CHAPTER FOUR

PROJECT PREPARATION AND

APPRAISAL

1
 Situation Analysis
Objectives
Internal

SWOT Brainstorming

External
Alternative
Project
Possibilities

Criteria
Screening

Candidate Project
Proposals

2
 Situation Analysis
Internal and External Situations Analysis
• SWOT Analysis:
 Internal Strengths and Weaknesses
• Resources
• Management
 External Opportunities and Threats
• Suppliers, Competitors, Customers
• PEST/PESTEL

3
 Situation Analysis
Basis for Project Screening
• Does the project support the organization’s
mission?
• Does the Proposed Solution align with the
organization’s strategic plan/technical
architecture?
• Is there an available/plausible funding source
for this effort?
• Does the project’s cost/benefit analysis justify
its initiation?
4
 Situation Analysis
Basis for Project Screening
Needs – to make available to all people in an area
minimum amount of certain basic material
requirements or services.
 A needs assessment survey establishes the urgency for
intervention;
 Market demand –domestic or overseas;
 Resource availability – opportunity to make
profitable use of available resource.
Technology – to make use of available technology
Natural calamity – hedging against the adverse
effects of natural events as drought or floods; and
Political consideration-
5
 Technical Analysis
• Existing technologies and human resource
(management teams and employees)
• Will the project work?
• Has due attention been paid to technical
factors affecting the project design?
• Given the human and material resources
identified, can the project activities be
undertaken and outputs achieved within the
time available and to the required standards?

6
 Market Analysis
• More detail analyses of:
Customers’ demand for product/services of a
project
Supply of the same or similar products/services
Demand gap (shortage).
Determinants of demands for the product/service

7
 Economic Analysis
• Will the nation and society at large be better off as a result of
the project?
• Will the project benefits be greater than the project costs
over the life of the investment when account is taken of time
(namely, is the Net Present Value of the project positive at
the test discount rate)?
• Social cost -benefit analysis
• Direct economic benefits and costs in terms of shadow prices
• Impact of project on distribution of income in society
• Impact on level of savings and investments in society
• Impact on fulfillment of national goals :-
– Self sufficiency
– Employment and
– Social order
8
 Economic Analysis
• Reflect social value or cost.
Interest on money invested
Depreciation
Land
Price Changes
Opportunity costs
Discounting
Labor wage

9
 Economic Analysis
• Government policy distorts market by

Subsidy
Tax allocation
Setting minimum wage rate
Controlling foreign exchange rate etc.

10
 Economic Analysis
• In economic analysis of projects, the price at the
actual market should be converted into somehow
appropriate value.

• Price converted from market price (it is also called

“Financial Price”) is called “Economic Price, which
will be the price to express the value of the goods
and services under perfect competition market
leading to optimal and efficient use of limited
resources.

11
 Economic Analysis
• The items to consider in economic analysis
are:

Transfer payments
Production Goods (Traded Goods and Non-traded
Goods)
Labor
Land etc.

12
 Economic Analysis
• The international market price (border price as
the price is expressed at the border of the
countries) is a better measure of opportunity
cost than domestic price.
• Several factors make domestic price unsuitable
as an indicator of relative value of a project
product/service without a lot of adjustment.
– Import tariffs, indirect taxes, overvalued exchange
rates, subsidies, overstated labor costs, monopoly
prices and other forms of administrative intervention
affect the (internal) market price of very many
products and services.
13
 Economic Analysis
Calculation of Economic Price
• Elimination of Transfer Payments
– When calculating economic cost, only resources
inputted in the project will be accounted as cost, in
another word, transfer payments are eliminated in
calculating economic cost.
– Taxes, duties, subsidies are considered to be transfer
payments.
• These are the command of the government for transferring
the resources from one to another.
• In another word, economic analysis is carried out in such a
world without governments.
• Government is the distortion factor for the market.
14
 Economic Analysis
Calculation of Economic Price
• Elimination of Transfer Payments
– Taxes
• In economic analysis, taxes are transfer payments
within a society, not the payment for resources used
for project.
• For private firm, taxes are obviously actual
expenditures; hence it is considered as costs.
• From a viewpoint of national economy, taxes are just
transfer of cost from firm to government (among the
members of the society); hence, tax is eliminated from
cost.
15
 Economic Analysis
Calculation of Economic Price
• Elimination of Transfer Payments
– Subsidies
• If government subsidizes a project implemented by a
private firm, this subsidy is accounted as a benefit for
the private firm.
• From the viewpoint of national economy, subsidies are
also transfer of cost among the members of the
country; therefore, subsidies are eliminated from the
cost or benefit.

