paybackperiod
3.5years
4.5years

Postpaybackprofitabilityindex
600x100dividedby
300x100dividedby
1000=60%
2000=15%
Returnperinvestment
1600dividedby1000= 2300dividedby2000=
160%
115%
Averagerateofreturn
320dividedby1000=
460dividedby2000=
32%
23%

NetPresentvalue(NPV)

Rs000
Costofcapitalsay10%

Cashflows
Presen
Cashflows
Present
Year
Discountin
tvalue
value
gfactor
@10%
0
1000
1000
2000
2000
1.00000
1
0.90909
200
182
400
364
2
0.82654
300
248
400
331
3
0.75131
300
225
400
301
4
0.68301
400
273
500
341
5
0.62092
400
248
600
373
1600
1176
2300
1710
TotalPVofcashinflows
1000
1000
2000
2000
TotalPVofcashoutflows
600
176
300
(290)
NetPresentValue
ProfitabilityIndex
1176dividedby1000=1.18 1710dividedby2000=0.86
Conclusion

Accept

Reject