Project

Analysis
 Pre-feasibility Study
 Preliminary filtration.

 This involves the study of the project idea at

a more elaborate level than that

carried out at the opportunity study.

• This stage is recommended to be followed:

 When a detailed feasibility study is both costly and

time consuming.
 Pre-feasibility Study
• on the basis of results from pre-feasibility
study, the investor should be able to decide:
whether the project can be straightaway
accepted or rejected,
the project requires a detailed analysis
(i.e. a feasibility study)
 Contents of pre-feasibility & Feasibility Studies
• UNIDO'S outline of pre-feasibility study only for industrial
projects:
 Executive Summary
 Project Background and Basic Idea
 Market Analysis and Marketing Concept
 Raw Materials and Supplies
 Location, Site and Environment
 Engineering and Technology
 Organization and Overhead Costs
 Human Resources
 Implementation Planning and Budgeting
 Financial Analysis and Investment Appraisal

4
Pre-feasibility Study Vs. Feasibility study

• The analysis involved in a feasibility study in

much more rigorous and requires
specialized skills of a higher order,
 even though the basic framework is similar to the
outline presented above.

• It is usually based on additional, and more

reliable, data especially gathered through
research, surveys
Feasibility study
Objective:
• Provide commercial, technical, financial and
economic information needed for investment
decision-making

Characteristics:
• Clear project concepts and criteria
• Comprehensive project design
• Reliable information, often primary data
• Quantified prediction of performance
• Detailed analysis with high confidence level
 Market and
Demand Analysis
• In most cases, the first step in
project analysis is to estimate the
potential size of the market for the
product proposed to be
manufactured (or service planned to
be offered) and get an idea about
the market share that is likely to be
captured. Put differently, market and
demand analysis is concerned with
two broad issues:
Cont.

• What is the likely aggregate

demand for the product/ service?

• What share of the market will the

proposed project enjoy?

• Given the importance of market and

demand analysis, it should be
carried out in an orderly and
systematic manner.
Cont.

• The key steps in such analysis are as

follows:
 Situational analysis and specification
of objectives
 Collection of secondary information

 Conduct of market survey

 Characterization of the market

 Demand forecasting

 Market planning
1. Situation analysis and Specification of
Objectives

• In order to get a "feel" for the relationship

between the product and its market, the
project analyst may informally talk to
customers, competitors, middlemen, and
others in the industry. Wherever possible,
he may look at the experience of the
company to learn about the preferences
and purchasing power of customers,
actions and strategies of competitors, and
practices of the middlemen.
Cont.

• If such a situational analysis

generates enough data to measure
the market and get a reliable handle
over projected demand and
revenues, a formal study need not
be carried out, particularly when
cost and time considerations so
suggest. In most cases, of course, a
formal study of market and demand
is warranted.
Cont.

• To carry out such a study, it is

necessary to spell out its
objectives clearly and
comprehensively. Often this
means that the intuitive and
informal goals that guide
situational analysis need to
be expanded and articulated
with greater clarity.
Cont.

• A helpful approach to spell out objectives

is to structure them in the form of
questions. Of course, in doing so, always
bear in mind how the information
generated will be relevant in forecasting
the overall market demand and assessing
the share of the market the project will
capture. This will ensure that questions
not relevant to market and demand
analysis will not be asked unnecessarily..
2. Collection of Secondary Information

• secondary / primary sources

• While secondary information is available

economically and readily (provided the
market analyst is able to locate it) its
reliability, accuracy, and relevance for
the purpose under consideration must
be carefully examined.

• The market analyst should seek to

know:
Cont.
Who gathered the information? What
was the objective?
When was the information gathered?
When was it published?
How representative was the period for
which the information was gathered?
Have the terms in the study been
carefully and unambiguously defined?
What was the target population?
How was the sample chosen?
Cont.
How representative was the sample?
How satisfactory was the process of
information gathering?
What was the degree of sampling bias
and non-response bias in the information
gathered?
What was the degree of
misrepresentation by respondents?
How accurately was the information
edited, tabulated, and analyzed?
Was statistical analysis properly
applied?..
3. Conduct of Market Survey

• Secondary information, though useful, often

does not provide a comprehensive basis for
market and demand analysis. It needs to be
supplemented with primary information
gathered through a market survey, specific
to the project being appraised.
• The market survey may be a census survey
or a sample survey.

• The information sought in a market survey

may relate to one or more of the following:

• Total demand and rate of growth of demand

Cont.

• Demand in different segments of the market

• Income and price elasticity of demand

• Motives for buying

• Purchasing plans and intentions

• Satisfaction with existing products

• Unsatisfied needs

• Attitudes toward various products

• Distributive trade practices and preferences

• Socio-economic characteristics of buyers..

Steps in a Sample Survey

1. Define the Target Population

2. Select the Sampling Scheme and

Sample Size

3. Develop the Questionnaire

4. Recruit and Train the Field

Investigators

5. Obtain Information as per the

Questionnaire from the Sample of
Respondents
Cont.

