COLLEGE OF SOCIAL SCIENCE AND HUMANITIES

DEPARTMENT OF GEOGRAPHY AND ENVIRONMENTAL STUDIES

Project Design and Development (GeES 2071) Assignment I

PREPARED BY: ALEMAYEHU MOGES

Section: A

ID NUMBER: 0738/08

SUBMITTED TO: _______________________

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 Table of contents
Contents Pages
1) Basic concepts of project and project development plan ------------------------------ 3

2) Basic aspects of project planning --------------------------------------------------------- 6

3) Meaning of project management ---------------------------------------------------------- 9

4) Project design/development ---------------------------------------------------------------- 12

5) Project management life cycle ------------------------------------------------------------- 14

6) Generation and screening of project idea (Identification) ------------------------------ 15

7) Project preparation and analysis appraisal ------------------------------------------------ 20

8) Project appraisal techniques ---------------------------------------------------------------- 21

9) Project time value of money ---------------------------------------------------------------- 23

10) Project investment criteria ------------------------------------------------------------------ 35

11) Project cost of capital and social cost benefit analysis ---------------------------------- 36

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 UNIT 1: Project

1.1 The Project Concept

Project is a means of implementing the firm’s plans. As a means of plan implementation, project
involves a complex process. Before discussing the complex process of project, it is reasonable to
introduce basic concepts of projects.
 Definition of Project
The term ‘project’ may be defined as a complex set of economic activities in which scarce
resources are committed in expectation of benefits that exceed the costs of resources
consumed. It refers to an investment activity in which resources are committed within a given
time framework, to create assets over an extended time in expectations of benefits which exceeds
the committed resources. Thus, Projects require resources. They are also expected to derive
benefits. Projects are said to be desirable if their benefits are greater than the costs incurred on
them. A project can also be referred to as a non-repetitive activity. A project is viewed as a
conversion process. This implies that a project involves a transformation of some form of inputs
into an output. (See the following diagram).
Constraints

Inputs Project Output

Mechanism
s
In the above diagram, we observe that project is a conversion process which serves in
transforming inputs into outputs. Inputs represent want or need whereas outputs represent
satisfied need. Constraints consist of factors such as financial, legal, ethical, environmental,
time, and quality. Mechanisms include people, knowledge of expertise, capital, tools and
techniques, and technology.
In general, a project is a temporary endeavor, having a defined beginning and end (usually
constrained by date, but can be by funding or deliverables), undertaken to meet unique goals and
objectives, usually to bring about beneficial change or added value.
 Basic Characteristics of Projects
Projects could be small or large. However, regardless of the size of a project, projects have
common characteristics. Some of these characteristics are:
 A project has a unique purpose.
Every project should have a well-defined objective. For example, many people hire
firms to design and build a new house, but each house, like each person, is unique.
 A project is temporary.
A project has a definite beginning and a definite end. For a home construction project,
owners usually have a date in mind when they’d like to move into their new homes.
 A project is developed using progressive elaboration or in an iterative fashion.
Projects are often defined broadly when they begin, and as time passes, the specific
details of the project become clearer. For example, and there are many decisions that

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 must be made in planning and building a new house. It works best to draft preliminary
plans for owners to approve before more detailed plans are developed.
 A project requires resources, often from various areas. Resources include people,
hardware, software, or other assets. Many different types of people, skill sets, and
resources are needed to build a home.
 A project should have a primary customer or sponsor. Most projects have many
interested parties or stakeholders, but someone must take the primary role of
sponsorship. The project sponsor usually provides the direction and funding for the
project.
 Have definite location and target group (beneficiaries)
 A project involves uncertainty. Because every project is unique, it is sometimes
difficult to define the project’s objectives clearly, estimate exactly how long it will take
to complete, or determine how much it will cost. External factors also cause uncertainty,
such as a supplier going out of business or a project team member needing unplanned
time off.
 Classification of project /capital investment/
The term capital refers to investments in fixed assets. Capital investments deal with the whole
process of identifying and analyzing which projects should be pursued. Capital investments may
be classified in different ways. Capital investments may be classified into physical assets,
monetary assets, and intangible assets. Capital investments in physical assets include investments
in building, machinery, equipment, vehicles, and computers. Investments in monetary assets
include investments in debt or equity securities. Debt securities involve bonds, notes, deposits etc
whereas equity securities include equity shares (common stock and preferred stock), options,
warrants and the like.
Projects may also be classified into cost reduction (replacement) investments, revenue
expansion projects, or mandatory investments. Replacement investments aim at replacing the
worn out equipment with new equipment to reduce operating costs (material, labor and/or
overhead costs), increase the yield (productivity), and/or improve quality. An expansion
investment is meant to increase the capacity to cater to a growing demand in the form of entering
new markets (market development), introducing new products to the existing market (product
development), operating with the same products in the existing markets (penetration), or
introducing the new product for new market (diversification). A mandatory investment is a
capital expenditure required to comply with statutory requirements, such as pollution control, fire
fighting, medical dispensary and so on.
Projects may also be classified into development projects and business projects. While
business (industrial) projects aim at profit or value maximization of the owners, development
projects aim at reducing poverty and are pursued by the government or NGOs.
1.2. The importance of project/capital investment
Almost all projects involve a capital expenditure decision. Capital expenditure decisions often
represent the most important decisions taken by an economic entity. The importance of project as
capital expenditure decision stems from three inter – related facts:
1. They have long-term effects

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 Capital investments have the consequences that extend far in to the future. They provide
the framework for future activities and have a significant impact on the basic character of
a firm.
2. Irreversibility. A wrong capital investment decision often cannot be reversed without
incurring a substantial loss. This is due to the fact that the market for used capital assets
(equipment) in general is ill-organized i.e., the investment may be sold below purchase
price or the market for such as second hand investment may be non-existent.
3. Substantial outlays
Capital investments require substantial outlays. This is especially the case with
investments in advanced technology.
1.3. Difficulties of capital investment
What are the major difficulties in capital investments? What are the sources of these difficulties?
Although capital investments are so important, they are not without difficulties. These
difficulties arise from three major sources; namely,
1. Measurement problems
It is difficult to identify and measure the costs and benefits of capital investment proposals.
2. Uncertainty
The costs and benefits of capital investments are characterized by a great deal of uncertainty. It is
impossible to predict exactly what will happen in the future.
3. Temporal spread
The costs and benefits with a capital expenditure decision spread out over a long-period of time,
such as 10 – 20 years, or 20 – 40 years this creates problems in estimating the discount rates and
establishing equivalences.
1.4. Project success criteria (Parameters)
During a project’s life, management focuses attention on three basic parameters: quality, cost and time. A
successfully managed project is one that is completed at the specified level of quality; on or before the
deadline; and within the budget. In addition, client satisfaction will indicate success and possibility for
replication or sustainability.
Every project is constrained in different ways. Some project managers focus on scope, time, and
cost constraints. Other people focus on the quadruple constraint, which adds quality as a fourth
constraint. The scope, time, and cost limitations are sometimes referred to in project management
as the triple constraint.
To create a successful project, a project manager must consider scope, time, and cost and
balance these three often-competing goals:
1. Scope: What work will be done as part of the project? What unique product, service, or
result does the customer or sponsor expect from the project?
2. Time: How long should it take to complete the project? What is the project’s schedule?
3. Cost: What should it cost to complete the project? What is the project’s budget? What
resources are needed?
Other people focus on the quadruple constraint, which adds quality as a fourth constraint.
 Quality: How good does the quality of the products or services need to be? What do
we need to do to satisfy the customer?

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 Other also suggests these four constraints plus risk.
 Risk: How much uncertainty are we willing to accept on the project?
Whatever its size, a project’s success is based on the three main criteria.
Project
parameters

Quality Cost Tim

e

Specification Budget Schedule

s
Therefore, project will deem to be successful if it:
Delivers the outcome with an agreed upon quality.
Does not overrun its end date.
Remains within budget (cost of resources).
Project development plan

After the project has been defined and the project team has been appointed, you are ready to enter
the second phase in the project management life cycle: the detailed project planning phase.

