CHAPTER SEVEN

CAPITAL PROJECT APPRAISAL METHODS

 INTRODUCTION

One of the aspects of project management is

proper decision making in respect of investment
of funds. Successful operations of any business
depend upon the investment of resources on
such a way as to bring in benefits or best
possible results from any investment.
 Cont…

An investment can be simply defined as

expenditure in cash or its equivalent during one
or more time periods in anticipation of enjoying
a net inflow of cash or its equivalent in some
future time period or periods.
An appraisal of any investment proposal is
necessary to ensure that the investment of
resources will bring in desired benefits in future.
 Cont…

If the financial resources were in abundance, it

would be possible to accept several investment
proposals which satisfy the norms of approval or
acceptability. Since resources are limited a
choice has to be made among the various
investment proposals by evaluating their
comparative merit.
 Need for Appraisal

You must have observed that the project investment

proposals:
 Involve large amount of funds
 Involve greater amount of risk on account of
unforeseen situations, and
 Often mean irreversibility once the investment
decision is made.
In view of the above tasks, appraising investment
proposals is very important in project management.
 Project Report

Preparation of a project report is a complicated

process. It includes not only the projection of financial
data related to outflows and inflows of cash, but also
a meticulous exercise to access the following aspects:
• Potentiality for the marketing of the project
• Technical feasibility of the project
• Availability of managerial skills
• Environmental impact
• Financial viability
In this chapter, we are mainly concerned with only the
“Financial” aspect for the appraisal of an investment
 Relevant Data

The following relevant data need to be

considered before appraisal is taken up:
• The amount and timing of initial cash outlay or
investment.
• The amount and timing of subsequent
investment outlays.
• The economic life of the project.
• Salvage value at the end of the project.
• The amount and timing of the cash flows.
 Methods of Appraisal

There are two main methods used for evaluating project

investment proposals. These are;
1) Non-discounted cash flow method – This method
doesn’t take into account or consider the time value
of money. It includes;
a) Pay Back Period
b) Accounting Rate of Return
2) Discounted Cash Flows – This method considers the
time value of money. Under this method, we have;
a) Net Present Value
b) Profitability index
c) Internal Rate of Return
Decision Rule
 Non-discounted method

1) Pay Back Period - In a simple term it means the

total period with which the total amount invested
will be recovered throughout net cash flow after tax.
It can be calculated using the following formula:
P = E + B/C
Where,
P = Payback period
E = Number of years immediately preceding the year
of final recovery
B = Balance amount still to be recovered
C = Cash flow during the year of final recovery
 Cont…

Example one:
Suppose a sum of $500,000 has to be invested in
a project who’s expected net cash flows are as
follows;
Year Annual net cash flows
0 ($500,000)
1 185,000
2 125,000
3 140,000
4 170,000
5 180,000
 Cont…

Required – Calculate;
a) The pay back period for the project?
b) If the project’s pay back period set by the
management is 4 years, then will the project
be accepted or rejected? Justify your reason.
 Cont…

Solution;
a) The pay back period;
year Annual net cash Cumulative
flow
0 ($500,000) ($500,000)
1 185,000 (315,000)
2 125,000 (190,000)
3 140,000 (50,000)
4 170,000 120,000
5 180,000 300,000
 Cont…

Thus, the project investment could be recovered

during the 4th year. To be exact, the payback
period is calculated below:
P = E + B/C
P = 3 years + ($50,000/$170,000) = 3.29 years
b) Since the pay back period set by the
management is 6 years (which is above the
actual 3.29 years), then it will be rejected.
N.B – The shorter the pay back period, the
better is the project and vice versa.
 Cont…

2) Accounting Rate of Return (ARR) – This

method, which is also termed as return on
investment, is the ratio of average annual net
profit to original investment. It is calculated as
follow;
ARR = Average Annual Net Income X 100
Average Investment
 Cont…
Example two:
Determine ARR from the following data of Project –A.
Particulars Project –A
Cost ------------------------------- $35,000
Year Annual Net Income
1 $3,000
2 $5,000
3 $7,000
4 $9,000
5 $11,000
Total Income -------------------------- $35,000
Estimated Life: 5 Years
Estimated Salvage Value: Zero
 Cont…

Solution;
First, we have to calculate the average net
income as follow;
Average net income = $35,000/5 = $7,000
Hence, ARR = ($7,000/$56,000)x100 = 12.5%
 Discounted cash flow method

1) Net Present Value (NPV) - NPV is a technique

which used to evaluate investment proposal and
it explicitly recognizes time value of money. NPV
is the excess of the present value (PV) of cash
inflows generated by project over the amount of
the initial investment (I).
NPV= PV-I
Where,
NPV = Net present value
PV = Present value of cash inflows
 Cont…