6. Scrutinize the Information Gathered

7. Analyze and Interpret the Information

• Results of data based on sample

survey will have to be extrapolated to
the target population. For this
purpose, appropriate inflationary
factors, based on the ratio of the size
of the target population to the size of
the sample studied, will have to be
used……
4. Characteristics of the Market
Based on the information gathered from
secondary sources and through the market
survey, the market for the product/service
may be described in terms of the following:
• Effective demand in the past and present
• Breakdown of demand
• Price
• Methods of distribution and sales promotion
• Consumers
• Supply and competition
• Government policy…….
5. Demand Forecasting

• A wide range of forecasting

methods is available to the market

analyst. These may be divided into
three categories:
qualitative methods,

time series projection methods, and

causal methods…….
6. Market planning

• Broadly it should cover

pricing,

distribution,

promotion, and

Service!!!!
TECHNICAL
ANALYSIS
 Technical analysis is concerned primarily
with:
• Material inputs and utilities
• Manufacturing process/ technology
• Product mix
• Plant capacity
• Location and site
• Machineries and equipments
• Structures and civil works
• Project charts and layouts
• Work schedule
 1. MATERIAL INPUTS AND
UTILITIES

• may be classified into four broad

categories:

(i) raw materials,

(ii) processed industrial materials and

components,

(ill) auxiliary materials and factory

supplies, and

(iv) utilities. …
 2. MANUFACTURING
PROCESS/TECHNOLOGY

Choice of Technology

The choice of technology is influenced by a

variety of considerations:

• Plant capacity

• Principal inputs

• Investment outlay and production cost

• Use by other units

• Product mix

• Latest developments

• Ease of absorption
Cont.

Acquiring Technology

• The acquisition of technology from

some other enterprise may be by
way of

(i) technology licensing,

(ii) outright purchase, or

(iii) joint venture arrangement.

Cont.

Appropriateness of Technology

• Appropriate technology refers to those

methods of production which are suitable
to local economic, social, and cultural
conditions. In recent years the debate
about appropriate technology has been
sparked off. The advocates of appropriate
technology urge that the technology
should be evaluated in terms of the
following questions:
Cont.

• Whether the technology utilizes

• local raw materials?

• Whether the technology utilizes local

manpower?

• Whether the goods and services produced

cater to the basic needs?

• Whether the technology protects ecological

balance?

• Whether the technology is harmonious with

social and cultural conditions? ….
 3. PRODUCT MIX

• The choice of product mix is

guided by market
requirements. In the
production of most of the
items, variations in size and
quality are aimed at
satisfying a broad range of
customers.
 Cont.

• While planning the production

facilities of the firm, some flexibility

with respect to the product mix must be

sought. Such flexibility enables the firm to
alter its product mix in response to changing
market conditions and enhances the power of
the firm to survive and grow under different
situations. The degree of flexibility chosen
may be based on a careful analysis of the
additional investment requirement for
different degrees of flexibility…..
4. PLANT CAPACITY

• Plant capacity (also referred to

as production capacity) refers
to the volume or number of
units that can be manufactured
during a given period. Several
factors have a bearing on the
capacity decision:
Cont.

• Technological requirement

• Input constraints

• Investment cost

• Market conditions

• Resources of the firm

• Governmental policy….
5. LOCATION AND SITE

• The choice of location and site follows

an assessment of demand, size, and
input requirement. Though often used
synonymously, the terms 'location' and
'site' should be distinguished. Location
refers to a fairly broad area like a city,
an industrial zone, or a coastal area;
site refers to a specific piece of land
where the project would be set up.
Cont.

• The choice of location is influenced

by a variety of considerations:
proximity to raw materials and markets,

availability of infrastructure,

governmental policies, and

other factors (labor situation, climatic

conditions, and general living
conditions).
Cont.

Site Selection

• It may be noted in this context that the

cost of the following may vary
significantly from site to site: power
transmission lines from the main grid,
railway siding from the nearest railroad,
feeder road connecting with the main
road, transport of water, and disposal of
effluent……
6. MACHINERIES AND EQUIPMENTS

• To determine the kinds of machinery

and equipment required for a
manufacturing industry, the following
procedure may be followed: (i) Estimate
the likely levels of production over time.
(ii) Define the various machining and
other operations. (iii) Calculate the
machine hours required for each type of
operation. (iv) Select machineries and
equipments required for each function…
7. STRUCTURES AND CIVIL WORKS

• Structures and civil works may be

divided into three categories:

(i) site preparation and

development,

(ii) buildings and structures, and

(iii) outdoor works…….

8. PROJECT CHARTS AND LAYOUTS

• The important charts and layouts

drawings are:
 General Functional Layout

 Material Flow Diagram

 Production Line Diagrams

 Transport Layout

 Utility Consumption Layout

 Communication Layout

 Organizational Layout and Plant Layout……

9. WORK SCHEDULE
• The purpose of the work schedule is:
• To anticipate problems likely to arise
during the installation phase and
suggest possible means for coping with
them.
• To establish the phasing of investments
taking into account the availability of
finances.
• To develop a plan of operations
covering the initial period (the running-
in period)…..
NEED FOR CONSIDERING ALTERNATIVES

• There are alternative ways of

transforming an idea into a concrete
project. These alternatives may differ in
one or more of the following aspects:
• Nature of project
• Production process
• Product quality
• Scale of operation and time phasing
• Location!!!
Financial
Analysis
• To judge a project from the financial
angle, we need information about
the following:

• Cost of project

• Means of financing

• Estimates of sales and production

• Cost of production
Cont.

