Project Ka Bazigaar

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Project Appraisal By-Rahul Jain

Project AppraisalOverview and “vocabulary”Methods

Payback, discounted paybackNPVIRR Sensitivity AnalysisBreakeven Analysis

What is Project Appraisal?

Analysis of potential projects.Long-term decisions; involve large

expenditures.Very important to firm’s future.

Steps in Project AppraisalEstimate cash flows (inflows & outflows).Determine r = WACC for project.Evaluate cash flows.

Cash Flow Estimation Of Project

0 1 2 3 4 5 n6 . . .

TerminalTerminalCash flowCash flow

Annual Cash FlowsAnnual Cash Flows

InitialInitialoutlayoutlay

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 FlowsInitial InvestmentNet 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 FlowsSalvage 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 BusinessThe 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:

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1NCF 1 NCF

TV n nn

g

k g k g

Additional Aspects of Cash Flow AnalysisOpportunity Costs of ResourcesSunk CostsTax Incentives

Investment allowance    Other tax incentives  

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Case StudyWarehouse Case

There is nothing like

FREE LUNCH

Cost of CapitalThe 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 CapitalThe opportunity cost is the rate of return

foregone on the next best alternative investment opportunity of comparable risk.

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OCC

. Equity shares

Risk

. Preference shares. Corporate bonds. Government bonds. Risk-free security

The Weighted Average Cost of CapitalThe following steps are involved for

calculating the firm’s WACC:Calculate the cost of specific sources of

fundsMultiply 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

Model1

0

DIVek g

P

Cost of DebtDebt Issued at Par

Tax adjustment  0

INTdk i

B

After-tax cost of debt (1 )dk T

WACCCost 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?

10 8060

0 1 2 3

-100

=

CFt

Cumulative -100 -90 -30 50

PaybackL 2 + 30/80 = 2.375 years

0100

2.4

70 2050

0 1 2 3

-100CFt

Cumulative -100 -30 20 40

PaybackS 1 + 30/50 = 1.6 years

100

0

1.6

=

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 8060

0 1 2 3

CFt

Cumulative -100 -90.91 -41.32 18.79

Discountedpayback 2 + 41.32/60.11 = 2.7 yrs

Discounted Payback: Uses discountedrather than raw CFs.

PVCFt -100

-100

10%

9.09 49.59 60.11

=

Recover invest. + cap. costs in 2.7 yrs.

.

10t

tn

t r

CFNPV

NPV: Sum of the PVs of inflows and outflows.

Cost often is CF0 and is negative.

.

10

1

CFr

CFNPV t

tn

t

10 8060

0 1 2 310%

Project L:

-100.00

9.09

49.59

60.1118.79 = NPVL NPVS = $19.98.

NPV = PV inflows - Cost= Net gain in wealth.

Accept project if NPV > 0.

Choose between mutually exclusive projects on basis ofhigher 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

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forcesPV inflows = cost. This is the sameas forcing NPV = 0.

.

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NPVr

CFt

tn

t

t

nt

t

CF

IRR

0 10.

NPV: Enter r, solve for NPV.

IRR: Enter NPV = 0, solve for IRR.

10 8060

0 1 2 3IRR = ?

-100.00

PV3

PV2

PV1

0 = NPV

Enter CFs in CFLO, then press IRR:IRRL = 18.13%. IRRS = 23.56%.

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 aseries of positive cash inflows. One change of signs.

Nonnormal Cash Flow Project:

Two or more changes of signs.Most common: Cost (negativeCF), then string of positive CFs,then cost to close project.Nuclear power plant, strip mine.

Inflow (+) or Outflow (-) in Year

0 1 2 3 4 5 N NN

- + + + + + N

- + + + + - NN

- - - + + + N

+ + + - - - N

- + + - + - NN

Individual AssignmentComplete All the questions