Project Appraisal Capital Budgeting Methods

Dr. Janardhan G Naik

M.com, LL.B, AICWA,Ph.D

Cost Accountant and Professor, Head Dept of Accountancy Gogte College of Commerce, Belgaum 590 006 Karnataka State, INDIA Cell : (0091) 9448578089 Email: jgnaik52@yahoo.com

Project Appraisal
Based on the Techno-Economic Analysis, and other factors of detailed project report a Project Appraisal or capital budgeting or capital expenditure or investment decisions are arrived. The decision is to select a particular project or not or which alternate project is the best to be selected

Types of Investment Decisions

Public Sector Investment Decisions Private Sector Investment Decisions Expansion of existing business Expansion of new business Replacement and modernisation Research & Development project Independent (accept or reject) investments Contingent investments Mutually exclusive investments

Public Sector Investment Decisions

1. By Administrative Ministry:
1. If the project is within the ceiling of approved budget and plan provisions 2. For Railway, Defense, Dept. of Atomic Energy, Dept of Space, & Dept. of Electronics, no budget ceiling.

2. By Committee for Public Investment Board (CPIB) if the project is above the ceiling of approve budget and plan provisions

Procedure
Pre-Feasibility Report (PFR) evaluation (clearance or objection) by Project Appraisal Division of the Planning Commission, Dept. of Public Enterprises, Dept. of Environment & Forest, Dept. of Plan Finance from different angles Techno-Economic Feasibility Report (TEFR) preparation if PFR is cleared, and submitted to Public Investment Board through secretary of the Administrative Ministry for second stage clearance Detailed Project Report (DPR) prepared, if TEFR is cleared and submitted for clearance for PIB and also by Cabinet Committee on Economic Affairs (CCEA)

Private Sector Investment Evaluation Criteria

In private Sector Board of Directors or Top management takes project decisions. Procedure of Investment Decisions:
1. Estimation of cash flows 2. Estimation of the required rate of return (the opportunity cost of capital) 3. Evaluation Criteria i.e. Application of decision rules to choose

Investment Decision Rule

Consider all cash flows to determine the true profitability of the project. Maximise the shareholders wealth. Choose among mutually exclusive projects which maximises the shareholders wealth. Rank projects according to their true profitability. Bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones. Provide for an objective and unambiguous way of separating good projects from bad projects. Decision rules must be capable of application to any investment project.

Components of Cash Flows

Initial Investment Net Cash Flows
Revenues and Expenses Depreciation and Taxes Change in Net Working Capital
Change in accounts receivable Change in inventory Change in accounts payable

Change in Capital Expenditure Free Cash Flows

Components of Cash Flows

Terminal Cash Flows
Salvage Value
Salvage value of the new asset Salvage value of the existing asset now Salvage value of the existing asset at the end of its normal Tax effect of salvage value

Release of Net Working Capital

Cash Flows - Types

Conventional Cash flow has initial cash outlay followed by cash inflows. Conventional projects produce initial negative and subsequent positive cash flows, i.e. the initial outflow followed by inflows, i.e., + + + + +. Non-conventional cash flow has cash outlays mingled with cash inflows throughout the life of the project. Non-conventional investments produce cash flows of the pattern like, ++++++++.

Estimation of the Required Rate of Return (RRR)

RRR may be cost of capital (after tax) or the opportunity cost of capital (after tax) After Tax because cash flows are taken post tax. RRR would be used as the Discounting rate for cash flow. RRR is considered as cut off rate for project selection

Evaluation Criteria
1. Traditional or Non-discounted Cash Flow Criteria
1. Payback Period (PB)
a. Post pay back Cash flow / Profitability b. Bailout payback period c. Discounted Payback Period (DPB)

2. Payback reciprocal
3. 1. 2. 3. Accounting Rate of Return (ARR) Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI)

2. Discounted Cash Flow (DCF) Criteria

Payback Period (PBP)

Payback is the number of years required to recover the original cash outlay invested in a project. Calculation of payback is different for:
Annual cash inflows are uniform or constant Annual cash inflows are unequal or varying

Payback Period- constant annual cash inflows i.e. annuity

The payback period can be computed by dividing cash outlay by the constant annual cash inflow ie (annuity). E.g. A project requires an outlay of Rs 50,000 and yields annual cash inflow of Rs 12,500 for 7 years. What is the payback period ?

