Financial Appraisal in Project Scanning and Selection

Financial Appraisal in Project Scanning and Selection

TIME VALUE OF MONEY Money value can be increased if it keeps on rolling. This is what is known as time value of money.

Understanding Time Value of Money
Year 1 2 3 4 Rs. -1,000 250 Compounding: The future value of money that is available today can be calculated using the concept of Compounding and that value is known as Future Value ( FV) or Compounded Value ( CV). Discounting: The present value of money accruing later is estimated by the process of Discounting and the value is known as Present Value ( PV) or Discounted Value (DV).

Table 1 – Process of Compounding
Cash outflow in the beginning (year 0) Cash inflow in year 1 Cash inflow in year 2 Cash inflow in year 3 Cash inflow in year 4 -1000 250 +FV(250) +FV(-1000)

Table 2: Process of Discounting
Cash outflow in the beginning (year 0) Cash inflow in year 1 Cash inflow in year 2 Cash inflow in year 3 Cash inflow in year 4 -1000 250 +PV(250) Simple Interest: The future value (FV) of a sum of money invested at a given annual rate of interest will depend on whether the interest is paid only on the original investment ( called Simple Interest). Compound Interest: It is calculated on the original investment plus accrued interest ( called Compound Interest). In the case of compound interest, there is a further factor affecting the future value, namely the frequency with which interest is paid (e.g. monthly, quarterly or annually).

Compounded or Future Value
With simple interest, the future value is determined by: FVn = V0(1+i*n), where , FVn = future value at time n, V0 = original sum invested or the principal value i = annual rate of simple interest Say, you win Rs.100,000 from a TV Realty Show and decide to invest in Fixed deposit of a commercial bank at a simple interest of 10% for five years. The future value will be the original of Rs plus five years interest, giving a total of Rs.150,000. FV5 = Rs.100,000 [1+ (0.10)(5)] = Rs.150,000.

If i is compound interest, in subsequent years the interest is paid on the original capital plus accrued interest. FV(i,n) = V0(1+i)n Suppose your Rs investment was put into a building society paying a fixed 10% compound interest yearly. What will your investment be worth after five years? In one year time, the investment will be worth 100,000(1+0.10) = Rs.110,000 After 2 years it will be worth 100,000(1+0.10)2 = 121,000 After 5 years it will be worth: FV5 = 100,000(1+0.10)5 = 161,000 Hence the effect of compound interest yields a much higher value than simple interest, which yielded

More Frequent Compounding
The generalized formula for these shorter compounding period is FVn = V0( 1+ k/m)m*n, where m is no. of years compounding is done & k is nominal interest rate. Suppose you deposit Rs.20,000 with an investment company which pays 12% interest with quarterly compounding. How much will this deposit grow in 5 years? Solution : FV = 20,000 * (1+0.12/4)4*5 = 20,000(1+.03)20 =Rs.36,120

Annual Percentage Rate (APR) for a Loan: Annually (1+0.22) -1 0.22 or 22% Semi-annually (1+0.22/2)2 – 1 0.232 or 23.2% Quarterly (1+0.22/4)4 – 1 0.239 or 23.9% Monthly (1+0.22/12)12 – 1 0.244 or 24.4% Daily (1+0.22/365)365 – 1 0.246 or 24.6%

Effective interest rate= r = (1+k/m)m -1, Where r = effective interest rate, k = nominal interest rate, m = frequency of compounding per year If the nominal interest rate is 10% and frequency of compounding is half yearly, the effective interest rate is r = (1+k/m)m -1 = ( /2)2 – 1 = or 10.25%

Doubling Period (DP) A frequent question asked by the investor is, “ How long it will take to make an amount double for a certain rate of interest?” This question can be answered by a thumb rule known as ‘rule of 72’ or ‘rule of 69’. By rule of 72 , DP = 72/i for an interest rate = i%. By rule of 69, DP = /i for an interest rate = i%. Example : Find out the doubling period for an interest rate of 10% by applying the two rules. By rule of 72 , DP = 72/i for an interest rate of i% = 72/10 = 7.2 years. By rule of 69, DP = /i for an interest rate of i% = /10 = = 7.25 years.

