Chapter Four

Project Appraisal (Evaluation)

4.1 Commercial Profitability Appraisal (Evaluation)

Project appraisal is the process of detailed examination of various aspects of a given
project for recommending it for implementation. You must have observed that the
investment/proposals proposals:
(i) involve large amount of funds
(ii) involve greater amount of risk on account of unforeseen situation and
(iii) Often mean irreversibility once the investment decision is made.

In view of these the task of appraising investment/project proposals is very important in

financial management.

Relevant Data: The following need to be considered before appraisal is taken up:
 The amount and timing of initial investment outlays
 The amount and timing of subsequent investment outlays
 The economic life of the project
 Salvage value at the end of the project
 The amount and timing of cash inflows

1. Initial Investment Outlays: This covers the total cash required to implement the
proposal. It includes expenditure on design, survey, consultancy fees and the working
capital costs, such as costs of maintaining stocks, contingency reserves to cover the cost
of supporting additional debtors. Benefit of credit from suppliers will have the effect of
reducing the quantum of additional working capital required.
2. Subsequent Investment Outlays: The cost of maintenance, replacement and updating
exercises are to be treated as outflows during the period in which they are expected to be
incurred.
3. Economic Life of a Project: The economic life of a project is to be distinguished from
the life of an individual asset. A building may have a life of sixty years, plant may have a
life of fifteen years and some equipment may have a life of five years only. The
economic life of the project is determined by the duration of the `earnings flow' generated
by the project.
 The economic life may end:
 When the cost of replacement or renovation becomes uneconomical in relation to
the likely benefits;
 When the viability of the project is adversely affected due to obsolescence,
 When rising maintenance costs exceed the estimated disposal value; and
 When the development of new technology necessitates new investment.
4. Salvage Value: Some equipment may have some value for the enterprise at the end
of the life of the project or there may be an anticipated sale value of the equipment.
Such amount is to be treated as an inflow at the end of the life of the project.
5. Operating Cash Flows: Three main areas are to be considered here:

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a).Sales revenue: It is a function of sales volume and unit selling price. Any
miscalculation of sales revenue may have a crucial impact on appraisal of an investment
proposal. In assessing any investment opportunity, the additional or incremental revenues
generated by it need to be considered.
b). Production costs: A distinction between fixed and variable costs will be very
meaningful to anticipate the likely behavior of costs. Only incremental costs have to be
considered.
c). Other direct costs: These costs will cover selling and promotion costs and additional
rent, etc. The net inflow/outflow of cash can be worked out by allocating the aforesaid
items period-wise. It may appear to you that in order to make an appraisal regarding the
financial viability of an investment proposal, or to make a choice between two proposals,
it will be enough to find out the net cash flow, that is the difference between total outflow
(amount to be invested) and the inflow (net of Sales Revenue + Salvage Value).
4.2 Methods of Appraisal: After the costs and benefits for a project are defined in the
form of cash flows, the profitability of the project has to be determined. There are several
criteria that have been suggested by economist, accountant, and other to judge the
worthwhileness of capital project. The important investment evaluation methods
discussed in the following subsequent paragraphs are classified into two broad categories
are:
 Non-Discounting Methods
1. Urgency (Priority)
2. Pay Back Period (PBP)
3. Accounting Rate of Return (ARR)
 Discounting Methods
4. Net Present Value (NPV)
5. Benefit Cost Ratio (BCR)
6. Internal Rate of Return (IRR)
4.2.1 Non-Discounting Methods
1. Urgency (Priority): According to this criterion projects that are deemed to be more
urgent get priority over projects that are regarded as less urgent. However, it is
difficult to determine the relative urgency of projects because of the lack of an
objective basis. The use of urgency criterion may imply that the persuasiveness of
those who propose/ prepare projects would become a very important factor in
investment decisions. Resource allocation may deteriorate into a political battle
2. Pay Back Period (PBP): The pay back period is the number of years needed to
recover the initial investment of the project. It is the number of years required for
investments cumulative cash flows to equal its net investment.
Decision rule: An investment is acceptable if it calculated payback period is less than
some pre-specified number of years (maximum desired pay back period).
Example 1: a) Uniform (annuity) cash flow
Investment $20,000
Cash flows per year $4,000

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Pay Back Period = Investment
Uniform Cash Flows
= = 3 years
When cash flow of an investment is an annuity form, pay back period is computed by
dividing the net investment by the annuity as shown in above example.
b) Non-Uniform Cash Flows: Suppose the annual cash flows are not equal for the same
initial investment of $20,000. The cash inflows from the project for the first five
consecutive years are $8, 000, $9, 000, $15, 000, $20,000 and $ 25,000 respectively.
What is the pay back period? To determine the pay back period of the above project, we
have to use the cumulative cash flow method as follows.