C0 Initial Investment Payback = = Annual Cash Inflow C

Rs 50000 PBP = ----------------Rs 12500 PBP = 4 years

Payback Period- Varying annual cash inflows

Payback period can be found out by adding up (cumulate) the cash inflows until the total is equal to initial cash outlay.
I) Project X requires a cash outflow of Rs 20,000, & generates cash inflows of Rs 8,000; 7,000; 5,000; and 4,000 during the next 4 years. What is the payback? Answer: At 3 yrs Rs 20000 = 20000 II) If in 2nd year cash flow is 6000, What is the new pay back? Answer: At 3 yrs Rs 1900020000, 3 years + 12 (1,000/4,000) months = 3 years + 3 months (I) Years Cash out 0 Cash inflow 1 2 3 4 (II) Years Cash out 0 Cash inflow 1 2 3 4 Cash flow Cum Flow -20000 8000 7000 5000 4000 8000 15000 20000 24000

Cash flow Cum Flow -20000 8000 6000 5000 4000 8000 14000 19000 23000

Payback - Acceptance Rule

Accept project if its payback period is less than the maximum or standard payback period set by management. While in ranking alternate projects, highest rank for shortest payback period and lowest rank for highest payback period.

Payback Period Evaluation

1. 2. 3. 4. 5.

Merits:
Simplicity Cost effective Short-term effects Risk shield Liquidity

1. 2. 3. 4.
5.

Demerits:
Post payback Cash flows ignored Cash flow patterns (timing) irrelevant Terminal or scrap value ignored Inconsistent with shareholder value creation
Aggregation of payback periods of all projects of the firm not possible

Post Payback Cash flow/Profitability

Years Project Cash flow Cash outflow 0 2 3 4 -20000 8000 7000 5000 4000 8000 15000 20000 24000 Cash inflow 1 X Cum Flow Project Cash flow -20000 5000 6000 7000 8000 5000 11000 18000 26000 Y Cum Flow

Project X has payback of 3 years when cash out =cash in, But post cash flow is just 4000 extra. Select on payback basis, but reject on post pay back cash flow. Project Y has payback of 3years + 12 x (2000/8000)months PBP = 3Yrs + 3 months. But post cash flow is Rs 6000 extra. Select on post payback basis, although rejected on payback baisi

Bailout Payback Period

1. Consider salvage value at every years on assumption of termination of project 2. Cumulate cash inflow along with salvage 3. Payback period is that when cumulated cash inflow equal to cash outflow, Here below 3 yrs.
Years Cash flow Cash outflow Cash inflow 0 1 2 PBP 3 4 -20000 6000 7000 5000 4000 6000 13000 18000 22000 8000 5000 2000 1000 14000 18000 20000 23000 Cum Flow Project M Cum Flow +Scrap Scrap Value

Discounted Payback Period (DPBP)

Project N out flow Rs 4000, life 4 yr, K =10% Year 1 2 3 4 Cash inflow 3000 1000 1000 1000 PVF10% 0.909 0.827 0.751 0.683 DistdVal 2727 827 751 683 4988 4000 988 PBP (simple) = 2yrs Distd PBP = 2yr + 12(446/751) = 2yr 7 months Cum Distd Val 2727 3554 4305 4988 Project M out flow Rs 4000, life 4 yr, K =10% Year 1 2 3 4 Cash inflow 0 4000 1000 2000 PVF10% 0.909 0.827 0.751 0.683 DistdVal 0 3308 751 1366 5425 4000 1425 PBP (simple) = 2yrs Distd PBP = 1yr + 12(692/751) = 2yr 11 months Cum Distd Val 0 3308 4059 5425

Total PV Cash Inflow Less Total PV Cash Outflow NPV

Total PV Cash Inflow Less Total PV Cash Outflow NPV

The discounted payback period is the number of periods taken in recovering the investment outlay on the present value basis. The discounted payback period still fails to consider the cash flows occurring after the payback period.

Reciprocal Payback (RP)

Timing of cash flow and rate of return may be accommodated by taking reciprocal of payback Reciprocal payback = 1/Payack x 100 = 1/3yrs x 100 = 33.3% RP is approximation of the internal rate of return (IRR) if the following two conditions are satisfied:
The life of the project is large or at least twice the payback period. The project generates equal annual cash inflows.

Accounting Rate of Return Method

ARR is the ratio of the average after-tax profit divided by the investment. 1) ARR on average investment. The average investment is equal to half of the original investment. 2) ARR on Initial Investment

1)

Average After Tax Profit ARR = --------------------------------Average Investment

2) Average After Tax Profit ARR = --------------------------------Initial Investment

ARR Acceptance Rule

Accept all those projects with ARR higher than the minimum rate established by the management Reject those projects which have ARR less than the minimum rate. Ranking a project as number one if it has highest ARR and lowest rank would be assigned to the project with lowest ARR.