16
 Economic Analysis
Calculation of Economic Price
• Elimination of Transfer Payments
– Interest
• Investing capital in a project will consume resources
such as raw material, equipment, labor etc.
• Interest of the capital is not the cost used for
consuming resources for the project but a kind of
accounting operation like depreciation cost.
• Interest is a transfer of value among the members of
the country (from borrower to lender); therefore,
interest is eliminated from project cost.

17
 Economic Analysis
Calculation of Economic Price
• Shadow Price
It is also called efficiency price.
It is the equilibrium price, with which supply and
demand meet under perfect competition market
(considered to be the most appropriate price).
The perfect competition market does not exist on
the earth and therefore, the price determined at
considerably competitive market is used as
approximate shadow price.
• International market is considered to be very
competitive one.
18
 Economic Analysis
Calculation of Economic Price
• Shadow Price
Price in the international market (border price) is
used as approximate shadow price.
Internal market price will be converted into the
value of international market.
Goods are categorized to traded goods and non-
traded goods.
• For traded goods international market price is used,
and for non-traded goods domestic market price is
used.

19
 Economic Analysis
Calculation of Economic Price
• Valuing Goods as Economic Price
– To adjust the level of prices obtained from different
markets, some converting factors are applied.
• When converting the price of international market into
that of internal market, Shadow Exchange Rate (SER)
(UNIDO method) is used.
– Unit of currency is the one in the country.
• When converting the price of internal market into that of
international market, Conversion Factor (CF) (Little
and Mirrlees method) is used.
– An international currency, namely, US$ will be the unit of
currency.
20
 Economic Analysis
Calculation of Economic Price
• Valuing Goods as Economic Price
Traded (tradable) Goods
– Traded goods (or tradable goods) are valued on the basis
of their marginal international (border) price, CIF (Cost
Insurance and Freight) for imports and FOB (Free on
Board) for exports.
Example:

21
 Economic Analysis
Calculation of Economic Price
• Valuing Goods as Economic Price
Non-traded goods
– Non-traded goods, which has only internal market price, is
converted into the level of international market price by
applying Standard Conversion Factor (SCF).
– SCF has a function to eliminate the factors of
distorting internal market price on border of the
country, namely import and export tariffs, and
export subsidies.

22
 Economic Analysis
Calculation of Economic Price
• Labor
– Labor is categorized with skilled labor and unskilled labor.
– It is considered that the supply of skilled labor is usually
scarce, and therefore, the wage of skilled labor meets at
its demand (market price can be used as its shadow
price).
– As for unskilled labor, it is usually considered in over
supply situation.
• Under such situation, unskilled labor wage in the market could be
more than its economic cost.

23
 Social Analysis
• A detail analysis of the likely impact of the
project on different stakeholders, their
opportunities for participation, and the
project’s contribution to poverty reduction.
What will be the effect of the project on different
groups, at individual, household and community
levels?
How will they participate in various stages of the
project cycle?
Will the social benefits of the project be greater
than the social costs over the life of the
investment when account is taken of time?
24
 Social Analysis
Who comprise the different stakeholders?
What are their interests?
How will they be affected by the proposed
project?
What are the project priorities between the
different groups?
What is their capacity to participate in the project?
What social organization exists within the
community?
How is it arranged?
How may it be used to strengthen the project?
25
 Environmental Analysis
• Detail analysis of:
– Impact of a project on quality of air, water, noise,
vegetation, human life
• Will the project have any adverse effects on the
environment?
– Likely damage & the cost of restoration
• Have remedial measures been included in the project
design?

26
 Political Analysis
• A detail appraisal which answers the following
key questions.
Will the project be compatible with government
policy, at both central and regional levels?
Is the project likely to be politically controversial?
• Will there be different political effects on different
members of a society?