Year Cash Flow Cumulative Cash Flow Investment to be recovered

0 - - 20,000
1 8,000 8,000 12,000
2 9,000 17,000 3,000
3 15,000 - -
3rd year = $3,000/$15,000 = 0.2 years
PBP = 2 years +0.2 years= 2.2 years
Pay back period (PBP) can be determined by using the following formula:
PBP= E+ B
C
Where, PBP stands for payback period
E stands for number of years immediately proceeding the year of final recovery
B stands for the balance amount still to the recovered
C stands for cash flow during the year of final recovery
Example 2: Consider two projects A and B each with initial outlay and expected cash
flow as set out below.
Year Description Project A Project B
0 Initial Investment 15,000 12,000
1 Cash flow 6,000 3,000
2 Cash flow 6,000 5,000
3 Cash flow 3,000 2,000
4 Cash flow 500 1,000
5 Cash flow 500 1,000
Required:
a) What is the pay back period for each period?
b) Which of the two projects would you choose? Why?
Advantage of pay back period method:
- It is simple, both in concept and application. It does not use involved concepts and
tedious calculations and has few hidden assumptions.
- Adjust for uncertainty of later cash flows
- Biased toward liquidity

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Disadvantage of pay back period:
- It fails to give any considerations to each proceeds earned after the payback date.
- It is a measure of the project's capital recovery, not profitability.
- It fails to take into account the time value of money.
- It is unusable to distinguish between projects with the same payback period.
- It may lead to excessive investment in short term projects.
Modified Pay Back Period (Discounted Pay Back Period): As we can see from the
disadvantages of PBP method, it ignores the time value of money. To overcome this
limitation, the discounted pay back period has been suggested. In this method cash flows
are first converted in to their present value and then calculate the discounted pay back
period. The discounted pay back period is the length of time it takes for the discounted
cash flows to equal the amount of initial investment.
Decision rule: Accept, if a project discounted payback is less than some prespecified
numbers of years.
Example: Initial investment of a project $25,000
Annual Cash Flow for 5 years 10,000
Required: assume that the discount rate is 10%.
a) Compute the modified (discounted) PBP.
b) If the expected PBP is 4 years, should the project be accepted or rejected?
c) If the expected PBP is 2 ½ years, should the project be accepted or rejected?
Solution
Years Cash Flow PV of $1 PV of Cash Cumulative Investment to
@10% Flow Cash Flow be Recovered
0 (25,000) - - - 25,000
1 10,000 0.909 9,090 9,090 15,910
2 10,000 0.826 8,260 17,350 7,650
3 10,000 0.751 7,510 24,860 140
4 10,000 0.863 6,830 - -
5 10,000 0.621 6,210 - -
th
4 year = 140/6830=0.2 years
a) Discounted (Modified) PBP= 3+0.2 =3.2 years.
b) The project has to be accepted.
c) The project has to be rejected.
3. Accounting (Average) Rate of Return (ARR)
The accounting rate of return (ARR), also referred to as the average rate of return on
investment, is a measure of profitability which relates income to investment, both
measured in accounting terms. Since income and investment can be measured in various
ways, there can be a very large number of measures for accounting rate of return.
The measures that are employed commonly in practice are:
1) ARR = Average Income after Tax (AIAT)
Initial Investment
2) ARR = Average Income after Tax (AIAT)
Average Investment
3) ARR= Average Income after Tax but before Interest
Initial Investment

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 4) ARR= Average Income after Tax but before Interest
Average Investment
5) ARR= Average Income before Interest and Taxes (AIBIT)
Initial Investment
6) ARR= Average Income before Interest and Tax (AIBIT)
Average Investment
7) ARR= Total income after tax but before Depreciation-Initial Investment
{[Initial Investment/2] x years}
Example 1: Various Methods of ARR with 50% tax rate.
Year Investment Depreciation EBIT Interest EBT Tax EAT
1 100,000 10,000 40,000 5000 35,000 17,500 17,500
2 80,000 10,000 50,000 15,000 35,000 17,500 17,500
3 60,000 22,000 60,000 10,000 50,000 25,000 25,000
4 40,000 25,000 50,000 10,000 40,000 20,000 20,000
5 40,000 28,000 70,000 10,000 60,000 30,000 30,000
6 40,000 25,000 90,000 10,000 80,000 40,000 40,000
Total 360,000 120,000 360,000 60,000 300,000 150,000 150,000
Average 60,000 20,000 60,000 10,000 50,000 25,000 25,000
a) AIAT=150,000/6 =25,000
b). Initial Investment =100,000
c). Average Investment=360,000/6 =60,000
d). AIAT but before interest=25,000+10,000 =35,000
e). AIBIT=25,000+10,000+25,000 =60,000
Or 360,000/6 =60,000
1. ARR = Average Income after Tax (AIAT) =25,000/100,000=25%
Initial Investment
2. ARR = Average Income after Tax (AIAT) =25,000/60,000=41%
Average Investment
3. ARR= Average Income after Tax before Interest =35,000/100,000=35%
Initial Investment
4. ARR= Average Income after Tax but before Interest =35,000/60,000=58%
Average Investment
5. ARR= Average Income before Interest and Tax (AIBIT) =60,000/100,000=60%
Initial Investment
6. ARR= Average Income before Interest and Tax (AIBIT) =60,000/60,000=100%
Average Investment
7. ARR= Total Income after Tax but before Depreciation-Initial Investment
{[Initial Investment/2] x years}
= {[150,000+120,000]-100,000]
{(100,000/2) x6}
=57%
The higher the ARR the better the project would be.
Projects which have an ARR equal or greater than a prespecified cut-off rate of return
are accepted.
Advantages of Accounting Rate of Return (ARR)