Future Value

Discounted or Present Value
An alternative way of assessing the worth of an investment is to invert the compounding process to give the present value of the future cash flows. This process is called discounting. Today’s value of any future cash flow is known as Discounted or Present Value. . Discounting is the process of adjusting future cash flows to their present values. It is, in effect, compounding in reverse.

Future Value We have seen that Future Value
Dividing both sides by (1+i)n, Future Value n Example : Compute the present value of Rs.1,611 receivable after 5 years at the rate of 10% . Note: Do not pay more than Rs.1,000 today for an investment offering a certain return of Rs.1,611 after 5 years, assuming a 10% market rate of interest.

Effect of discounting It is useful to see how the discounting process affects present values at different rates of interest. This is seen in the following figure that the value of Rs.1 decreases as the rate and period increases from 0 to 20% and within years. Present value of a single future sum Rs.1 year 10% 15% 20% 1.0 5 0.6 0.5 0.4 10 0.25 0.16 15 0.24 0.12 0.06 20 0.15 0.03 25 0.19 0.01

The relationship between present value of Rs.1 and interest over time
Discount factors Present value(Rs) % 1.0 0.75 5% 0.5 10% 0.25 15% 0.0 20% Period(years) 2 4 6 8 10 The relationship between present value of Rs.1 and interest over time

Present value formula Much of the medium of using formulae and power functions can be eased by using discount tables or computer based spreadsheet packages. The discount factor or interest factor Rs.1 for a 10% discount rate in three years’ time is: 1/(1.10)3= 1/1.33 = 0.751 PVIF(i, n)= 1/(1+i)n

Future value formula The inverse of PVIF is Future Value Interest Factor (FVIF). The above equation can be written as follows: PVn = Present Value = FVn = FVn * PVIF(i,n) (1+i)n Therefore, Compounded value or Future value = FVn = PVn* (1+i)n = PVn* FVIF(i,n). FVIF(i,n) = (1+i)n Therefore, PVIF(i,n) = 1/ FVIF(i,n)

Example Rama Raju promises you to give you Rs.5,000 after 10 years in exchange for Rs.1,000 today. What interest is implicit in his offer? Let i be the rate of interest. It is given that Rs.1000* FVIF(i,10) = 5000, FVIF(i,10) = 5 From the tables we find FVIF(16,10) = 4.411 And FVIF(18,10)= 5.234 Applying a linear approximation in the interval, we get i = 16% + 2% * (5.0—4.4111) = %. (5.234—4.411)

Present Value

Annuity An annuity is an investment paying a fixed sum each year(A) for a specified period of time(n) at the rate of interest k. Examples of annuities include many credit agreements and house mortgages. Present Value of an annuity The present value of a regular annuity can be represented in terms of the symbols defined in the table as follows: PVAn = A/(1+i) + A/(1+i)2 + A/(1+i) A/(1+i)n (1) Multiplying both sides by (1+i) we get, PVAn(1+i) = A + A/(1+i) + A/(1+i) A(1+i)n (2) Subtracting equation (1) from equation (2), we get PVAni = A – A/(1+i)n = A[ 1 – 1/(1+i)n] PVAn = A [(1+i)n – 1] = A*PVIFA(i,n) i* (1+i)n

Present Value Of Annuity
Example : Suppose an annuity of Rs.1000 is issued for 20 years at 10%. Using the table Z1 in Appendix 2, we can find the present value as follows: PVA(10,20) = Rs.1,000 * PVIFA(10,20) = Rs.1,000 * = Rs.8,513.60 Time Amount 1 2 3 4 5 PV 1,000 +1,000(1.1)-1 +1,000(1.1)-2 +1,000(1.1)-3 +1,000(1.1)-4

Future value of an annuity
The future value of a regular annuity can be expressed as follows: FVAn = A(1+i)n-1 +A(1+i)n A (3) Multiplying equation (3) by (1+i) on both sides, we get FVAn(1+i) = A(1+i)n +A(1+i)n A(1+i) (4) Subtracting equation (3) from equation (4), we get FVAn = A[(1+i)n – 1]/i = A* FVIFA(i,n) Therefore, PVIFA(i,n) = FVIFA(i,n)*PVIF(i,n)