27
 Institutional Analysis
• Detail analysis which answers the following
basic questions.

Are the supporting institutions in place?

Can they operate effectively within the existing
legislative and policy environment?
Has the project identified opportunities for
institutional strengthening and capacity building?

28
 Financial Analysis
• Answers the following fundamental questions.
Can the project be financed?
Will there be sufficient funds to cover the
expenditure requirements during the life of the
project?
• Servicing debt
• Meeting return expectations

29
 Risk Analysis
• A detail analysis answering the following main
questions.

Will the project be exposed to any undue risks?

Will the project benefits be sustainable beyond
the life of the project?

30
 Project Selection Approaches
• There are two types of project selection
approaches:

1) Non-numeric and
2) Numeric Approaches

• Non-numeric methods do not use numbers as

inputs
• The non-numeric models are older and simpler.

31
 Project Selection Approaches
Kinds of non-numeric Approaches:
a) The Sacred Cow: the project is suggested by a senior and
powerful official.
– The project is “sacred” in the sense that it will be maintained until
successfully concluded, or until the boss, personally, recognizes the idea as
a failure and terminates it.
b) The Operating Necessity: If a flood is threatening the plant, a
project to build a protective dike does not require much formal
evaluation.
c) The Competitive Necessity: for example, companies may need
to modernize their work to remain competitive.
d) The Product Line Extension: adding new products to the line
making sure that it strengths a weak link.
e) Comparative Benefit Model: selecting a project based on the
benefits it brings
32
 Project Selection Approaches
Kinds of Numeric Approaches
a) Ranking by Inspection
 It answers the basic question: Given alternative
investments which one should be implemented and which
one should be discarded in a mutually exclusive
investments?
 There may be an alternative as to build a hotel or a
factory on the same site.
 The investor might choose to start one with limited
resources he/she has.
 It consists of choosing the best investment by comparing
the net proceeds of alternative investments.
 The project have more cash proceeds will be preferred
though are some peculiarities on inspections.
33
 Cont’d
Steps:
• Comparing the net proceeds of A & B projects, we can find
out which project has shorter life period.
• Compare the net proceeds of the short lived project with
long lived one.
• If the two have the same initial investment & proceeds
throughout the period of the short lived investment; & if the
long lived investment continues to earn income after the
end of the short lived one, then the long lived one is more
desirable as the second project continues to earn
proceeds while the first one has ended.

34
 Cont’d
Example
Net Cash Flow of 4 Proposed Projects with Identical Initial
Investment Outlays & Life Periods
Project Initial Net Cash Proceeds in Years
Investment Cost
1 2 Total

A 20,000 20,000 - 20,000

B 20,000 20,000 2,000 22,000
C 20,000 14,600 9,850 24,450
D 20,000 16,325 8,125 24,450
Then, which one is more desirable-taking into account the net
proceeds?
35
 Cont’d

• Although the total net proceeds of C & D

are equal, D earns more income earlier
than C.
– Thus D is more desirable than C
• Project B is more desirable than A

36
 Project Selection Approaches
• Kinds of Numeric Approaches
b) Payback Period
• The length of time from the beginning of the project
until the sum of net incremental benefits of the
project equal to total capital investment.
• It is the amount of time it takes to recover the
original/investment cost.
• Decision rule:
– If the calculated payback period is less than or equal to
some pre-specified payback period, then accept the
project. Otherwise reject it.
37
 Cont’d
Limitations
• fails to consider the time & amount of net
benefits after the payback period.
• does not adequately take into account
the time value of money even in the
payable periods.

38
 Cont’d
• If the expected cash inflow is constant :

PBP= Cash outlay (investment)

Net Annual cash inflows

• If the expected cash inflow varies from period to period:

PBP=Year before full recovery + Unrecovered cost at the start of year

Cash flow during the year

39
 Cont’d
Example1:
• If Birr 5 million is invested to earn Birr 2,500,000
per annum for 4 years, the pay back period is
computed as follows:
• Pay back period = Br 5million/2,500,000= 2yrs

40
 Cont’d
Example 2:
• Assume that a firm is considering two projects: project A
and project B, each requiring an investment of ETB120
million. The cost of capital is 10%. Below is the summary
of expected net cash flows in millions.
• Then find the payback period for the two projects and
indicate which project should be chosen, given that the
projects are mutually exclusive.