Project planning is at the heart of the project life cycle, and tells everyone involved where you’re
going and how you’re going to get there. The planning phase is when the project plans are
documented, the project deliverables and requirements are defined, and the project schedule is
created. It involves creating a set of plans to help guide your team through the implementation and
closure phases of the project. The plans created during this phase will help you manage time, cost,
quality, changes, risk, and related issues. They will also help you control staff and external suppliers
to ensure that you deliver the project on time, within budget, and within schedule.

The project planning phase is often the most challenging phase for a project manager, as you need
to make an educated guess about the staff, resources, and equipment needed to complete your
project. You may also need to plan your communications and procurement activities, as well as
contract any third-party suppliers.

The purpose of the project planning phase is to:

 Establish business requirements

 Establish cost, schedule, list of deliverables, and delivery dates
 Establish resources plans
 Obtain management approval and proceed to the next phase

The basic processes of project planning are:

 Scope planning – specifying the in-scope requirements for the project to facilitate creating the work
breakdown structure

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 Preparation of the work breakdown structure – spelling out the breakdown of the project into tasks
and sub-tasks
 Project schedule development – listing the entire schedule of the activities and detailing their
sequence of implementation
 Resource planning – indicating who will do what work, at which time, and if any special skills are
needed to accomplish the project tasks
 Budget planning – specifying the budgeted cost to be incurred at the completion of the project
 Procurement planning – focusing on vendors outside your company and subcontracting
 Risk management – planning for possible risks and considering optional contingency plans and
mitigation strategies
 Quality planning – assessing quality criteria to be used for the project
 Communication planning – designing the communication strategy with all project stakeholders

The planning phase refines the project’s objectives, which were gathered during the initiation phase.
It includes planning the steps necessary to meet those objectives by further identifying the specific
activities and resources required to complete the project. Now that these objectives have been
recognized, they must be clearly articulated, detailing an in-depth scrutiny of each recognized
objective. With such scrutiny, our understanding of the objective may change. Often the very act of
trying to describe something precisely gives us a better understanding of what we are looking at.
This articulation serves as the basis for the development of requirements. What this means is that
after an objective has been clearly articulated, we can describe it in concrete (measurable) terms and
identify what we have to do to achieve it. Obviously, if we do a poor job of articulating the
objective, our requirements will be misdirected and the resulting project will not represent the true
need.
Users will often begin describing their objectives in qualitative language. The project manager must
work with the user to provide quantifiable definitions to those qualitative terms. These quantifiable
criteria include schedule, cost, and quality measures. In the case of project objectives, these
elements are used as measurements to determine project satisfaction and successful completion.
Subjective evaluations are replaced by actual numeric attributes.
Example 1
A web user may ask for a fast system. The quantitative requirement should be all screens must load
in under three seconds. Describing the time limit during which the screen must load is specific and
tangible. For that reason, you’ll know that the requirement has been successfully completed when
the objective has been met.
Example 2
Let’s say that your company is going to produce a holiday batch of eggnog. Your objective
statement might be stated this way: Christmas Cheer, Inc. will produce two million cases of holiday
eggnog, to be shipped to our distributors by October 30, at a total cost of $1.5 million or less. The
objective criteria in this statement are clearly stated and successful fulfillment can easily be
measured. Stakeholders will know that the objectives are met when the two million cases are
produced and shipped by the due date within the budget stated.
When articulating the project objectives you should follow the SMART rule:
 Specific – get into the details. Objectives should be specific and written in clear, concise, and
understandable terms.

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 Measurable – use quantitative language. You need to know when you have successfully completed
the task.
 Acceptable – agreed with the stakeholders.
 Realistic – in terms of achievement. Objectives that are impossible to accomplish are not realistic
and not attainable. Objectives must be centred in reality.
 Time based – deadlines not durations. Objectives should have a time frame with an end date
assigned to them.
Plan, Project and Program
Plan is courses of action determined in order to be done in the future to achieve certain level of goals. It is
lists of activities which are going to be done to reach desired objectives. Plans could be divided into two
major categories as strategic plan and operational plan. Operational plans are those which are designed
to bring strategic plan into practice. They are plans designed to implement the day to day activities of an
organization. They are functional plans that operationalize an organization. Operational plan could be
classified as standing plan and single use plan. Further single use plan is classified as projects, programs
and budget. Therefore, projects and programs are types of plans.
It is necessary to distinguish between projects and programs because there is sometimes a tendency to use
them interchangeably. While a project refers to an investment activity where resources are used to create
capital assets which produces benefits over time and has a beginning and an ending with specific
objectives, a program is an on-going development effort or plan. A program is therefore a wider concept
than a project. It may include one or several projects at various times whose specific objectives are linked
to the achievement of higher level of common objectives. For instance, a health program may include a
water project as well as construction of a health center both aimed at improving the health of a given
community that previously lacked access to these essential facilities. Projects which are not linked with
others to form a program are sometimes are referred to as stand- alone projects. The following are the
similarities and differences of projects and programs.
A program is a collection of projects. The projects must be completed in a specific order for the program
to be considered complete. Because programs comprise multiple projects, they are larger in scope than a
single project. For example, the United States government has a space program that includes several
projects such as the Challenger project. A construction company contracts a program to build an industrial
technology park with several separate projects. Unlike projects, programs can have many goals. The
NASA space program is such that every launch of a new mission includes several dozen projects in the
form of scientific experiments. Except for the fact that they are all aboard the same spacecraft, the
experiments are independent of one another and together define a program.
Project Program
 Has specific • May not have specific
Difference area/geographic unit area
 Is specific in • Has got general
objectives/purpose objectives
 Has specific targets • May not have specific
groups target groups
 Has clearly determined • May not have clear and
and allocated fund detailed financial
 Has specific life time allocation
• May not have specific
time of ending (open
ended)
 Has purpose/objectives
Similarities
 Require input (financial, manpower, material, etc.)
 Generate output (goods and/or services)
 Operate over space and time

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 Project management
Project management is a critical practice that applies knowledge of process, skills, tools,
deliverables, and techniques to project activities to ensure a solid path to project success
by meeting goals and requirements.
We encounter projects in our everyday lives—in business and at home. Think about
projects for a minute: at work you might be building or contributing to a deliverable
(like a report, a website, a tool or product, or even a building), and at home you might
be making a meal, planning a vacation, or even working on upgrades to your home.
These are true projects that have a defined start and end date, a goal, a scope, and
resources. And, they all require some level of management.
In business, which is where we’ll focus in this chapter, projects are typically unique
operations that are conducted to meet specific goals. Projects may include the
development of software to increase employee productivity, the construction of a
building to house community events, or the design of a website to decrease call volume
to a business. The list could go on and on. All of these types of projects require a team
of people who are responsible for different aspects of the delivery. For instance, you’d
likely see a designer, developer, and copywriter working on website design projects. In
many instances, a project manager is staffed to these projects to ensure that the team
delivers the project on time, under budget, and meeting its stated goals.
Project management processes fall into five groups:
1. Initiating
2. Planning
3. Executing
4. Monitoring and Controlling
5. Closing
Project management knowledge draws on ten areas:

1. Integration
2. Scope
3. Time
4. Cost
5. Quality
6. Procurement
7. Human resources
8. Communications
9. Risk management
10.Stakeholder management
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 All management is concerned with these, of course. But project management brings a
unique focus shaped by the goals, resources and schedule of each project.
There are essential elements you must include to create a good project plan. Keep in mind
that creating and working with a flawed project plan is just as bad as working without one.
Timeline, costs, and deliverables should be detailed clearly to show the scope of your
project. In the ten sections below, you’ll find ten essential elements of a project plan you
shouldn't overlook.

1. Outline of business justification and stakeholder

needs
Before starting your project, it is essential to align the project's goals and needs with your
team and organization’s. How important is this project to the organizational objectives?
How does it tie in with the goals for the year or quarter? What do the involved stakeholders
expect?
These are a few questions you can ask to outline and align the new project with your
organization and stakeholder needs.