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  It is simple to calculate
 It considers benefits over the entire life of a project as well as the profitability of
employed resources.
 It is based on accounting information which is readily available and familiar to
businessmen.
Disadvantages of Accounting Rate of Return (ARR)
 It does not take account of the timing of the profits from an investment
 It implicitly assumes stable cash receipts over time.
 It is based on accounting profits and not cash flows. Accounting profits are
subject to a number of different accounting treatments.
 It is a relative measure rather than an absolute measure and hence takes no
account of the size of the investment.
 It takes no account of the length of the project.
 It ignores time value of money.
4.2.2 Discounting Methods
This concept is based on the premise of the `time value of money'. The flow income is
spread over a few years. The real value of a rupee in your hand today is much more than
that of a rupee which you will earn after a year. Why is it so? It is the value of time. The
future income, therefore, has to be discounted in order to be associated with the current
outflow of funds in the investment. Two methods of appraisal of investment project are
based on this concept. These are Net Present Value method and Internal Rate of Return
method.
1. Net Present Value (NPV) Method: The net present value of the project is the sum of
the present value of all the cash flows-positive as well as negative-that are expected to
occur over the life of the project. This means that, NPV= PV of Inflows-PV of Outflows.

The formula of NPV is given by:

NPV of a Project = - Initial Investment

Where Ct = cash flow at the end of year t

n= life of the project
r= discount rate
t= time or year
Decision rule:
The net present value represents the net benefit over and above the compensation for time
and risk. Hence the decision rule associated with the net present value criteria is:
If the net present value (NPV) is positive or greater than 0; accept the project
If the net present value (NPV) is negative or less than 0; reject the project.
If we are going to select one project from two or more projects with a NPV>0,
mutually exclusive, we should select the project which has greater NPV.

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Example 1: Consider a project which has the following cash flows.
Year Cash Flows
0 65,000
1 (2,000)
2 (4,000)
3 25,000
4 40,000
5 42,000
If the cost of cash is 10%, what is the NPV?
Solution
Year Cash Flow PV of $1 @10% Total PV
0 (65,000) 1.000 (65,000)
1 (2,000) 0.909 (1,818)
2 (4,000) 0.826 (3,304)
3 25,000 0.751 18,775
4 40,000 0.683 29,320
5 42,000 0.621 26,082
Total PV of CIF - - 67,055
Total PV of COF (65,000)
NPV 2,055
Example 2: Project ‘Y’ has a net investment of $10,000 and a cash flow of $4,000 for
each three years. Compute and interpret the NPV if the required rate of return (cost of
capital) is 12%.
Advantage of NPV method
- The cash flows from the beginning to the end of the project are considered
- It gives a measure of the discounted absolute surplus from an investment
- It is particularly used for comparison and selection from among mutually exclusive
projects that are of the same size
- It discounts cash flows by the cost of capital which gives explicit recognition to the
returns required by investors
- Since it is expressed in birr/dollar the decision maker can easily understand it than
percentage and ratio.
Disadvantage of NPV method
- The NPV method can be employed in selection from mutually exclusive projects only
when the projects are of the same size. If the levels of investment are different,
deciding the acceptability of the project only on the basis of NPV is misleading.
- The discount rate needs to be obtained externally to the method of calculation. that is
determined exogenously
- The opportunity cost of capital is assumed to remain constant throughout the life of
the project. But usually the cost of capital changes over the lifespan of project.
- It does not show the exact profitability rate of the project
2. Benefit Cost Ratio (BCR) or Profitability Index (PI): BCR gives the return for
each dollar invested. There are two ways of defining the BCR.

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 - The first definition related the PV of benefits (PVB) to the initial
investment.
- The second measure relates NPV to initial investment.
The benefit cost ratio is obtained by dividing the present worth of the benefit stream by
the present worth of the cost stream.
Benefit Cost Ratio: BCR= or Present Value of Cash Inflows
Present Value of Cash Outflows
Net Benefit Cost Ratio: BCR= or BCR-1
Where PVB = Present Value of Benefit
I = Initial investment
Decision rule:
When BCR or NBCR Decision rule
>1 >0 Accept
=1 =0 Indifferent i.e., benefit=cost
<1 <0 Reject
Example 1: The project which has a cost of capital of 12%, initial investment and cash
flows are given below
Year 0 1 2 3 4
Cash Flows $ 1,000,000 25,000 40,000 40,000 50,000

The benefit cost ratio measures for this project are:

Benefit cost ratio: BCR =

= 1.145
Net Benefit Cost Ratio = BCR - 1 = 1.145 - 1 = 0.145
The project should be accepted, since the BCR is greater than 1.

