Financial Appraisal of Project Dr. Raghu Bista, NASC

Financial Appraisal Financial appraisal involves critically examining the basic data, assumptions and methodology used in project preparation to assure project’s viability, profitability, sustainability from the financial point of view.

Financial Appraisal Cont.. The scope of financial appraisal varies considerably with the nature of project and whether it is revenue producing (e.g. industry, agriculture) or not (e.g. roads, public schools). It covers: - Review on investment cost and operating cost (is there over or under estimation) Sales and Pricing Financing Income and expenditure Liquidity plan Selection of discount rate Profitability or self sustainability etc.

Aspects to Review Estimation of Investment Cost (Construction Cost) Estimation of Operating Cost for the Operating Period Estimation of Operating Benefits for Operating Periods Estimation of Scrap Value Differences Between Benefits and Costs

Investment Cost of the Project The Investment cost of the project includes cost of all the items, consulting fees, Project implementation costs. In Infrastructure Project, it is also called Construction Cost.

Cost Estimation Cost of land and site development Building cost Plant and machinery cost Other fixed assets Project management cost Contingencies cost etc.

Cost of Land and Site Development (examples) Cost Items Quantity Price Total cost Cost of land Cost of leveling and development 5 ropani - 5 lakhs per ropani 25 lakhs 5 lakhs Total 30 lakhs

Cost of Building Total Cost Items Quantity Price Total cost Building for main plant Administrative Building Canteen Guest house Quarter for staff 1 10 lakhs 5 lakhs 2 lakhs 6 lakhs Total 25 lakhs

Cost of Machinery Total Cost Items Quantity Price Total cost Imported machinery Indigenous machinery Installation charges 1 2 - 10 lakhs 2 lakhs 4 lakhs 1 lakhs Total 15 lakhs

Other Fixed Assets Total Cost Items Quantity Price Total cost Furniture Fire fighting equipment 5 sets 10 sets 1 lakhs 50 thousands lakhs 5 lakhs Total 10 lakhs

Project Management and Administration Cost Cost Items Units Months Cost per month Total Salary to Project Manager Salary to Project staffs Salary to Technical Advisor 1 3 12 5 20000 10000 240000 360000 100000 7 lakhs

Total budget (in Lakhs) Cost Items 1st Q 2nd Q 3rd Q 4th Q Total Budget Cost of land and site development Cost of Building Cost of Machinery Other Fixed Assets Project Management cost 30 - 10 15 5 25 7 Contingency cost 3 Quarterly cost 90 lakhs

Review on sales Estimation Estimation of Sales Quantity Estimation of Price per unit Estimation of Project’s benefit periods.

Basis of Project’s Benefit Analysis Period Physical life of the plant Technical life of the plant (Until plant will not be obsolete by new technology) Product market life of the plant Investment planning horizon of the firm

Estimated Sales and Production Budget for 10 yrs (Examples) Cost Items 1st yr 2nd yr 3rd yr 4th yr 5th to 10th yr Installed Capacity 100 million lt 100 million lt Estimated Annual production and Sales 40 ml 40ml 50ml 80 ml Selling price per lt Rs. 10 Rs. 12 Total sales Volume Rs. 400 million Rs. 400 Million Rs 600 Million Rs. 960 Million

Cost Items 1st yr 2nd yr 3rd yr 4th yr 5th to 10th yr Estimation of Total Cost operation and Maintenance for operational life of project Cost Items 1st yr 2nd yr 3rd yr 4th yr 5th to 10th yr Maintenance Depreciation Tax Administrative Cost (Office rent Stationary, telephone etc.) Selling and Distribution Expenses - Sales person’s commission - Advertisement - Traveling expenses etc. Total Cost of Operation

Operational working result of Project (yearly Profit) Cost Items 1st yr 2nd yr 3rd yr 4th yr 5th to 10th yr A. Sales Revenue Less: Maintenance Depreciation Tax Administrative Cost (Office rent Stationary, telephone etc.) Selling and Distribution Expenses - Sales person’s commission - Advertisement - Traveling expenses etc. B. Total Cost of Operation C. Net Profit Before tax (A- B) D. Tax (30%) E. Net Profit after tax (C – D)

