Financial appraisal techniques

Basically computation of Project Appraisal technique with a special reference to financial parameters - Payback, Discounted Cash flow, NPV, IRR etc are explained. The slides are used for educating those who have taken up Project Finance recently

1. Financial Appraisal, Sensitivity
and Scenario Analysis
R.Ganesh, Sr.faculty, SBSC, Hyd

2. Capital Investment Process
•TT
Identification
Evaluation
Implementation &
Follow up
Selection
Type of
Investment
•Required
Investment
•Replacement
Investment
•Expansion
Investment
•Diversification
investment
Input
•Expected
cashflow
stream
•Discount
rate
Decision Rule
•Net Present
Value
•Profitability
Index
•Internal rate of
return
•Payback period
Performance
Evaluation
•Monitor magnitude and
timing of cash flows
•Check project still meets
selection criterion
•Decide on continuation
or abandonment
•Review steps if failure
rate is high

3. Payback Period
Payback period is the number of periods for the sum of
project’s expected Cash Flows to equal its initial cash outlay.
Payback period is the time it takes to recover its initial
investment.
A project is acceptable if the payback period is shorter
than or equal to CUT-OFF period.

4. Expected cashflow streams – alternative
investment proposals – Initial outlay of ONE million rupees
End of YearInvestment
A
Investment
B
Investment
C
Investment
D
Invesrtment
E
Investment
F
1 600,000100,000250,000250,000325,000325,000
2 300,000300,000250,000250,000325,000325,000
3 100,000600,000250,000250,000325,000325,000
4 200,000200,000250,000250,000325,000325,000
5 300,000300,000250,000250,000325,000925,000
Total
Cashflows
1,500,0001,500,0001,250,0001,250,0001,625,0002,275,000
Payback
period
3.00 3.00 4.00 4.00 3.08 3.08

5. Drawbacks of Payback method
•Strongest appeal !!
Adjustment for timing of Cash Flows ?
Adjustment for Risk ?
Maximisation of the Firm’s Equity Value ?
Its simplicity & ease of application
Contributes to overall liquidity
It is easy to employ when future events are
difficult to quantify

6. Discounted payback period
Discounted payback is the number of
periods required for the sum of
present values of project’s
expected cash flows to equal its
initial cash outlay.

7. Discounted Payback –calculations-
Investment ‘A’
End of YearExpected
cashflows
Discount factorPresent ValueCumulative
Present value
1 600,000 0.9091 545,455 545,455
2 300,000 0.8264 247,934 793,389
3 100,000 0.7513 75,131 868,520
4 200,000 0.6830 136,603 1,005,123
5 300,000 0.6209 186,276 1,191,399

8. Expected cashflow streams and cost of capital –
alternative investment proposals – Initial outlay of ONE
million rupees
End of YearInvestment
A
Investment
B
Investment
C
Investment
D
Invesrtment
E
Investment
F
1 600,000100,000250,000250,000325,000325,000
2 300,000300,000250,000250,000325,000325,000
3 100,000600,000250,000250,000325,000325,000
4 200,000200,000250,000250,000325,000325,000
5 300,000300,000250,000250,000325,000925,000
Total
Cashflows
1,500,0001,500,0001,250,0001,250,0001,625,0002,275,000
Cost of
capital
10% 10% 5% 10% 10% 10%
NPV 191,399112,51182,369 -52,303232,006635,605
Discounted
Payback
period
3.96 4.40 4.58 More
than 5
3.86 3.86

9. Internal Rate of Return(IRR)
IRR is the discount rate that makes the Net Present Value
(NPV) of the Project EQUAL to ZERO.
An investment to be accepted if its IRR is higher than its
Cost of Capital and should be rejected, if lower.
IRR can be interpreted as a measure of profitability
of its expected cashflows.
IRR takes into account Time Value of money and
risk of investment

10. Expected cashflow streams and cost of capital –
alternative investment proposals – Initial outlay of ONE
million rupees
End of YearInvestment
A
Investment
B
Investment
C
Investment
D
Invesrtment
E
Investment
F
1 600,000100,000250,000250,000325,000325,000
2 300,000300,000250,000250,000325,000325,000
3 100,000600,000250,000250,000325,000325,000
4 200,000200,000250,000250,000325,000325,000
5 300,000300,000250,000250,000325,000925,000
Total
Cashflows
1,500,0001,500,0001,250,0001,250,0001,625,0002,275,000
Cost of
capital
10% 10% 5% 10% 10% 10%
IRR 19.05%13.92%7.93%7.93%18.72%28.52%

11. Net Present Value
Discount factor is the inverse of compounding factor.
NPV(k,N) = -CF0 + CF1 X DF1 + CF2 X DF2 + ……………
…….CFt X DFt + ………………………...CFN X DFN

NPV = (-)Initial cash outlay + Present value of future cash
flows at the cost of capital.
Investment to be undertaken if its NPV is positive and should
be rejected if NPV is negative

12. Why NPV rule is a good investment
rule ?
•It is a measure of value creation – when NPV is
positive, project creates value and when negative,
destroys value.
•It adjusts for the timing of project’s expected cash
flows
•It adjusts for the risk of project’s expected cash
flows
•It is additive.