Future value of an annuity
Example : You can save Rs.6,000 a year for 5 years. What will be these savings cumulate to at the end of 10 years, if the rate of interest is 10%? The accumulated value after 10 years will be as follows: = Rs.[6,000*FVIFA(10,5)*FVIF(10,5)] = Rs.[6000*6.105*1.611] = Rs Time Amount 1 2 3 4 5 FV 1,000 1,000(1.1)5 +1,000(1.1)4 +1,000(1.1)3 +1,000(1.1)2 +1,000(1.1)

Annuity Due In case of annuity, it is generally assumed that payment has been made at the end of each year. If the payment is made at the beginning of each year, then this is called annuity due and it’s value is found by the product of the value (either present or future) of a regular annuity and the factor (1+i). FVAn(due) = A*FVIFA(i,n)*(1+i) PVAn(due) = A*PVIFA(i,n)*(1+i) Example : What is the present value of a 5 year annuity due of Rs. 5,000 at 10%? PVAn(due) = A*PVIFA(i,n)*(1+i) = Rs.5,000*PVIFA(10,5)*(1+0.1) = Rs.2, Perpetuity Frequently, an investment pays a fixed sum each year for a specified number of years. A series of annual receipts or payments is termed an annuity. The simplest form of an annuity for an infinite series is called Perpetuity.

Perpetuity PVperpetuity = A/i Example :
Uncle Shyam wishes to leave you in his will an annual sum of Rs.10,000 a year starting next year. Assuming an interest rate of 10%, how much of his estate must be set aside for this purpose? PV = Rs.10,000/0.1 = Rs.100,000 Let your benevolent uncle now wishes to compensate for inflation estimated to be at 6% per annum (say). Then PV = A/(i-g) = Rs.10,000/( ) = 250,000. Similarly, Present value of growing perpetuity = A/ (i-g) where, g = growth rate.

Calculating interest rates
We know that PV = FV* PVIF(i,n) Therefore, PVIF(i,n) = PV/FV = 1/(1+i)n Or, (1+i)n = FV/PV i = (FV/PV)1/n - 1 Example : A credit company may offer to lend you Rs.1,000 today on condition that you repay Rs. 1,643 at the end of three years. Then what is the compound interest rate for this offer? i = (1643/1000)1/3 – 1 = 18%

Cost of Capital The cost of source of finance is defined as the rate of discount which equates the present value of the expected payments to that source of finance with the net proceeds received from the same source. Opportunity Cost of Capital The first step in calculating a company’s Weighted Average Cost of Capital (WACC) is to calculate the cost of the individual components of its capital. Here we consider the different sources of long-term finance available to a company and how to calculate the cost of using the source.

Cost of Equity – DCF Approach
Discounted Cash Flow (DCF) Approach: According to the Dividend Forecast Approach, the intrinsic value of an equity stock is equal to the sum of the present values of the dividends associated with it, i.e., Pe = ∑ Dt / (1+ke)t for t= 1 to n Where, Pe = price per equity share, Dt = expected dividend per share at the end of year t, And ke = rate of return required by the equity shareholders. Pe = D1 / (ke – g) Or, ke = (D1/Pe ) + g = {D0(1+g)/P0} + g where P0 = ex-dividend current share price, g = expected annual increase in dividends, D0 = dividend to be paid shortly, D1 = dividend to be paid after one year.

Capital Asset Pricing Model (CAPM)
Using the CAPM, the cost of equity finance is given by the following linear relationship: kj = Rf + βj*(Rm – Rf) Where, kj = the rate of return of security j predicted by the model Rf = the risk-free rate of return βj = the beta coefficient of security j Rm = the return of the market

Bond-Yield-Plus-Risk-Premium-Approach
kx = Bond yield + risk premium = 9% +4% =13%.

