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) involves
current (current or future) outlay of funds
(expenditures) creating future benefits ( a stream
of benefits extending far into future).
A capital expenditure is incurred when a business
spends money either to buy fixed assets or to add
to the value of an existing fixed asset with a
useful life extending beyond the taxable year.
All assets depreciate except Land. Expenditure on
R&D, advertising and equipment reconditioning
expenditure 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 and
measuring the costs and benefits of a capital
expenditure proposal tend to be difficult.
Uncertainty : A capital expenditure decision
involves costs and benefits that extend far into
the future. Future is uncertain.
Temporal Spread : The costs and benefits are
often spread out over a long period of time,
usually 10-20 years for industrial projects and 20-
50 years for infrastructural projects. Such a
temporal spread creates some problems in
estimating discount rates and establishing
equivalences.
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 complex
process which may be divided
into six broad phases:
The dashed arrows indicate
that the phases of capital
budgeting are not related in a
simple, sequential manner.
Instead, there are several
feedback loops reflecting the
iterative nature of the process.
Planning: Investment strategy
The planning phase is concerned with the
(1)articulation of its broad investment strategy
and the generation and (2) preliminary screening
of project proposals.
The investment strategy of the firm delineates
the broad areas or types of investments the firm
plans to undertake.
This provides the framework which shapes,
guides, and circumscribes the identification of
individual project opportunities.
Planning: Preliminary screening of
project proposals
Once a project proposal is identified, it needs
to be examined. To begin with, a preliminary
project analysis is done. A prelude to the full
blown feasibility study, this exercise is meant
to assess
(i) whether the project is prima facie
worthwhile to justify a feasibility study and
(ii) what aspects of the project are critical to
its viability and hence warrant an in-depth
investigation.
Analysis
If the preliminary screening suggests that the
project is prima facie worthwhile, a detailed
analysis of the marketing, technical, financial,
economic, and ecological aspects is undertaken.
The focus of this phase of capital budgeting is on
gathering, preparing, and summarizing relevant
information about various project proposals
which are being considered for inclusion in the
capital budget.
Based on the information developed in this
analysis, the stream of costs and benefits
associated 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 payback
period 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 of
project 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 on
balance sheets in India) consists of paid-up
capital, share premium, and retained earnings.
Debt (referred to as loan funds on balance
sheets in India) consists of term loans,
debentures, working capital advances and so
on.
Flexibility, risk, income, control, and taxes
(referred to by the acronym FRICT) are the key
business considerations.
Implementation
Project and
engineering
designs,
Site probing and prospecting, preparation of blueprints, and
plant designs, plant engineering, selection of specific
machineries and equipments.
Negotiations
and contracting
Negotiating and drawing up of legal contracts with respect to
project financing, acquisition of technology, construction of
building and civil works, provision of utilities, supply of
machinery and equipment, marketing arrangements, etc.
Construction Site preparation, construction of buildings and civil works,
erection and installation of machinery and equipment.
Training Training of engineers, technicians, and workers. (This can
proceed
simultaneously along with the construction work.)
Commissioning Start up of the plant. (This is a brief but technically crucial stage
in the project development cycle.)
Avoiding Delays in Implementation
Translating an investment proposal into a
concrete project is a complex, time-consuming,
and risk-fraught task. Delays in implementation,
which are common, can lead to substantial cost
overruns. 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 underlying
the project;
2. A documented log of experience that is highly
valuable in future decision making
3. Corrective action to be taken in the light of
actual performance;
4. Uncover judgmental biases;
5. It induces a desired caution among project
sponsors.
Levels of decision making
Session2
1. What are the key questions raised in market analysis?
2. What are the important questions raised in technical analysis?
3. What aspects are looked into while conducting financial analysis?
4. What questions are sought to be answered in economic and
ecological analysis?
5. Present a schematic diagram of the feasibility study.
6. What key issues are examined while making a major investment
decision?
7. What is the rationale for the goal of shareholder wealth
maximization?
8. Discuss the weaknesses found in capital budgeting systems in
practice.
Facets of project analysis
The important facets of project analysis are:
1. Market analysis
2. Technical analysis
3. Financial analysis
4. Economic analysis
5. Ecological analysis
Key Issues in Project Analysis

Market analysis
Concerned mainly with aggregate demand and market
share. Information required is
Consumption trends in the past and the present
consumption 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 analysis
Whether
1. preliminary tests and studies have been done or provided
for?
2. availability of raw materials, power, and other inputs has
been 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 works
have 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 the
social 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 costs
and benefits of a project which may often be different from
its 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 in
terms 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 the
fulfillment of certain merit wants like self-sufficiency,
employment, and social order?
Ecological Analysis
In recent years, environmental concerns have assumed
a great deal of significance - and rightly so.
Ecological analysis should be done particularly for
major projects which have significant ecological
implications (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 the
environment?
What is the cost of restoration measures required to
ensure that the damage to the environment is contained
within acceptable limits?
Issues in major investment decisions
Apart from issues of comparative advantages, risks, DCF
and financing options:
Impact on Short-term EPS: Investors and equity analysts
consider EPS as a key indicator of a firm's performance.
Equally, or even more important, the incentive
compensation of managers is often linked to some measure
of earnings like profit after tax or EPS.
Options The traditional DCF model does not fully capture
the value of a capital project, as it does not reflect the
value of options embedded in it: option to delay, the option
to expand, the option to change the outputs or inputs of
the project, and the option to contract or abandon the
project. As these options give managers flexibility to
amplify gains or to reduce losses, they are valuable.
Objective of capital budgeting
Enhancing the firm's market value.
What should a firm do to maximize its contribution to
the 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 more
robust 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."
Weaknesses in capital budgeting
1. Poor alignment between Strategy and Capital
Budgeting
2. Deficiencies in Analytical Techniques
Base case is poorly identified
Risk is treated inadequately
Options are not properly evaluated
Lack of uniformity of assumptions
Side effects are ignored
3. No linkage between compensation and financial
measures
4. Reverse financial engineering
5. Weak linkage between capital budgeting and expense
budgeting
6. Inadequate post audits
Summary
Essentially a capital project represents a scheme for
investing resources that can be analyzed and appraised
reasonably independently.
The basic characteristic of a capital project is that it
typically involves a current outlay or current and future
outlays) of funds in the expectation of a stream of
benefits ; extending far into the future.
Capital expenditure decisions often represent the most
important decisions taken by a firm. Their importance
stems from three inter-related reasons: long-term
effects, irreversibility, and substantial outlays.
While capital expenditure decisions are extremely
important, they pose difficulties, which stem
from three principal sources: measurement
problems, uncertainty, and temporal spread.
Capital budgeting is a complex process which may
be divided into six broad phases: planning,
analysis, selection, financing, implementation,
and review.
One can look at capital budgeting decisions at
three levels: operating, administrative, and
strategic
The important facets of project analysis are:
market analysis, technical analysis, financial
analysis, economic analysis, and ecological
analysis .
While making a major investment decision, the
following key issues are examined: investment story,
risks, DCF value, financing, impact on short-term EPS,
and options.
Financial theory, in general, rests on the premise that
the goal of financial management should be to
maximize the present wealth of the firm's equity
shareholders.
The common weaknesses found in capital budgeting
systems in practice are:
poor alignment between strategy and capital budgeting;
deficiencies in analytical techniques,
no linkage between compensation and financial
measures;
reverse financial engineering;
weak integration between capital budgeting and expense
budgeting,
inadequate post-audits.