• Working capital requirement and

its financing

• Estimates of working results

• Break-even point

• Projected cash flow statements

• Projected balance sheets

1. COST OF PROJECTS

• Conceptually, the cost of project

represents the total of all items of
outlay associated with a project which
are supported by long-term funds. It is
the sum of the outlays on the following:
• Land and site development
• Buildings and civil works
• Plant and machinery
• Technical know-how and engineering
fees
Cont.

• Expenses on foreign technicians and

training of local technicians abroad
• Miscellaneous fixed assets
• Preliminary and capital issue expenses
• Pre-operative expenses
• Provision for contingencies
• Margin money for working capital
• Initial cash losses…….
2. MEANS OF FINANCE

• To meet the cost of project the following

means of finance are available:

• Share capital

• Term loans

• Deferred credit

• Incentive sources

• Miscellaneous sources..
3. ESTIMATES OF SALES AND
PRODUCTION

• Typically, the starting point for

profitability projections is the forecast
for sales revenues. In estimating sales
revenues, the following considerations
should be borne in mind:

• It is not advisable to assume a high

capacity utilization level in the first year
of operation.
Cont.
• It is not necessary to make adjustments

for stocks of finished goods. For practical

purposes, it may be assumed that production
would be equal to sales.

• The selling price considered should be the price

realizable by the company net of excise duty.

• The selling price used may be the present

selling price-it is generally assumed that
changes in selling price will be matched by
proportionate changes in cost of production..
4. COST OF PRODUCTION

• Given the estimated production, the

cost of production may be worked out.
The major components of cost of
production are:

• Material cost

• Utilities cost

• Labor cost

• Factory overhead cost..

5. WORKING CAPITAL REQUIREMENT
AND ITS FINANCING

• In estimating the working capital

requirement and planning for its

financing, the following points have to
be borne in mind:

• The working capital requirement

consists of the following:
Cont.

• (i) raw materials and components

(indigenous as well as imported),

(ii) stocks of goods-in-process (also referred

to as work-in-process), (iii) stocks of finished
goods, (iv) debtors, and (v) operating
expenses.

• The principal sources of working capital

finance are: (i) working capital advances
provided by commercial banks, (ii) trade
credit, (ill) accruals and provisions, and (iv)
long term sources of financing.
Cont.

• There are limits to obtaining working

capital advances from commercial
banks.

• They are in two forms: (i) the

aggregate permissible bank finance
is specified as per the norms of
lending (ii) against each current asset
a certain amount of margin money
has to be provided by the firm..
6. ESTIMATES OF WORKING RESULTS
(PROFITABILITY PROJECTIONS)
• The estimates of working results may
be prepared along the following lines:
• A Cost of production
• B Total administrative expenses
• C Total sales expenses
• D Royalty and know-how payable
• E Total cost of production (A + B + C +
D)
• F Expected sales
Cont.

• G Gross profit before interest

• H Total financial expenses

• I Depreciation

• J Operating profit (G - H - I )

• K Other income

• L Preliminary expenses written off

• M Profit/loss before taxation (J + K - L)

Cont.

• N Provision for taxation

• O Profit after tax (M - N)

• Less Dividend on

• - Preference capital

• - Equity capital

• P Retained profit

• Q Net cash accrual (P + I + L)..

7. BREAK-EVEN POINT

Fixed costs __________

Unit selling price – Unit variable cost

 8. PROJECTED CASH FLOW
STATEMENTS

• The cash flow statement shows the

movement of cash into and out of the
firm and its net impact on the cash
balance with the firm.

9. PROJECTED BALANCE
SHEETS….!!!!
 Risk
Analysis
• With increasing market competition,
increasing technology and an
increasing rate of change, risk
management is gaining significance
and importance. The risk continuum
indicates the boundaries of risk
management between certainty and
uncertainty.
• It can be seen that risk, uncertainty
and opportunity are closely related.
When a risk occurs, with some
ingenuity, this may open up an
opportunity, and conversely when
pursuing an opportunity there will be
associated risks. Risks are generally
deemed acceptable if the possible
gains exceed the possible losses.
Cont.

• Project Risk Management is

defined by the project
management body of knowledge
(PMBOK) as: "the processes
concerned with identifying,
analyzing and responding to
uncertainty [throughout the
project life-cycle]. It includes
maximizing the results of positive
events and minimizing the
consequences of adverse events".
Cont.

• A project risk may be defined as any

event that prevents or limits the
achievement of your objectives as
defined at the outset of the project,
and these objectives may be revised
and changed as the project progresses
through the project life-cycle. The
generally accepted risk management
model sub-divides the risk
management process into the following
headings:
Cont.

• Define Objectives: define the

context of your work and your plan for
success. This defines what you have to
achieve to be successful and
establishes a basis for dealing with
risk and future decisions.
• Identify Risk: identify areas of risk
and uncertainty which may limit or
prevent you achieving your objectives.
• Quantify Risk: evaluate and prioritize
the level of risk and uncertainty and
quantify frequency of occurrence and
impact.
Cont.

