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Project Ka Bazigaar

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.

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Project Ka Bazigaar

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  1. Project Ka Bazigaar

  2. Project Appraisal By-Rahul Jain

  3. Project Appraisal • Overview and “vocabulary” • Methods • Payback, discounted payback • NPV • IRR • Sensitivity Analysis • Breakeven Analysis

  4. What is Project Appraisal? • Analysis of potential projects. • Long-term decisions; involve large expenditures. • Very important to firm’s future.

  5. Steps in Project Appraisal • Estimate cash flows (inflows & outflows). • Determine r = WACC for project. • Evaluate cash flows.

  6. Terminal Cash flow Initial outlay . . . 0 1 2 3 4 5 6 n Annual Cash Flows Cash Flow Estimation Of Project

  7. 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.

  8. 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

  9. 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

  10. 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.

  11. Terminal Value for a New Business • The terminal value included the salvage value of the asset and the release of the working capital. • Managers make assumption of horizon period because detailed calculations for a long period become quite intricate. The financial analysis of such projects should incorporate an estimate of the value of cash flows after the horizon period without involving detailed calculations. • A simple method of estimating the terminal value at the end of the horizon period is to employ the following formula, which is a variation of the dividend—growth model:

  12. Additional Aspects of Cash Flow Analysis • Opportunity Costs of Resources • Sunk Costs • Tax Incentives • Investment allowance • Other tax incentives

  13. Case Study • Warehouse Case

  14. There is nothing like FREE LUNCH

  15. Cost of Capital • The project’s cost of capital is the minimum required rate of return on funds committed to the project, which depends on the riskiness of its cash flows. • The firm’s cost of capital will be the overall, or average, required rate of return on the aggregate of investment projects.

  16. OCC . Equity shares . Preference shares . Corporate bonds . Government bonds . Risk-free security Risk The Concept of the Opportunity Cost of Capital • The opportunity cost is the rate of return foregone on the next best alternative investment opportunity of comparable risk.

  17. The Weighted Average Cost of Capital • The following steps are involved for calculating the firm’s WACC: • Calculate the cost of specific sources of funds • Multiply the cost of each source by its proportion in the capital structure. • Add the weighted component costs to get the WACC. WACC is in fact the weighted marginal cost of capital (WMCC); that is, the weighted average cost of new capital given the firm’s target capital structure.

  18. Cost of Equity Capital • Cost of Equity: The Dividend—Growth Model

  19. Cost of Debt • Debt Issued at Par • Tax adjustment 

  20. WACC • Cost of capital (WACC)= (Cost of Equity x Proportion of equity from capital)+ (Cost of debt x Proportion of debt from capital)+

  21. What is the payback period? The number of years required to recover a project’s cost, or how long does it take to get the business’s money back?

  22. Payback for Franchise L(Long: Most CFs in out years) 2.4 0 1 2 3 CFt -100 10 60 100 80 Cumulative -100 -90 -30 0 50 PaybackL = 2 + 30/80 = 2.375 years

  23. Franchise S (Short: CFs come quickly) 1.6 0 1 2 3 CFt -100 70 100 50 20 Cumulative -100 -30 0 20 40 PaybackS = 1 + 30/50 = 1.6 years

  24. Strengths of Payback: 1. Provides an indication of a project’s risk and liquidity. 2. Easy to calculate and understand. Weaknesses of Payback: 1. Ignores the TVM. 2. Ignores CFs occurring after the payback period.

  25. 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 + 41.32/60.11 = 2.7 yrs = Recover invest. + cap. costs in 2.7 yrs.

  26. NPV: Sum of the PVs of inflows and outflows. Cost often is CF0 and is negative.

  27. What’s Franchise L’s NPV? Project L: 0 1 2 3 10% -100.00 10 60 80 9.09 49.59 60.11 18.79 = NPVL NPVS = $19.98.

  28. Rationale for the NPV Method NPV = PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value.

  29. 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 > 0.

  30. Internal Rate of Return: IRR 0 1 2 3 CF0 CF1 CF2 CF3 Cost Inflows IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.

  31. NPV: Enter r, solve for NPV. IRR: Enter NPV = 0, solve for IRR.

  32. What’s Franchise L’s IRR? 0 1 2 3 IRR = ? -100.00 10 60 80 PV1 PV2 PV3 0 = NPV Enter CFs in CFLO, then press IRR: IRRL = 18.13%. IRRS = 23.56%.

  33. Rationale for the IRR Method 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.

  34. Normal Cash Flow Project: 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.

  35. Inflow (+) or Outflow (-) in Year 0 1 2 3 4 5 N NN - + + + + + N - + + + + - NN - - - + + + N + + + - - - N - + + - + - NN

  36. Individual Assignment • Complete All the questions

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