St-Cap Budgeting lec-4 0909

Project Management Lecture – 4 : 

Project Management Lecture – 4

Capital Budgeting (Financial Appraisal) : 

Capital Budgeting (Financial Appraisal)

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Importance of Capital Budgeting: * Involves huge expenditure as such very careful planning is needed. * Cost of error is very high. * Irreversibility of decisions or point of no‑return. * Future prospects or existence depend on it. * Since risk and uncertainty about future cash flows is very high careful estimation and calculation is needed .

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* Timely decisions make a firm capable to harvest future benefits & competitiveness. * Technological obsolescence can be avoided & firm can be made up to date in technology. * Capital Expenditure planning would make the firm more cost ‑ effective & competitive.

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Phases of Capital Budgeting: 1. Identification of opportunities for capital investments. 2. Formulation of capital project plan and preparation of feasibility report including analysis of suitable alternatives. 3. Appraisal by various authorities & obtaining sanction there from including market appraisal, technical appraisal and financial appraisal, SCBA, environmental analysis.

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4. Formulation of financing plan. 5. Implementation & monitoring. 6. Review & Post implementation evaluation.

BASIC FEATURES OF PROJECT APPRAISAL: A sound appraisal method should be used to measure the economic worth of an investment project. So any project appraisal method should at least : 

BASIC FEATURES OF PROJECT APPRAISAL: A sound appraisal method should be used to measure the economic worth of an investment project. So any project appraisal method should at least

* The methods or tools/techniques by applying which we can accept or reject a project; * Setting priority in accordance with the national demand/desirability; * Financial profitability of the executing/sponsoring agency; * To what extent the project is in conformity with the different policies like export import policy, commerce policy, industry policy, education policy, and health policy etc; : 

* The methods or tools/techniques by applying which we can accept or reject a project; * Setting priority in accordance with the national demand/desirability; * Financial profitability of the executing/sponsoring agency; * To what extent the project is in conformity with the different policies like export import policy, commerce policy, industry policy, education policy, and health policy etc;

* Should solve the problems of choosing among alternative projects; and * Should introduce a norm implying that maximum benefits are preferable to smaller ones and early benefits are preferable than to latter benefits. : 

* Should solve the problems of choosing among alternative projects; and * Should introduce a norm implying that maximum benefits are preferable to smaller ones and early benefits are preferable than to latter benefits.

TYPES OF PROJECT APPRAISAL: * Technical Appraisal * Financial Appraisal * Economic Appraisal * Social Appraisal/Project * Appraisal for Service Sector Project: 

TYPES OF PROJECT APPRAISAL: * Technical Appraisal * Financial Appraisal * Economic Appraisal * Social Appraisal/Project * Appraisal for Service Sector Project

1 TECHNICAL APPRAISAL: Means analysis of technical & engineering aspects which is mainly done in consideration of the following aspects: * Material; * Inputs; * Justification of location; * Appropriateness of Technology * Suitability of Equipment. : 

1 TECHNICAL APPRAISAL: M eans analysis of technical & engineering aspects which is mainly done in consideration of the following aspects: * Material; * Inputs; * Justification of location; * Appropriateness of Technology * Suitability of Equipment.

FINANCIAL APPRAISAL: * FA is conducted from the point of view of private entrepreneur includes only direct costs & direct benefits valued at market prices. * Financial & managerial soundness are examined to measure the investment worth. * FA seeks to ascertain whether the proposed project will be financially viable in the sense of being able to meet the burden of servicing debt and satisfy the return expectations of the investor’s of capital.: 

FINANCIAL APPRAISAL: * FA is conducted from the point of view of private entrepreneur includes only direct costs & direct benefits valued at market prices. * Financial & managerial soundness are examined to measure the investment worth. * FA seeks to ascertain whether the proposed project will be financially viable in the sense of being able to meet the burden of servicing debt and satisfy the return expectations of the investor’s of capital.