Evaluation of ARR Method

Merits:
1. Simplicity 2. Accounting data 3. Accounting profitability

Limitations:
1. Cash flows ignored 2. Time value ignored 3. Arbitrary cut-off

Net Present Value Method

Based on realistic assumptions forecast project cash flows. Select appropriate discount rate to discount the forecasted cash flows. The appropriate discount rate is the projects opportunity cost of capital. Present value of cash flows is found by multiplying cash flow with PVF of the opportunity cost of capital, the discount rate.

NPV Formula
Take sum of PV of cash inflow and cash out flow Difference between PV of Cash inflow and PV of Cash out flow is Net Present Value (NPV) The formula is :
3 n 2  L   NPV ! 1  2 3 n (1  k ) (1  k ) (1  k ) (1  k )
NPV !
t !1 n t 0

(1  k )

Calculating Net Present Value

Project X costs Rs 2,500 now and is expected to generate year-end cash inflows of Rs 900, 800, 700, 600 and 500 in 1 to 5 years of project life. The opportunity cost of the capital is 10%.

Calculating NPV
(1.Formula method & 2.Table method)
Project X out flow Rs 2500, life 5 yrs, K =10%

R 900 R 800 R 700 R 600 R 500 s s s s s Year Cash inflow N V! P s     R 2,500 0.10) (1+ 2 (1+ 3 (1+ 4 (1+ 5 0.10) 0.10) 0.10) 0.10) (1+ 1 900 N V![R 900(P F 0.10) +R 800(P F 0.10) +R 700(PV 3, 0.10) P s V1, s V 2, s F 2 800 +R 600(P F 0.10) +R 500(P F 0.10)]R 2,500 s V4, s V 5, s N V![R 900v0.909+R 800v0.826+R 700v0.751+R 600v0.683 P s s s s +R 500v0.620]R 2,500 s s N V!R 2,725R 2,500 +R 225 P s s s
3 4 5 700 600 500

PVF 10% 0.909 0.827 0.751 0.683 0.621

Distd Val 818 662 526 410 311 2726 2500 226

Total PV Cash Inflow Less Total PV Cash Outflow NPV

NPV Acceptance Rule

Accept the project when NPV is positive NPV > 0 Reject the project when NPV is negative NPV < 0 May accept the project when NPV is zero NPV = 0 Suitablitiy: For selecting one among mutually exclusive projects; the one with the higher NPV should be selected.

Evaluation of the NPV Method

Merits of NPV :
Most acceptable investment rule as it has below merits:

Limitations:
1. Not easy to find Discount rate 2. Difficulties Cash flow estimation 3. Ranking of projects
1. Projects with uneven life decisions 2. Projects with uneven investment 3. Mutually exclusive projects

1. Time value 2. Suited for constant & even cash flows 3. Measure of true profitability 4. Considers flow over entire life 5. Value-additivity 6. Shareholder value
7. Assumed to be reinvested at cost of capital

Internal Rate of Return (IRR)

IRR is the rate that equates the present value of investment outlay with the present value of cash inflows over life of project. IRR implies that the rate of return is equal to the discount rate which makes NPV = 0. It is Discounted Rate of Return In the following equation, r is IRR when NPV = 0

C3 Cn C1 C2 C0 !   L  2 3 (1  r ) (1  r ) (1  r ) (1  r ) n
n

C0 !

t !1 n

Ct (1  r ) t Ct  C0 ! 0 t (1  r )

t !1

Calculation of IRR
a) b) When constant (annuity) cash flows When unequal cash inflow

a) Constant (annuity) Cash Flows

When annual cash inflows are constant IRR is equal to r of present value annuity factor (PVAF) for the life of the project (n) of mean cash flow. IRR = PVAF(n,r) {Cash outlay/Constant cash inflow) By referring to PVAF table for given n life of project, find r which is IRR, that produces zero NPV

Constant (annuity) Cash Flows

Project X outlay is Rs 18,000 and its annual cash inflow is Rs 6,000 for 5 years. What is IRR of X ? The IRR of the investment can be found out as follows:
NPV = Cash outflow Annuity cash inflow(PVAFn,,r ) NPV = 18000 6000(PVAF 5,r) = 0 PVAF 5,r = (18000/6000)= 3 From PVAF table we find PVAF 5,r = 3, For 5 years, at 20% from PVAF table it is 2.991, is nearer to 3. So that is r = IRR.