2. List of requirements and project objectives

Even though a project plan is a living set of documents that is sure to change during the
project, it is necessary to set a deliberate course to meet the project objectives.
As a project manager, you should analyze the needs of all parties involved in the project and
determine the requirements to achieve them. What objectives must the project achieve to be
successful? What features and capabilities should the deliverables have?
As the project progresses, there may be a need to correct some aspects of your project plan
and that’s okay.

3. Project scope statement

The project scope statement is one of the most essential elements of a project plan. It forms
a foundation for the rest of the project plan.
In the project scope statement, the project manager finalizes and records all project details to
get everyone involved on the same page. This statement describes the project and its steps
and requirements. It is usually the reference to get agreement and buy-in from external
stakeholders involved in the project.

4. List of deliverables and estimated due dates

From the preparation of the project scope statement, you should now have a clearer idea of
the deliverables and outcomes to be delivered to complete this project. From there, you
should list out what tasks and deliverables each team member is expected to produce and
when.

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 A work breakdown structure is typically the best way to achieve this step. You can use a
simple list, flow chart, spreadsheet, or Gantt chart to map out all the project work, assign to
teammates, set due dates, and mark any dependencies.
In this breakdown, it is also necessary to note which deliverables or tasks will need to be
approved by external stakeholders and ensure there are no delays due to task dependencies
or reviews and approvals.

5. Detailed project schedule

A common misconception about project plans is that the project plan is the same as
the project schedule. The project schedule is simply one of many components of a project
plan.
In a project schedule, you estimate how long it will take to complete each task while leaving
enough room for slack and dependencies. It is a clear calendarization of all required tasks
and timelines. It shows the project's duration, who is doing what, and when each task begins
and ends.

6. Risk assessment and management plan

It’s important to assess the risks involved with a project while creating the project plan. Is
your organization stable at this time? What's your risk tolerance? What potential hazards
and opportunities could come from executing this project, and what is your mitigation plan?
Potential events identified in your project risk plan may not happen but they could
significantly affect a project's outcome if they did. Risk management includes not just
assessing the risk itself but developing risk management plans to communicate how the
team should respond if these events happen.
Risks are inevitable, which is why the best project plans include elaborate risk management
sections. If you can identify risks earlier in a project, you can control them and increase
your chances of success.

7. Defined roles and responsibilities

Clarify the responsibilities of each person on the project team, including the external
stakeholders. Various tasks may include reviews and approvals from specific stakeholders,
though typically, many of the project's key stakeholders are not involved in all aspects of the
project.
A project sponsor funds the project; they may need to review and approve critical aspects of
the plan. Designated business experts define requirements for projects and deliverables; they
may also need to review and approve parts of the project. Project managers create, execute,
and control the project plan. And the project team completes the tasks and builds the end
product.

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 Other contributors to a project may include auditors, quality and risk analysts, procurement
specialists, etc. They may need to approve parts of the project plan that pertain to their
expertise, such as the quality or procurement plan.

8. Resource allocation
When it comes to resource allocation in project planning, you break down and allocate your
team's time, materials, and budget. You should identify all available resources and resources
for each task if known. Estimate their costs and contributions.
Consider resource constraints, how much time each resource can realistically devote to this
project, and determine the best combinations or variations of the resources available to
achieve the project's goals in good time — and with the best possible results.

9. Quality assurance (QA) plan

In your quality assurance plan, you want to implement processes to ensure project
requirements and deliverables meet quality expectations. Throughout the project's
execution, maintaining project quality ensures that the final deliverable meets the customer
specifications and ticks the boxes of the executive teams, project sponsors, and business
experts.
The emphasis here is on preventing errors, rather than inspecting the final deliverable at the
end of the project. Creating the QA plan involves setting the project standards, acceptance
criteria, and metrics that will be used throughout the project. This becomes the foundation
for all quality reviews and inspections performed during the project.

10. Communication plan

A communication plan outlines how often you'll speak with and update external
stakeholders, project owners, and even your team members. It also details the kind of
updates they expect, which decisions need reviews and approval, and who's responsible for
each action.
Your communication plan must answer: who receives the reports and who prepares and
delivers these reports. You can go as far as to include the format in which the reports are
created and shared.
A communication plan also clarifies which issues should be escalated, where project
information is stored, and who can access it. This plan documents every aspect of the
project team's communication methods throughout the project. This includes routine status
updates, problem resolution, risk mitigation, etc.

Project design or development

There are different approaches to project design. Many development organizations and
donor agencies use project cycle management methodology and the logical framework tool
the most. In many cases, they are even mandatory. Project cycle management Every project
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 has to follow a series of phases, allowing the process to be guided from the moment the
problem is identified until it is solved. This series of phases is known as the project cycle.
Project cycle management (PCM) is a results-based decision-making tool. Each phase is
crucial and should be fully completed before going on to the next. Programming new
projects will draw on the final evaluation in a structured process of feedback and
institutional learning. Design is the starting point of the project cycle. Project design
provides the structure of what has to be achieved, how it is to be implemented and how
progress will be verified. Therefore the design is the most crucial phase. Its quality will
influence the following stages in the project cycle. Too often, little time is devoted to this
phase due to scarcity of resources. Designing a project requires an upfront investment.
Nevertheless, the less people are willing to invest in designing their project, the higher the
risk of compromising its quality when the time for implementation comes. In the case of
resources, it is best to allocate a considerable amount to this stage, which can facilitate and
improve the quality of analysis and identification of real needs. If financial resources are not
available, time is still an important factor, one that can, for instance, contribute to cohesion
among stakeholders and familiarity with the context and its main problems and challenges.
The project cycle management approach helps to ensure that:
• projects are relevant to the real problems of the target groups and make the most of
existing opportunities;
• projects are feasible: objectives can be realistically achieved within the constraints of the
external environment and capacities of the organization;
• the benefits generated by the projects are sustainable;

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 Step 1 - Identification is a participatory consultative process that analyses the situation and
the problem.
Step 2 - Once the situation has been analyzed and understood, the team in charge of the
formulation of the project should establish concrete outcomes (objectives and outputs) to
achieve, and outline the actions to be taken and the resources needed. It should also
establish proper indicators for each objective.
Step 3 - Then, an implementation plan will be devised, based on the logical framework, in
order to have both a results-based work plan and a budget.
Step 4 - Finally, your monitoring & evaluation system will be planned and budgeted for.
Project Life cycle
Project passes through series of activities called stages. There are different approaches to
describing the project cycle. Above, we present one way of describing the project cycle or stages
in capital investments. In the following section we try to highlights two other approaches to
project cycle; namely, the World Bank and United Nations Industrial Development organizations
(UNIDO).
Project cycle refers to the various stages through which project planning proceeds from the
inception to implementation. In other words, it is the life cycle through which a project advances
from infancy to maturity. The main features of this cycle are information gathering, analysis, and
decision–making. What is the primary preoccupation at each stage in the project cycle?
Project life cycle – BAUM (World Bank) Approach
According to World Bank, project cycle involves five stages; namely, project identification,
project preparation, project appraisal, project implementation, and project evaluation. See the
following diagram:

Identification

Evaluation Preparation

Implementation
Appraisal

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 Figure 1.1: Baum's project cycle (Source: Baum 1978)
Let’s highlight the major activities in each stage
Project identification
This stage is also called pre-feasibility studies. In this stage, projects that can contribute towards
achieving the specified objectives are identified (listed). Project ideas may come from:
New experiments from previous project failures
New experiments from expansion
Replication of successful project tested elsewhere
New experiments from shortages or excess of resources
External threats
Opportunities
Internal strengths and/or weaknesses
Other sources
Project identification is also concerned with elimination of inferior alternatives (projects) from
the identified ones. The output of this stage is project that is prima-facie (at first sight or based
on first impression) promising and further work is justified.
Project preparation
Project preparation is the most important stage in project planning. Project preparation stage,
also called feasibility study, is concerned with the detailed study of all aspects of the projects.
Project Appraisal
Appraisal is the comprehensive and systematic assessment of all aspects of the proposed project.
The project is reviewed (appraised) to confirm that it accords with the broad objectives. It is to
ensure that the project represents a high priority use of the firm’s resources. What aspects of the
project should be appraised? The project is appraised from different perspectives: technical,
commercial (market), financial, economic and ecological.
Project implementation
It is the stage at which the conclusions are reached & decisions made are put into action. What
activities should be done during project implementation? Some of the major activities in during
project implementation phase include:
Detailed designs and specifications are drawn;
Tender documents are prepared;
Bids are invited and evaluated,
Orders for imputes are placed;
Contracts are signed; workers are hired, trained and put to work;
Materials are moved to sites etc.
Project Evaluation
What is the major focus of project evaluation phase? Where it begins? Implementation phase is
followed by supervision and follow up. The execution of the project should be supervised closely
and progress should be reported regularly to ensure that the implementation is progressing
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 without deviating from the envisaged path and the objectives of the project have been reached.
Project evaluation is a monitoring (checking) activity in order to:
Find out how things are going
Encourage the project team
Check that promised resources are in fact working on project tasks
Rapidly learn about concerns and difficulties
Show concern for the success of the project
Take corrective action if things go wrong
Project cycle- UNIDO approach
Projects implemented during the Baum’s traditional project cycle approach were not successful
mainly due to lack of popular participation in their formulation, selection, implementation and
evaluation. The projects could not achieve their objectives, if ever at all, they were not
sustainable. Recognizing these limitations, during 1994 the World Bank changed its approach
from top down planning to bottom up, which emphasizes on the need of the beneficiary
participation in project planning. The essence is that the beneficiaries can better identify their
problems; identify possible alternative course of action; generate ideas for project planning
addressing what resources need for its implementations and how it helps them to overcome their
problems.
There are different levels of participation and accordingly different views as to its role in project
planning and overall economic development. Some view participation as means for sustainability
of project. Others view it as an end result of sustainable project to community. However, the
reality is that as far as project is a policy instrument to achieve development and as far as popular
participation is means and ends for development, it should be safely concluded that participation
is both a means and ends for sustainable development. But, the decision as to which level of
participation is desirable depends on the level of democratization in a community, educational
level of the community, level of awareness of the community and objectives of the project
sponsoring entity.
According to the new project cycle (WB, 1994), project cycle has four phases:
A. Listening to stakeholders: As the issue of the project is the issue of development, and since
development is community issue, the community is supposed to the agents of the project
planning. In essence, the idea for the project should come first from the beneficiaries and the
role of the project sponsoring entity is limited to facilitating issues related to its
implementation.
B. Piloting the project: refers to from implementing the proposed project ideas from the
community on a very small scale to be used as a testing ground. This is the experimentation
phase.
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 C. Demonstrating : refers to showing the result of the experiments to the community so that
they can judge its viability and decide whether to continue or discontinue with the project
idea.
D. Mainstreaming the project: this refers to expanding the project ideas which receive
sufficient community supports and decide to be viable to other areas.
A project is not a one shot activity. Even a shooting star has a time and life span. Project
lifecycle is spread over a period of time. There is an unavoidable gestation period for the
complex of activities involved to attain the objectives in view. This gestation period, however,
varies from project to project but it is possible to describe, in general terms, the time phasing of
the project planning activities common to most projects.
The principal stages in the life of the project are:
The project life cycle can be put in different ways based on the detailness of the identification
of the different phases of the project process. Accordingly, we will have two project life- cycle
models.
1. The six phased project life cycle model and
2. The four phased project life cycle model
The six phased project life cycle model- this project cycle model has six stages for project
development like identification, initial formulation, evaluation or project appraisal, formulation,
project implementation and project completion.
A. Identification: Development projects are expressly designed to solve the varied problems of the
economics whether in the short or long run. Business projects can be initiated from
problems/potential problems of stakeholders of a business entity. The surveys or in depth studies
would locate the problems and the project planner will have to identify the projects that would solve
the problems most effectively. At this stage, we are concerned with the kind of action and type of
project that would be required in rather broad term.
B. Initial Formulation: Identification is only the beginning in the lifecycle of a project. Having
identified the prospective projects, the details of each project will have to be worked out and analyzed
in order to determine which of them could be reckoned as suitable for inclusion in the surveys, and
number of feasibility study group are set up, as the name implies to examine the possibility
formulating suitable projects and to put concrete proposals in sufficient detail to enable authorities
concerned to consider the feasibility of the proposal submitted.
C. Evaluation or Project Appraisal: After the business or socio –economic problems of an economy
have been determined and development objectives and strategies agreed, concrete steps have to be
taken. The main this takes is that of formulating appropriate development projects to achieve plan

17
 objectives and meet the development needs of the economy. Proposals relating to them are then put to
the plan authorities for consideration and inclusion of the plan. These proposals as pointed out above
take the following forms of feasibility studies:
 Commercial feasibility
 Economic feasibility
 Socio-economic feasibility
 Financial feasibility
 Technical feasibility
The scope for scrutiny under each of these five heads would necessarily render their careful assessment
and the examination of all possible alternative approaches. The process almost invariably involves
making decision relating to technology, scale, location, costs and benefits, time of completion (gestation
period), degree of risk and uncertainty , financial viability, organization and management, availability of
inputs, know-how, labor etc. The detail analysis is set d own in what is called a feasibility report.
D. Formulation: One the project has been appraised and approved, next step would logically appear to
that of implementation. This is, however, not necessarily true, is the approval is conditional to certain
modifications being affected or for other reasons, such as availability of funds, etc. The
implementation stage will be reached only after these pre-conditions have been fulfilled. Project
formulation divides the process of the project development into eight distnict and sequential stages.
These stages are:
 General Information
 Project description
 Market Potential
 Capital cost
 Source of finance
 Assessment of working capital requirement
 Other financial aspects
 Economic and social variables
E. Project Implementation: Last but not least, every entrepreneur should draw an implementation time
table for his project. The network has been prepared, the project authorities are now ready to embark
on the main task of the implementation of the project. To begin with, successful implementations
depend on how well the network has been designed. However, during the course of implementation,
many factors arise which cannot be anticipated techniques have been developed for the project
implementation. Some of them are PERT, CPM, GERT, WRSP and LOB.
F. Project Completion: It is often debated as to the point at which the project life cycle is completed.
The cycle is completed only when the development objectives are realized.

18
 Project Identification
Completio
n

Implementation Initial Formulation

Final Evaluatio
Formulatio n (Select
n or Reject)

Four phase project life cycle model – the four phase project cycle model has four stages for project
development which include: - Initiating, Planning, Executing, and controlling and Monitoring.
A. Initiating
During the initiation process, you will
 Refine the project goals
 Review the expectations of all stakeholders, and
 Determine assumptions and risks in the project.
Project team selection and statement of work (SOW) is also made. SOW is a document that provides a
description of the services or products that need to be produced by the project.
B. Planning
During the planning process,
 You will detail the project in terms of outcome, team members’ roles and responsibilities,
schedules, resources, scope and costs.
 You will produce a project management plan, which is a document that details how your project
will be executed, monitored and controlled, and closed.
 Such a document also contains a refined project scope, and is used as the project baseline.
C. Executing
During the executing process, you apply your project management plan. In other words you direct your
team so that it performs the work to produce deliverables as detailed in the plan. The executing process
also involves implementing approved changes and corrective actions.
D. Controlling and monitoring

19
 During the controlling and monitoring process, you supervise the project activities to ensure that they do
not deviate from the initial plan and scope. When this happens, you will use a change control procedure to
approve and reject change requests, and update the project plan/scope accordingly. The controlling and
monitoring phase also involves getting approval and signoff for project deliverables.
E. Closing
During the closing process, you formally accept the deliverables and shut down the project or its phase.
You will also review the project and its results with your team and other stakeholders of the project. At
the end of the project you will produce formal closure document, and a project evaluation report.

Closin
g

controllin
Executin g Initiation
g and
monitorin
g

Plannin
g

What is Project Appraisal?