Example 2: The following are the cash flows of a project.

Year 0 1 2 3 4
Cash Flows $ 25,000 8,000 7,000 20,000 15,000

The discount rate is 7%. Calculate the BCR and NBCR.

Solution
Year Cash Flow PV of $1 @7% Total PV
1 8,000 0.935 7,480
2 7,000 0.873 6,111
3 20,000 0.816 16,320
4 15,000 0.763 11,445
Total PV of Benefit (PVB) - 41,356

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 Benefit Cost Ratio (BCR) = PVB = 41,356 = 1.65
I 25,000
 NPV= $41,356 ( NPV of IF )-$25,000 (NPV of OF)=$16,356
 NBCR=NPV = $16,356 = 0.65
I 25,000
 BCR (1.65) means $1 investment will becomes $1.65 including the investment and
profit.
 NBCR (0.65) means $1 investment will bring $ 0.65 profit.
 Therefore, the project should be accepted, since its BCR and NBCR are greater than 1
and 0 respectively.
Advantage of Cost Benefit Ratio method:
- Closely related to NPV, generally leading to identical decisions.
- Easy to understand and communicate
- May be useful when available investment funds are limited.
Disadvantage of Cost Benefit Ratio method:
- May lead to incorrect decision in comparison of exclusive investment.
3. Internal Rate of Return (IRR): The IRR is the discount rate that makes the NPV of
the incremental net benefit stream equal to zero. The IRR may also be defined as the
discount rate that equates the present value of benefits with the present value of costs.
Thus, it is the discount rate at which it is worth while doing the project. This is the
maximum interest rate that a project could pay for the resources used if the project is to
recover its investment and operating cost till breakeven.
IRR is the rate where PV of Inflows=PV of Outflows or NPV
NB: an IRR of a series of value such as a cash flow can exist only when at least one value
is negative .If all the values are positive no discount rate can make the NPV equal to zero.
No matter how high the discount rate the NPV of a series would have to be positive if it
includes no negative number. Thus, we need to treat the initial investment as negative.
How do we compute IRR? The arithmetical rule for computing the IRR relies on using
two discount rates. In the NPV calculation we assume that the discount rate (cost of
capital) is known and determine the NPV. In the IRR calculation, we set the NPV equal
to zero and determine the discount rate that satisfies this condition.
Example 1: Consider the following:
Year 0 1 2 3 4 5
Cash Flows $ 60,000 10,000 20,000 15,000 15,000 20,000

Required: Find the IRR (use the Trail and Error Method).
Solution: Trail and Error Method
a) Guess any discount rate and compute the NPV
b) If the NPV is negative (<0) try with a lower discount rate.
c) If the NPV is positive (>0) try with a higher discount rate

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Computing the starting points
a) Compute the average cash flow=10,000+20,000+15,000+15,000+20,000
5
=$16,000
b) Divide the investment by the average cash flow=$60,000/16,000=3.75
c) Look at the annuity table and fin out a discount rate that will make annuity of
$1(equal to the life of the project) equal to the figure obtained in step two.
This is the starting point:
We get 3.790787=10%
Starting discount rate=10%
d) The compute the NPV using 10% discount rate as follow:
Year Cash Flow PV of $1 @10% Total PV
1 10,000 0.909 9,090
2 20,000 0.826 16,520
3 15,000 0.751 11,265
4 15,000 0.683 10,245
5 20,000 0.621 12,420
Total PV of CIF - 59,540
Total PV of COF - 60,000
NPV - (460)
e) Since the NPV is negative (460), we should try the lower discount rate.
Year Cash Flow PV of $1 @10% Total PV
1 10,000 0.917 9,170
2 20,000 0.842 16,840
3 15,000 0.772 11,580
4 15,000 0.708 10,620
5 20,000 0.650 13,000
Total PV of CIF - 61,210
Total PV of COF - (60,000)
NPV - 1,210
f) Use interpolation method
9% 10%
$61,210--------------------------------------------$59,540
The total distance between 9% and 10%: =$61,210-59,540 =1,670
Percentage of distance between 9% and 10%= 1210/1670=0.72
Therefore, IRR= Lower discount rate+ % of distance b/n lower and higher distance rate
= 9% +0.7 =9.72%
Example 2: To compute the IRR of a project, consider a project that has cash flows of
the following amount of Dollar.
Year 0 1 2 3 4
Cash flow (100,000) 30,000 30,000 40,000 45,000
The IRR is the value of r that satisfies the following equation:

