CHAPTER 3

Part-II

FINANCIAL APPRAISAL
TECHNIQUES
Financial appraisal
The purpose of the financial appraisal is to determine
whether the project is worthwhile, comparing its costs
with its expected benefits.
Financial appraisal is a method used to evaluate the
viability of a proposed project by assessing the value of
net cash flows that result from its implementation.
Financial appraisal addresses not only the adequacy of
funds, but also the financial viability of the project,
estimating in the end if and when the project returns a
profit or not. i.e.
A financial analysis of a project is undertaken to assess
whether it will be commercially profitable for the enterprise
implementing it.
In addition to being financially viable, a development
project cannot usually be considered acceptable unless it
is economically, technically and institutionally sound. It
should be the least-cost feasible solution to the problem
being solved and should expect to produce net economic
and/or social benefits.
For example, irrigation projects may facilitate the
growing of cash crops in one locality, but cause water
shortages, and hence economic, social and environmental
pressures in another.
 In order to apply appropriate project appraisal techniques,
it is useful to understand the nature of investment projects:
1. Mutually Exclusive Projects:
A set of projects where only one can be accepted. i.e.
the acceptance of one project excludes the acceptance
of other projects.

For example, a set of projects which are used to

accomplish the same task.
Thus, when choosing between "Mutually Exclusive
Projects" more than one project may satisfy the
Capital Budgeting criterion. However, only
one, i.e., the best project can be accepted.
4
 Cont…..
2. Independent Projects:
Is one whose cash flows are not related to the cash
flows of any other project. i.e. Accepting or rejecting
an independent project does not affect the acceptance
or rejection of other projects.

An Independent Project is a project whose cash

flows are not affected by the accept/reject decision
for other projects. Thus, all Independent
Projects which meet the Capital Budgeting criterion
should be accepted.
5
3. Contingent Projects Cont…
It is also known as dependent projects, Projects that
necessitate the implementation of another projects. The
functioning of one project depends on the functioning of the
other project as well. i.e they are dependent on the
acceptance of another project.
A project that can be accepted only if one or more other
projects is accepted first.

4. Complementary Projects:
The investment in one enhances the cash flows of one or
more other projects. Consider a manufacturer of personal
computer equipment and software.
If it develops new software that enhances the abilities of a
computer mouse, the introduction of this new software may6

enhance its mouse sales as well.

Financial appraisal techniques:
There are several techniques that have been
suggested by accountants, economists and
others to judge the worthwhileness of capital
projects.

The important appraisal criteria are classified

in to two broad categories:
1. Non-discounting techniques

2. Discounting techniques
1. Non-discounted techniques:
Simplicity is the main benefit, i.e. Theses techniques
are simple to understand and easy to compute, but
suffers from drawbacks.
They don’t recognize the time value of money and
not consistent with wealth maximization.
The common non-discounted techniques are
(a) Pay back period
(b) Accounting Rate of Return
A) Pay back period :
The amount of time needed to recover the initial
investment is called Payback period.

The length of time required for an investment’s net

revenues to cover its cost. i.e.

Time period required to recover the cost of the

investment from the annual cash inflow produced by
the investment.

It answers the question “how long will the project

take to recover its cost”
According to the pay back period criteria, the shorter
the pay back period, the more desirable the project.
Firms using this criteria generally specify the maximum
acceptable payback.

If this is “n” years, projects with pay back period of “n”
years or less are deemed worthwhile and projects with a
pay back period exceeding “n” years are considered as
unworthy.
How to calculate pay back period?
1. When the cash inflows are constant , the pay back period
is simply the initial out lay divided by the annual cash
inflows.
That is:

Example:
A project which costs cash outlay of Birr 1,000,000 is
expected to generate a constant annual cash inflow of
Birr 300,000 for five years. Compute its pay back period.
=

i.e. It takes 3 years and 4 months to cover the initial

investment.
2. When the cash inflows are not constant

Example:
Year Cash flow
0 Birr 600,000
1 50,000
2 150,000
3 150,000
4 200,000
5 150,000
Compute the payback period
The decision rule is:
A project is accepted if the computed payback period
is less than or equal to the pay back period set by
management.
A project is rejected if the computed payback period
is greater than the pay back period set by
management
Advantages of Pay back period
It is simple both in concept and application
It is based on cash flows
Focuses on earlier cash flows and liquidity
Disadvantages:
Does not consider the time value of money
It is a measure of the project’s capital recovery, not
profitability
It ignores cash flows beyond the pay back period-this
leads to discrimination against projects which generate
substantial cash inflows in latter years.
Difficulty in setting the standard pay back period
B) Accounting Rate of return (ARR)
Also called average rate of return on investment.
It measures profitability, which relates income to
investment.
This method provides a percentage return of the
investment. Since income and investment can be measured
in various ways, but the common one is:
Average Net Income
A R R=
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 Investent

The decision rule is:

A project is accepted if its rate of return is greater than
management’s minimum rate of return.
A project is rejected if its rate of return is less than management’s
minimum rate of return.
Example

Consider a company that is evaluating whether to buy a

new store in a new mall. The purchase price is Br.

