Project appraisal

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Project Ka Bazigaar

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Project Appraisal By-Rahul Jain

What is Project Appraisal?

 Analysis of potential projects.

 Long-term decisions; involve large expenditures.

 Very important to firm’s future.

Steps in Project Appraisal

 Estimate cash flows (inflows & outflows).

 Determine r = WACC for project.

 Evaluate cash flows.

Cash Flow Estimation Of Project

Terminal Cash flow

Annual Cash Flows Initial

outlay

Cash Flows Versus Profit

 Cash flow is not the same thing as profit, at least, for two reasons:

First, profit, as measured by an accountant, is

based on accrual concept.

Second, for computing profit, expenditures

are arbitrarily divided into revenue and

capital expenditures.

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CF (REV EXP DEP) DEP CAPEX

CF Profit DEP CAPEX

Components of Cash Flows

 Initial Investment

 Net Cash Flows/Annual 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

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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

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Depreciation for Tax Purposes

 Two most popular methods of charging

depreciation are:

 Straight-line

 Diminishing balance or written-down value

(WDV) methods.

 For reporting to the shareholders, companies

in India could charge depreciation either on

the straight-line or the written-down value

basis

 For the tax purposes, depreciation is

computed on the written down value (WDV) of the block of assets.

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Terminal Value for a New Business

 The terminal value included the salvage value of the asset and the release of the working capital.

 Managers make assumption of horizon period because detailed calculations for a long period become quite intricate The financial analysis of such projects should incorporate an estimate of the value of cash flows after the horizon period without involving detailed calculations.

 A simple method of estimating the terminal

value at the end of the horizon period is to

employ the following formula, which is a

variation of the dividend—growth model:

Additional Aspects of Cash Flow Analysis

Opportunity Costs of Resources

Case Study

 Warehouse Case

There is nothing like

FREE LUNCH

Cost of Capital

The project’s cost of capital is the

minimum required rate of return on funds committed to the project, which depends

on the riskiness of its cash flows

The firm’s cost of capital will be the

overall, or average, required rate of return

on the aggregate of investment projects.

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The Concept of the Opportunity Cost of Capital

 The opportunity cost is the rate of return

foregone on the next best alternative

investment opportunity of comparable risk

. Government bonds. Risk-free security

The Weighted Average Cost of Capital

 The following steps are involved for

calculating the firm’s WACC:

 Calculate the cost of specific sources of

funds

 Multiply the cost of each source by its

proportion in the capital structure.

 Add the weighted component costs to get the WACC.

WACC is in fact the weighted marginal cost of

capital (WMCC); that is, the weighted average

cost of new capital given the firm’s target

capital structure.

Cost of Equity Capital

 Cost of Equity: The Dividend—Growth

Model

1 0

 Cost of capital (WACC)=

(Cost of Equity x Proportion of equity from capital)+ (Cost of debt x Proportion of debt from capital)+

The number of years required to recover a project’s cost,

or how long does it take to get the business’s money back?

2.4

=

Strengths of Payback:

1 Provides an indication of a

project’s risk and liquidity.

2 Easy to calculate and understand.

Weaknesses of Payback:

1 Ignores the TVM.

2 Ignores CFs occurring after the

payback period.

10 60 80

CF t

Cumulative -100 -90.91 -41.32 18.79 Discounted

 1  .

0

t t n

NPV = PV inflows - Cost

= Net gain in wealth.

Accept project if NPV > 0.

Choose between mutually

exclusive projects on basis of higher NPV Adds most value.

Using NPV method, which

franchise(s) should be accepted?

 If Franchise S and L are mutually

exclusive, accept S because NPVs >

NPVL .

 If S & L are independent, accept

both; NPV > 0.

0 1 2 3

IRR is the discount rate that forces

PV inflows = cost This is the same

as forcing NPV = 0.

1  .

0

NPV r

CF

t t n





NPV: Enter r, solve for NPV.

IRR: Enter NPV = 0, solve for IRR.

If IRR > WACC, then the project’s rate of return is greater than its

cost some return is left over to

boost stockholders’ returns.

Example: WACC = 10%, IRR = 15%.

Profitable.

Cost (negative CF) followed by a series of positive cash inflows One change of signs.

Nonnormal Cash Flow Project:

Two or more changes of signs Most common: Cost (negative CF), then string of positive CFs, then cost to close project.

Nuclear power plant, strip mine.

Inflow (+) or Outflow (-) in Year

Individual Assignment

 Complete All the questions