• Develop Response: define how

you are going to respond to the
identified risks; eliminate, mitigate,
deflect or accept.

• Document: the risk management

plan documents how you propose
to tackle risk on your project.
Cont.

• Risk Control: the risk control

function implements the risk
management plan. This may involve
training and communication. And as
the risks and the work environment
are continually changing, it is
essential to continually monitor and
review the level of risk and your
ability to effectively respond…
Risk Through the Project Life-Cycle

• Risk and opportunity are high at the

outset of the project (during the concept

and design phases), when there is the greatest

degree of uncertainty about the future.

• As the project progresses these parameters

reduce as decisions are made, design freezes
are implemented, and the remaining unknowns
are translated into known.

• These unknowns are eventually zero when the

project has been successfully completed.
 Cont.

• The amount at stake (investment cash

flow), on the other hand, starts low
and steadily rises as capital is
invested to complete the project.

• The period of highest vulnerability to risk

occurring is during the last two phases
(implementation and commissioning).
During these phases, adverse conditions
may be discovered, particularly during
commissioning and start-up. This is also
when the level of influence is low and
the cost to change is high…
Risk Management Responsibility
• Who is responsible for managing risk?
 The general manager and managing
director are ultimately responsible to
the board of directors and the
shareholders for managing risk within
the company. However, this
responsibility is usually delegated
through the corporate hierarchy with
the project managers responsible for
project risk and the functional managers
responsible for their department's risks.
This process of pushing risk
responsibility down the hierarchy is
consistent with risk management being
a company wide issue (empowerment).
Cont.

• The respective managers would then

be responsible for developing a risk
management plan to identify,
quantify, respond and control risks
that affect their scope of work. As
with other management techniques,
it should be the managers’
responsibility to ensure that their
team members have a working
understanding of risk within the
context of their scope of work and
feel accountable for the
consequences of their actions…
Define Objectives

• A risk may be defined as

any event that prevents
you achieving the
project's goals and
objectives. It is therefore
necessary at the outset to
define these goals and
objectives in some detail
Cont.
• Develop Risk Assessment
Criteria against which risks can
be assessed and decisions made.
These criteria may be based on
operational, technical, financial,
legal, social and humanitarian
requirements. There will be
internal and external constraints
which set your boundaries. It is
important to understand the
environment of the project or the
nature of the problem.
 Risk Identification
• Risk identification should be a systematic
process to ensure nothing significant is
over looked.

• Techniques for identifying risk include:

analyzing historical records (closeout
reports)
structured questionnaires
structured interviews
brainstorming
Cont.
structured checklists
flow charts
judgment based on knowledge
and experience
system analysis
scenario analysis (what-if)…
Common reasons for project failure:
• Misinterpreting the scope of work
• Mixing and confusing; tasks, specifications,
approvals, and special instructions
• Using imprecise or vague language, for example;
nearly, optimum, about or approximately can
lead to confusion, ambiguity or misinterpretation.
• No pattern, structure, or chronological order. The
WBS and CPM techniques have not been used.

• Wide variation in size of tasks and work

packages, again caused by not using the WBS to
sub-divide all the work packages to a common
level of detail.
Cont.

• Wide variation in how to describe work

details.

• Failing to get third-party review or

verification from the client, sub-
contractors and suppliers.

• Not working closely with the client.

• Poor estimating.

• Inadequate planning.

• Insufficient reviews and control.

Cont.

• Lack of commitment : gain commitment

by involving the responsible people in the
planning.

• Incomplete information, for example,

during the tendering process the
contractor is attempting to assess the
correct market price for a project not yet
built, for a design which is subject to
revision, on a site about which there is
little information and a labour force not
yet recruited.
Risk Quantification

• Risk quantification is primarily

concerned with determining what
areas of risk warrant a response and
where resources are limited, a risk
priority will identify the areas of risk
that should be addressed first.
• Probability / Impact Matrix: This
matrix plots the probability of the risk
occurring against the impact on the
project. They are quantified as high,
medium, or low- this will give a matrix
of nine possibilities
Risk Response
• Develop a risk response plan which
defines ways to address adverse risk and
enhance opportunities before they occur.
The levels of risk should be compared
against pre-established criteria, then
ranked to establish management
priorities. There are a range of responses
which should be developed in advance
during the planning phase:
Cont.

• Eliminate risk Mitigate/reduce

risk

• Deflect/transfer risk Accept risk

• These are not mutually exclusive - your
response may use a combination of them all. A
natural sequence would be to first try and
eliminate the risk completely - failing that, at
least mitigate it. And for the remaining risk the
options are to try and deflect it and / or accept
it with a contingency. All these responses cost
money, so a cost-benefit analysis should be
performed as it may be more cost effective to
accept a risk rather than taking expensive steps
to eliminate it…
Risk Control

• The risk control function implements

the risk management plan to make it
happen- this is the most important
part which is often neglected! The risk
management plan needs to be
communicated to all the project
participants and where necessary
followed up with appropriate training
and practice runs. The training should
not only ensure that the risk
management plan is understood, but
also develop a company wide risk
management culture and attitude.
Cont.