500,000. We will assume that the store has an estimated
life of 5 years. We assume that the store will worth
nothing at the end of the lifetime.
Based on the given data determine ARR
 Year 1 Year 2 Year 3 Year 4 Year 5
Net Income 100,000 150,000 50,000 0 -50,000

Then, the average net income is given by

Average Net Income =(100,000+150,000+50,000+0-50,000)/5=50,000

Thus, the average accounting return of this example is

given by:
$ 50,000
𝐴𝑅 𝑅= =2 0 %
$ 250 , 000
• If the company has a target average accounting return
smaller than 10% (say 8%), the project will be
accepted. If the company had a target AAR greater than
10%, the project will be rejected.
Advantages of ARR
It is simple to calculate
It considers benefits over the entire life of the project
Shortcomings of ARR
 It is not based on cash flows
It does not consider the time value of money
Confusion and inconsistency of measures used to
compute ARR
Difficulty in setting the standard rate
2. Discounted project appraisal techniques
(A) Net present value
(C) Profitability Index
(B ) Discounted pay back period
(D) Internal Rate of Return
 Discounted appraisal techniques considers both the
estimated total cash inflows and the time value of money.

That is:
 Recognize the time value of money

 Recognize the benefits of the project in totality

(except discounted pay back period)
A) Net present Value method:
Net present value (NPV) method, relies on discounted cash
flow techniques. To implement this approach:
1. Find the present value of each cash flow, including both
inflows and outflows discounted at the project’s cost of
capital.

2. Sum these discounted cash flows and deducted the initial

investment.

3. If the NPV is positive, the project should be accepted,

while if the NPV is negative, it should be rejected. If two
projects with positive NPVs are mutually exclusive, the one
with the higher NPV should be chosen.
How to calculate NPV?
n
CFt
NPV    CF0 .
t 1 1  r 
t

Cost often is CF0 and is negative.

Decision rule of NPV:

Accept if NPV is positive
Reject if NPV is negative
Indifferent if NPV is zero
Example:

Year Cash flow

0 Birr 1000,000
1 200,000
2 200,000
3 300,000
4 300,000
5 350,000

Assume the cost of capital is 10 percent. Calculate the NPV

NPV?

NPV= -5,273
Advantage
Considers the time value of money
Considers the project in totality
 Based on cash flows
Does not require the estimation of decision standard
Shortcomings
Relatively complex
B) Benefit-Cost ratio: is the ratio of the present value of
cash flows (PVCF) to the initial investment of the project.
It is also called profitability Index (PI)
Is the ratio of benefits to costs
If once the NPV is computed, it can be automatically
calculated.
Consider the above example and find PI

Decision rule:
Accept if PI > 1 (NPV is positive)
Reject if PI < 1 (NPV is negative)
Indifferent if PI=1 (NPV is zero)

 Both NPV and PI leads to the same accepted and reject

decisions
C) Discounted pay back period
A major shortcoming of the conventional payback period is
that it does not take into account the time value of money.
To over come this limitation, the discounted pay back period
has been suggested.
In this modified method, cash flows are first converted in to
their present values and then added to ascertain the period
of time required to recover the initial outlay on the project.
Except converting the cash flows in to their present values,
the calculation of the discounted pay back is similar to the
that of the conventional pay back period.
Similar to payback period approach with one difference that
it considers time value of money but not consistent with
wealth maximization
 Discounted Payback: Uses discounted
rather than raw CFs.
0 1 2 3
10%

CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback = 2 + 41.32/60.1= 2.7 yrs

Recover investment in 2.7 yrs.

Exercise
Consider the first example of pay back period. i.e.
A project which costs cash outlay of Birr
1,000,000 is expected to generate a constant
annual cash inflow of Birr 300,000 for five years.
Compute the discounted pay back period. Assume
the discounted rate is 8%.
D) Internal Rate of Return
The rate that will cause the present value of
the proposed capital expenditure equal to the
present value of the expected annual cash
inflows.
It is found through trail and error
It is the rate at which NPV is zero.
At IRR, NPV is zero that is
 PV(Inflows) = PV(Investment costs),
It is the rate that forces the NPV to equal
zero:
IRR is calculated by finding the discount rate
that equates the present value of future cash
inflows to the project’s cost.
The discount rate that forces the PV of a
project’s inflows to equal the PV of its costs.
The decision rule is:
Accept when internal rate of return is greater
than the required rate of return
Reject when internal rate of return is less than
required rate.
Using the trial and error
Steps in the IRR trial and error calculation method
1. Compute the NPV of the project using an arbitrary
selected discount rate
2. If the NPV so computed is positive then try a higher rate
and if negative try a lower rate.
3. Continue this process until the NPV of the project is equal
to zero
4. Use linear interpolation to determine the exact rate Linear
interpolation is given by:
IRR = LR + ( NPV@ LR ) X (HR – LR)
NPV@LR –NPV@HR
Where:
LR is the lower rate,
HR is the higher rate
Chapter End!
Thank You