Project Appraisal Introduction PDF

**CHAPTER 1 -- INTRODUCTION TO PROJECT APPRAISAL** **OUTCOME 1:** Discuss the nature and importance of project appraisal, classify different investment projects, explain the basic principles of capital investment, differentiate between accounting profits and cash flows, and calculate relevant cash...

**CHAPTER 1 -- INTRODUCTION TO PROJECT APPRAISAL** **OUTCOME 1:** Discuss the nature and importance of project appraisal, classify different investment projects, explain the basic principles of capital investment, differentiate between accounting profits and cash flows, and calculate relevant cash flows for investment projects; **PROJECT -- DEFINITION** Outcome-wise: A project is "a temporary endeavor undertaken to produce a unique product, service, or result". Process wise: A project can also be defined as a set of inputs and outputs required to achieve a particular goal. **CHARACTERISTICS OF A PROJECT** Following are the main characteristics of a project: **Objectives:** A project has a set of objectives / a mission. Once they are achieved the project is treated as completed. **Life cycle:** A project has a life cycle. The life cycle consists of five stages i.e. conception, definition, planning & organizing, implementation and commissioning. **Uniqueness:** Every project is unique and no two projects are similar. Setting up a cement plant and construction of a highway are two different projects having unique features. **Team Work:** Project is a team work of personnel specialized in their respective areas. **Complexity:** A project is a complex set of activities relating to diverse areas. **Risk and uncertainty:** Risk and uncertainty go hand in hand with project. A risk-free project only means that the element is not apparently visible on the surface and it will be hidden underneath. **Customer specific nature:** A project is always customer specific who decides the product to be produced / services offered. **Change:** Changes occur throughout the life span of a project as a natural outcome of many factors. **Optimality:** A project is aimed at optimum utilization of resources for the overall development of the economy. **Sub-contracting:** The more the complexity of the project, the more will be the extent of sub-contracting. **Unity in diversity:** A project is a complex set of thousands of varieties. The varieties are in terms of technology, equipment and materials, machinery and people, work, culture and others. **RISKS IN PROJECTS** **Project Conceptualization Risk** **A lot of groundwork needs to be done before a project idea gets off the ground and becomes a project. These entail investment of time and cost for the entrepreneur. After investing in the ground work, the entrepreneur may find that the idea cannot be translated into a project.** **Financial Closure Risk** **Once a decision is taken to proceed with the project, the resources need to be mobilized to invest in the project. Unless financial closure is achieved, it becomes difficult to implement the project, especially if the investment required is large.** **Project Construction Risk** **Various problems can come up in the course of project construction. Problems of technical knowledge can be solved by engaging a good collaborator or Engineering, Procurement & Construction (EPC) Contractor. The contract terms should be worked out well, including a provision for liquidated damages in case of delays. Similarly, ethical standards and safety standards need to be imposed on the contractor.** **Political Risk:** It refers to the risk that a host country will make political decisions that will prove to have adverse effects on the multinational\'s profits and/or goals. Adverse political actions can range from very detrimental to those of a more financial nature, such as the laws that prevent the movement of capital. **Market Risk:** After the project is commercialized, the project may find that its products do not have a market, or that the demand is much lower than anticipated or at a lower selling price than planned. The problem can be minimized by engaging a good firm for market study. **Policy Risk:** Tax policy as well as incentive schemes do change according to the change in the Government. These may not be aimed at a specific project, but affect the overall economy. Similarly, policies on FDI limit, sectors permitted for the private sector, import tariffs etc. are susceptible to change. It is considered prudent to do a sensitivity analysis for every project. **Exchange Risk:** Changes in exchange rates can cause havoc to businesses. This may be either through the home currency cost of imports or exports, or the repayments on foreign currency loans. **Environmental Risk:** The role of environment in commercial decisions and litigation by third parties is expected to increase in the years to come. The company should therefore do a thorough study of the environmental risks inherent to the project. **Force Majeure (Superior force or Act of GOD):** Despite the best efforts, some events happen that are beyond the control of any party. There could be an earthquake, cyclone or any other acts of God. Acts of terrorism are another source of risk. **CLASSIFICATION OF INVESTMENT PROJECTS** **A. Based on Nature** - Lowering costs of labor, materials, and other inputs such as electricity; - Introducing new technology; - Increasing capacity/ improving speed of service. **B. Based on Inclusiveness** **Example 1:** **Identify the type of project.