100,000= + + +

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The calculation r involves a process of trial and error. We try different values of r till we
find that the right-hand side of the above equation is equal to 100,000. Let us, to begin
with, try r=15 %. This makes the right-hand side equal to:
+ + + = 100,802
This value is slightly higher than our target value, 100,000. So we should increase the
value of r from 15% to 16%. (In general, a higher r lowers and a smaller r increases the
right-hand side value). The right hand side becomes the following value at 16% interest
rate;
+ + + = 98,641.
Since this value is now less than $100,000, we conclude that the value of r lies between
15 percent and 16 percent. If a more refined estimate of r is needed, use the following
procedure:
1. Determine the net present value of the two closest rates of return. In our example the
NPV at 15% is $802 and NPV at 16% is 1,359
2. Find the sum of the absolute values of the net present values obtained in step 1, that
is, in our example, 802 + 1,359 = $2,161.
3. Calculate the ratio of the net present value of the smaller discount rate, identified in
step 1, to the sum obtained in step 2. That is, = 0.37
4. Add the number obtained in step 3 to the smaller discount rate. That is, 15%+ 0.37=
15.37 %.
 We can use the following formula to determine the IRR of a project also.
IRR= LDR + (NPVLDR) X (HDR-LDR)
(NPVLDR-NPVHDR)
Where, LDR= Lower Discount Rate
HDR=Higher Discount Rate
NPVLDR=Net Present Value of Lower Discount Rate
NPVHDR= Net Present Value of Higher Discount Rate
Example 3: Consider the following project with the initial investment of $60,000 and 4
years of life to calculate the IRR. It has the following the estimated cash flows.
Year Estimated Cash Flow
1 15,000
2 20,000
3 30,000
4 20,000
Advantages of Internal Rate of Return (IRR)
 It is clearly understood and it is closer to business man's rate of return measure.
 It is determined internally as part of the calculation method, i.e., it conveys direct
message about the yield on the project.
 It is a useful measure to calculate where there is uncertainty about the correct
discount rate.
Disadvantages of Internal Rate of Return (IRR)
 It omits a consideration of the size or scale of an investment because it is a ratio.
 It requires specification of an opportunity cost of capital to make a decision.

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  It might be tedious to calculate.
Depreciation, Tax and Inflows: It must be made clear that depreciation is excluded
from Discounted Cash Flow (DCF) computations. A common error is to discount cash
flows obtained after deducting the amount of depreciation. This type of error, in fact,
shows lack of understanding of the basic idea involved in DCF. The DCF approach is
fundamentally based on inflows and outflows of cash and not on the accrual concept of
revenues and expenses. Depreciation does not involve any cash flow. It is merely a book
entry to allocate the cost of the asset over its useful life. It has of course the effect of
reducing the disposable income.
In the DCF approach, the initial cost of an asset is usually regarded as a lump sum
outflow of cash at time zero. The cash inflows in our illustrations are assumed to be after
income taxes. Depreciation, as you have noted, is not a factor in discounted cash-flow
techniques. Nevertheless, depreciation has some bearing on the annual cash flows
because of its connection with income tax. Probably, you are aware that depreciation is
deductible as a regular business expense in the determination of the income tax payable.
Because depreciation does not require the repeated outlay of cash over the useful life of
the asset, it does not reduce the cash earnings from a particular investment. But the
incremental earnings from such an investment are taxed at the prevailing rate, and the
incremental tax payments (paid in cash) reduce cash earnings. Since depreciation on the
asset is a tax deduction, it reduces the tax payment. It thus acts to `shield' part of the cash
inflow from the tax burden.
Exercises
1. Rank the following projects in order of their desirability according to Pay Back
Period (PBP), Net Present Value (NPV) and Profitability Index (PI). Assume the
discount rate is 10%.
Project Initial Outlay Annual Cash Flow Life in Years
A 10,000 2,500 5
B 8,000 2,600 7
C 4,000 1,000 15
D 10,000 2,400 20
E 5,000 1,125 15
F 6,000 2,400 6
G 2,000 1,000 2
2. A company has an investment opportunity costing $40,000 with the following
expected net cash flows after tax and before depreciation.

Yea Net Cash Flow

r
1 7,000
2 7,000
3 7,000
4 7,000
5 7,000
6 8,000
7 10,000
8 15,000
9 10,000

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 10 4,000
Using 10% as a cost of capital determine the following:
a) Pay back period (PBP)
b) NPV at 10% discount factor.
c) Profitability Index at 10% discount factor.
d) Internal Rate of Return.
3. Sulabh international is evaluating a project whose expected cash flows are as follows:
Year Cash Flow
0 (1000,000)
1 100,000
2 200,000
3 300,000
4 600,000
5 300,000
Required:
a) What is the NPV of a project, if the discount rate is 14% for the entire period?
b) What is the NPV of the project if the discount rate is 12% for year 1 and rises
every year by 1%?
5. What is the IRR of an investment which involves a current outlay of $300,000 and
results in an annual cash inflow of $60,000 for 7years?
6. How much can be paid for a machine which brings in an annual cash inflow of
$25,000 for 10 years? Assume that the discount rate is 12%.
7. Farewell Company has an investment opportunity costing $30,000 with the following
expected net cash flow (i.e. after taxes and before depreciation);
Year Net Cash flow
1 4,000
2 4,000
3 4,000
4 4,000
5 4,000
6 7,000
7 9,000
8 12,000
9 9,000
10 2,000