Cost of Retained Earnings and Cost of External Equity
The cost of retained earnings or internal accruals is generally taken to be the same as the cost of equity, i.e. , kr representing cost of retained earnings) = ke. But when for raising external equity, the company has to incur certain floatation costs (cost incurred during public issue, like brokerage, underwriting commission, fees to managers of issue, legal charges, advertisement and printing expenses etc.). The formula for ke in this case will be as follows: ke = kr / (1-f) where, f = floatation costs. Example : Gorky Ltd. has an issue 500,000 Rs.1 ordinary shares whose current ex-dividend market price is Rs.1.5 per share. The company has just paid a dividend of 27 paisa per share, and dividends are expected to continue at this same level for some time. If the company has no debt capital, what is the cost of capital?

Cost of Retained Earnings and Cost of External Equity
Cost of equity = ke = dividend/market price per share = 0.27/1.5= 0.18 or 18% (growth rate of dividend = g = 0) Since there is no debt capital, cost of capital = 18%. Example : Gorky Ltd. has got Rs. 5 lakhs of retained earnings and Rs. 5 lakhs of external equity through a fresh issue, in its capital structure. The equity investors expect a rate of return of 18%. The cost of issuing external equity is 3%. What is cost of retained earnings and the cost of external equity? Cost of retained earnings: kr = ke = 18% Cost of external equity = ke = kr /(1-f) = 0.18/(1-0.03) = 18.56%.

Cost of Debt P = ∑ I (1-t) / (1+kd)t + RV/ (1+kd)n t=1 to n
Where, kd = post-tax cost of debt I = annual interest payment t = corporate tax rate RV = redemption value n = no. of years to redemption P = current market price of bond An approximation formula , to save the trouble of doing an interpolation calculation, as given below can also be used. Alternatively, kd can be estimated using the yield approximation method developed by Hawanini and Vora (1982). This is given by the following equation: Where, P = Face value or per value NPD = Net proceed from sale or market value I,t, n = as above.

Cost of Debt Example : Apeejay Limited has recently made an issue of non-convertible debentures for Rs.500 lakhs. The terms of the issue are as follows: each debenture has a face value of Rs.100 and carries a rate of interest of 15%. The interest is payable annually and the debenture is redeemable at a premium of 7% after 7 years. If Apeejay Limited realizes Rs.90 per debenture and the corporate tax rate is 50%, what is the cost of the debenture to the company? kd = 15(1 – 0.5) + (107-90)/7 = = 10.08% (107+90)/ )

Cost of Preference Capital
The cost of irredeemable preference share is equal to the cost of irredeemable bond or debenture . The cost of redeemable preference share (kp) is defined as that discount rate which equates the proceeds from preference capital issue to the payments associated with the same i.e., dividend payments and principal payments i.e., P = ∑ D / (1+kp)t + F/ (1+kp)n t=1 to n Where, kp = cost of preference capital D = annual preference dividend per share F = redemption value n = maturity period P = net amount realized per share An approximation formula , to save the trouble of doing an interpolation calculation, as given below can also be used. kp = D + (F – P)/n (F + P)/2

Cost of Preference Capital
Example : The terms of preference share issue made by Arjun Co. Ltd. are as follows: Each preference share has a face value of Rs.100 and carries a rate of dividend of Rs.15% payable annually. The share is redeemable after 10 years at par. If the net amount realized per share is Rs.105, what is the cost of preference share capital? Given, D = 15, F = 100, P = 105, n =10

Weighted Average Cost of Capital (WACC)
Once the costs of a company’s individual sources of finance have been calculated, the overall weighted average cost of capital (WACC) can be determined. In order to calculate the WACC, the costs of the individual sources of finance are weighted according to their relative importance as a source of finance. WACC can be calculated either for the existing capital structure (average basis) or for additional incremental finance packages (marginal basis).

