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TECHNIQUES OF PROJECT APPRAISAL

PAYBACK PERIOD
One of the simplest investment appraisal techniques is the
payback period. Payback technique states how long does it
take for the project to generate sufficient cash-flow to cover
the initial cost of the project.

XYZ Inc. is considering buying a machine costing $100,000.


There are two options Machine A and Machine B. Machine A
will generate revenue of $ 50,000, $ 50,000 & $ 20,000 in year
1, year 2 & year 3 respectively. Machine B will generate
revenue of $ 30,000, $ 40,000 & $ 60,000 in year 1, year 2 &
year 3 respectively. As per above example payback period is 2
years & 2.5 years for machine A & machine B respectively.
According to the payback period method, machine A will be
given preference.

The advantage of payback is, it is very easy to calculate &


understand. Even people not from finance background can
easily understand it. But the disadvantage is that it ignores
the time value of money & anything that happens after a
payback point.

ACCOUNTING RATE OF RETURN METHOD


Accounting rate of return is an accounting technique to
measure profit expected from an investment. It expresses the
net accounting profit arising from the investment as a
percentage of that capital investment. It is also known
as return on investment or return on capital.
ARR=(Average annual profit after tax / Initial investment) X
100
For Example,
XYZ Inc. is looking to invest in some machinery to replace its
current malfunctioning one. The new machine, which costs $
420,000, would increase annual revenue by $ 200,000 and
annual expense by $ 50,000. The machine is estimated to have
a useful life of 12 years.

 Depreciation expense per year = $ 420,000/ 12 = $ 35,000


 Increase in average annual profit = $ 200,000 – ( $ 50,000
+ $ 35,000) = $ 115,000
 Initial investment = $ 420,000
 ARR = ( $ 115,000 / $ 420,000 ) * 100 = 27.38%
NET PRESENT VALUE
It is the most common method of investment appraisal. Net
present value is the sum of discounted future cash inflow &
outflow related to the project. Generally, the weighted
average cost of capital (WACC) is the discounting factor for
future cash-flows in net present value method.
In essence, this method sums up the discounted net cash
flows from the investment by the minimum required rate of
return & deducts initial investment to give the ‘net present
value’. The company should accept the project if the NPV is
positive.

The formula of NPV ={ + + …….. } – Initial Investment


Where,
CFi = Cash-flow of first period

CFii = Cash-flow of second period

CFiii = Cash-flow of third period

CFn = Cash-flow of nth period


n = No. of Periods

i = Discounting rate
For Example,
XYZ Inc. is starting the project at cost of $ 100,000. The
project will generate cash-flow of $ 40,000 , $ 50,000 & $
50,000 in year 1, year 2 & year 3 respectively. Company’s
WACC is 10%. Find out NPV.

Formula of NPV    =   [ $40,000/( 1+0.1)1] + [ $


50,000 / (1+0.1)2 ]   +[ $ 50,000/ (1+0.1)3 ]   – 100,000
Net present value = $ 36,363.63 + $ 41,322.31 +$ 37,565.74 – $
100,000

= $ 115,251.68 – $ 100,000

The net present value of the project is $ 15,251.68.

Here, the net present value of the project is positive &


therefore the project should be accepted.

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