CHAPTER FOUR

PROJECT
APPRAISAL
 Feasibility study??

Financial viability Vs
Economic viability??
Chapter
Contents
Project Appraisal??

Financial techniques used

for project appraisal??
 Feasibility study refers to
whether or not a project will
be successful and how to
Feasibility overcome potential
Study obstacles for the project.
Feasibility studies set budget
limits and can be used to
monitor costs during
construction.
  Feasibility studies are also vital to
architects and developers to
promote or defend suggested
designs and proposals.
Cont...
 Feasibility studies may be used to
deal with several different
questions concerning the financial
and economic viability of projects.
 FINANCIAL VIABILITY
Is concerned with the requirement that
a building must generate sufficient
funds to enable a developer to

Financial undertake a proposed development,

repay any loans and make a profit.
Vs.
Economic ECONOMIC VIABILITY

Viability Involves both financial and non-

financial aspects, such as spillover
effects and opportunity costs.
 Therefore, financial feasibility
studies only consider financial
costs and benefits, while
Cont… economic feasibility studies
take non-financial considerations
into account.
 The basic questions facing every investor
are whether the investment will be worth
more than the amount invest, and if so, by
how much?

Project Project appraisal is a cost and benefits

analysis of different aspects of proposed
Appraisal project with an objective to decide its
viability.

A project involves employment of scarce

resources. An entrepreneur needs to
appraise various alternative projects
before allocating the scarce resources for
the best project.
 Therefore the main objectives of
project appraisal are:
Assessment of a project in
terms of its economic, social
Cont… and financial viability.
Decide to accept or reject a
Project based on results of the
assessment.
 There are available several
financial techniques, which use
discounting for assessment of
projects.
Cont… But before discussing these
techniques, we will see the
general concept of time value of
money.
 Money can have different values at
different times. This is because money
can be used to earn more money
between the different instances of time.

Obviously, $10,000 now is worth more

than $10,000 a year from now.
Time
Value of This is the earning power of money over
Money time and is called time value of money.

We have to be careful not to confuse the

earning power of money, which is related
to interest rate, with the buying power of
money, which is related to inflation.
 CASH FLOW

 A cash flow is the difference

between total cash receipts
(inflows) and total cash
disbursements (outflows) for a
Cash Flow & given period.
Cash Flow
Diagrams CASH FLOW DIAGRAMS

 The graphic presentation of the

costs and benefits over the time is
called the cash flow diagram
(CFD).
 • The following conventions are
used in the construction of the
cash flow diagram:
• The horizontal axis represents
time
• The vertical axis represents
costs and benefits
Cont… • Costs are shown by downward
arrows
• Benefits are shown by upward
arrows
• Each cash flow occurs at the
end of the respective time
period
  Single Cash Flow = Single
disbursement or receipt
 Uneven Series = set of different
disbursements or receipts
 Annuity/Equal/uniform Series
Types of = set of equal disbursements or
Cash flow receipts.

Diagrams  Linear/Arithmetic gradient

series = set of disbursements or
receipts that change by a
constant amount.
 Irregular/Geometric Gradient
Series = set of disbursements or
receipts that change by a
constant proportion.
Types of
Interest Simple
interest
Compound
interest
 Simple interest: the practice of
charging an interest rate only to the
principal amount.
F1 = P +Pr = P(1+r)
F2 = P + Pr + Pr = P + 2Pr = P(1+2r)
F3 = P + Pr + Pr + Pr = P + 3Pr =
Simple P(1+3r)

Interest:
Fn = P +nPr = P(1+nr)
Where:
F = Future value
P = Principal/initial amount
r=Interest rate
n=number of interest periods
 Example 1 : Given P = $1000, r
= 10% and n = 3years
Cont.…
Find the final accumulation at
the end of year three.
Beginning Interest Ending/Final
End of Year
Balance Earned Balance

Cont…
0 $1,000 0 $1,000
1 $1,000 $100 $1,100
2 $1,100 $100 $1,200
3 $1,200 $100 $1,300

Example 2. If the firm is due to receive Birr

550,000 in 2 years at a time when money is
worth 10 percent simple interest. What is the
present value?
F = P(1+nr) → P = F/(1+nr)
P = 55000/(1+2*0.1)= 45833.33
  Example 3:
 A student borrows $3000 from his uncle
in order to finish school. His uncle
agrees to charge him simple interest at
the rate of 5.5% per year. Suppose the
student waits two years and then
repays the entire loan. How much will
Cont… he have to repay?

 Solution:
 The interest type is simple interest
 F= P+nPr
 F = P(1+nr) = 3000*(1+2*0.055)= 3330
Compound  Compound interest: the
Interest: practice of charging an
interest rate to an initial
sum and to any previously
accumulated interest that
has not been withdrawn.
 Cont…
Principal
Interest Future Value
Period Amount
(I) (F) = (P) + (I)
(P)
1 P Pi P+Pi = P(1+i)
2 P(1+i) P(1+i)*i P(1+i) + P(1+i)*i =P(1+i)(1+i) = P(1+i)2
3 P(1+i)2 P(1+i)2*i P(1+i)2 + P(1+i)2*i = P(1+i)2(1+*i) = P(1+i)3
4 P(1+i)3 P(1+i)3*i P(1+i)3 + P(1+i)3*i = P(1+i)3(1+i) = P(1+i)4
. . . .
. . . .

