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Project Ka Bazigaar Project Appraisal By-Rahul Jain Project Appraisal Overview and “vocabulary” Methods Payback, discounted payback NPV IRR Sensitivity Analysis Breakeven Analysis What is Project Appraisal? Analysis of potential projects Long-term decisions; involve large expenditures Very important to firm’s future Steps in Project Appraisal Estimate cash flows (inflows & outflows) Determine r = WACC for project Evaluate cash flows Cash Flow Estimation Of Project Terminal Cash flow Initial outlay Annual Cash Flows n Cash Flows Versus Profit Cash flow is not the same thing as profit, at least, for two reasons: First, profit, as measured by an accountant, is based on accrual concept Second, for computing profit, expenditures are arbitrarily divided into revenue and capital expenditures CF = (REV − EXP − DEP) + DEP − CAPEX CF = Profit + DEP − CAPEX Components of Cash Flows Initial Investment Net Cash Flows/Annual Cash Flows Revenues and Expenses Depreciation and Taxes Change in Net Working Capital Change in accounts receivable Change in inventory Change in accounts payable Change in Capital Expenditure Free Cash Flows Components of Cash Flows Terminal Cash Flows Salvage Value Salvage value of the new asset Salvage value of the existing asset now Salvage value of the existing asset at the end of its normal Tax effect of salvage value Release of Net Working Capital Depreciation for Tax Purposes Two most popular methods of charging depreciation are: Straight-line Diminishing balance or written-down value (WDV) methods For reporting to the shareholders, companies in India could charge depreciation either on the straight-line or the written-down value basis For the tax purposes, depreciation is computed on the written down value (WDV) of the block of assets 10 CFt -100 Cumulative -100 PaybackL = 2 10 -90 + 30/80 2.4 60 100 -30 80 50 = 2.375 years CFt -100 Cumulative -100 PaybackS 1.6 70 100 50 20 -30 40 20 = + 30/50 = 1.6 years Strengths of Payback: Provides an indication of a project’s risk and liquidity Easy to calculate and understand Weaknesses of Payback: Ignores the TVM Ignores CFs occurring after the payback period Discounted Payback: Uses discounted rather than raw CFs 10% 10 60 80 CFt -100 PVCFt -100 9.09 49.59 60.11 Cumulative -100 -90.91 -41.32 18.79 Discounted = payback + 41.32/60.11 = 2.7 yrs Recover invest + cap costs in 2.7 yrs NPV: Sum of the PVs of inflows and outflows n CFt NPV = ∑ t t = (1 + r ) Cost often is CF0 and is negative n CFt NPV = ∑ − CF0 t t =1 (1 + r ) Project L: -100.00 10% 10 60 80 9.09 49.59 60.11 18.79 = NPVL NPVS = $19.98 NPV = PV inflows - Cost = Net gain in wealth Accept project if NPV > Choose between mutually exclusive projects on basis of higher NPV Adds most value Using NPV method, which franchise(s) should be accepted? If Franchise S and L are mutually exclusive, accept S because NPVs > NPVL If S & L are independent, accept both; NPV > CF0 Cost CF1 CF2 Inflows CF3 IRR is the discount rate that forces PV inflows = cost This is the same as forcing NPV = NPV: Enter r, solve for NPV n CFt = NPV ∑ t t =0 (1 + r ) IRR: Enter NPV = 0, solve for IRR CFt ∑ t = t = (1 + IRR) n IRR = ? -100.00 PV1 PV2 PV3 = NPV 10 60 80 Enter CFs in CFLO, then press IRR: IRRL = 18.13% IRRS = 23.56% If IRR > WACC, then the project’s rate of return is greater than its cost some return is left over to boost stockholders’ returns Example: WACC = 10%, IRR = 15% Profitable Cost (negative CF) followed by a series of positive cash inflows One change of signs Nonnormal Cash Flow Project: Two or more changes of signs Most common: Cost (negative CF), then string of positive CFs, then cost to close project Nuclear power plant, strip mine Inflow (+) or Outflow (-) in Year N - + + + + + N - + + + + - - - - + + + N + + + - - - N - + + - + - NN NN NN Individual Assignment Complete All the questions .. .Project Appraisal By-Rahul Jain Project Appraisal Overview and “vocabulary” Methods Payback, discounted payback NPV IRR Sensitivity Analysis Breakeven Analysis What is Project Appraisal? ... potential projects Long-term decisions; involve large expenditures Very important to firm’s future Steps in Project Appraisal Estimate cash flows (inflows & outflows) Determine r = WACC for project. .. + r ) Project L: -100.00 10% 10 60 80 9.09 49.59 60.11 18.79 = NPVL NPVS = $19.98 NPV = PV inflows - Cost = Net gain in wealth Accept project if NPV > Choose between mutually exclusive projects