ECONOMIC APPRAISAL: * Economic analysis assessed from the point of view of the nation including both direct and indirect cost and benefits in terms of shadow price or accounting prices; * EA based on willingness to pay; * Better allocation of resources; and * Indication to the govt. about real return on investment.: 

ECONOMIC APPRAISAL : * Economic analysis assessed from the point of view of the nation including both direct and indirect cost and benefits in terms of shadow price or accounting prices; * EA based on willingness to pay; * Better allocation of resources; and * Indication to the govt. about real return on investment.

PROJECT APPRAISAL Market Appraisal 1. Aggregate demand of the product/ Service produced/ rendered relating to goods and services produced or rendered by the project 2. Demand forecasting. Methods of forecasting: a. Trend projection b. Consumption level c. Economic method 3. Expected share of market 4. Consumption trends in the past, present and future (Projection) : 

PROJECT APPRAISAL Market Appraisal 1. Aggregate demand of the product/ Service produced/ rendered relating to goods and services produced or rendered by the project 2. Demand forecasting. Methods of forecasting: a. Trend projection b. Consumption level c. Economic method 3. Expected share of market 4. Consumption trends in the past, present and future (Projection)

5. Past and present supply position 6. Smuggling or illegal entry of goods or free movement of goods as conceived of in open market economy operation by WTO 7. Production potentialities and constraints. 8. Import and export including survey of world by demand 9. Nature of competition 10. Cost structure: 

5. Past and present supply position 6. Smuggling or illegal entry of goods or free movement of goods as conceived of in open market economy operation by WTO 7. Production potentialities and constraints. 8. Import and export including survey of world by demand 9. Nature of competition 10. Cost structure

11. Elasticity of demand, income and supply 12. Consumer behavior, intentions, test and fashion, motivation, attitudes preferences and requirements 13. Distributions channels and marketing strategies 14. Product mix 15. Product life cycle 16. Administrative, technical and legal constraints. 17. Source of availability of raw materials 18. Government’s import and export policy 19. Quality of goods or services produced 20. Market information system-Source of marketing data: a. Primary data (market survey) b. Secondary data : 

11. Elasticity of demand, income and supply 12. Consumer behavior, intentions, test and fashion, motivation, attitudes preferences and requirements 13. Distributions channels and marketing strategies 14. Product mix 15. Product life cycle 16. Administrative, technical and legal constraints. 17. Source of availability of raw materials 18. Government’s import and export policy 19. Quality of goods or services produced 20. Market information system-Source of marketing data: a. Primary data (market survey) b. Secondary data

TECHNICAL APPRAISAL 1. Whether any technical study or test have been done 2. Availability of raw materials and possible changes in future in its uses 3. Availability of power and other inputs (water, spare parts etc.) 4. Selection of scale of operation or plant size a. Technology required b. Inputs constraints c. Investment cost d. Market condition e. Resource of the firm f. Government policy g. Optimal size (best size) 5. Selection of production process and its technology : 

TECHNICAL APPRAISAL 1. Whether any technical study or test have been done 2. Availability of raw materials and possible changes in future in its uses 3. Availability of power and other inputs (water, spare parts etc.) 4. Selection of scale of operation or plant size a. Technology required b. Inputs constraints c. Investment cost d. Market condition e. Resource of the firm f. Government policy g. Optimal size (best size) 5. Selection of production process and its technology

6. Choice of machinery, equipment and auxiliary of equipment 7. Choice of appropriate technology 8. Safety measures 9. Disposal of industrial waste and effluents. 10. Ecological and environmental pollution through the technology adopted 11. Projecting project time and cost 12. Time until ready to install and length of disruption of production during installation 13. Length of trial production and learning curve: 

6. Choice of machinery, equipment and auxiliary of equipment 7. Choice of appropriate technology 8. Safety measures 9. Disposal of industrial waste and effluents. 10. Ecological and environmental pollution through the technology adopted 11. Projecting project time and cost 12. Time until ready to install and length of disruption of production during installation 13. Length of trial production and learning curve

14. Proposed layout of the factory and process 15. Justification of locating site 16. Availability of infrastructural facilities 17. Quality control and its cost 18. Cost management 19. Use of network analysis for implementation of the project 20. Avoidance of time and cost overruns 21. Manpower required and its combination among unskilled, skilled and high skilled 22. Availability of spare parts and transfer and technical know-how 23. Need for foreign technicians their cost, and availability 24. Technical licensing, franchising, joint-venture etc. 25. Project designs, charts for structures and civil works : 