Project appraisal is an important activity to evaluate the key factor of the project to check the viability of a
project proposal. We can use various Appraisal methods and tools to accept or reject the project. For
example, economic or financial appraisal analysis, Excel Templates and other decision techniques.
And in this topic, we will see the different aspects of the Appraisal process of Project in project management.
And Its types, methods, factors, Excel & PowerPoint Templates, tools and techniques.
Project Appraisal Definition & Meaning:
It is an important activity to evaluate the key factor of the project to decide and proceed with the project
proposal and ability.
Project Appraisal Objectives:
Here are the Key objectives of the Appraisal Process of a Project:
 Assessment of a project in terms of its economic, social and financial viability
 Decide to Accept or reject a Project
 It is a tool to check the viability of a Project Proposal
This topic will answer all the above questions related to Project Appraisal.
Project appraisal in the international context:
International context of Project Appraisal: Assessment of a project in terms of its financial, economic,
technical and management and governance viability.

20
 Importance of project appraisal:
As mentioned earlier, Appraisal process of a Project is a very important activity to perform before accepting
a Project. And this will help you to check if you can complete the project. So that you can accept and reject
the Project Proposal.
Features project appraisal
Here are the Key Features of the Appraisal of Project:
 Evaluate the key factor of a project
 Decide to Accept or reject a Project
 It is a tool to check the viability of a Project

Steps in project appraisal process

Here are the key steps this process. Proposal of a Project is assessed with the below steps and aspects.
 Financial and Economic appraisal
 Organizational or Management Appraisal
 Marketing and Commercial Appraisal
 Technical and Legal Appraisal

Types of Project Appraisal and aspects

Project Appraisal is process of assessing the following types of the Appraisal Aspects. And these Key
aspects of appraisal will be evaluated before committing a Project. Appraisal factors are evaluated by a
personal who is not involved in the preparation of the Project Proposal.
 Organizational Aspects
 Technical Aspects
 Managerial Aspects
 Economic Aspects
 Financial Aspects
 Marketing and Commercial Aspects

Project Appraisal Guidelines

Here are the guidelines for Project Appraisal Process:
 Project should assess in terms of its economic, social and financial viability
 Various aspects of a Project should asses before committing a project
 An individual person or a team who are not involved it’s the preparation of Project Proposal should
assess the Project.
Project Appraisal Techniques and Methods
Here are the key techniques of this process. Proposal of a Project is assessed with the below techniques and
methods.
 Technical Feasibility
 Economic and Financial Analysis
 And Marketing and Management Competence
We use various techniques for assessment of the Project Proposal. Let us see each appraisal technique in
detailed:
Project Appraisal Financial Analysis:
Financial analysis helps to assess the cost of the project and review the project revenues. And this type of
appraisal analysis helps the company to avoid overspending on a project resource and requirements to
produce the outputs. This will also help the organizations to check feasibility of alternatives to spend less and
gain more profits. Below are the key things we can understand by performing the Financial Analysis.
What do you understand by Financial appraisal of a project?
 Cost: Finding out the cost to complete the project and produce the outputs
 Pricing: Setting of the Product Pricing for Profits
 Financing: Increasing in investment and efficient use of the fund
 Investment vs Income: Understanding the cost of production and Profits

21
 Project Appraisal Economic Analysis:
Economic analysis of Appraisal helps to justify the benefits of the project vs cost to produce the product.
And below are the key things we can understand by performing the Economic Analysis.
What do you understand by economic appraisal of a project?
 Benefits of the Projects, Products and Features
 Justification of the products by comparing with the Project Cost of Production.
This will also help to check the following benefits the project.
 Better output
 Better services
 Better employment
 Better revenue
 Better earnings
 Better standards
 Better income
 Better distribution

Technical Analysis:
Technical analysis helps to study the technical aspects of the Project. For example, assessment of Tools and
Techniques, Design, Plans and Schedules.
Organizational Analysis
Organizational analysis of helps to see if project is adequately staffed with the structure of the Organization.
And helps to check Resource, Recruitment, and Training aspects.
Managerial Analysis
Managerial analysis of helps to assess competency and business knowledge of the promoter’s aspects.
Market/Commercial Aspects:
Market/Commercial analysis helps to assess the market opportunities, marketing objectives, Marketing
process Plans
Project appraisal report:
We can create Appraisal Report to understand the different aspects of project viability.
Here is the Example format of appraisal report format of a company.
Project appraisal tools and techniques
We have already seen the various techniques of Project Appraisal Process. And below are the Project
Assessment tools and templates to capture the various topics and assess it.
Project appraisal format
Below are the top Project Appraisal Formats. We can maintain these Excel or PowerPoint File to capture the
required topics and techniques. And this helps to assess and to decide to accept or reject a Project Proposal.
Project appraisal examples
The below Project Appraisal Examples are provided with dummy data with no valid meaning. You can clear
the existing data and capture your information.
Project appraisal excel template
Here is the Excel Template. You can go to the second sheet to see the template. The first sheet of the
template contains the brief information about the Project Appraisal Excel Template. And the second sheet is
the actual spreadsheet to capture your data.
Also, you can capture the topics with appraisal techniques and methods. The Fourth Column (Feasibility
Score) you can enter the number between -5 and 5. And the Weight is important factor of the assessment
topic.
On the right-hand side, you can see the overall Appraisal Score of Project, and you can enter the minimum
acceptance score to decide to accept/reject the project proposal.
Project appraisal PPT template
22
 Here is the PPT Template. It is a PowerPoint Format Appraisal Report Template. You can enter the project
information which you have assessed.
You can use the left-hand side section in this Project appraisal PPT template for your observations. And
right-hand side table will help you to capture the assessed metrics.
The bottom section of the PPT template helps you to write your conclusion or Summary. You can also use
this appraisal PPT template in Team and Customer Presentations.
Project appraisal PDF Template
Here is the PDF Template, this is the copy of the above (PowerPoint) template in the pdf file format. And
you can use this Project appraisal PDF Template to Print and write your Appraisals.
Project appraisal questions and answers
Here are the Frequently asked Project appraisal questions and answers:
 What is project appraisal?: It is an important tool to evaluate the key factor of the project to check
the viability of a project. We can use various methods and tools to commit the Project. For example,
economic aspects analysis of the Project or financial aspects analysis of the Project. We can use
Excel, PPT Templates and other decision techniques for this process.
 What are the various aspects?: The important aspects of the Project are: Technical aspects,
Economic aspects, Financial aspects, Marketing aspects and Management aspects
 What is market appraisal of a project?:Marketing appraisal analysis of a Project helps to assess
the market opportunities, marketing objectives and Marketing process Plans
 What is financial appraisal of a project?: Financial appraisal analysis of a project helps to assess the
cost of the project and review the project revenues. This helps the organizations to avoid over
budgets on a project resource and requirements to produce the outputs. This will also help the
companies to check feasibility of alternatives to spend less and gain more profits.
 What is economic appraisal of a project?: Economic Appraisal analysis of project helps to justify
the benefits of the project vs cost to produce the product.
 What is technical appraisal of a project?: Technical Appraisal analysis of project helps to observe the
technical aspects of the Project. For example, assessment of Tools and Techniques, Design, Plans
and Schedules.
 What are the methods and components of project appraisal?: The methods, components, factors
and elements are: Technical methods, Economic methods, Financial methods, Marketing methods
and Management methods
Project time value of money
Recall that the interaction of lenders with borrowers sets an equilibrium rate of interest. Borrowing
is only worthwhile if the return on the loan exceeds the cost of the borrowed funds. Lending is only
worthwhile if the return is at least equal to that which can be obtained from alternative opportunities
in the same risk class.
The interest rate received by the lender is made up of:
i) The time value of money: the receipt of money is preferred sooner rather than later. Money can
be used to earn more money. The earlier the money is received, the greater the potential for
increasing wealth. Thus, to forego the use of money, you must get some compensation.
ii) The risk of the capital sum not being repaid. This uncertainty requires a premium as a hedge
against the risk, hence the return must be commensurate with the risk being undertaken.
iii) Inflation: money may lose its purchasing power over time. The lender must be compensated for
the declining spending/purchasing power of money. If the lender receives no compensation, he/she
will be worse off when the loan is repaid than at the time of lending the money.

a) Future values/compound interest

Future value (FV) is the value in dollars at some point in the future of one or more investments.
FV consists of:
i) the original sum of money invested, and
ii) the return in the form of interest.
The general formula for computing Future Value is as follows:

23
 ; where

Vo is the initial sum invested

r is the interest rate n is the number of periods for which the investment is to receive interest.
Thus we can compute the future value of what Vo will accumulate to in n years when it is
compounded annually at the same rate of r by using the above formula.
Now attempt the following exercise:

b) Net present value (NPV)

24
 c) Annuities
 A set of cash flows that are equal in each and every period is called an annuity.
d) Perpetuities
 A perpetuity is an annuity with an infinite life. It is an equal sum of money to be paid in
each period forever.