Using 10% as the cost of capital (rate of discount), determine the following:
a) Payback period
b) Net present value at 10 % discounting factor
c) Profitability index at 10% discounting factor.
d) Internal rate of return with the help of 10 % discounting factor and 15 %
discounting factor.
8. The Deccan Corporation, which has a 50% tax rate and a 20% after-tax cost of
capital, is evaluating a project which will cost $ 125,000 and will require an increase
in the level of inventories and receivables of $25,000 over its life. The project will
generate additional sale of $100,000 and will require cash expenses of $ 25,000 in
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 each of its 5 year life. It will be depreciated on a straight-line basis. What are the net
present value and internal rate of return for the project?
9. The management of Maratha Udyog has two alternative projects under consideration.
Project `A' requires a capital outlay of $ 300,000 but project `B' needs $ 420,000:
Both are estimated to provide a cash flow for six years: A $ 80,000 per year and B
$110,000 per year. The cost of capital is 12%. Show which of the two projects is
preferable from the viewpoint of (i) Net Present Value and (ii) Internal Rate of
Return.
4.3 Risk/Threat Analysis
Risk is inherent in almost every business decision. More so in capital budgeting
decisions as they involve cots and benefits extending over a along period of time during
which many things can change in unanticipated ways.

Sources, Measures, and Perspectives on Risk

Sources of Risk: there are several sources of risk in a project. The important ones are
project-specific risk, competitive risk, industry-specific risk, market risk and international
risk.
- Project-specific risk: the earnings and cash flows of the project may be lower than
expected because of an estimation error or due to some other factors specific to the
project like the quality of management.
- Competitive risk: the earnings and cash flows of the project may be affected by the
unanticipated actions of the competitors.
- Industry-specific risk: unexpected technological developments and regulatory
changes that are specific to the industry, to which the project belongs, will have an
impact on the earnings and cash flows of the projects as well.
- Market risk: unanticipated changes in macroeconomic factors like the GDP growth
rate, interest rate, and inflation have an impact on all projects, although in varying
degrees.
- International risk: in case of a foreign project, the earnings and cash flows may be
different than expected due to the change rate risk or political risk.
Measures of Risk: risk refers to variability. It is ca complex and multi-faceted
phenomenon. A variety of measures have been used to capture different facets of risk.
The more important ones are range, standard deviation, coefficient of variation, and semi-
variance. To illustrate the calculation of these measures, consider a capital investment
whose net present value has the following distribution.

NPV Probability
200 0.3
600 0.5
900 0.2
The expected NPV works out to: E (NPV) =∑ pi NPVi
= 0.3x200+0.5x600+0.2x900=$540
Now let us see the various measures of risk as follows:

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Range: is the difference between the highest value and the lowest value i.e., $900-
$200=$700
Standard Deviation: ∂= [∑ pi (Xi- ) 2]1/2
Where, ∂= standard deviation
Pi=probability associated with the ith value
Xi=ith value
=expected value
The standard deviation of the NPV distribution presented above is:
∂= [0.3(200-540)2 +0.5(600-540)2 +0.2(900-540)2
= [62,500)1/2 =250
The square of standard deviation is called variance i.e., Variance=∂2
The variance of the above distribution is 62,500.
Coefficient of Variation (CV) = Standard Deviation
Expected Value
The coefficient of variation for the investment in our illustration is:
CV=250 =0.46
540
Semi-Variance (SV) =∑pidi2
= 0.3(200-540)2 =34,680
Perspectives on Risk: regardless of the risk measure employed, there are different
perspectives on risk. You can view a project from at least three different perspectives.
These are:
- Stand-alone risk which represents the risk of a project when it is viewed in
isolation.
- Firm risk also called corporate risk; this reflects the contribution of a project to the
risk of the firm.
- Systematic risk represents the risk of a project from the point of view of a
diversified investor. It is also called market risk.
4.4 Social Cost Benefit (Economic) Analysis
Social cost benefit analysis is a methodology developed for evaluating investment
projects from the point of view of the society (economy) as a whole. SCBA, also referred
to as economic analysis, has received increasing emphasis in recent years in view of the
growing importance of public investments in many developing countries where
governments are playing a significant role in economic development. It is also relevant
to private investments as these have to be approved by the government. The encouraging
attitude of the government of Ethiopia towards private investments necessitates for
SCBA of such investments in Ethiopia.
4.4.1 Rational for SCBA
SCBA focuses on the social costs and benefits of the projects. These costs may differ
from the monetary costs and benefits of the project. The major sources of discrepancy
between the monetary costs and the social costs are the following:
1. Market Imperfections: market prices which form the basis for computing the
monetary costs and benefits from the viewpoint of project expenses reflect social values