14. Proposed layout of the factory and process 15. Justification of locating site 16. Availability of infrastructural facilities 17. Quality control and its cost 18. Cost management 19. Use of network analysis for implementation of the project 20. Avoidance of time and cost overruns 21. Manpower required and its combination among unskilled, skilled and high skilled 22. Availability of spare parts and transfer and technical know-how 23. Need for foreign technicians their cost, and availability 24. Technical licensing, franchising, joint-venture etc. 25. Project designs, charts for structures and civil works

FINANCIAL APPRAISAL 1. Profitability measurement - BCR, NPV, ARR, IRR, PI 2. Cost of the project-Fixed assets and working capital 3. Cost of technology 4. Need of foreign exchange and its availability 5. Cost escalation 6. Means or source of financing a. Equity participation b. Debt or bonded capital c. Terms loan from FDI d. Leasing or buying e. Suppliers’ credit f. Loan or grants g. Capital subsidies h. Unsecured loans i. Working capital financing : 

FINANCIAL APPRAISAL 1. Profitability measurement - BCR, NPV, ARR, IRR, PI 2. Cost of the project-Fixed assets and working capital 3. Cost of technology 4. Need of foreign exchange and its availability 5. Cost escalation 6. Means or source of financing a. Equity participation b. Debt or bonded capital c. Terms loan from FDI d. Leasing or buying e. Suppliers’ credit f. Loan or grants g. Capital subsidies h. Unsecured loans i. Working capital financing

Estimation of scales and production 8. Cost of production at various level of output 9. Breakeven production and sales point that is operating and financial breakeven points. 10. Cost of capital and investment schedule 11. Debt servicing 12. Tax structure and burden regarding IT and VAT 13. Provision for tax holiday 14. Pay back period 15. Impact on cash flows : 

Estimation of scales and production 8. Cost of production at various level of output 9. Breakeven production and sales point that is operating and financial breakeven points. 10. Cost of capital and investment schedule 11. Debt servicing 12. Tax structure and burden regarding IT and VAT 13. Provision for tax holiday 14. Pay back period 15. Impact on cash flows

16. Cash requirements with time frame 17. Impact of seasonal and cyclical fluctuations 18. Pre operating expenses 19. Profitability projection over the life of the project 20. Financial projections: a. Projected income statement b. Projected balance sheet c. Projected cash flow statement : 

16. Cash requirements with time frame 17. Impact of seasonal and cyclical fluctuations 18. Pre operating expenses 19. Profitability projection over the life of the project 20. Financial projections: a. Projected income statement b. Projected balance sheet c. Projected cash flow statement

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Techniques of Capital Budgeting: Urgency : How much important a particular project is to be implemented for the company or the country. projects that are deemed to be more urgent get priority over projects that are regarded as less urgent.

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Problems of the Criteria : * How can the degree of urgency be determined? In certain situations, of course, it may not be difficult to identify really urgent investments. For example, some minor equipment that has failed may have to be replaced immediately to ensure continuity of production

In many situations it is difficult to determine the relative degree of urgency because of the lack of an objective basis. * The use of this criterion may imply that the persuasiveness’ of those who propose projects would become a very important factor in investment decisions. In view of these limitations of the criteria, we suggest that in general it should not be used for investment decision making. In exceptional cases, where genuine urgency exists, it may be used provided invest outlet are not large. : 

In many situations it is difficult to determine the relative degree of urgency because of the lack of an objective basis. * The use of this criterion may imply that the persuasiveness’ of those who propose projects would become a very important factor in investment decisions. In view of these limitations of the criteria, we suggest that in general it should not be used for investment decision making. In exceptional cases, where genuine urgency exists, it may be used provided invest outlet are not large.

Payback period: The Pay Back Period is defined as the length of time required for the stream of cash proceeds produced by an investment to equate the original cash outlay required by the investment. : 

Payback period : The Pay Back Period is defined as the length of time required for the stream of cash proceeds produced by an investment to equate the original cash outlay required by the investment.