• The risk management plan should be

monitored and updated on a regular basis to
ensure you learn from recurring risks and
that it is relevant to changing circumstances:

 changes in the scope of work

 changes in the build method

 changes in the team members

 changes in the suppliers…

Disaster Recovery Planning

• A disaster is a sudden, unplanned

catastrophe that prevents your
company providing its critical
business functions for a period of
time and could result in
significant damage or loss. The
time factor will determine
whether a problem or service
interruption is an inconvenience
or a disaster - losing power for a
few hours may be an
inconvenience but losing power
for a few weeks/months could be
a financial disaster.
Cont.

• The objective of disaster recovery

management is to reduce the
consequence of a disaster to an
acceptable level. This is the
ultimate contingency plan!
• For the ultimate unplanned
catastrophe that prevents your
company providing its critical
business functions for a period of
time, and results in significant
damage or loss, your company
needs to develop a disaster
recovery plan.
Cont.

• The objective of disaster recovery

planning is to reduce the
consequence of a disaster to an
acceptable level. The responsibility
for developing and implementing the
disaster recovery plan should be
assigned to a particular manager as
part of your company's risk
management plan.
• Therefore, in the event of a disaster
the plans will have been developed,
updated and a functioning team will
be ready to implement them.
 Cont.

• Disaster recovery planning is essentially a

contingency response from your risk
management planning, but due to the
unique nature and size of the problems it is
probably best managed separately - as a
project. The management of the disaster
recovery plan should be assigned to a
manager with responsibility to set up a
team to:
• develop the disaster recovery plan; control
the disaster recovery plan; and when the
time comes - implement the disaster
recovery plan quickly and effectively!!//!!
 Institutional analysis
• An Institutional Appraisal assesses the soundness of
institutional arrangements for implementing the Project.

• It covers:
 ORGANISATIONAL arrangements,

 adequacy of PERSONNEL & examines the their

HIERARCHICAL line of authority,
 FINANCIAL MANAGEMENT processes, including fund flows,
capacities of the people involved.

• Institutional appraisal normally would highlight capacity

gaps and identify Training requirements.
04/07/25 88
 Institutional analysis
• Is focused on the following questions :

Are authority and responsibility properly

linked?

 Does the project have sufficient

authority?

 is the project manageable? Team

building, motivation of employees and

managers etc
89
Institutional & Social Analysis-Cont’d
Social Analysis
• Social analysis is undertaken to examine the aspects of national
objectives like employment opportunities and income distribution.
• To examine social implications:
 Poverty, income distribution, quality of life
 Gender
 Health
 Ethnic considerations
 there must also be a sense of empowerment and security.

• A good strategy to deal with social issues for projects is:

 to ensure that beneficiaries and disadvantaged groups have
inclusion in the project activities;

90
 Social analysis
• Examine the social implication of the project:

income distribution to the low income group

adverse effects of a project on particular

groups
The impact of the project on improving the
quality of life.

• Social Analysis will actually improve the design of the

project and will ensure that equality in the opportunities
and benefits are taken by many people.

91
 Question for reflection
• What are some issues to be considered in social
analysis for ‘Education project’?

constructing a school
 A project that involves:

and designing a curriculum in order to

improve access to education

92
 Social Cost-Benefit Analysis (SCBA)
• Social Cost-Benefit Analysis (SCBA) is the
social appraisal of projects.

is used for determining the attractiveness

of a proposed investment in terms of the
welfare of society as a whole.

93
 Rationale (Importance) of Social Cost Benefit Analysis

• Market Failure
 A private firm would only look at profitability instead of
providing social benefits but the government has to look at
other factors.
• Savings & Investment
 A project that induces more savings is investment in an
economy and not the other way round.
• Distribution & Redistribution of Income:
 The project should not lead to accumulating income in the
hands of a few but it should distribute the income equitably.
• Employment and Standard of Living
 The project should lead to increase in employment and
standard of living.

94
Example: The possible Social costs and
social benefits for ‘ construction of a bridge
on a river’ project

Social costs Social benefits

Social costs could be:
• employment to workers
• Increased pollution during
construction, during construction,
• migration of labor from • less cost in travel and
farming,
transportation,
• shortage and price increase
of raw materials, • saving of time of
• unemployment to people people, and
engaged in ferries/boat
makers, • employment in toll tax
• loss of farms and houses of collection, if any.
some families, if any.
95
project appraisal (project
evaluation techniques)

96
Contents

• Non-discounting Methods
• Ranking by inspection

• The payback period

• Proceeds per unit of outlay

• Discounting methods of project selection

• The Net present Value (NPV)

• The internal rate of return of a project (IRR)

• Modified Internal Rate of Return

97
Introduction
• There are two types of measures of project appraisal
techniques: undiscounted and discounted.

 The basic underlying difference between these two lies in the

consideration of time value of money in the project
investment.

• Undiscounted measures do not take into account the

time value of money, while discounted measures do.

98
Introduction

• Many economic decisions

involve benefits and

 (for example: fish production

costs that are expected to occur at future

time period.
 The construction of ponds, and fish tank, for example, requires
immediate cash outlay, which with the production and sale
of fish, will result in future cash inflows or returns
 In order to determine whether the future cash
inflows justify present Initial investment, we must
compare money spent today with the money
received in the future.

