Project appraisal

Dr. P. I. A. Gomes

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• Project appraisal is important, as it will decide whether the project is
viable or not?

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Project appraisal methods
• Net present value (NPV)
• Internal rate of return (IRR)
• Pay back period
• Average rate of return
• Profitability index
• Etc……

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Pay back period
• Time required to recover the original investment

• Under this method, an investment project is accepted or rejected on the basis of

payback period.
• Payback period means the period of time that a project requires to recover the money
invested in it.

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Examples
1) ABC catering decides to buy a van to distribute its products with the expectation that it will increase the revenue. The usable
life of a van is 8 years, and company’s desired payback period is six years. The associated cash inflows and outflows are as follows.
Check whether it is rational to purchase the van?
Purchase price Rs. 70,00,000
Answer
Annual cash inflow:
Revenue Rs. 100,00,000 Investment = Rs. 70,00,000
Annual cash outflow: Net cash inflow= Rs. (100,00,000 – 75,00,000 – 10,00,000
Material costs Rs. 75,00,000 -1,00,000) = Rs. 14,00,000
Salaries expenses Rs. 10,00,000
Fuel costs Rs. 1,00,000
Pay back period = 70,00,000/14,00,000
Non cash expenses:
= 5 years
Depreciation Rs. 30,000
Yes should purchase, as it is less than the desired payback
period. Also, note that company’s desired payback period is
6 years which is less than the vans life time.
# depreciation is a non-cash expense, thus has not been
considered in net cash inflow/outflows

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Examples
2) PQR Pvt Ltd buys an equipment for Rs 1 million. The annual cash inflows for the first fours years are Rs., 0.1 million; 0.5
million; 0.5 million and 1 million, respectively. Company’s expectation is recoup the investment in two years. Can they do so?

Answer

Year Description Investment (Rs. Million)Cash inflow (Rs. Million) Net investment (Rs. Million)
0 Purchase/investment (1) - -
1 Cash inflow 0.1 (0.9)
2 Cash inflow 0.5 (0.4)
3 Cash inflow 0.5 0.1
4 Cash inflow 1.0 1.1

# investment recovers in between 2 and 3rd year (, thus cant recover the investment within two years
Take note that cash inflows are heavily weighted toward the end of the time period, therefore, working out pay back period as 1
million/(average annual cashflow) = 1 million/(2.1/4) = 1.9 years is wrong!

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Pay back methods advantages and
disadvantages
• Advantages: (1) Simple and easy (2) suitable when the project is short
• Disadvantages: (1) Not consider cash flows beyond the payback
period (2) not suitable for large projects (3) more on liquidity than
profitability

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Return on investment (Average rate of
return)
• Is the benefit from an investment

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Example
1) An investor buys Rs. 1 million worth of stocks and sells the shares
two years later for Rs. 1.4 million. Calculate ROI

Answer

ROI = (1.4-1)/1 =0.4 = 40%

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ROI advantages and disadvantages
• Advantages: (1) considers all earnings of the projects in its economic
time (up to project completion) (2) Relatively simple (3) Consider tax
as well as depreciation
• Disadvantages: (1) Time value of money is ignored (2) As this is a ratio,
size of the investment is not considered (3) re-investment of the profit
do not considered

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Net Present value (NPV)
• Express present and future cash flows in present terms
• If NPV > 0, the project is acceptable (sign convention: + cash inlows; -
cash out flows)

r is discount rate (interest rate) and n is number of years

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Example
1) The management is considering to purchase an equipment to be attached with the
main manufacturing machine. The equipment will cost 6,000 USD and will increase
annual cash inflow by 2,200 USD. The useful life of the equipment is 6 years. After 6
years it will have no salvage value. The management wants a 20% return on all
investments. Should the equipment be purchased according to NPV analysis?

Answer
1317 USD. Yes they should purchase it
Note: present value of an annuity….

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2) An investor has an option to purchase a tract of land that will be
worth 10,000 USD in six years. If the value of land increases 8% each
year, how much should the investor be willing to pay now for this
property?
Answer

PV = 10,000 (0.6302)
= 6302 USD

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NPV advantages and disadvantages
• Advantages: (1) Time value of money is considered (2) Whole project
period is covered
• Disadvantages: (1) Can be difficult to calculate (2) Impact of non-
financial activities such as marketability is not considered (3)

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Profitability index (PI)
• Ratio of PV of inflows and outflows
• Also known as
• If PI > 1 accept the project

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PI advantages and disadvantages
• Advantages: (1) Time value of money is considered (2) Different
projects/options can be ranked
• Disadvantages: (1) Different interpretation

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Internal Rate of Return(IRR)
• Interest rate (or discount rate) at which NPV = 0

r is discount rate (interest rate) and n is number of years

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Example
1) Find the IRR of an investment having initial cash
outflow of Rs 200,000. The cash inflows during
the first, second, third and fourth years are
expected to be Rs 50,000, 100,000, 75,000 and
50,000 respectively. Find the IRR?

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IRR advantages and disadvantages
• Advantages: (1) Time value of money is taken into account
• Disadvantages: (1) Assumes re-investment should be at IRR

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