WACC = Cost of equity*weight of equity + (1-tax rate) *Cost of Debt*weight of debt (considering only equity and debt) Let a Company X & Co. has total capital structure C, E= value of equity share capital, R= value of retained-earning, P = value of preference capital, D = value of debenture, T=value of term loan, t= corporate tax rate, ke = cost of equity, kr =cost of retained earning=ke, kp= cost of preference capital, kd = cost of debenture, ki = cost of term loan. Then C= E+R+P+D+T WACC = k e × E/C + k r × R/C + k p ×P/C +k d × D(1-t)/C +k t × T/C = k e × We + k r × W r + k p W p + k d (1-t)Wd + k t × W t = ∑k i W i for i = 1 to n, W i = (value of capital i)/ (value of total capital) Market Value or Book Value Weights

DLPC Ltd is currently trying to work out its Weighted Average Cost of Capital (WACC). As a finance manager of the company find out that and show the necessary calculations. Balance sheet as on 31st March 2009 In Rs.(0,000,000) Fixed asset 545 Current asset 135 Current liabilities (210) Total asset 470 Ordinary Share capital(Rs.1per share) 90 10% preference shares(Rs.1.0 per share) (redeemable after 5 years) 40 Reserves 130 12% , 5 year redeemable debenture(15 crores) 150 Bank loans 60

The current dividend, shortly to be paid, is 25 paisa per share. Dividends in future are expected to grow at a rate of 6% per year. Corporate tax is currently 40%. The interest rate on bank borrowings is 11.55%. Stock market prices as on 31st march,2009 Ordinary shares: Rs. 5.6 per share Preference shares: Rs.0.89 per share 12% redeemable debenture: current market rate : Rs.9.5 per share Cost of each sources of finance: 1. Cost of equity: Using the Gordon model and ignoring issue cost ke = Do(1+g)/Po + g = 0.25(1+0.06)/ = 10.73% 2. Cost of retained earnings = kr = 10.73% 3. Cost of preference shares: kp = D +(F-P)/n = 1+(1-0.89)/5 = 10.82% (F+P)/ (1+0.89)/2

4. Cost of debenture : kd = I(1-t) +(RV-P)/n = 1.2(1- 0.4)+(10-9.5)/5 = 8.41% (RV+P)/ (10+9.5)/2 5. Cost of bank loan (after tax): ki = 11.55(1-0.4) = 6.93% WACC (book value) = 10.73%*220/ *40/ %*150/ %*60/470 = 9.51% WACC (market value) = 10.73%*504/ %*35.6/ %*142.5/ %*60/742.1 = 9.98% Source of Finance Book Value (Rs. Crores) Market Value (Rs. Crores) Equity = 220 90*5.6 = 504 Preference Shares 40 40*0.89 = 35.6 Redeemable Debenture 150 15*9.5 = 142.5 Bank Loan 60 Total 470 742.1

The marginal cost (MC) and average cost (AC) of capital
Gearing MC and AC of Capital

Fundamentals of Capital Budgeting Decisions
Capital budgeting deals with the investment decisions that a company may undertake for the long-term profitability. This investment may involve purchase of stocks as well as new equipment, or even introduction of new products in the market. Steps in CAPEX decisions: Identification of potential investment opportunities. Assembling proposed investments. Decision making. Implementation. Performance review.

Value Creation and Corporate Investment
Stakeholders supply funds to a firm due to one simple reason. That reason, generally, is to receive a return on their precious resources. The management of the firm using the finance provided to invest mostly in capital assets generates the return. The objective of investment within a firm is to create value for its owners, the shareholders.

Cash flow table CASH FLOWS Cash Inflows Cash Outflows
Operational Flows Terminal Flows Initial Flows Profit after tax plus Depreciation and other Non-cash charges Salvage value of fixed assets plus Salvage value of Net working capital Outlays on Plant and machinery and other Fixed outlays on net working Capital.

Investment Appraisal Techniques: Non DCF and Chart
Decision Inputs Decision Analysis Cash flow projections and time value of money Mainly DCF technique of evaluation The fundamental question is a proposed course of action wealth creating ? Decision Yes No

Investment Appraisal Criteria
Non-DCF Criteria DCF Criteria Payback Period Method (PBP) Accounting Rate of Return (ARR) Net Present Value Method (NPV) Probability Index Method (P/I) Discounted Payback Period Method (DPBP) Internal Rate of Return Method (IRR)

NPV (Net present Value)
Techniques: Decide on the discounting rate applicable for the project under review, keeping the risk exposure of the project into consideration. Estimate the future cash flows of the project over its useful life. Find out the present values of cash outflows and cash inflow. Compute NPV as follows. NPV=PV of cash inflows – PV of cash outflows. Rules: Accept projects with positive NPV. Reject projects with negative NPV. When comparison is made between two or more projects, the project with the highest positive NPV is undertaken.

