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Project Appraisal: Traditional Methods

The document discusses various techniques for project appraisal to evaluate capital investments including traditional methods like payback period and newer time-adjusted methods like net present value and internal rate of return. It provides details on calculating and applying each method, with the key criteria being whether the investment will earn a return that exceeds the cost of capital. Examples are given to illustrate comparing potential projects based on metrics like payback period, rate of return, net present value, and profitability index to determine which should be accepted.

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arajamani78
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138 views4 pages

Project Appraisal: Traditional Methods

The document discusses various techniques for project appraisal to evaluate capital investments including traditional methods like payback period and newer time-adjusted methods like net present value and internal rate of return. It provides details on calculating and applying each method, with the key criteria being whether the investment will earn a return that exceeds the cost of capital. Examples are given to illustrate comparing potential projects based on metrics like payback period, rate of return, net present value, and profitability index to determine which should be accepted.

Uploaded by

arajamani78
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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04.

ProjectAppraisal

Theprimeobjectiveofcapitalinvestmentistomakeprofitbywayofinvestingin
variouscapitalassets.

Similarlytheprimeobjectiveofthefinanciertofinanceforcapitalinvestmentisto
seethathisfinancegetsproperreturnandatendofthecontractedperiodtheloan
amountisrepaid.

Therearevarioustechniques,whichcanbeemployedtocarryoutprojectappraisal.

TraditionalMethods:
Paybackperiod.
Profitabilityindex(postpayback)
Rateofreturnmethod.

TimeAdjustedmethods:
Netpresentvaluemethod
Internalrateofreturnmethod.
ProfitabilityIndexmethod.

PaybackPeriod

Thisindicatestheperiodduringwhichtheentirecapitalinvestmentisrecovered.
Yearlycashinflowshouldbeaddeduptillthetotalisequaltoinitialcapital
investment/projectcost.

Financierprefersaunithavinglowerpaybackperiod.
Limitations:

Itdoesnotconsidertimevalueofmoney.

Itignoresallcashflowsafterthepaybackperiod.

Merits:
Itiseasytocalculate.
Itemphasizesshortandmediumtermliquidity.
Ittendstoeliminatehighriskprojects.

PostPaybackProfitabilityIndex

Postpaybackcashinflowsx100dividedbycapitalinvestment=Postpayback
profitabilityindex.

Cashinflowsafterreachingpaybackperiodareconsideredtoascertainsafety
margininrecoveryofcapitaloutlay.

RateofReturnMethod.

Returnperinvestment=
Totalcashinflowx100dividedbycapitalinvestment.

Averagerateofreturn=
Averagecashinflowsx100dividedbycapitalinvestment.

NetPresentValue(NPV)

Abirdinhandisequaltotwobirdsinbush.
Timevalueofmoneyisconsidered.
Anyproject,whichgivesbigreturnintheshortestpossibletime,ismoreimportant.
StepsinvolvedincomputingNPV:
Deciderateofreturnexpectedfromtheproject.Itshouldbeatleastequalto

3
costofcapital.

Findoutpresentvalueofcapitaloutlay.
Findoutpresentvalueofcashinflows.
IfNPVis0orpositive,theprojectshouldbeaccepted.
Incaseofmultipleprojects,theonewithmaximumNPVshouldbeaccepted.

Internalratereturn(IRR)

IncaseofNPVmethod,thenetpresentvalueisfoundoutbydiscountingcash
flowsatpredeterminedrate.i.e.Costofcapital.

UnderIRRmethod,thecashflowisdiscountedatasuitablerate,whichequatesthe
presentvalue.

If IRR is > Cost of Capital, the project may be accepted. In case of


multiple projects, the one with maximum IRR should be accepted.
ProfitabilityIndexmethod

ProfitabilityIndex=Presentvalueofcashinflowsdividedbypresentvalueofcash
outflow.

NetProfitabilityIndex=Netpresentvaluedividedbyinitialcapital
investment/projectcost.

Ifprofitabilityindexis>1,theprojectshouldbeaccepted.
Refer Chapter 05- Financial Concepts for explanation of Internal Generation,
Cost of Capital etc.

4
ProjectAppraisalExamples.

Cashinflows=PATlessdividend+depreciationRs000

Year
ProjectA
ProjectB

P.A.
Cum.
P.A.
Cum.
Cashoutflow
Cashoutflow
0
1000
2000
1
200
200
400
400
2
300
500
400
800
3
300
800
400
1200
1200
4
400
500
1700
2300
5
400
1600
600
Totaloutflow
1000
2000
TotalInflow
1600
2300
Net
600
300

ProjectA
ProjectB
Paybackperiod
3.5years
4.5years

Postpaybackprofitabilityindex
600x100dividedby
300x100dividedby
1000=60%
2000=15%
Returnperinvestment
1600dividedby1000= 2300dividedby2000=
160%
115%
Averagerateofreturn
320dividedby1000=
460dividedby2000=
32%
23%

NetPresentvalue(NPV)

Rs000
Costofcapitalsay10%

Cashflows
Presen
Cashflows
Present
Year
Discountin
tvalue
value
gfactor
@10%
0
1000
1000
2000
2000
1.00000
1
0.90909
200
182
400
364
2
0.82654
300
248
400
331
3
0.75131
300
225
400
301
4
0.68301
400
273
500
341
5
0.62092
400
248
600
373
1600
1176
2300
1710
TotalPVofcashinflows
1000
1000
2000
2000
TotalPVofcashoutflows
600
176
300
(290)
NetPresentValue
ProfitabilityIndex
1176dividedby1000=1.18 1710dividedby2000=0.86
Conclusion

Accept

Reject

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