Uneven Cash Flows

IRR is found by Trial and Error
Select any discount rate to compute the present value of cash inflows. If the present value of inflows is higher than the present value of outflows, ie NPV is positive, a higher rate should be tried. If the calculated present value of the expected cash inflow is lower than the present value of cash outflows, ie NPV is negative, a lower rate should be tried. Repeat until net present value becomes zero or else interpolate between two rate causing positive and negative NPV to find IRR when NPV = 0

Uneven Cash Flows

(IRR is found by Trial and Error) Project Z needs Rs 60000 outlay and produces cash flow of Rs15000, 20000,30000 & 20000 in 4 years of life. Find IRR?
IRR determination by Trial & Error (trial started with 14%, then 15% )

Years Cash Inflow PVF 14% PV Cash flow PVF 15% PV Cash flow 1 15000 0.877 13155 0.870 2 20000 0.769 15380 0.756 3 30000 0.675 20250 0.658 4 20000 0.592 11840 0.572 85000 60625 Less Cash ouflow -start of 1st year 60000 NPV = PV inflow - PV outflow By Interpolation r = r = IRR = 625 14% + 625/(625+650) x (15% - 14%) 14.50%
At 14% NPV is 625 and at 15% NPV is -650 So r lies between 14 - 15%

13050 15120 19740 11440 59350 60000 -650

Uneven Cash Flows

(modified annuity method) IRR is found by modifying annuity method using average cash inflow Average cash inflow =(15000+20000+30000+20000)/4 = 21250 NPV = Cash outflow Average cash inflow(PVAFn,,r ) = 0 NPV = 60000 - 21250(PVAF 4,r) = 0 PVAF 4,r = (60000/21250)= 2.82 From PVAF table we find PVAF 4,r = 2.82, For 4 years, at 15% from PVAF table it is 2.85, is nearer to 2.82. So try with 15% to get IRR.

NPV Profile Graph to find IRR

Cash inflow PVAF(6,r) Annuity 5430 5430 5430 5430 5430 5430 5430 1% 5% 10% 15% 16%IRR 20% 25% NPV 11472 7561 3649 550 0 (1942) (3974)

Initial outlay Rs 20000, life 6 Yrs

Acceptance Rule of IRR

Accept the project when r > k. Reject the project when r < k. May accept the project when r = k. K is cost of capital (WACC) Ranking based on highest IRR first, and last for lower IRR In case of independent projects, IRR and NPV rules will give the same results if the firm has no shortage of funds.

Evaluation of IRR Method

Merits:
Time value of money Profitability measure for entire life Determination of opportunity cost of capital not prerequisite Uniform ranking as IRR is in % Acceptance rule Shareholder value maximised

Limitations:
1. Multiple rates 2. Mutually exclusive projects 3. Different projects IRR cant be added 4. Assumed to be reinvested at IRR which may not match cost of capital

NPV Versus IRR

1. 2. 3. 4. 5. 6. 7. 8. 9. Reinvestment Assumption Varying Opportunity Cost of Capital Conventional Independent Projects Ranking Lending and borrowing-type projects Problem of Multiple IRRs (non-conventional) Ranking of Mutually Exclusive Projects Timing of Cash Flows Scale of Investment Project Life Span

Reinvestment Assumption
The IRR method assumes that the cash flows generated by the project can be reinvested at its internal rate of return, The NPV method assumes that the cash flows are reinvested at the opportunity cost of capital.

Varying Opportunity Cost of Capital

There is no problem in using NPV method when the opportunity cost of capital varies over time. If the opportunity cost of capital varies over time, the use of the IRR rule creates problems, as there is not a unique benchmark opportunity cost of capital to compare with IRR.

Conventional Independent Projects

Conventional Independent Projects which are economically independent of each other, NPV and IRR methods result in same accept-or-reject decision if the firm is not constrained for funds in accepting all profitable projects.

Lending or borrowing-type projects

(Both are conventional projects)
Lending type Project R out flow Rs 1000, life 1 yr, K =10% Year 1 Total PV Cash Inflow Less Total PV Cash Outflow NPV IRR comes to 20% Cash inflow 1200 PVF 10% 0.909 Distd Val 1091 1091 1000 91 Borrowing type Project Q yr end outflow Rs 1200, life 1 yr, K =10% Year 1 Total PV Cash outflow Total PV Cash inflow yr 0 NPV IRR comes to 20% Cash outflow 1200 PVF 10% 0.909 Distd Val 1091 1091 1000 -91

Project R is a lending type, which involves initial outflow Rs 1000, followed by inflow of Rs 1200 over one year life. This has NPV 91 positive, Accepted. But IRR = 20% Project Q is a borrowing type, where there is initial inflow of Rs 1000, followed by outflow of Rs 1200 at first year end of life. This has NPV -91, Rejected. But IRR = 20% for both Q and R. Choose any project on IRR basis.