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only under conditions of perfect competition. When imperfections are obtained, market
prices do not reflect social values. For example particular type of cigarette can be sold
for Birr 1. Does the price of cigarette take account of the higher probability of heart
disease or cancer? A person who offers Birr 1 for something expects to get at least Birr 1
worth satisfaction from it. But, it doesn’t mean that the social value is also Birr 1. This
is what social cost benefit analysis is trying to look into.
The common market imperfections found in developing countries are:
(1) Rationing,
(2) Prescription of minimum wag rate, and
(3) Foreign exchange regulation.
Under rationing, the price paid by a consumer is less than the price that would prevail in
a competitive market. When minimum wages are fixed, the wages paid to labour are
usually more than what the wages would be in a competitive labour market. The official
rate of foreign exchange is usually less than the rate that would prevail in the absence of
foreign exchange regulations. This is why foreign exchange usually commands premium
in unofficial transactions.
2. Externalities: A project may have external effects. For example, it may create certain
infrastructural facilities like roads which benefit the neighboring areas. Such benefits are
considered in SCBA, though they are ignored in assessing the monetary benefits to the
project sponsors. Likewise, a project may have harmful external effects like pollution,
the cost of which is relevant in SCBA whereas it is irrelevant in commercial profitability.
Thus, externalities are relevant in SCBA whether they are paid or not.
3. Taxes and subsidies: Taxes are definite monetary costs and subsidies are monetary
gains from the private point of view. However, they are considered as transfer payments
and considered irrelevant from the social point of view.
4. Concern for savings: From a social point of view, the division of benefits between
consumption and savings (which leads to investment) is relevant. A Birr saved is deemed
more valuable than a Birr of benefits consumed.
A private firm does not put differential valuation of savings and consumption. In SCBA,
a higher valuation is placed on savings and a lower valuation is put on consumption.
5. Concern for redistribution: A private firm does not bother how its benefits are
distributed across various groups in the society. The society is concerned about the
distribution of benefits across different groups. A birr of benefit going to poor section is
considered more valuable than a Birr of benefit going to an affluent section.
6. Merit wants: Goals and preferences not expressed in the market place, but believed
by policy makers to be in the larger interest, may be referred to as Merit Wants. For
example, the government may prefer to promote an adult education programme or a
nutrition programme. While merit wants are not relevant from the point of view of the
investor, they are important from the social point of view.
7. Discounting rate: Commercial profitability is computed in terms of present value
using the opportunity cost of capital. However, the social rate of discount may differ
from commercial cost of capital.
Principal Approaches For SCBA

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Towards the end of the sixties and in the early seventies, two principal approaches for
SCBA emerged, the UNIDO approach and the Little Mirrlees Approach.
4.4.2.1 UNIDO Approach
The UNIDO approach of project appraisal involves five stages:
1. Calculation of financial profitability of the project measured in terms of market
prices.
2. Obtaining the net benefit of project measured in terms of economic (efficiency)
prices.
3. Adjustment for the impact of the project on savings and investment.
4. Adjustment for the impact of project on income distribution.
5. Adjustment for the impact of project on merit goods and demerit goods whose social
values differ from their economic value.
Stage two of the UNIDO approach is concerned with the determination of the net benefit
of the project in terms of Economic Efficiency Prices, also referred to as Shadow
Prices.
Shadow prices are defined as the value of the contribution to the country’s basic socio
economic objectives made by any marginal change in the availability of commodities or
factors of production.
Shadow pricing: the basic issues of shadow pricing are the following.
1. Choice of Numeraire: One of the important aspects of shadow pricing is the
determination of the numeraire, the unit of account in which the values of inputs or
output are expressed. To define the numeraire, the following questions have to be
answered:
a) What unit of currency (domestic or foreign) should be used to express
benefits and costs?
b) Should costs and benefits be measured in current values or constant values?
c) With reference to which point (present or future) should costs and benefits be
evaluated?
d) What use (consumption or investment) will be made of the income of the
project?
e) With reference to which group should the income of the project be measured?
The specification of the UNIDO numeraire in terms of the above questions is “net present
consumption in the private sector in terms of constant price in domestic accounting birr.”
2. Concept of tradability: A key issue in shadow pricing is whether a good is tradable
or not. For a tradable good, the international price is a measure of its opportunity cost to
the country because it is possible to substitute import for domestic production and vice
versa. Hence, the International Price, also referred to as the Border Price, represents
the “real” value of the goods in terms of economic efficiency.
3. Sources of shadow price: The UNIDO approach suggests three sources of shadow
pricing, depending on the impact of the project on national economy. A project may:
1.Increase or decrease the total consumption in the economy,
2.Increase or decrease production, and
3.Increase or decrease imports and exports

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If the impact of the project is on consumption in the economy, the basis of shadow
pricing is consumer willingness to pay. If the impact is on production in the economy,
the basis is the cost of production. If the impact is on import and export, the basis is the
foreign exchange value.
4. Taxes: When shadow prices are being calculated, taxes usually pose difficulties. The
general guidelines in the UNIDO approach with respect to taxes are as follows:
a) For fully traded goods, taxes should be ignored
b) When the project adds to non-traded consumer goods, taxes should be included.
5. Consumer willingness to pay: If the impact of the project is on consumption in the
economy, the basis of shadow pricing is consumer willingness to pay. How is this
measured? Prince
D S/

E
P

S
D/

0 Q Quantity
In the graph, DD’ represents the demand schedule, SS’ represents the supply schedule
and E represents equilibrium. The consumer who buys the first unit is willing to pay OD
and the consumer who buys the last unit is willing to pay OP for that unit. The consumer
willingness to pay for various units is indicated by the schedule DE. So the total
willingness to pay by consumers who buy the product is measured by the area ODEQ.
The price paid by them, however, is only OPEQ. The difference between ODEQ and
QPEQ, namely DEP, is referred to as the consumer surplus.