** 1. 2. 3. 4. 5. 6. **Solution -- Example 1:** **PROJECT MANAGEMENT** Project management is application of knowledge, skills, tools, and techniques to project activities to achieve project requirements. It is accomplished through the application and integration of the project management processes of initiating, planning, executing, monitoring and controlling, and closing. **Conception & initiation:** Project charter, project initiation. **Definition & planning:** Scope and budget, work breakdown schedule, Gantt chart, communication plan, risk management. **Launch/ execution:** Status and tracking. KPIs, quality, forecast. **Performance & control:** Objectives, quality, deliverables, effort and cost tracking, performance. **Project close:** Post mortem, project punch-list, reporting. **Project Management's Triple Constraints** Cost: Budget available Scope: The tasks required to fulfill the project's goals Time: The schedule for the project to reach completion *Triple constraints are interrelated and influence each other*. **Project Management comprises a body of methods and tools that facilitate the achievement of project objectives within scope, cost and time. Following guideline help become a successful Triple Threat Project Manager:** - - - - **CAPITAL BUDGETING PROCESS** The extent to which the capital budgeting process needs to be **formalized and systematic** procedures established depends on the size of the organization, number of projects to be considered, direct financial benefit of each project, the composition of the firm\'s existing assets and management\'s desire to change that composition, timing of expenditures associated with projects accepted. Capital budgeting process included six steps. **Planning:** The capital budgeting process begins with the **identification of potential investment opportunitie**s. **Evaluation:** This phase involves the **determination of proposal** and its investments, inflows and outflows. Investment appraisal techniques, ranging from the simple payback method and accounting rate of return to the more sophisticated discounted cash flow techniques, are used to appraise the proposals. **Selection:** Considering the returns and risks associated with the individual projects as well as the cost of capital to the organization, the organization will **choose among projects** so as to maximize shareholders' wealth. **Implementation:** When the final selection has been made, the firm must acquire the necessary funds, purchase the assets, and begin the **implementation of the project.** **Control:** The progress of the project is monitored with the aid of **feedback reports**. These reports will include capital expenditure progress reports, performance reports comparing actual performance against plans set and post completion audits. **Review:** When a project terminates, or even before, the organization should **review the entire project** to explain its success or failure. This phase may have implication for firms planning and evaluation procedures. Further, the review may produce ideas for new proposals to be undertaken in the future. **PROJECT APPRAISLA -- DEFINITION** In simple means project appraisal is a cost and benefits analysis of different aspects of proposed project with an objective to adjudge its viability. **Importance of Project Appraisal** - - - - - - - - - - - - **REASONS FOR MAKING CAPITAL INVESTMENTS** The objective of capital budgeting is to maximize the profitability. This objective can be achieved by: - - - **ENVIRONMENTAL ANALYSIS - PEST ANALYSIS:** +-----------------------------------+-----------------------------------+ | **Political:** | **Social:** | | | | | - - - - | - - - - - - | +===================================+===================================+ | **Economic:** | **Technological:** | | | | | - - - - - - - | - - - | +-----------------------------------+-----------------------------------+ **ENVIRONMENTAL ANALYSIS -- PORTER'S FIVE FORCES:** +-----------------------------------+-----------------------------------+ | **Potential new entrants:** | **Bargaining power of | | | suppliers:** | | - - - - - - - - | | | | - - - - - | +===================================+===================================+ | **Bargaining power of buyers:** | **Competitive rivalry:** | | | | | - - - - - - - | - - - - - | +-----------------------------------+-----------------------------------+ | **Threat of substitutes:** | | | | | | - - - - | | +-----------------------------------+-----------------------------------+ **ALTERNATIVES IN ASSESSING CAPITAL INVESTMENT PROPOSALS** **1. Accounting profit:** - - - **2. Cash flow:** - 'Cash flow' refers to cash revenues minus cash expenses. - It consider timing of Cash Flow by Discounting Techniques. **WHY CASH CASH FLOWS ARE BETTER MEASURE OF ECONOMIC VIABILITY?