Problem of Multiple IRRs

(non-conventional)
A project may have both lending and borrowing features together (nonconventional). IRR method can yield multiple internal rates of return because of more than one change of signs in cash flows is possible here.
P (R s) P R s

iscount R ( ) ate

Ranking of Mutually Exclusive Projects

The NPV and IRR rules give conflicting ranking to the projects under the following conditions:
The cash flow pattern of the projects may differ. That is, the cash flows of one project may increase over time, while those of others may decrease or vice-versa. The cash outlays of the projects may differ. The projects may have different expected lives.

Investment projects are said to be mutually exclusive when only one investment could be accepted and others would have to be excluded. Two independent projects may also be mutually exclusive if a financial constraint is imposed.

Timing of Cash Flows

CashFlows (Rs) Project M N C0 1,680 1,680 C1 1,400 140 C2 700 840 C3 140 1,510 N PV at 9% 301 321 IRR 23% 17%

Both projects are lending type, with initial outlay of Rs 1680, with life of 3 yrs, and K at 9%. But their NPV at 9% are different, Select N But their too IRR differ. On IRR basis accept M

Scale of Investment
C a sh F lo w (R s) P ro ject A B C0 -1,000 -100,000 C1 1,500 120,000 NP V at 10% 364 9,080 IR R 50% 20%

Both projects are lending type. But initial outlay of A is Rs 1000, while B is Rs 100000. But life of both is 1 yr, and K at 10%. But their NPV at 10% are different, Select B But their IRR too differ. On IRR basis accept A

Project Life Span

Cas lo s ( s) Project
X Y

C0
10,000 10,000

C1
12,000 0

C2
0

C3
0

C4
0

C5
20,120

PVat 10%
908 2,495

I
20 15%

Both projects are lending type with same initial outlay of Rs 10000. But life of X is 1 yr and of Y is 5yrs. K at 10%. But their NPV at 10% are different, Select Y But their IRR too differ. On IRR basis accept X

Modified Internal Rate of Return (MIRR)

The modified internal rate of return (MIRR) is the compound average annual rate that is calculated with a reinvestment rate different than the projects IRR. Modified internal rate of return is the compound average annual rate that is calculated with a reinvestment rate different than the projects IRR.

Profitability Index
Profitability index is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment.

Profitability Index
It is time adjusted method, also known as benefit-cost ratio
Sum of Present Value of Cash inflows PI = ---------------------------------------------------Sum of Present Value of Cash outflows Net Present Value ---------------------------------------------------Sum of Present Value of Cash outflows

PI (Net) =

PI (Net) = (PI - 1)

Profitability Index
The initial cash outlay of M project is Rs 1,00,000 and it can generate cash inflow of Rs 40000, 30000, 50000 and 20000 in year 1 through 4. Opportunity cost of capital is10%. Calculate PI.

PV ! Rs 40,000(PVF1, 0.10 ) + Rs 30,000(PVF 2, 0.10 ) + Rs 50,000(PVF 3, 0.10 ) + Rs 20,000(PVF 4, 0.10 ) Rs 40,000 v 0.909 + Rs 30,000 v 0.826 + Rs 50,000 v 0.751 + Rs 20,000 v 0.68 NPV ! Rs 112,350  Rs 100,000 Rs 12,350 Rs 1,12,350 ! 1.1235 . PI ! Rs 1,00,000

Acceptance Rule
The following are the PI acceptance rules:
Accept when PI > 1 or PI (net) is +Ve Reject when PI < 1 or PI (net) is -Ve May accept PI = 1 or PI (net) is 0

The project with positive NPV will have PI greater than one. PI less than means that the projects NPV is negative.

Evaluation of PI Method
Merits Time value of money. Shareholder value maximisation.. A project with PI > 1 will have positive NPV and if accepted, it will increase shareholders wealth. Relative measure of a projects profitability - as the present value of cash inflows is divided by the initial cash outflow Limitations: PI criterion requires calculation of cash flows and Estimate of the discount rate. In practice both are pose problems in estimation.