Calculation of Operational Cash inflow Cost Items 1st yr 2nd yr 3rd yr 4th yr 5th to 10th yr A. Sales Revenue Less: Maintenance Depreciation Tax Administrative Cost (Office rent Stationary, telephone etc.) Selling and Distribution Expenses - Sales person’s commission - Advertisement - Traveling expenses etc. B. Total Cost of Operation C. Net Profit Before tax (A- B) D. Tax (30%) E. Net Profit after tax (C – D) F. Cash inflow (E + Depreciation)

Review on Estimation of Terminal Cash inflow Scrap value of assets at the end of operational year Recovery of working capital at the end of operational year

Review on Estimation of Working Capital Working capital is the fund required to finance stock level of raw material, finished goods, receivables and minimum cash or bank balance. Funds required for Working Capital Should be planned carefully Liquidity plan

Liquidity Cycle related to working Capital

Sources of Finances and Suitability Equity Capital Preference Share Debenture Public Deposits Incentive Sources Bank Loan Lease Finance etc.

Estimation of Net Cash flow of Project Net cash flow of the project will be estimated for whole life of the project. Net cash flow will help to analyze financial profitability of the project

Criteria of Financial Viability Payback Period Calculation of Net Present Value (NPV) Calculation of Internal rate of return (IRR) Calculation of Benefit/Cost Ratio

Payback Period The payback period method calculates the period of time a project takes for the future net cash flows to equal the original cost of projects. The payback method therefore indicates how quickly the investment cost will be recovered. A quick pay back period indicates a reduction in risk. Projects with early payback period are therefore usually more attractive. However, payback method ignores the later cash inflow and time value of money.

Time Value of Money Before discussing NPV,IRR and Benefit/Cost ratio, discussion on time value of money and cost of capital (opportunity cost of capital) is necessary) A rupee in hand today is worth more than a rupee received in the future.

Methods for Dealing with Time Value of Money Calculation of Future value FV = PV (1+k)n Where FV = Future value, PV = Present Value, K = Interest rate per year, n = number of years) 2. Calculation of Present Value PV = FV (1+k)n

Estimation of Cost of Capital Cost of capital is the weighted average cost of capital the project has to pay for its sources of finance. It is also called discount rate.

Calculation of NPV NPV is defined as present value of benefits (cash inflows) less present value of costs (cash outflows) Formula for calculating present value PV = FV (1+k)n If the NPV > 0, the project will be accepted. If the NPV < 0, the project should be rejected.

Calculation of Internal Rate of Return (IRR) The internal rate of return is calculated at the rate at which the NPV of a project is zero. In the IRR calculation, we set the NPV equal to Zero, and determine a rate that satisfies the condition. This is found by trial and error.

Decision Under IRR criteria If the IRR is greater than cost of capital (discount rate), the project will be accepted. If the IRR less than the cost of capital, then the project should be rejected.

Process for calculation of IRR 1. Determine the NPV at two closest discount rate to produce one positive NPV and another negative NPV. (example) NPV at 15% = 802, NPV at 16% = - 1359 2. Find the sum of absolute values of NPV in step 1 e. g. 802 + 1359 = 2161 3. Calculate the ratio of NPV of the smaller discount rate identified in step 1 to the sum of obtained in step 2 e.g. 802 ÷ 2161 = 0.37

Process for calculation of IRR cont… 4. Add the number obtained in Step 3 to the smaller discount rate e.g. 15% + 0.37 = 15.37% 5. The IRR is the 15.37%.

Calculation of Benefit/Cost ratio Benefit/cost ratio is the present value of benefit (cash inflow) divided by present value of cost (cash outflow). B/C ratio > 1, Project will be accepted B/C ration < 1, Project should be rejected

Sensitivity Analysis Sensitivity analysis is a technique to understand to what extent change in a variable of a project will affect its profitability. For Example what will happen to the Net Present Value if labor cost increases by 50%? This will give an indication of risk and among the variables which variable is risky.

Further Study Identification of errors if any Review data sources, assumption, methodology Collect and analysis further data if needed Recommendations required to approve and finance the project

Thank You