Examples

1) You are promised a perpetuity of $700 per year at a rate of interest of 15% per annum. What
price (PV) should you be willing to pay for this income?
Solution

2) A perpetuity with growth: Suppose that the $700 annual income most recently received is
expected to grow by a rate G of 5% per year (compounded) forever. How much would this
income be worth when discounted at 15%?
Solution: Subtract the growth rate from the discount rate and treat the first period's cash flow as a
perpetuity.

25
 e) The internal rate of return (IRR)

· The IRR is the discount rate at which the NPV for a project equals zero. This rate means that the
present value of the cash inflows for the project would equal the present value of its outflows.
· The IRR is the break-even discount rate.
· The IRR is found by trial and error.

where r = IRR

IRR of an annuity:

where:
Q (n,r) is the discount factor
Io is the initial outlay
C is the uniform annual receipt (C1 = C2 =....= Cn).

Example:

What is the IRR of an equal annual income of $20 per annum which accrues for 7 years and costs
$120?

= 6

From the tables = 4%

Economic rationale for IRR:

If IRR exceeds cost of capital, project is worthwhile, i.e. it is profitable to undertake.

Net present value vs internal rate of return

Independent vs dependent projects

NPV and IRR methods are closely related because:

i) both are time-adjusted measures of profitability, and

ii) their mathematical formulas are almost identical.

So, which method leads to an optimal decision: IRR or NPV?

a) NPV vs IRR: Independent projects

Independent project: Selecting one project does not preclude the choosing of the other.

With conventional cash flows (-|+|+) no conflict in decision arises; in this case both NPV and IRR lead to the
same accept/reject decisions.

Figure 6.1 NPV vs IRR Independent projects

26
 If cash flows are discounted at k1, NPV is positive and IRR > k1: accept project.

If cash flows are discounted at k2, NPV is negative and IRR < k2: reject the project.

Mathematical proof: for a project to be acceptable, the NPV must be positive, i.e.

Similarly for the same project to be acceptable:

where R is the IRR.

Since the numerators Ct are identical and positive in both instances:
· implicitly/intuitively R must be greater than k (R > k);
· If NPV = 0 then R = k: the company is indifferent to such a project;
· Hence, IRR and NPV lead to the same decision in this case.
b) NPV vs IRR: Dependent projects
NPV clashes with IRR where mutually exclusive projects exist.
Example:
Agritex is considering building either a one-storey (Project A) or five-storey (Project B) block of offices on a
prime site. The following information is available:
Initial Investment Outlay Net Inflow at the Year End
Project A -9,500 11,500
Project B -15,000 18,000
Assume k = 10%, which project should Agritex undertake?

= $954.55

= $1,363.64
Both projects are of one-year duration:

27
 IRRA:
$11,500 = $9,500 (1 +RA)

= 1.21-1
therefore IRRA = 21%

IRRB:
$18,000 = $15,000(1 + RB)

= 1.2-1
therefore IRRB = 20%
Decision:
Assuming that k = 10%, both projects are acceptable because:
NPVA and NPVB are both positive
IRRA > k AND IRRB > k
Which project is a "better option" for Agritex?
If we use the NPV method:
NPVB ($1,363.64) > NPVA ($954.55): Agritex should choose Project B.
If we use the IRR method:
IRRA (21%) > IRRB (20%): Agritex should choose Project A. See figure 6.2.
Figure 6.2 NPV vs IRR: Dependent projects

Up to a discount rate of ko: project B is superior to project A, therefore project B is preferred to project A.
Beyond the point ko: project A is superior to project B, therefore project A is preferred to project B
The two methods do not rank the projects the same.
Differences in the scale of investment
NPV and IRR may give conflicting decisions where projects differ in their scale of investment. Example:
Years 0 1 2 3
Project A -2,500 1,500 1,500 1,500
Project B -14,000 7,000 7,000 7,000

28
 Assume k= 10%.
NPVA = $1,500 x PVFA at 10% for 3 years
= $1,500 x 2.487
= $3,730.50 - $2,500.00
= $1,230.50.
NPVB == $7,000 x PVFA at 10% for 3 years
= $7,000 x 2.487
= $17,409 - $14,000
= $3,409.00.

IRRA =

= 1.67.
Therefore IRRA = 36% (from the tables)

IRRB =

= 2.0
Therefore IRRB = 21%
Decision:
Conflicting, as:
· NPV prefers B to A
· IRR prefers A to B
NPV IRR
Project A $ 3,730.50 36%
Project B $17,400.00 21%
See figure 6.3.
Figure 6.3 Scale of investments

To show why:
i) the NPV prefers B, the larger project, for a discount rate below 20%
ii) the NPV is superior to the IRR
a) Use the incremental cash flow approach, "B minus A" approach
b) Choosing project B is tantamount to choosing a hypothetical project "B minus A".
0 1 2 3
29
 Project B - 14,000 7,000 7,000 7,000
Project A - 2,500 1,500 1,500 1,500
"B minus A" - 11,500 5,500 5,500 5,500

IRR"B Minus A"

= 2.09
= 20%
c) Choosing B is equivalent to: A + (B - A) = B
d) Choosing the bigger project B means choosing the smaller project A plus an additional outlay of $11,500
of which $5,500 will be realised each year for the next 3 years.
e) The IRR"B minus A" on the incremental cash flow is 20%.
f) Given k of 10%, this is a profitable opportunity, therefore must be accepted.
g) But, if k were greater than the IRR (20%) on the incremental CF, then reject project.
h) At the point of intersection,
NPVA = NPVB or NPVA - NPVB = 0, i.e. indifferent to projects A and B.
i) If k = 20% (IRR of "B - A") the company should accept project A.
· This justifies the use of NPV criterion.
Advantage of NPV:
· It ensures that the firm reaches an optimal scale of investment.
Disadvantage of IRR:
· It expresses the return in a percentage form rather than in terms of absolute dollar returns, e.g. the IRR will
prefer 500% of $1 to 20% return on $100. However, most companies set their goals in absolute terms and not
in % terms, e.g. target sales figure of $2.5 million.
The timing of the cash flow
The IRR may give conflicting decisions where the timing of cash flows varies between the 2 projects.
Note that initial outlay Io is the same.
0 1 2
Project A - 100 20 125.00
Project B - 100 100 31.25
"A minus B" 0 - 80 88.15
Assume k = 10%
NPV IRR
Project A 17.3 20.0%
Project B 16.7 25.0%
"A minus B" 0.6 10.9%
IRR prefers B to A even though both projects have identical initial outlays. So, the decision is to accept A,
that is B + (A - B) = A. See the following figure.
Figure: Timing of the cash flow

30
 The horizon problem
NPV and IRR rankings are contradictory. Project A earns $120 at the end of the first year while project B
earns $174 at the end of the fourth year.
0 1 23 4
Project A -100 120 - - -
Project B -100 - - - 174
Assume k = 10%
NPV IRR
Project A 9 20%
Project B 19 15%
Decision:
NPV prefers B to A
IRR prefers A to B.
The profitability index - PI
This is a variant of the NPV method.