* If an investment is expected to produce a stream of cash proceeds that is constant from year to year, then the pay back period can be determined by dividing the total original cash outlay by the amount of annual cash proceeds expected. * If the stream of expected proceeds is not constant from year to year, then the pay back period must be determined by adding up the proceeds expected in successive years until the total is equal to the original outlay. : 

* If an investment is expected to produce a stream of cash proceeds that is constant from year to year, then the pay back period can be determined by dividing the total original cash outlay by the amount of annual cash proceeds expected. * If the stream of expected proceeds is not constant from year to year, then the pay back period must be determined by adding up the proceeds expected in successive years until the total is equal to the original outlay.

The pay back period can also be used to rank investment alternatives, those having the shortest pay back periods being given the highest ranking.: 

The pay back period can also be used to rank investment alternatives, those having the shortest pay back periods being given the highest ranking.

NET PRESENT VALUE (NPV): In using a discount rate which quantifies our preference for present consumption over future, it reduces costs and benefits accruing in different years to the common time dimension, i.e., the present time period. Surplus of income or return over cost reduced to present period would provide us with an indicator to take investment decisions. The following example indicates the procedure for calculating the net present value of a project.: 

NET PRESENT VALUE (NPV): In using a discount rate which quantifies our preference for present consumption over future, it reduces costs and benefits accruing in different years to the common time dimension, i.e., the present time period. Surplus of income or return over cost reduced to present period would provide us with an indicator to take investment decisions. The following example indicates the procedure for calculating the net present value of a project .

Calculation of NPV: (Table is shown in LS: 

Calculation of NPV: (Table is shown in LS

NPV=Discount total Benefits – Discounted Total Cost or NPV= Present Value of Benefits – Present Value of Cost = 173.168 – 136.544 = 36.624: 

NPV=Discount total Benefits – Discounted Total Cost or NPV= Present Value of Benefits – Present Value of Cost = 173.168 – 136.544 = 36.624

The Net Present Value criterion is an absolute figure to decide whether investment in a particular project or a number alternative projects should be implemented or not. If NPV is higher than zero, than investment in the project is worthwhile. In the case of the selection of a project from a number of alternative projects, the projects would be arranged in descending order of NPV.: 

The Net Present Value criterion is an absolute figure to decide whether investment in a particular project or a number alternative projects should be implemented or not. If NPV is higher than zero, than investment in the project is worthwhile. In the case of the selection of a project from a number of alternative projects, the projects would be arranged in descending order of NPV.

NPV being an absolute figure does not provide us with the information on the rate of return on investment. It is not so much the value of net present value which is a guiding factor as the cost of getting the NPV. In order to get an indicator of this type, another investment criterion which is commonly used is the Benefit Cost Ratio. : 

NPV being an absolute figure does not provide us with the information on the rate of return on investment. It is not so much the value of net present value which is a guiding factor as the cost of getting the NPV. In order to get an indicator of this type, another investment criterion which is commonly used is the Benefit Cost Ratio.

BENEFIT COST RATIO (BCR): The procedure of deriving the benefit cost ratio criterion is the same, as that of NPV. What has to be done is to divide the present value of benefit, by the present value of cost. The ratio between the two would give us the benefit cost ratio which indicates benefit per Taka of cost. : 

BENEFIT COST RATIO (BCR): The procedure of deriving the benefit cost ratio criterion is the same, as that of NPV. What has to be done is to divide the present value of benefit, by the present value of cost. The ratio between the two would give us the benefit cost ratio which indicates benefit per Taka of cost.