N-1 P(1+i)(N-2) P(1+i)(N-2)*i P(1+i)(N-2) + P(1+i)(N-2)*i = P(1+i)(N-2)(1+i) = P(1+i)(N-1)

N P(1+i)(N-1) P(1+i)(N-1)*i P(1+i)(N-1) + P(1+i)(N-1)*i = P(1+i)(N-1)(1+i) = P(1+i)N

 Example 1 : Given P = $1000, r = 10% and
Cont.…
n = 3years
Find the final accumulation at the end of
year three.
F = P(1+i)n
F = 1000(1+0.1)3 = 1331

Cont…
End of Beginning Interest Ending/Final
Year Balance Earned Balance
0 $1,000 0 $1,000
1 $1,000 $100 $1,100
2 $1,100 $110 $1,210
3 $1,210 $121 $1,331
 Relationship between PV and FV
Compound
F Interest

Simple
Cont… Interest

Periods
 Economic analysis techniques are
used to find economically the most
feasible one among various
alternatives.

Project If a decision on one investment does

Appraisal not affect the other, the investments
are Independent.
Methods
If a decision on one investment
automatically eliminates acceptance
of the others, the investments are
Mutually Exclusive.
  A wide range of methodology has
been suggested to judge the
worthwhileness of investment
projects.
 Equivalent Present worth method

Cont…  Equivalent future worth method

 Equivalent annual worth method
 Rate of return method
 Benefit cost ratio
 Life time worth
 Present and
Future Values
of Single Cash
Flow
  A student deposited $1000 in a
savings account that pays
interest at the rate of 6% per

Class year, compounded annually.

How much will be the
Work accumulated amount the
student has after 5 years? Show
the cash flow on a cash flow
diagram.
 A1 A2 An n At
PV    ...   
n 1 r  1 r 2 1 r n t 1 1 r t

Present At = cash flow occurring at the end of year t

Value of an
Uneven
Series
  𝑭𝑽 = 𝑨𝟏 𝟏 + 𝒓 𝒏−𝟏
+ 𝑨𝟐 𝟏 + 𝒓 𝒏−𝟐 +
𝑨𝟑 𝟏 + 𝒓 𝒏−𝟑 + ⋯ + 𝑨𝒏 𝟏 + 𝒓 𝒏−𝒏

Future value
of an Uneven
Series
  A new machine is expected to cost
$6000 and have a life of 5 years.
Maintenance costs will be $1500 the
first year, $1700 the second year,
Class $1900 the third year, $2200 the fourth

Work
year, and $2300 the fifth year. How
much should be deposited in a fund
that earns 9% per year, compounded
annually, in order to pay for his
machine?
  An annuity is a stream of
constant cash flow occurring at
regular intervals of time.
Present Value 𝐴 1+𝑟 𝑛 −1
 𝑃𝑉 =
of Uniform 𝑟 1+𝑟 𝑛

Series
 𝑛
𝐴 1+𝑟 −1
𝐹𝑉 =
𝑟
Future Value
of Uniform
Series
  Example-1: If a firm is due to receive Birr
400,000 annually for three years with annual
discount rate of 10 percent. What is the
present value?
 Example-2: A construction company will
replace an excavator after 5 years. A new

Class one costs $250,000. How much is the annual

uniform payment the company has to put
Work into a bank in order to save enough money
in five years’ time for purchasing the
equipment if the bank is offering an interest
rate of 4% per annum? We have to bear in
mind that the excavator always costs
$250,000, whether now or after five years, as
the inflation-free assumption has been
made.
  A series of disbursements or receipts
that starts at zero at end of first period
and then increases at a constant
amount from period to period.
Present
Value of
𝟏 + 𝒊 𝒏 − 𝒊𝒏 − 𝟏
Arithmetic 𝑷 =
𝑮∗
𝒊𝟐 ∗ 𝟏 + 𝒊 𝒏
Series
  A series of disbursements or
receipts that starts at zero at
end of first period and then
increases at a constant amount
from period to period.
Future Value
of Arithmetic
Series 𝑭𝑽 =
𝑮∗ 𝟏 + 𝒓 𝒏 − 𝒓𝒏 − 𝟏
𝒓𝟐
 1. An employee is told that he is going to get
an annual pay increase of $1,200 each year.
The increase starts in the second year of his
employment. What is the total pay of his
increase compounded annually at the end of
5-years period with an assumed interest rate
of 7%?
1+𝑖 𝑁−𝑖𝑁−1
F=G* 𝑖2