Decision rule:
PI > 1; accept the project
PI < 1; reject the project
If NPV = 0, we have:
NPV = PV - Io = 0
PV = Io
Dividing both sides by Io we get:

PI of 1.2 means that the project's profitability is 20%. Example:

PV of CF Io PI
Project A 100 50 2.0
Project B 1,500 1,000 1.5
Decision:
Choose option B because it maximises the firm's profitability by $1,500.
Disadvantage of PI:
Like IRR it is a percentage and therefore ignores the scale of investment.
The payback period (PP)
The CIMA defines payback as 'the time it takes the cash inflows from a capital investment project to equal
the cash outflows, usually expressed in years'. When deciding between two or more competing projects, the
usual decision is to accept the one with the shortest payback.
Payback is often used as a "first screening method". By this, we mean that when a capital investment project
is being considered, the first question to ask is: 'How long will it take to pay back its cost?' The company
might have a target payback, and so it would reject a capital project unless its payback period were less than
a certain number of years.
Example 1:
Years 0 1 2 3 4 5
Project A 1,000,000 250,000 250,000 250,000 250,000 250,000
For a project with equal annual receipts:

= 4 years
Example 2:

31
 Years 0 1 2 3 4
Project B - 10,000 5,000 2,500 4,000 1,000
Payback period lies between year 2 and year 3. Sum of money recovered by the end of the second year
= $7,500, i.e. ($5,000 + $2,500)
Sum of money to be recovered by end of 3rd year
= $10,000 - $7,500
= $2,500

= 2.625 years
Disadvantages of the payback method:
· It ignores the timing of cash flows within the payback period, the cash flows after the end of payback
period and therefore the total project return.
· It ignores the time value of money. This means that it does not take into account the fact that $1 today is
worth more than $1 in one year's time. An investor who has $1 today can either consume it immediately or
alternatively can invest it at the prevailing interest rate, say 30%, to get a return of $1.30 in a year's time.
· It is unable to distinguish between projects with the same payback period.
· It may lead to excessive investment in short-term projects.
Advantages of the payback method:
· Payback can be important: long payback means capital tied up and high investment risk. The method also
has the advantage that it involves a quick, simple calculation and an easily understood concept.
The accounting rate of return - (ARR)
The ARR method (also called the return on capital employed (ROCE) or the return on investment (ROI)
method) of appraising a capital project is to estimate the accounting rate of return that the project should
yield. If it exceeds a target rate of return, the project will be undertaken.

Note that net annual profit excludes depreciation.

Example:
A project has an initial outlay of $1 million and generates net receipts of $250,000 for 10 years.
Assuming straight-line depreciation of $100,000 per year:

= 15%

= 30%
Disadvantages:
· It does not take account of the timing of the profits from an investment.
· It implicitly assumes stable cash receipts over time.
· It is based on accounting profits and not cash flows. Accounting profits are subject to a number of different
accounting treatments.
· It is a relative measure rather than an absolute measure and hence takes no account of the size of the
investment.
· It takes no account of the length of the project.
· it ignores the time value of money.
The payback and ARR methods in practice
Despite the limitations of the payback method, it is the method most widely used in practice. There are a
number of reasons for this:
32
 · It is a particularly useful approach for ranking projects where a firm faces liquidity constraints and requires
fast repayment of investments.
· It is appropriate in situations where risky investments are made in uncertain markets that are subject to fast
design and product changes or where future cash flows are particularly difficult to predict.
· The method is often used in conjunction with NPV or IRR method and acts as a first screening device to
identify projects which are worthy of further investigation.
· it is easily understood by all levels of management.
· It provides an important summary method: how quickly will the initial investment be recouped?
Now attempt exercise 6.5.
Exercise 6.5 Payback and ARR
Delta Corporation is considering two capital expenditure proposals. Both proposals are for similar products
and both are expected to operate for four years. Only one proposal can be accepted.
The following information is available:
Profit/(loss)
Proposal A Proposal B
$ $
Initial investment 46,000 46,000
Year 1 6,500 4,500
Year 2 3,500 2,500
Year 3 13,500 4,500
Year 4 Loss 1,500 Profit 14,500
Estimated scrap value at the end of Year 4 4,000 4,000
Depreciation is charged on the straight line basis. Problem:
a) Calculate the following for both proposals:
i) the payback period to one decimal place
ii) the average rate of return on initial investment, to one decimal place.
Allowing for inflation
So far, the effect of inflation has not been considered on the appraisal of capital investment proposals.
Inflation is particularly important in developing countries as the rate of inflation tends to be rather high. As
inflation rate increases, so will the minimum return required by an investor. For example, one might be
happy with a return of 10% with zero inflation, but if inflation was 20%, one would expect a much greater
return.
Example:
Keymer Farm is considering investing in a project with the following cash flows:
ACTUAL CASH FLOWS
Z$
TIME
0 (100,000)
1 90,000
2 80,000
3 70,000
Keymer Farm requires a minimum return of 40% under the present conditions. Inflation is currently running
at 30% a year, and this is expected to continue indefinitely. Should Keymer Farm go ahead with the project?
Let us take a look at Keymer Farm's required rate of return. If it invested $10,000 for one year on 1 January,
then on 31 December it would require a minimum return of $4,000. With the initial investment of $10,000,
the total value of the investment by 31 December must increase to $14,000. During the year, the purchasing
value of the dollar would fall due to inflation. We can restate the amount received on 31 December in terms
of the purchasing power of the dollar at 1 January as follows:
Amount received on 31 December in terms of the value of the dollar at 1 January:

= $10,769
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 In terms of the value of the dollar at 1 January, Keymer Farm would make a profit of $769 which represents
a rate of return of 7.69% in "today's money" terms. This is known as the real rate of return. The required rate
of 40% is a money rate of return (sometimes known as a nominal rate of return). The money rate measures
the return in terms of the dollar, which is falling in value. The real rate measures the return in constant price
level terms.
The two rates of return and the inflation rate are linked by the equation:
(1 + money rate) = (1 + real rate) x (1 + inflation rate)
where all the rates are expressed as proportions.
In the example,
(1 + 0.40) = (1 + 0.0769) x (1 + 0.3)
= 1.40
So, which rate is used in discounting? As a rule of thumb:
a) If the cash flows are expressed in terms of actual dollars that will be received or paid in the future, the
money rate for discounting should be used.
b) If the cash flows are expressed in terms of the value of the dollar at time 0 (i.e. in constant price level
terms), the real rate of discounting should be used.
In Keymer Farm's case, the cash flows are expressed in terms of the actual dollars that will be received or
paid at the relevant dates. Therefore, we should discount them using the money rate of return.
TIME CASH FLOW DISCOUNT FACTOR PV
$ 40% $
0 (150,000) 1.000 (100,000)
1 90,000 0.714 64,260
2 80,000 0.510 40,800
3 70,000 0.364 25,480
30,540
The project has a positive net present value of $30,540, so Keymer Farm should go ahead with the project.
The future cash flows can be re-expressed in terms of the value of the dollar at time 0 as follows, given
inflation at 30% a year:
TIME ACTUAL CASH FLOW CASH FLOW AT TIME 0 PRICE LEVEL
$ $
0 (100,000) (100,000)
1 90,000 69,231

2 80,000 47,337

3 70,000 31,862

The cash flows expressed in terms of the value of the dollar at time 0 can now be discounted using the real
value of 7.69%.
TIME CASH FLOW DISCOUNT FACTOR PV
$ 7.69% $
0 (100,000) 1.000 (100,000)
1 69,231 64,246

2 47,337 40,804

3 31,862 25,490

30,540
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 The NPV is the same as before.
Expectations of inflation and the effects of inflation
When a manager evaluates a project, or when a shareholder evaluates his/her investments, he/she can only
guess what the rate of inflation will be. These guesses will probably be wrong, at least to some extent, as it is
extremely difficult to forecast the rate of inflation accurately. The only way in which uncertainty about
inflation can be allowed for in project evaluation is by risk and uncertainty analysis.
Inflation may be general, that is, affecting prices of all kinds, or specific to particular prices. Generalised
inflation has the following effects:
a) Inflation will mean higher costs and higher selling prices. It is difficult to predict the effect of higher
selling prices on demand. A company that raises its prices by 30%, because the general rate of inflation is
30%, might suffer a serious fall in demand.
b) Inflation, as it affects financing needs, is also going to affect gearing, and so the cost of capital.
c) Since fixed assets and stocks will increase in money value, the same quantities of assets must be financed
by increasing amounts of capital. If the future rate of inflation can be predicted with some degree of
accuracy, management can work out how much extra finance the company will need and take steps to obtain
it, e.g. by increasing retention of earnings, or borrowing.
However, if the future rate of inflation cannot be predicted with a certain amount of accuracy, then
management should estimate what it will be and make plans to obtain the extra finance accordingly.
Provisions should also be made to have access to 'contingency funds' should the rate of inflation exceed
expectations, e.g. a higher bank overdraft facility might be arranged should the need arise.
Many different proposals have been made for accounting for inflation. Two systems known as "Current
purchasing power" (CPP) and "Current cost accounting" (CCA) have been suggested.
CPP is a system of accounting which makes adjustments to income and capital values to allow for the
general rate of price inflation.
CCA is a system which takes account of specific price inflation (i.e. changes in the prices of specific assets
or groups of assets), but not of general price inflation. It involves adjusting accounts to reflect the current
values of assets owned and used.
At present, there is very little measure of agreement as to the best approach to the problem of 'accounting for
inflation'. Both these approaches are still being debated by the accountancy bodies.