41
Cont’d

42
 Project Selection Approaches

Kinds of Numeric Approaches

C) Return on Investment (ROI)
– Also called Average Income on Cost or Average Rate of
Return
– Calculated by dividing the average income by the cost
of investment
– Some planners prefer to take the ratio of the average
income to the book value (cost of investment after
depreciation)

43
 Project Selection Approaches
Kinds of Numeric Approaches
C) Return on Investment (ROI)
– The ratio of the average annual profit (either after or before
taxes) to the average or initial investment in the project is
referred to as the average rate of return.
– It is mostly misunderstood as the reciprocal of payback
period.
– The average rate of return does not generally equal the
reciprocal of the payback period because average annual
profits are generally not equivalent to the net cash inflows.

44
 Project Selection Approaches

Kinds of Numeric Approaches

C) Return on Investment (ROI)
Example-1
• Suppose a project costs $200,000 to operate. It
has annual net cash inflows of $40,000. and the
average annual profits are $30,000
ROI= $30,000/$200,000= 0.15

45
 Cont’d
Example-2
Projects Initial Cost ($) Average NP ($) ROI (%) Ranking

A 20,000 0 0 4
B 20,000 66,000 3.3 3
C 20,000 80,000 4 1
D 20,000 80,000 4 1

• Project C & D are preferred than A or B, but B is preferred

than A.
• Weakness of ROI: It doesn’t take into account the time
value of money.
46
 Project Selection Approaches
Kinds of Numeric Approaches
D) Accounting Rate of Return (ARR)
• The accounting rate of return (ARR), expresses the profit
forecast as a percentage of the capital expenditure
involved.
• ARR is also known as accrual accounting rate of return,
unadjusted rate of return model and the book value model.
• ARR is a measure of profitability in accounting terms.
• This method aims to quantify the profits expected from
investment projects under consideration.
• There are different methods of calculating the ARR.

47
 Cont’d
• ARR=Average Income after tax
Initial Investment

• ARR=AIAT, but before Interest

Initial Investment

• ARR= Average Inc. before Interest &tax

Initial Investment

• If the investment is a fixed asset such as property, plant, and

equipment (PP&E), subtract any depreciation expense from the
annual revenue to achieve the annual net profit.

48
 Project Selection Approaches

Kinds of Numeric Approaches n

Ct
NPV  A0   t
e) Net Present Value (NPV) i 1 (1  r )

Suppose that the project has the following data

• Initial Investment (Ao)= 300,000 Birr

• Annual costs of operation = 20,000 Birr

• Expected annual revenue =

100,000 Birr/year in the first 2 years and

200,000 Birr/year in the next 3 years

• Duration of the project is 5 years

49
 Cont’d
Time 0 1 2 3 4 5
(yrs)
Revenue - 100,000 100,000 200,000 200,000 200,000
Costs (300,000) 20,000 20,000 20,000 20,000 20,000
Gross -300,000 80,000 80,000 180,000 180,000 180,000
Profit

NPBP =
DPBP=

50
 Cont’d
NPV: it determines the net present value of all cash flows
by discounting them by the required rate of return.
n
Ct
NPV  A0   t
i 1 (1  r )

Where, Ct = the net cash flow in period t

r = the required rate of return, and

A0 = initial cash investment (because this is an outflow, it will be
negative).

51
 Cont’d
Discounted cash flows for interest rate 10%
Year 0 1 2 3 4 5
Cash flows -300 80 80 180 180 180

DF (10%) 1 0.909 0.826 0.751 0.683 0.621

Discounted -300 72.72 66.08 135.18 122.94 111.78
Cash flow
(DCF)
Cum DCF -300 -227.28 -161.2 -26.02 96.92 208.7