Profitability Index-P/I or Benefit Cost Ratio-BCR
Techniques: The profitability index is alternatively known as Desirability Factor (D/F) or Benefit Cost Ratio (BCR). P/I = PV of cash inflows / PV of cash outflows. Rules: Accept projects where P/I is greater than one. Reject projects where P/I is less than one. When comparison is made between two or more projects, the project with the highest P/I is selected provided it is greater than one.

Internal Rate of Return - IRR
Techniques: The Internal Rate of Return of a project is defined as that discount rate for which its NPV is equal to zero. In other words while applying the NPV technique, the discount rate is assumed and the NPV is assumed as zero and the corresponding discount rate is discovered (say by applying trial and error approach). Rules: The project having the highest IRR is considered better and safer.

Pay Back Period - PBP Discounted Pay Back Period - DPBP Technique:
The payback period, defined as the expected number of years required to recover the original investment, was the first method used to evaluate capital budgeting projects. Rule: The shorter the payback period, the better. Discounted Pay Back Period - DPBP Under this system, the future cash flows are discounted prior to payback calculations. Rule: Same as PBP method

Accounting Rate of Return - ARR
Technique: ARR = Average Profit After Tax/ Average Book Value of the Investment Rule: The ARR of a project is compared with the ARR of the firm as a whole or against some external yard-stick like the average rate of return for the industry as a whole.

Comparative Analysis of Investment Appraisal Techniques.
NPV vs. IRR: In certain situations, NPV and IRR may produce contradictory results. These different rankings may occur under the following circumstances. Projects with unequal life. If the projects are having different useful lives, it is perfectly possible that rankings may vary under NPV and IRR methods. Mini Case Let there be two projects X and Y of unequal life but equal initial investment. Project X’s life span is 1 year and project Y’s life span is 3 years. The initial cash outlay for both the projects is Rs 1,00,000. The cash proceeds for project X at the end of first year is Rs 1,50,000 and for project Y one-time cash generated at the end of third year is Rs 2,00,000. Assumed that the appropriate discount rate for both the projects is 12 %

Projects with unequal life
(year) Initial outlay (Rs.) Cash proceeds in year 1 Cash proceeds in year 2 Cash proceeds in year 3 Present value of cash proceeds (discount rate 10%) (Rs.) NPV IRR X 1 100,000 150,000 133,930 33,930 50% Y 3 200,000 142,356 42,356 26% Hence as per NPV rule project Y is better whereas, as per IRR rule project X is better.

Time disparity problem
Mutually exclusive proposals may differ on the basis of the pattern of cash flows generated although their initial investments are identical. This is known as the time disparity problem. Mini Case The initial investment of both projects A and B is Rs 1,05,000. Useful lives in both cases = 4 years and appropriate discounting rate in both cases can be taken as 8%. The expected cash flows of the above projects for those 4 years are shown in the table below. Table Project Initial investments (Rs) End of Year 1 (Rs) End of Year 2 (Rs) End of Year 3 (Rs) End of Year 4 (Rs) A 10,5000 60,000 45,000 30,000 15,000 B 75,000

Time disparity problem
NPV of project A= (60000×0.9259) + (45000 × ) + (30000×0.7938) + (15,000×0.7350) = NPV of project B= (15000×0.9259) + (30,000× ) + (45,000×0.7938) + (75,000×0.7350) = Hence project B is better as per NPV rule, but IRR of project A is higher than project B.