99
 Introduction
• The time value of money influences many
production decisions. Everyone prefers money
today to money in the future.

• The preference for the Birr now instead of a Birr

in the future arises from three basic reasons:

Uncertainty - Influences preferences because one is

never sure what will take place tomorrow.

Reinvestment-The sooner you get the dollar back,

the sooner you can reinvest it and earn a positive return;

Inflation - affects the purchasing power of the money.

100
Undiscounted methods

1.Inspection by ranking
2.Payback period
3. Proceeds per unit of outlay

101
 Ranking by inspection
• By this, the assessor will be interested in the
 Investment cost of the project
 Cash flow patterns
• EX: Cash flows of hypothetical investments

Investment Initial cost Net cash proceeds per year

(Birr) (Birr)
Year 1 Year 2

A 10,000 10,000 -
B 10,000 10,000 1,100
C 10,000 3,762 7,762
•D The deficiency of
10,000
this method: 5,762 5,762
 It does not take into account the timing of the proceeds

102
 Ranking by inspection

1. Two investments have identical cash flows

 investment B is better than investment A, because all
factors are equal except that B continues to earn
proceeds after A has been retired.
2. Two investments have the same initial outlay and
the same earning life and earn the same total
proceeds.
 Thus, investment D is more desirable than investment
C
• The deficiency of this method:
 It does not take into account the timing of the
proceeds
103
 2. Payback period:
• the length of time required to recover the initial
investment
 using project cash flows, PBP answers 'How long
will it take to pay back its cost?'

• Among alternative projects, the one with the

shortest payback period is more desirable .

Decision Rules:
• • If payback < acceptable time limit, accept project
• If payback >acceptable time limit, reject project

104
 For a project with equal annual receipts

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:

Payback period= Initial
investment/Annual cash flow

PBP= 1,000,000/250,000= 4 years.

105
If the cash flows of a project are not uniform, the
payback period is calculated by accumulating a series of
cash flows until the amount reaches the initial investment. i.e.
The progressive sum of the cash flows after the initial outlay:
Years 0 1 2 3 4
Project B - 10,000 5,000 2,500 4,000 1,000
Cumulative - 10,000 -5,000 -2,500 1,500 2,500
incremental flow
• Payback period lies between year 2 and year 3.
• At the end of year 2, the remaining amount to be
collected= 2,500.
• This means (2500/4000)=0.625 or 62.5 % of the time
is required to gain a financial return equal to the original
investments.

= 2.625 years or 2
years and (.625 * 12 months)= 2 years and 8 months
106
Example: Computing Payback for the
Project

Capital Budgeting Project

Year CF Cum. CFs

0 $ (165,000) $ (165,000)
1 $ 63,120 $ (101,880)
2 $ 70,800 $ (31,080)
3 $ 91,080 $ 60,000

Payback = year 2 +
+ (31080/91080)

Payback = 2.34 years

• Do we accept or reject the project?

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 Advantages of Payback
• It is simple to calculate.

• It is helpful in weeding out risky projects

• The pay back period is sometimes used by

investors who are short of cash and need to
reinvest all cash flows that occur in early
stages of the projects. 108
 Disadvantages of Payback
• It ignores the time value of money.

• It may divert attention from profitability

• There is no objective measure of what constitutes an

acceptable payback period.

• It overlooks cash flows beyond the payback

period.

109
 Undiscounted method-cont’d
3. Proceeds per unit of outlay
• This is the ratio of the net value of production (proceeds) to
the total volume of the capital invested.

Ranking by proceeds per unit (a Birr)of outlay

Investment project
Total Investment Proceeds per Ranking
proceeds outlay Birr of outlay
A
10,000 10,000 1.0 4
B
11,100 10,000 1.11 3
C
11,524 10,000 1.15 2
D
11,800 10,000 1.18 1

• The deficiency of this method:

 It does not take into account the timing of the proceeds
110
Discounted methods

1.NPV
2.IRR

111
 Time value of money
• The Discounted Cash Flow (DCF) method takes
into account the time value of money
 the value of money will change over time.
• All other things being equal, a dollar received soon is worth
more than a dollar expected to be received in the distant
future
• This is true for three different, yet related reasons:
 Risk/ uncertainty
 Reinvestment-The sooner you get the dollar back, the sooner you
can reinvest it and earn a positive return;
 Due to the forces of economic inflation, the dollar we receive
in the distant future will have proportionately less buying power
than it does today.
• In project management, the time value of money concept is a
foundational element to performing a financial analysis on a
project
112
 Net present value (NPV)

the present
• Net present value is the sum of
values of all the positive cash flows minus
the sum of the present values of all the
negative cash flows.

• Interpretation
CF2

NPV measures
CF
the
1

CF net contribution of the

4

project
t = 0 to firm wealth. t = 0
t=3
t=3
t=1 t=2 t=4 t=1 t=2 t=4
r = req’d return
–CF3
Initial Outlay0 NPV0 = ?

113
 Discounting
• Discounting: The process of converting future
benefits and costs/Cash flows into today’s
dollars/Birr.
 the recognition that a future payoff amount is worth something less
than that amount today.

 Discount rate, the interest rate used in the

discounting process, reflecting the time value of
money.