The present value of cash inflows is calculated as

follows;
PV = CF1/(1+k)+CF2/(1+k)2+CF3/(1+k)3+…..+CFn/(1+k)n

or
PV=
Therefore, the formula for NPV is given as follow;
NPV = - I
 Cont…
Example three:
Suppose X project initially requires $56,000 for
its investment and the expected cash inflows for
the consecutive 5 years are given as follows;
Year Annual cash inflow
1 14,000
2 16,000
3 18,000
4 20,000
5 25,000
 Cont…

If the investors required rate of return is 10%,

then calculate;
a) NPV?
b) Will the project be acceptable or not? Justify
your reason.
Solution;
 Cont…
a) NPV
First, lets calculate the present value of the cash
inflows;
PV =[14,000/(1+0.1)+16,000/(1+0.1)2+18,000/(1+0.1)3 +
20,000 /(1+0.1)4 + 25,000/ /(1+0.1)5 ] – 56,000
PV = [14,000(0.909)+16,000(0.826)+18,000(0.751)+
20,000(0.683)+25,000(0.621)]
PV = 12,726+13,216+13,518+14,660+15,525
PV = $69,645
Therefore, NPV = $69,645 - $56,000 = $13,645
b) Acceptable since NPV is positive, i.e. $13,645
 Cont…
2) The Profitability Index (PI) - The profitability index
is called also benefit cost ratio; the ratio of the sum of
the present values of a project’s net cash inflows to
the project’s present values of cash outflows. The PI
indicates the increase in the value of the firm created
by each birr invested in the project. The formula is
given as follow;
PI = /I
Where,
PI = Profitability index
PV = Present value
I = Initial cash outlay or investment
 Cont…

Example four;
By considering example three, calculate the PI?
Will the project be acceptable or not? Justify
your reason.
Solution;
PI = $69,645/$56,000 =
Since PI is greater than 1, then the project is
acceptable.
 Cont…

3) Internal rate of return (IRR) - The IRR, which

is also termed as Yield on Investment, is usually
the rate of return that a project earns. It is
defined as the discount rate (r) which equates
the aggregate values of the net cash inflows
(NCFA) with the aggregate present value of cash
outflows of a project. In other words, it is that
rate which gives the project NPV of zero.
 Cont…

Mathematically, the IRR is represented by the

rate “r” or ‘’k’’ such that:
Zero = - I
Where:
k = Internal rate of return.
CFt = Cash inflows at different time periods, and
I = Original investment.
 Cont…

Unlike the NPV method, calculating the value of IRR

is more difficult. The formula is given as follow;
IRR = LRD + (NPVL) X ∆R
∆NPV
Where;
IRR = Internal Rate of Return,
LRD = is the lower rate of discount rate,
NPVL = is the net present value at the lower rate of
discount,
∆NPV= is the difference in present values at lower and
higher discount rates, and
∆ R = is the difference between two rates of discount.
 Cont…
For example assume that the initial cost of a
project is $3,500,000 and its expected cash
inflows over the given periods is as shown
below;
Year Annual cash inflows
1 $1,000,000
2 1,000,000
3 1,000,000
4 1,000,000
5 500,000
6 500,000
 Cont…
Required – Calculate the project’s internal rate
of return (IRR)?
Solution - First let the IRR be 12% and see the
result of NPV.
Year Cash inflow PV factor (12%, 6yrs) PV
1 $1,000,000 0.893 $893,000
2 1,000,000 0.797 797,000
3 1,000,000 0.712 712,000
4 1,000,000 0.636 636,000
5 500,000 0.567 283,500
6 500,000 0.507 253,000
Total $3,575,000
 Cont…
The NPV @ k=12% is, therefore; NPV =
$3,575,00 - $3,500,00 = $75,00. Hence, k=12% is
not IRR since NPV is not zero. Again lets take
k=13% and see the result of NPV.
Year Cash inflow PV factor (13%, 6yrs) PV
1 $1,000,000 0.885 $885,000
2 1,000,000 0.783 783,000
3 1,000,000 0.693 693,000
4 1,000,000 0.613 613,000
5 500,000 0.543 271,500
6 500,000 0.480 240,000
Total $3,485,000
 Cont…
Again, the NPV @k=13 is;
NPV = $3,485,000 - $3,500,00 = -$15,000
When IRR is 12%, then NPV is $75,000 and when
IRR is 13%, NPV is -$15,000. So, this indicates
that the exact IRR for the project is between
12% and 13% and it can be calculated as follows;
 Cont…
IRR = LRD + (NPVL) X ∆R
∆NPV
IRR = 12% + $75,000 X (13% – 12%)
$75,000 – (- $14,500)
IRR = 12% + $75,000 X 1%
$89,500
IRR = 12% + (o.84 x 1%)
IRR = 12% + o.84%
IRR = 12.84 %
END