Size disparity problem
This arises when initial investments in projects under consideration are different. In such situations the NPV and IRR may give different rankings. A and B are two mutually exclusive projects of life 1 year each involving different outlays. The effective rate of discount for both the projects can be taken as 10%. The relevant details of the projects are as follows. A :- Initial Investment Rs 5,000 Cash Inflow Rs 6,250. B :- Initial Investment Rs 7,500 Cash Inflow Rs 9,150. NPV of project A = /1.1= NPV of project B = /1.1 = IRR of project A = 6250/5000 – 1= 0.25 i.e. 25% IRR of project B = 9150/7500 – 1 = 0.22 i.e. 22% Hence as per NPV project B is better and whereas as per IRR project A is better.

Drawback of IRR It needs to be admitted that, IRR suffers from some inherent computational problems. It’s greatest demerit lies in the concept of reinvestment rate assumption, which is an implicit factor in IRR computation vis-à-vis decisions applying IRR method. Mini case The life of both the projects A and B is two years and the appropriate rate of discount for both projects can be taken as 10%, and others are given in table. Projects Initial Investment (Rs lakhs) Cash Inflows (Rs lakhs) NPV IRR Year 1 A -20 40 14.78 100% B -40 70 20.87 75% As per NPV, B is better and as per IRR A is better

Reasons for continued popularity of IRR
1. Knowledge of required rate of return is not required. In case of NPV calculations it is necessary to project future cash flows along with estimation of the required rate of return namely the cost of capital, which is applied as the discounting factor in NPV computation. It is needless to say that cost of capital estimation is a very complicated and tedious, exercise and none of the accepted techniques for the same are free from assumptions. Alternatively in IRR as computed is simply vetted against a pre specified cut off rate and the final decision is taken. 2. Lack of Knowledge Some of the managers may not be fully aware or familiar with the inherent limitations of the IRR method and may be of the opinion that ranking can be accurately done with the aid of this method. 3. Psychological Usually managers are comfortable in expressing financial data in the form of percentage.

Ranking Problem (IRR vis-à-vis NPV)
Table Projects Cash Flows (Rs Lakhs) IRR (%) NPV applying 1 year life Yr Yr % discounting rate A (20) % B (40) %

Computation of NPV applying different discount rates
Table Discount Rate in % Project A Project B (5) (2.22) (8.89)

NPV vs. IRR graph

Modified Internal Rate of Return (MIRR)
The MIRR is the rate of return ,which if used to compound the initial investment amount (i.e. the original cash outlay) produces the same terminal value as the project cash inflows. Example The business development team of M/s A Limited has been working to find uses for a vacated factory premise. The two projects it has selected for further consideration by senior management both have a life of only three years, because the site will be flattened in three years when a new motorway would be constructed.

On the basis of the IRR the business development team is leaning to words acceptance of project but it is aware that the key Senior Manager believes in MIRR and therefore feels the necessity to present the data calculated through the available techniques. The opportunity cost of capital is 10%. The following table shows cash flows and IRR of both the projects Figures in Rs.( ’000,000 ). Time 1 2 3 IRR Project A -1 0.5 23.4% Project B 1.1 0.1 0.16 27.7% You are required to complete the MIRR and NPV of both projects and show their ranking as per these Criteria.

Project IRR NPV MIRR A 23.4% 0.24 18.3% B 27.7% 0.20 17% Decision B is better A is better MIRR calculations: 0.5(1+r) (1+r) (1+r)0 = (-1)(1+mirr)3 mirr = 18.3% for project A 1.1(1+r) (1+r) (1+r)0 = (-1)(1+mirr)3 mirr = 17% for project B Therefore MIRR and NPV have given the same solution.

Case Study A company is planning to set up a project at a cost of Rs 3,00,00,000. It has to decide whether to locate the plant in Mumbai or Delhi (which is a backward district). Locating the plant in Delhi would mean a cash subsidy of Rs 15,00,000 from the central government. In addition to this, the taxable profit to the extent of 20 % would be exempted from taxes for a period of 10 years if the plant were to be located at Delhi. The above project envisages a borrowing of Rs 2,00,00,000 in either case. The cost of borrowing will be 12 % for Mumbai and 10 % in case of Delhi. However, the revenue costs are likely to be higher in Delhi as compared to Mumbai. The borrowings have to be repaid in four equal annual instalments beginning from the end of the fourth year.