• It is set by Central Authority (MOFED in Ethiopia)

• It has been estimated to be in the range of 9.96- 10.49

percent with an average percentage figure of 10.23.
114
 NPV FV = PV(1 + r)n…
compounding
• All future cash flows should be discounted into present
values. The discount factor is:

• Assume that a given project has a life of five years & a

discount rate (r) of 8% is used.

• For example, the discount factor for year 3 (i.e. t=3) is

calculated as follows:

115
 Net present value (NPV)
$75,000
$45,000
$40,000

$20,000

Consider Project A with the following cash flows: t=0

t=1 t=2 t=3 t=4

r = 10%
The NPV for this project is…?
–$100,000

Decision?
$55,000
$45,000
$35,000
Consider Project B with the following cash flows:
$25,000

t=0

t=1 t=2 t=3 t=4

The NPV for this project is…?
r = 10%
Decision?
–$100,000

116
 Net present value (NPV)
$75,000
$45,000
$40,000

$20,000

Consider Project A with the following cash flows:t = 0

t=1 t=2 t=3 t=4

r = 10%

The NPV for this project is $29,872.52. –$100,000

Decision  Accept the project. $55,000

$45,000
$35,000
$25,000
Consider Project B with the following cash flows:
t=0

t=1 t=2 t=3 t=4

r = 10%
The NPV for this project is $27,783.12.
–$100,000

Decision  Accept the project.

117
 NPV calculations –example, r=8%
Question: Compute the NPV for project A & Project B:

year Cash flows for Project A Cash flows for Project B

0 (120,000) (75,000)

1 40,000 5,000

2 25,000 70,000

3 70,000 45,000

4 130,000 30,000

5 80,000 5,000

118
 Solution
year Project A Discount factor Discounted cash flow
=
0 (120,000) -120,000
1 40,000
37,037
2 25,000
21,433
3 70,000
55,568
4 130,000
95,554
5 80,000
54,447
Add them up NPV=
144,039
Project B

0 (75,000)
($75,000)
1 (5,000)
4,630)
2 70,000
60,014
3 45,000
35,723
4 30,000
22,051
5 5,000
3,403
Add them up NPV=
 NPV-cont’d
• where regular cash flows are expected [these are
termed as annuities], the above expression can be
reduced to:

• Take-home Exercise: Compute the NPV for the

following three project alternatives at 3%, 5% & 8%
discount rates.
Projects X Y Z
Costs ($)-Initial investment 10,380 10,380 10,380
Project life span (years) 5 15 25
Annual Benefits ($) 2,397 1,000 736
120
 NPV-cont’d

• Solution

Projects X Y Z
Discount rate (r)

3% 598 1,558 2,436

5% 0 0 0

8% -809 -1,821 -2,523

121
 NPV-Cont’d
• Net present value is expressed in terms of money, and
it represents the wealth that any single project is
expected to return to the company.
 This wealth typically comes in the form of either
making or saving money.

• In other words, a positive NPV project has the ability to

accomplish three things:
 cover its own financing costs /to service the debt
required to finance its execution/
 provide an attractive return to shareholders, and

 add to the accumulated wealth of the company.

122
Rationale for the NPV Method
• NPV = PV inflows – PV Cost
 NPV = net gain in shareholder wealth

 NPV=0 → Project’s inflows are “exactly sufficient to

repay the invested capital and provide the required
rate of return”

Decision Rules:
If the NPV is positive, accept the project
If the NPV is negative, reject the project.
If the NPV is zero, be indifferent
123
 Calculating NPVs with Excel
• NPV function: =NPV(rate,CF01:CFnn)------syntax
 First parameter = required return entered as a decimal (12% = 0.12)

 Second parameter = range of cash flows beginning with year 1

• After computing NPV, subtract the initial investment

(CF0)
A B C D
2 Required Return = 12%
3 Year CF Formula Disc CFs
4 0 (165,000.00) =(-165000)/(1.12)^0 = (165,000.00)
5 1 63,120.00 =(63120)/(1.12)^1 = 56,357.14
6 2 70,800.00 =(70800)/(1.12)^2 = 56,441.33
7 3 91,080.00 =(91080)/(1.12)^3 = 64,828.94
8 12,627.41
9
10 EXCEL =NPV(D2,B5:B7) 177,627.41
11 NPV + CF0 12,627.41
124
Advantages of NPV

• time value of money

• The cash flows

• It focuses on the profitability of the project.

• useful for the comparison and selection

from among mutually exclusive
projects or when capital rationing is used.

• It discounts cash flows by the cost of

capital
• the managers can understand it more 125
 Disadvantages of NPV
• If the investments are different, deciding the desirability of the project based on the
NPV will be misleading.
 We have learnt that NPV tells us ‘how much birr is the net result of the project’ but it does not tell us if this
amount is the outcome of a big effort or a small one.

Example:
• For Project A:
NPV= 10; {B-C=110-100=10]

Big differences in investment amount

• For Project B:
NPV=15; [10,015-10,000=15]

• The cost of capital is assumed to remain constant throughout the life of the
project. 126
IRR
Definition and Decision Rule
• Definition:
 IRR = discount rate that makes the
NPV = 0

• Decision Rules:
• If IRR > cost of capital, accept the project

• If IRR < cost of capital, reject the project

• If IRR = cost of capital, be indifferent.