Examples 𝐹 = 1200 ∗
1.403− 0.07∗5 −1
= 12,869.81
0.072
 2. An engineer is planning for a 15-year
retirement. In order to supplement his
pension and offset the anticipated effects of
inflation, he intends to withdraw $5000 at
the end of the first year, and to increase the
withdrawal by $1000 at the end of each
successive year. How much money must the
engineer have in his savings account at the

Cont… start of his retirement, if money earns 6%

per year, compounded annually?
Cont…
 A0 =5000
G = 1000

1+𝑖 𝑁−1 1+𝑖 𝑁−𝑖𝑁−1

𝑃 = [𝐴0 ∗ 𝑁 ] + [G* ]
𝑖∗ 1+𝑖 𝑖2∗( 1+𝑖 𝑁

Cont… 𝑃 = 5000 ∗
1.0615 − 1
0.06 ∗ 1.0615
+ 1000 ∗
1.0615 − 0.06 ∗ 15 − 1
0.062 ∗ 1.0615

𝑃 = 106,115.8
  A series of disbursements or
receipts that
increases/decreases with a
constant proportion from
Present period to period.
Value of 𝟏 + 𝒓 𝒏−𝟏 𝟏
Geometric 𝑷𝑽 =
𝒓 𝟏+𝒓 𝒏
∗
𝟏+𝑮
Series
  A series of disbursements or
receipts that
increases/decrease at a
Future constant proportion from
Value of period to period.

Geometric 𝑭𝑽 =
𝟏 + 𝒓 𝒏−𝟏
Series 𝒓 (𝟏 + 𝑮)
 40

In case of definite and short

project life one shall draw
and observe the cash flow
diagrams and discount their
PW at time zero.

Capitalized
Equivalent
(n>40yrs) However, in case of
perpetual projects life like
irrigation, dams,
hydropower plants, etc. one
uses the method of
capitalized equivalent.
 If a uniform series of cash flow
exists, then
 For perpetual life 𝐧 → ∞

 n 

Cont… 1 i 1
  
  
PW  A P / A,i,n  A








 

n



i1 i 
    
 
 
   

 n 

1 i
1 1 



 lim 

 
 
n i1 i n



i 


   
   

 
PW  A1  A
i  i
 42

Maintenance money for a new

building is to be deposited now.
The expected cost estimated is as
follows:
 40,000 per year for the first 5 yrs.
Example:  50,000 per year from year 6-10 yrs.
 60,000 per year perpetually there
after.
 If i=13%, how large shall be
deposited????
 What is the perpetual
equivalent annual cost????
 43

Solution: PW  40,000P / A,13,5 50000P / A,13,5P / F ,13,5

 60000 P / F ,13,10
i

 400003.5172 500003.51720.5428
 60000 0.2946
0.13

 140688  95457 135969

 372114
  We have seen the concept of
different project appraisal
methods above. But these are
the questions we have to
answer.
Decision  How the above methods can
Among help us to decide whether a
Alternatives project is viable or not?????

 How can we choose the best

alternative from mutually
exclusive alternatives using the
above methods?????
 To decide/evaluate the economic
benefits of a single investment/project,
Evaluation check the value of its PW/FW.
of Single  If PW/FW>0, accept the investment
investment  If PW/FW=0, remain indifferent
 If PW/FW<0, reject the investment
  A construction company is
considering the purchase of a dump
truck costing 652,500 birr. The MARR
is 15%.If revenue from the lease of the

Example: dump truck for the first three years is

as follows, evaluate the economic
benefits.
  PW = -652500 + 212280 (P/F,15,1) +
237858 (P/F,15,2) + 485112 (P/F,15,3)

Cont… = 30,911 >0

 So, the project is Acceptable
  If you need to select the best
alternative, based on the net-present-
worth/net future worth criterion, select
the one with the highest PW/FW, as
long as all the alternatives have the
Evaluation same service lives.

of more
than one  Comparison of mutually exclusive
alternatives with the same revenues is
Investment performed on a cost-only basis. In this
situation, you should accept the project
that results in the smallest PW/FW of
costs, or the least negative PW/FW
(because you are minimizing costs, rather
than maximizing profits)
 Example:
 Which alternative is the best if
i=10%?

Cont.… Project Cash Flow

N A B C D

0 -1000 -1000 -1000 -1000

1 0 600 -1200 900

2 0 800 800 900

3 3000 1500 1500 1800

 PW A = -1000 + 3000
(P/F,10,3)=1253.94

PW B = -1000+ 600(P/F,10,1) +
800 (P/F,10,2) +
1500(P/F,10,3)=1333.58

Cont.… PW C = -1000+ -1200(P/F,10,1)

+ 800 (P/F,10,2) +
1500(P/F,10,3)= -302.78

PW D = -1000+ 900(P/F,10,1) +
900 (P/F,10,2) +
1800(P/F,10,3)=1914.35
 Alternative D is the
Cont… best alternative
Thank you!