project appraisal 1a

8/11/2019 Project Appraisal 1a

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Project Appraisal-1

Overview: Chapter 1



Lec. Topic to be Covered Learning Objectives Chap

2 Overview Investment analysis & appraisal of scheme for investing resources. Linkage between Capital

Expenditure and Strategic Planning.

1

2 Investment

Opportunities

Methodologies and realistic assessment of investment opportunities 2&3

2 Market and Demand

Analysis

Systematic method and key steps for analyzing market and demand. 4

2 Technical Analysis Technological factors in project implementation. 5

2 Financial analysis Understanding and analysis of a project from a financial angle using financial parameters 6

3 Project cash flows

Principles and methodology of estimation of project cash flows. 9

2 Time value of money Effect of time value of money upon project 7

2 Cost of capital Determination of optimal capital structures for maximization of value of firm. 10

4 Appraisal criteria

Judging projects on the basic of payback, NPV, IRR and multiple criteria. 8

3 Analysis of Risk Various methods of estimating risk for optimal capital expenditure decision. 11

3 Social cost benefit

analysis

SCBA – UNIDO, LM approach 14

2 Financing of Projects Financing of Projects 18

2 Infrastructure Projects Financing Infrastructure Projects 19

2 Venture Capital and

Private Equity

Venture Capital and Private Equity 20



What is a project

• Project is a scientifically evolved work plan

devised to achieve a specific objective within a

specific period of time.

• It can be considered as proposal involving

capital investment for the purpose of

developing facilities to provide goods and

services.



Should we

build this

plant?



Objectives

1. Why are capital expenditures often the most

important decisions taken by a firm?

2. Explain the difficulties faced in capital

expenditure decisions.

3. Discuss the six broad phases of capital

budgeting.

4. Define the levels of decision making. What are

their key characteristics?



Capital Expenditure

•Capital expenditure (CAPEX or capex) involvescurrent (current or future) outlay of funds(expenditures) creating future benefits ( a streamof benefits extending far into future).

•

A capital expenditure is incurred when a businessspends money either to buy fixed assets or to addto the value of an existing fixed asset with auseful life extending beyond the taxable year.

•

All assets depreciate except Land. Expenditure onR&D, advertising and equipment reconditioningexpenditure may or may not be treated as CAPEX.



Capital investments: Importance

• Long Term Effects: The consequences of

capital expenditure decisions extend far into

the future.

• Irreversibility: If an equipment is acquired,

reversal of decision may mean scrapping the

capital equipment.

• Substantial: Capital costs tend to increase

with advanced technology.



Capital investments: difficulties•

Measurement Problems: Identifying andmeasuring the costs and benefits of a capitalexpenditure proposal tend to be difficult.

• Uncertainty : A capital expenditure decision

involves costs and benefits that extend far intothe future. Future is uncertain.

• Temporal Spread : The costs and benefits areoften spread out over a long period of time,usually 10-20 years for industrial projects and 20-50 years for infrastructural projects. Such atemporal spread creates some problems inestimating discount rates and establishingequivalences.



Types of capital investments

• Capital investments may be classified in

different ways .

• At the simplest level, capital investments may

be classified as physical, monetary, or

intangible.

• Strategic or Tactical

• Mandatory, Replacement, Expansion,

Diversification, R & D Investment or

Miscellaneous

Physical - land, building,

plant, vehicles, machinery

Monetary - deposits, bonds,

equity

Intangible - R&D,

training,franchises



Capital budgeting: an iterative Process

• Capital budgeting is a complexprocess which may be dividedinto six broad phases:

• The dashed arrows indicatethat the phases of capitalbudgeting are not related in asimple, sequential manner.Instead, there are several

feedback loops reflecting theiterative nature of the process.



Planning: Investment strategy

• The planning phase is concerned with the(1)articulation of its broad investment strategyand the generation and (2) preliminary screening

of project proposals.• The investment strategy of the firm delineates

the broad areas or types of investments the firmplans to undertake.

• This provides the framework which shapes,guides, and circumscribes the identification ofindividual project opportunities.



Planning: Preliminary screening of

project proposals

• Once a project proposal is identified, it needsto be examined. To begin with, a preliminaryproject analysis is done. A prelude to the full

blown feasibility study, this exercise is meantto assess

• (i) whether the project is prima facieworthwhile to justify a feasibility study and

• (ii) what aspects of the project are critical toits viability and hence warrant an in-depthinvestigation.



Analysis

•If the preliminary screening suggests that theproject is prima facie worthwhile, a detailedanalysis of the marketing, technical, financial,economic, and ecological aspects is undertaken.