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NPV vs. IRR

NPV: Enter r, solve for

NPV n CFt

t 0 (1  R )
t
NPV

IRR: Enter NPV = 0, solve for IRR.

n
CFt

t 0 (1  IRR )
t
 0

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 NPV?
Internal Rate of Return: Calculation

Then solve for r..=IRR

•The value of r in the equation where the cash inflows

and the investment outlay is zero is known as the
internal rate of return.

Example 1: Compute IRR

Period 0 1 2 3
CF -2000 2400 0 0
129
 IRR –using the NPV curve
• One of the more sophisticated project appraisal
techniques and also more difficult to calculate.
 Trial & error

The NPV curve:

• A number of NPVs are calculated using different

discount rates.

• These NPVs are plotted on a graph to calculate

IRR.----------the IRR graph or The NPV Curve

130
 The NPV Curve
• a chart that shows how the project's NPV varies with
changes in the discount rate.
• consider the following net cash flow stream (where all
cash flows are in units of Birr) for seven points in time, with
year 0 being 'now'.
Optio Year 0 1 2 3 4 5 6
n Net CF -1000 200 200 200 200 200 200
I

• At a discount rate of 5%, the NPV of this stream of cash

flows would be Birr 15.10.
• Now vary the discount rate (r) in small steps over the
interval from 0 to 0.1 (0% to 10%), obtain the NPV at each
then plot NPV (on the Y
of these intervals, and
axis) against r (on the X axis).
• It should resemble the following chart. 131
The NPV Curve The project IRR=
0.0547

132
 Calculating IRR with Excel

• Calculating Internal Rate of Return (IRR) can be tedious if

you have multiple cash flow periods to work with.

• Fortunately, Microsoft Excel make the process amazingly

simple.

• Start with the cash flows as you did to solve for NPV

• Use the IRR function

 Enter the range of cash flows, beginning with the initial
cash flow (Cash flow 0)

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Calculating IRR with Excel

A B C
1 IRR
2 Year CF
3 0 (165,000.00)
4 1 63,120.00
5 2 70,800.00
6 3 91,080.00
7
8 EXCEL =IRR(B3:B6) 16.13%

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 Comparison of IRR & NPV
• IRR is easier to understand by a wider community, since it
states yield in terms of %.

• NPV directly measures the increase in value to the firm

 NPV approach requires a discount rate, which may not
always be possible.

• While NPV is a absolute measure IRR is a relative

measure.

 Whenever there is a conflict between NPV and IRR always

use NPV 135
Advantages of IRR
• the time value of money
• the total cash flows during the project life
direct message about the yield on the
project.

Disadvantages of IRR
• It involves tedious work interpolation
• The IRR does not reflect the scale, or
Birr/dollar size
• all proceeds are reinvested at the
particular IRR,
• If there are non-conventional cash
flows, it can produce multiple rates. 136
 Discounted Payback Period
• This improves upon the payback period by taking into
account the time value of money.

• A project’s discounted payback period is the

number of years it takes for the net cash flows’
present values to pay back the net investment.

• Again, shorter paybacks are better than longer

paybacks.
 Discounted Payback Period-
Example:
• We will need a required rate of return for the
computation. Let’s use 10%.

Year CF (Birr)

0 -200,000

1 70,000

2 70,000

3 70,000

4 70,000

5 70,000
Discounted Payback Period
Year CF (Birr) PV of CF (Birr) Cumulative
(Birr)
0 -200,000 -200,000 -200,000

1 70,000 63,636 -136,364

2 70,000 57,851 -78,513

3 70,000 52,592 -25,921

4 70,000 47,811

5 70,000 43,463

139
 Discounted Payback Period
• The DPP will be 3 years plus whatever proportion of
year 4 is needed to pay back the final Birr 25,921.

25,921
DPP 3  3.54
47,811

• The discounted payback is 3.54 years.

• This project recovers its net investment in 3.54 years

when considering the time value of money.
 Discounted Payback Period
• The DPP is an improvement upon the payback period
in 2 ways:

 The DPP takes into account the time value of

money.

 There is an objective criterion for an acceptable

DPP if a project has normal cash flows.
 Under these circumstances a project is
acceptable if the DPP is less than the
economic life of the project.
 Discounted Payback Period-Exercise

• what is the discounted Payback period given

that the discount rate is 10%
Project Year Cash flow (in Birr)

0 -10000
1 5000
2 6000
3 8000
4 7000
5 6000

142
 Discounted Payback Period- Exercise

• what is the discounted Payback period?

Project Year Cash flow PV of Birr PV of cash flow Cumulative cash
1 at 10% savings
0 -10000 1.000 -10000 -10000
1 5000 0.909 4545 -5455
2 6000 0.826 4956 -499
3 8000 0.751 6008 5509
4 7000 0.683 4781 10290
5 6000 0.621 3726 14016

143
Summary _Project appraisal In
Practice
• Consider all project appraisal criteria when making
decisions

• NPV and IRR are the most commonly used primary

investment criteria

• Payback is a commonly used secondary investment criteria

• All provide valuable information

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THANK
YOU !!