Case Study With the help of information given in Table , please advise the management of the company as to where the project should be set up. Note: (a) A discount rate of 15 % can be assumed for computational purposes. (b) Income tax rate applicable to the company is 50 % of their profits. (c) Please apply the NPV criteria

Case Study Year Profit / (Loss) before interest / depreciation and taxes (in Rs lakhs). Mumbai Profit / (Loss) before interest / depreciation and taxes (in Rs lakhs). Delhi Discounting Factors applying a rate of 15% 1 (6) (50) 0.87 2 34 (20) 0.76 3 54 10 0.66 4 75 20 0.57 5 110 50 0.50 6 140 100 0.43 7 150 0.38 8 250 200 0.33 9 350 225 0.28 450 0.25

Case Study Solution: Mumbai: ( All figures are in Rs.’00,000). Year
EBDIT Depreciation 10% st. line Interest (12% of 200 lakhs or 2 crores) PBT Tax (50%) PAT NCF Net Cash Flow =(PAT+Dep.— Cash out flow) PV Present value 15% discount factor 1 (6) (30) (24) (60) =-130 -113.1 2 34 (20) -20+30=10 7.6 3 54 30 19.8 4 75 21 -50+51=1 0.57 5 110 (18) 62 1.5 60.5 =40.5 20.25 6 140 (12) 98 49 -50+79=29 12.47 7 150 114 57 -50+87=37 14.06 8 250 220 46.2 9 350 320 160 190 53.2 10 450 420 210 240 60 Total = 121.05

Case Study Tax rule : Previous years losses will be compensated from future profit. NPV for Mumbai = Rs (positive), hence accept the project. For Delhi, For cash subsidy, Cash c/o at 0the year = (100-15) lakhs = Rs. 8,500,000 . Tax rate: for 20% exempted, therefore effective tax rate = 50% of 80% = 40%. By applying the similar methods, NPV for Delhi projects NPV = --Rs.17 lakhs. Hence it should be rejected.

Numerical Example Example : ABC Limited is considering three financing plans. The key information is as follows. Total funds to be raised = Rs 2, 00,000 and plans of financing proportions are given in the Table below. Pre tax cost of debt and cost of preference share can be taken as 8% each and the effective tax rate of the organization is 50%. It may also be noted that the company will be in a position to issue equity shares (face value Rs 10) at a premium of Rs 10 per share. The expected EBIT under all the financing plans can be taken as Rs 80,000. Determine for each plan Earnings per equity share. Compute the EBIT range among the plans for indifference. Kindly indicate whether any of the plans dominate supported by adequate reasons. Plans Equity Debt Preference Shares A 100% - B 50% C

Plans A B C 100% equity 50% equity 50% debt 50% preference share No. of equity shares Equity Rs.100,000 Rs.50,000 Share Total equity Rs.200,000 Preference Rs Total Capital EBIT 80,000 Less - PBT 72,000 40,000 36,000 PAT Preference -- 8,000 Earning Available to Equity Shareholders 32,000 EPS 4 7.2 6.4

Numerical Example b)EPS = (EBIT—Interest)(1—T) – Dp No. of Shares
Let EPS is equal for EBIT = x For Plan A & B (x—0) = (x—8000)0.5 – 0 EBIT = x = , indifferent of A & B. If x > 16000, plan B is better and if x < 16000, plan A is better. For Plan A & C (x—0) = (x—0)0.5 – 8000 EBIT = x = 32000, indifferent of A & C. If x > 32000, plan C is better and if x < 32000, plan A is better. For Plan B & C (x—8000) = (x—0)0.5 – 8000 0.5x – 4000 = 0.5x – 8000 For same amount of EBIT, EPS of B is more than C at every level of EPS. B would dominate than C due to tax implication (tax shelter).

EBIT vs EPS graph Finally, for upto EBIT = 16000, Option A will dominate (because of having more EPS) and beyond EBIT > 16000, Option B will predominate

Financial Appraisal in Project Scanning and Selection

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