The formula of Benefit Cost Ratio is shown in the LS:: 

The formula of Benefit Cost Ratio is shown in the LS:

If BCR is more than one; investment in the project is worthwhile. In the selection of a project from various alternative projects, select than project whose BCR is the highest when projects are arranged in descending order BCR. NPV and BCR as investment criteria may not provide the same ranking of the projects. This is clear from the following example:: 

If BCR is more than one; investment in the project is worthwhile. In the selection of a project from various alternative projects, select than project whose BCR is the highest when projects are arranged in descending order BCR. NPV and BCR as investment criteria may not provide the same ranking of the projects. This is clear from the following example:

NPV & BCR and Ranking of Projects: ( PL. See LS): 

NPV & BCR and Ranking of Projects: ( PL. See LS)

Thus the NPV criterion ranks project B as 1 and A as 11, BCR reverses this ranking. In an investment decision, the selection of investment is equally important. As long as we are concerned with a single project or two or more projects whose costs are the same, the NPV criterion is adequate, but in a situation of more than one project with different costs, NPV, as an absolute measure, fails to provide a correct choice. In the case of more than one project, which has different costs, a relative measure of the worthiness of the projects is provided by the BCR. To recapitulate BCR criterion states: : 

Thus the NPV criterion ranks project B as 1 and A as 11, BCR reverses this ranking. In an investment decision, the selection of investment is equally important. As long as we are concerned with a single project or two or more projects whose costs are the same, the NPV criterion is adequate, but in a situation of more than one project with different costs, NPV, as an absolute measure, fails to provide a correct choice. In the case of more than one project, which has different costs, a relative measure of the worthiness of the projects is provided by the BCR. To recapitulate BCR criterion states:

(a) In the case of a single project select the project it BCR is greater than one, and (b) In the case of more than one project, rank the project in descending order to BCR. The number of projects to be chosen depends upon the availability of investment funds.: 

(a) In the case of a single project select the project it BCR is greater than one, and (b) In the case of more than one project, rank the project in descending order to BCR. The number of projects to be chosen depends upon the availability of investment funds.

Internal Rate of Return is another measure of using discounted cash flow for arriving at the worth of the project, by finding out that rate of return which makes NPV = 0 or BCR = 1. In fact, IRR itself is a discount rate at which NPV = 0 and BCR= 1. What it represents is essentially the average earning power of money used in the project over the project life.: 

Internal Rate of Return is another measure of using discounted cash flow for arriving at the worth of the project, by finding out that rate of return which makes NPV = 0 or BCR = 1. In fact, IRR itself is a discount rate at which NPV = 0 and BCR= 1. What it represents is essentially the average earning power of money used in the project over the project life.

It is difficult to calculate IRR except through the application of an interpolation formula. The following formula is used to find out IRR Quickly: (PL. See Formula in LS): 

It is difficult to calculate IRR except through the application of an interpolation formula. The following formula is used to find out IRR Quickly: (PL. See Formula in LS)

In order to apply this formula, one lower rate of discount has to be applied which will show a positive NPV. We have done this. At 15% of discount rate our NPV is positive. We shall have to calculate NPV at a higher rate of discount with a negative value of NPV. Let us take 15% as the lower discount rate and 35% as the higher discount rate and calculate the NPV at 35%. : 

In order to apply this formula, one lower rate of discount has to be applied which will show a positive NPV. We have done this. At 15% of discount rate our NPV is positive. We shall have to calculate NPV at a higher rate of discount with a negative value of NPV. Let us take 15% as the lower discount rate and 35% as the higher discount rate and calculate the NPV at 35%.

Pl. See table ion the LS for Calculation of IRR: 

Pl. See table ion the LS for Calculation of IRR

However, IRR on its own does not provide a criterion for selection of projects. It needs some other variables i.e. the market rate of interest, or the social rate of discount for comparison to arrive at decision. : 

However, IRR on its own does not provide a criterion for selection of projects. It needs some other variables i.e. the market rate of interest, or the social rate of discount for comparison to arrive at decision.

IRR as investment criteria can be written as follows: * Choose a project if IRR of the same is greater than market rate of interest, social discount rate or social opportunity cost. ** With more than one project, rank the project in a descending order of values of IRR and chose that set of projects for which IRR is greater than or equal to market rate of interest subject of available investment funds.: 

IRR as investment criteria can be written as follows: * Choose a project if IRR of the same is greater than market rate of interest, social discount rate or social opportunity cost. ** With more than one project, rank the project in a descending order of values of IRR and chose that set of projects for which IRR is greater than or equal to market rate of interest subject of available investment funds.

THANK YOU VERY MUCH: 

THANK YOU VERY MUCH