•

The focus of this phase of capital budgeting is ongathering, preparing, and summarizing relevantinformation about various project proposalswhich are being considered for inclusion in thecapital budget.

• Based on the information developed in thisanalysis, the stream of costs and benefitsassociated with the project can be defined.



Selection • Selection follows, and often overlaps, analysis. It

addresses the question-Is the project worthwhile?

• A wide range of financial appraisal criteria have

been suggested to judge the worthwhileness of a

project.

• They are divided into two broad categories, viz., non

discounting criteria and discounting criteria.

– The principal non-discounting criteria are the paybackperiod and the accounting rate of return.

– The key discounting criteria are the net present value,

the internal rate of return, and the benefit cost ratio.



Selection

Acceptable rates depend on a mix of financing, the level ofproject risk, and risk appetite of management.

Tools like sensitivity analysis, scenario analysis, simulation

analysis, decision tree analysis, portfolio theory, capital asset

pricing model, and so on are used for risk analysis.



Financing

• Equity (referred to as shareholders' funds onbalance sheets in India) consists of paid-upcapital, share premium, and retained earnings.

• Debt (referred to as loan funds on balancesheets in India) consists of term loans,debentures, working capital advances and soon.

• Flexibility, risk, income, control, and taxes(referred to by the acronym FRICT) are the keybusiness considerations.



Avoiding Delays in Implementation

•Translating an investment proposal into aconcrete project is a complex, time-consuming,

and risk-fraught task. Delays in implementation,

which are common, can lead to substantial costoverruns. Some techniques facilitate

implementation

– Adequate Formulation of Projects

– Use of the Principle of Responsibility Accounting

– Use of Network Techniques: Pert, CPM



Review

1. How realistic were the assumptions underlyingthe project;

2. A documented log of experience that is highly

valuable in future decision making3. Corrective action to be taken in the light of

actual performance;

4. Uncover judgmental biases;

5. It induces a desired caution among projectsponsors.



Key Issues in Project Analysis



Market analysis •

Concerned mainly with aggregate demand and marketshare. Information required is

– Consumption trends in the past and the presentconsumption level

– Past and present supply position

–Production possibilities and constraints

– Imports and exports

– Structure of competition

– Cost structure

– Elasticity of demand

– Consumer behaviour, intentions, motivations, attitudes,preferences, and requirements

– Distribution channels and marketing policies in use

– Administrative, technical, and legal constraints



Technical analysisWhether

1. preliminary tests and studies have been done or providedfor?

2. availability of raw materials, power, and other inputs hasbeen established?

3. selected scale of operation is optimal?

4. production process chosen is suitable?5. equipment and machines chosen are appropriate?

6. auxiliary equipments and supplementary engineering workshave been provided for?

7. provision has been made for the treatment of effluents?8. proposed layout of the site, buildings, and plant is sound?

9. work schedules have been realistically drawn up?

10. Technology proposed to be employed is appropriate from thesocial point of view?



Financial analysis

• Investment outlay and cost of project

• Means of financing

• Cost of capital

• Projected profitability

• Break-even point

• Cash flows of the project

• Investment worthwhileness judged in terms of

various criteria of merit• Projected financial position

• Level of risk



Economic Analysis • Economic analysis, also referred to as social cost benefit

analysis, is• concerned with judging a project from the larger social point

of view. In such an evaluation the focus is on the social costsand benefits of a project which may often be different fromits monetary costs and benefits. The questions sought to be

answered in social cost benefit analysis are: – What are the direct economic benefits and costs of the project

when measured in terms of shadow (efficiency) prices and not interms of market prices?

– What would be the impact of the project on the distribution of

income in the society? – What would be the impact of the project on the level of savings

and investment in the society?

– What would be the contribution of the project towards thefulfillment of certain merit wants like self-sufficiency,employment, and social order?



Ecological Analysis •

In recent years, environmental concerns have assumeda great deal of significance - and rightly so.

• Ecological analysis should be done particularly formajor projects which have significant ecologicalimplications (like power plants and irrigation schemes)and environment-polluting industries (like bulk drugs,chemicals, and leather processing).

• The key questions raised in ecological analysis are:

– What is the likely damage caused by the project to theenvironment?

– What is the cost of restoration measures required toensure that the damage to the environment is containedwithin acceptable limits?



Objective of capital budgeting

• Enhancing the firm's market value.

• What should a firm do to maximize its contribution tothe society? – The contribution to the society is maximized by maximizing

the value of the firm• "The quest for value drives scarce resources to their

most productive uses and their most efficient users.The more effectively resources are deployed, the morerobust will be the economic growth and the rate of

improvement in our standard of living.• Adam Smith's 'invisible hand' is at work when

investors' private gain is a public value."

project appraisal 1a

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