** - - - **ACCOUNTING PROFIT** **CASH FLOW** ----------------------------------------------- --------- --------------- -- --------- **Revenue** **xxx** xxx **(Less) Cost of goods sold** **xxx** xxx **Gross profit** **xxx** **xxx** **(Less) Operational exp. (Cash & non-cash)** **xxx** **Profit before tax** **xxx** **(Less) Tax** **xxx** **Profit after tax** **xxx** **IDENTIFYING & CALCULATING RELEVANT CASH FLOWS FOR INVESTMENT PROJECTS** **Depreciation:** Capital assets are subject to depreciation. To calculate profit before tax, operating expenses (including depreciation and other non-cash expenses) are deducted from the gross profit. To arrive at cash flows, the depreciation is added back to the profit after tax. **Working capital:** **Major investments may require increases to working capital. e.g. new production facilities often require more inventories and higher salaries payable.** **Hence, the net change in working capital associated with the project should be considered in identifying the relevant cash flows.** **Overhead:** **Many capital projects can result in increases to allocated overheads, such as computer support services. The subjective nature of overhead allocations may not make any difference at all. The impact of the capital project on overhead need to be assessed, to determine if these costs are relevant.** **Financing cost:** **Financing a capital project involves additional cash flows to investors. To account for financing costs, the best approach is to include them within the discount rate.** **Sunk cost:** **Sunk costs are ignored since they are already incurred. For example, a new product line may require some preliminary marketing research. This research is done regardless of the project and thus, it is sunk. *Sunk costs are not a relevant cost.*** **[PRACTICE QUESTIONS ]** **Question 1:** The following details are available regarding the operating activities of MSG Establishment for the year ended December 2023: **Particular** **OMR** --------------------------- --------- Fixed assets (cost) 250,000 Rate of depreciation 10% Cost of goods sold 125,000 Sales (less sales return) 325,000 Administrative expense 50,000 Selling expenses 25,000 Other non-cash expenses 10,000 Rate of tax 15% ***Required:*** You are required to calculate Profit after Tax and Cash Flow After tax. **Question 2:** Following details are available for a company XYZ Ltd. for the year ending December, 2022 (all amounts in OMR). You are required to calculate: **Fixed assets (cost)** **250,000** -------------------------- ------------- **Rate of depreciation** 8% **Cost of goods sold** 128,000 **Sales (less returns)** 300,000 **Selling expenses** 50,000 **Admin. Expenses** 25,000 **Other non-cash Exp** 8,000 **Tax rate** 10% ***Required:*** a\) Statement of net profit b\) Statement of cash flows after tax **Question 3:** A new project is being evaluated at present that involves purchasing a new assembly machine for OMR 25,000. It will cost OMR 2,000 to install the machinery. By making the investment, the annual operating costs will be reduced by OMR 7,000 and expect to save OMR 500 a year in maintenance. The new machine will require OMR 750 each year for technical support. The machinery will be subject to depreciation over 5 years under the straight-line method of depreciation with an expected salvage value of OMR 5,000. The effective tax rate is 35%. *Required:* Calculate relevant cash flows for capital project. **Question 4:** A company in the region is planning for a new project that requires an investment in a new machinery. The cost of machinery is OMR 20,000. The total expenses to transport and install the machinery will be OMR 5,000. Since the machinery uses the latest technology, it will result in a reduction of overall cost by OMR 10,000. The company offers free maintenance for the machinery. Savings on account of the free maintenance will be OMR 1,000 every year. The annual contract requires the company to pay OMR 1,500 every year for the vendor support. The total life of the project will be five years and it is expected that the machinery can be disposed at the end for 2,000. Straight line depreciation is used by the company. The effective tax rate is 12%. ***Required:*** Calculate Relevant Cash Flows for Capital Project. **Question 5:** A company will replace an old machine with new one. The proposed new machine costs OMR 2,000,000 and OMR 200,000 is needed to install it. Depreciation is over 5 years using Straight Line Method. The old machine was bought 2 year ago for OMR 800,000 (with 5-year Straight Line Method Depreciation). A buyer will pay OMR 600,000 for the old machine. Net working Capital requirement is expected to be OMR 30,000. Assume a tax rate of 30%. ***Required:*** Calculate Initial Investment of the Company.