13. NPV Profile
Expected Cash
Flows – CF(0),
CF(1), CF(2)
…….CF(n)
Risk of expected
cashflow stream
Cost of Capital
(k) required
rate of return
NPV = --CF(o) +
∑CF(t)/(1+k) t
t=1,n
NPV>
0
NPV
<0
Accept
Project
Reject
Project

14. Cost of capital
The Project is going to be financed entirely with Debt, so its relevant cost
of capital is the INTEREST Rate of Debt – or – Project is going to be
financed entirely with Equity, so its cost of capital is Cost of Equity
Although project does not have same risk as the Co, its relevant cost of
capital should be equal to firm’s WACC because firm’s shareholders and
debtors are paid with cash from firm’s cash flows, NOT from the
Project’s cash flows
When Project’s risk is different from the risk of the Firm, the
Project’s cost of capital should be lowered to account for the
risk reduction that diversification brings to the firm.

16. Summary
Evaluation
Method
Inputs Required DecisionRule Does
the Rule
Adjust cash
flows for
For
Calculation
For DecisionAccept RejectTime ?Risk ?
Net present
Value(NPV)
• Cash flows
•Cost of
Capital(k)
NPV NPV > 0NPV < 0Yes yes
Profitability
Index (PI)
•Cash flows
•Cost of
capital(k)
PI PI > 1 PI < 1Yes Yes
Internal Rate
of return(IRR)
• Cash flows•IRR
•Cost of
capital(k)
IRR > kIRR < kYes Yes
Discounted
Payback
period(DPP)
•Cash flows
•Cost of
capital (k)
•DPP cut off
period
DPP <
cutoff
period
DPP >
cutoff
period
Only
within
DPP
Only within
DPP
Payback
period(PP)
•Cash flows•PP
•Cutoff period
PP <
cutoff
period
PP >
cutoff
period
No No

17. 17
Financing Operation in India
Equity/Risk Capital
Public Equity Issue
Debt/Borrowed Capital
Foreign direct Investment
Project Finance
Term loans & Working capital finance
External Commercial Borrowings
Corporate Loan Market
Corporate Debt Market

18. 18
Equity Capital
•Various means of raising equity capital
–Bringing foreign funds
•Foreign direct Investment including ADRs/GDRs and
FCCBs
•Preference share capital (not included in ECBs or FDI
sectoral caps)
–Raising domestic funds
•Private placements
•Public issue of equity

19. 19
Raising Domestic equity
Private Placement
•To raise funds and dilute equity in favor of Indian shareholders (as per FDI
sectoral caps) while limiting the no. of shareholders.
•Private equity/venture capital investors to provide funding from ideation
stage as well as help nurture the growth.
Public Issue
•Well developed Equity markets with total market cap in excess of
Rs 60 lakh Crores as of Dec,2010
•Liquidity mainly in large cap and some mid cap companies
•Main participants – Mutual funds, Insurance companies, FIIs and retail
investors

20. 20
Private Equity
•Can be used to raise funds and dilute equity in favor of Indian
shareholders (as per FDI sectoral caps) while limiting the no. of
shareholders.
•Private equity/venture capital investors provide funding for
Sunrise industries – Biotech, Hightech, etc.
–Many US based funds invest in Indian companies or US companies with
focus on India
–Funding for startups and small scale units hard to come by, funding
mainly for second stage or later
–Typically look for the management team, their speed of execution,
ability to scale, managing customer expectation, infrastructure, client
relationships and dependence, order book/ pipeline and profitability.

21. 21
Corporate debt market in India
•Less deep than Equity markets contrary to world markets
•Liquidity mainly in Govt. securities and highly rated corporate
papers (AAA and AA)
•Primarily an OTC Market
•Listed corporate debt market
–Listed market underdeveloped
–Listed debt markets are also regulated by SEBI
–Listing requirements
•Rating must for listing of debt
•Credit Rating Agencies – Crisil (alliance with S&P), ICRA (alliance with
Moody’s), CARE and Fitch India.
•Banks investment in unlisted non SLR securities restricted to
10% of the total investments in non SLR securities.

22. 22
Corporate debt market in India
Market players:
•Qualified Institutional Investors (QIB)
–Public financial institution
–Scheduled commercial banks
–Mutual funds
–Foreign institutional investor registered with SEBI
–Multilateral and bilateral development financial
institutions

23. 23
Project finance
•
Project Finance
–Rupee project loans to fund Land & Buildings, Plant & Machinery, pre-
operative and preliminary expenses (including interest for the
construction and installation period) and margin money for working
capital
–Foreign currency project loans to fund imported capital equipment,
services incidental to the equipment such as technology transfer and
servicing fees, and domestic project expenditure.
–Syndication of domestic/international debt
–Use of EXIM bank US/Developed countries- funding for import of
capital equipment from those countries

24. 24
Project Finance (contd.)
•Rupee assistance by way of subscription to debentures and
shares
•Assistance by way of underwriting shares and debentures
•Guarantees for
• Foreign currency loans
• Export credits.
•Suppliers of equipment
•Foreign lenders
•Bond guarantees and confirming guarantees
•Equity
•Mezzanine finance
•Equity
•Take-out finance
•Assistance for a project loan would typically be for a longer
tenure than for a corporate loan

25. 25
Term loans and working capital
finance
Fund based working capital services
Cash credit facility
Working capital demand loan
Export packing credit / Pre-
shipment credit
Packing credit & foreign currency
Short term loan
MIBOR linked loans
Commercial paper
Invoice bill discounting (Clean &
LC backed)
Foreign currency non resident
(bank) loan
Buyers & suppliers credit
Over draft
Securitization
Receivables (present and future)
Off balance sheet funding
Plain vanilla corporate loans
Structured finance
Long term loans