Data are given in ‘000

NPV = 208.7
DPBP= 3.2 years

52
 Cont’d
Interest rate 14% 15% 16% 18% 20%
Investment 12000
Cash flow 4,000 5,000 7,000 6,000 5,000

PVC1 4,000 / 1.14 3509

PVC 2 5,000 /(1.14 1.15) 3814

PVC3 7,000 /(1.14 1.15 1.16) 4603

PVC4 6,000 /(1.14 1.15 1.16 1.18) 3344

PVC5 5,000 /(1.14 1.15 1.16 1.18 1.20) 2322

NPV of Project =3509+3814+4603+3344+2322-12000 = 5592

53
 Cont’d
Exercise
• Find the NPV of the following projects and choose more
appropriate project based on NPV and DPBP.
Projects Initial Investment Cash Flows
(Outlay)
Year 1 Year 2

A 10,000 10,000 -
B 10,000 10,000 1,100
C 10,000 3762 7762
D 10,000 5762 5762

Cost of capital (discount rates) are 5% and 10% in year 1

and year2 respectively.
Which project do you choose based on the basis of:
a) NPV and why?
b) DPBP and why? 54
 Project Selection Approaches
Kinds of Numeric Approaches
f) Internal rate of return (IRR)
• The internal rate of return is defined as the rate of discount,
which brings about equality between the present value of
future net benefits & initial investment.
• It is the value of r in the following equation.
n
Ct
I  
t 1 1  r t

• I – investment cost
• Ct – Net benefit for year t
• r - IRR
• n - Life of the project
• IRR is PV(Benefits) = PV(Costs)
55
 Cont’d
Example
Year Cash flow
0 -100000
1 30000
2 30000
3 40000
4 45000
The IRR is the value of r which satisfies the following equation:
 1000,000 30,000 30,000 40,000 45,000
0    
(1  r ) 0 (1  r ) 1 (1  r ) 2 (1  r ) 3 (1  r ) 4
30,000 30,000 40,000 45,000
100,000    
(1  r ) 1 (1  r ) 2 (1  r ) 3 (1  r ) 4
• The calculation of r consists of a process of trial & error by
assuming various values of r say e.g. 12, 14, 15, 16 and so on.
• The IRR % may fall anywhere between these % values.
56
 Cont’d
Year 0 1 2 3 4
Cash flow (100,000) 30,000 30,000 40,000 45,000

• IRR is the value of r which satisfies the following equation:

30,000 30,000 40,000 45,000
100,000    
1  r 1 1  r 2 1  r 3 1  r 4
• The calculation of r involves a process of trial and error. We try
different values of “r” till we find that the right-hand side of the
above equation is equal to 100,000. Let us try to use 15%. This
makes the right-hand side to be:
30,000 30,000 40,000 45,000
100,000     100,802
1.15 1.152 1.153 1 .154
• Since the value is slightly higher than our target value, which is
100,000, we increase the value to 16%.
30,000 30,000 40,000 45,000
100,000     98,641
1.16  1.16 2 1.16 3 1 .16 4
57
 Cont’d
• Since this value is now less than 100,000, we conclude that the
value of r lies between 15% and 16%.
– For most of the purposes, this indication suffices.
• If a more refined estimate of r is needed, we use the following
procedure:
1. Determine the NPV of the two closest rates of return
(NPV/15%) = 802
(NPV/16%) = 1,359
2. Find the sum of the absolute values of the NPVs obtained in Step 1
802+1,359 = 2,161
3. Calculate the ratio of the NPV of the smaller discount rate, identified
in Step 1, to the sum obtained in Step 2
802/2,161 = 0.37
4. Add the number obtained in Step 3 to the smallest discount rate
15+0.37 = 15.37

58
 Cont’d
• When using IRR, the investment criterion is that the IRR
should be greater than the discounted rate

IRR Relationship with other numeric approaches

 When the NPV (the discounted benefits are excess of the
discounted costs) is positive, then the IRR is greater than
the rate of discount.
 When the NPV is 0, then the IRR is equal to the rate of
discount and the discounted benefits are equal to the
discounted costs.
 When the NPV is negative, then the IRR is smaller than the
discount rate and the discounted benefits are smaller than
the discounted costs
59
 Cont’d
Conditions of Financial Viability of a Project
• The acceptance criterion for an investment is:
 NPV positive,
 IRR greater than the discounted rate; and
 Discounted benefits greater than discounted costs

60