Investment criteria
Investment Criteria of Capital Budgeting:

1. Accounting or Average Rate of Return Method

The Average Rate of Return (ARR) method is used in order to measure the profit-abilities of the
investment proposals. This is practically an accounting method and it incorporates the expected
return which may be obtained from the project. Under this method average annual profit (after tax)
is expressed as percentage of investment.
2. Pay Back Period
The Pay Back Period Method is the second unsophisticated method of capital budgeting and is
widely employed in order to overcome some of the shortcomings of ARR method It recognises that
recovery of the original investment is an important element while appraising capital expenditure
decisions.
3. Discounted Cash Flow Techniques
The earlier two methods, viz. ARR method and Pay Back Period method, discussed so far for the
purpose of appraising the investment proposals, do not consider the basic facts, i.e., the timing of
cash flows.
Because, the Accounting or Average Rate of Return method recognises cash proceeds to the
original or average cost of investment whereas Pay Back Period method considers all cash flows
received before the pay-back period equal but do not consider the cash flow after pay-back period.
Thus, both methods fail to recognise the basic fact that the sum of money received in future is less
valuable than it is to-day, i.e., the time value of money.
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 There are three reasons for this. They are:
(a) Re-investment opportunities,
(b) Uncertainty and
(c) Inflation
4. Net Present Value Method
The Net Present Value Method (NPV) is the time value of money approach to evaluate the return
from an investment proposal. Under this method, we discount a project using the required return as
the discount factor In other words, a stipulated compound interest rate is given and by the use of
this percentage net cash flows are discounted to present values.
The present value of the cost of the project is subtracted from the sum of present values of various
cash inflows. The surplus is the net present value. If the NPV is positive, the proposal’s forecast
return exceeds the required return, hence, the proposals are acceptable.
But if the NPV is negative, the forecast return is less than the required return, the proposals is not
acceptable. Thus, the decision rule for a project under NPV is to accept the project if the NPV is
positive. and reject if it is negative. Or,
(1) NPV > zero = Accept.
(2) NPV < zero = Reject.
5. Internal Rate of Return or Yield Method
The Internal Rate of Return (IRR) method is the second discounted cash flow or time adjusted
method for appraising capital investment decisions. It was first intro-duced by Joel Dean. It is also
known as yield on investment, marginal efficiency of capital, rate of return over cost, time-adjusted
rate of return and so on.
Internal rate of return is a rate which actually equates the present value of cash inflows with the
present value of cash outflows.
6. Profitability Index (PI) or Benefit Cost Ratio
Another time-adjusted techniques for evaluating investment proposals is the Prof-itability Index
(PI) or Benefit Cost Ratio (B/C Ratio). It is the relation between present value of future net cash
flows and the initial cash outlay, i.e. this ratio is computed by dividing the present value of net cash
flows by the initial cash outlay.
It is computed as under:

It is similar to the NPV approach. It measures the present value of return per rupee invested.
Whereas NPV depends 011 the difference between PV of NCF and PV of cash outflow.
7. Terminal Value (TV) Method
Under this method, it is assumed that each cash inflow is re-invested in another asset at a certain
rate of return and calculating the terminal value of net cash flows at the end of project life. In short,
the NCF and the outlay are compounded forward rather than backward by discounting which is
used by NPV method.
Project cost of capital
In economics and accounting, the cost of capital is the cost of a company's funds
(both debt and equity), or, from an investor's point of view "the required rate of return on a portfolio
company's existing securities". It is used to evaluate new projects of a company. It is the minimum
return that investors expect for providing capital to the company, thus setting a benchmark that a
new project has to meet.
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 For an investment to be worthwhile, the expected return on capital has to be higher than the cost
of capital. Given a number of competing investment opportunities, investors are expected to put
their capital to work in order to maximize the return. In other words, the cost of capital is the rate of
return that capital could be expected to earn in the best alternative investment of equivalent risk;
this is the opportunity cost of capital. If a project is of similar risk to a company's average business
activities it is reasonable to use the company's average cost of capital as a basis for the evaluation or
cost of capital is a firm's cost of raising funds. However, for projects outside the core business of
the company, the current cost of capital may not be the appropriate yardstick to use, as the risks of
the businesses are not the same.
A company's securities typically include both debt and equity, one must therefore calculate both the
cost of debt and the cost of equity to determine a company's cost of capital. Importantly, both cost
of debt and equity must be forward looking, and reflect the expectations of risk and return in the
future. This means, for instance, that the past cost of debt is not a good indicator of the actual
forward looking cost of debt.
Once cost of debt and cost of equity have been determined, their blend, the weighted average cost
of capital (WACC), can be calculated. This WACC can then be used as a discount rate for a
project's projected free cash flows to the firm.

Cost of debt
When companies borrow funds from outside lenders, the interest paid on these funds is called the
cost of debt. The cost of debt is computed by taking the rate on a risk-free bond whose duration
matches the term structure of the corporate debt, then adding a default premium. This default
premium will rise as the amount of debt increases (since, all other things being equal, the risk rises
as the cost of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt
is computed on an after-tax basis to make it comparable with the cost of equity (earnings
are taxed as well). Thus, for profitable firms, debt is discounted by the tax rate. The formula can be
written as

Cost of equity
The cost of equity is inferred by comparing the investment to other investments (comparable) with
similar risk profiles. It is commonly computed using the capital asset pricing model formula:

The risk free rate is the yield on long term bonds in the particular market, such as government
bonds.

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 An alternative to the estimation of the required return by the capital asset pricing model as above, is
the use of the Fama–French three-factor model.
Expected return
The expected return (or required rate of return for investors) can be calculated with the "dividend
capitalization model", which is

Weighted average cost of capital

The weighted cost of capital (WACC) is used in finance to measure a firm's cost of capital. WACC
is not dictated by management. Rather, it represents the minimum return that a company must earn
on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will
invest elsewhere.
The total capital for a firm is the value of its equity (for a firm without
outstanding warrants and options, this is the same as the company's market capitalization) plus the
cost of its debt (the cost of debt should be continually updated as the cost of debt changes as a result
of interest rate changes). Notice that the "equity" in the debt to equity ratio is the market value of all
equity, not the shareholders' equity on the balance sheet. To calculate the firm's weighted cost of
capital, we must first calculate the costs of the individual financing sources: Cost of Debt, Cost of
Preference Capital, and Cost of Equity Cap.
Calculation of WACC is an iterative procedure which requires estimation of the fair market value of
equity capital if the company is not listed. The Adjusted Present Value method (APV) is much
easier to use in this case as it separates the value of the project from the value of its financing
program.

Project social cost benefit analysis (SCBA)

SCBA is also referred to as economic society benefit analysis, is a part of the economic analysis in
project appraisal. It is a methodology developed for evaluating investment projects from the point
of view of the society (or economy) as a whole.
SCBA is used primarily for evaluating public investments and has received increased emphasis in
recent years due to the growing importance of public investments especially in developing countries
where government play significant role in economic development. SCBA is also relevant in major
private investments, which require governmental approval since these investments have bearing on
national considerations.
In modern times, all project investments have impact on society and nations economy.

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