Shadow Pricing of Specific Resources

 Tradable inputs and outputs: A good is fully traded when an increase in its
consumption results in a corresponding increase in import or decrease in export or when
an increase in its production results in a corresponding increase in export or decrease in
import. For fully traded goods, the shadow price is the Border Price, translated in
Domestic Currency at the market exchange rate.
 None Tradable Inputs and Outputs: A good is none tradable when the
following conditions are met:
o Its import price (CIF) is greater than its domestic cost of production, and
o Its export price (FOB) is less than its domestic cost of production.
On the output side, if the impact of the project is to increase the consumption, the
measure of value is the marginal consumers’ willingness to pay. If the impact of the
project is to substitute other production of the same none tradable in the economy, the
measure of value is the saving in cost of production.

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On the input side if the impact of the project is to reduce the availability of the inputs to
other users, their willingness to pay for that input represents social value. If the project
input requirement is met by additional production of it, the production cost of it is the
measure of social value.
 Externalities: An externality, also referred to as an external effect, is a special class
of good which has the following characteristics:
a) It is not deliberately created by the project sponsor but is an incidental outcome of
legitimate economic activity.
b) It is beyond the control of the persons who are affected by it.
c) It is not traded in the market place.
An external effect may be beneficial or harmful. Since SCBA seeks to consider all costs
and benefits, external effects need to be taken into account. The valuation of external
effect is rather difficult because they are often intangible in nature and there is no market
price which can be used as a starting point. Their value is estimated by indirect means:
For example,
a) The cost of noise may be inferred from the differences in rent in noise-affected area
and non-affected area,
b) The cost of pollution may be estimated in terms of the loss of earnings a result of
damage to health,
c) The value of better transport provided by the approach roads may be estimated in
terms of increased activities and benefits derived from them.
 Labour Inputs
When a project hires labour, it could have three possible impacts on the rest of the
economy:
 It may take labour away from other employments,
 It may induce the production of new workers, and
 It may involve import of workers.
When a project takes labour away from other employments, the shadow price of labour is
equal to what other users of labour are willing to pay for this labour.
 The social cost associated with inducing additional production of workers consists of:
(1) the marginal product of the worker in the previous employment,
(2) the value assigned by the worker on the leisure that he may have to forego, (3) the
additional consumption of good when a worker is fully employed as opposed
when he is idle or partly employed,
(3) the cost of training to improve skills, and
(4) the cost of transport and rehabilitation when a worker is moved from one location
to another.
The social cost associated with import of foreign workers is the wage they command. In
their case, a premium should be added on account of foreign exchange remitted abroad.
 Capital Goods: The shadow pricing capital investments involves the value of
physical assets and the opportunity cost of capital. The shadow price of physical assets is
equal to its border price if it is a fully traded good. If it is a none traded goods, its price is
measured in terms of cost of production or consumer willingness to pay.

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The opportunity cost of capital is measured by the consumption rate of interest which
reflects the price the saver must be paid to sacrifice present consumption.
 Foreign Exchange The UNIDO method uses domestic currency as the numeraire.
So the foreign exchange input must be identified and adjusted by an appropriate
premium. This means that the valuation of inputs and outputs that were measured in
border price has to be adjusted to reflect the shadow price of foreign exchange. The
foreign exchange requirement of a project is met from the sacrifice of others. The use of
foreign exchange may also induce the production of foreign exchange through additional
exports. In such a case, the shadow price of foreign exchange would be based on the cost
of producing foreign exchange. However, consumer willingness to pay for foreign
exchange is generally used as the basis for calculating the shadow price of foreign
exchange.
 Measurement of the Impact on Income Re-distribution: Stages three and four of
the UNIDO approach are concerned with the measuring the value of a project in terms of
its contribution to savings and income redistribution. For income distribution analysis,
the society may be divided in to various groups. To facilitate such assessments, we must
first measure the income gained or lost by different groups within the society, such as the
project itself, other private business, government, workers, consumers, and external
sector.
 Measure of Gain or Loss: The gain or loss to an individual group within the society
as a result of the project is equal to the difference between the shadow price and the
market price of each input or output.
For example a project requires 100 labourers. These labourers are prepared to offer
themselves for work at a daily wage rate of Birr 4. The wage rate paid to the labourers is
Birr 7 per day. So, the redistribution benefit enjoyed by the group of 100 labourers is 300
(100 x 3) per day.
 Savings impact and its value: Most of the developing countries face scarcity of
capital. Hence, the governments of these countries are concerned about the impact of a
project on savings and its value. Stage three of the UNIDO method, concerned with this
seeks to answer the following questions:
1. Given the income distribution impact of the project, what would be its effects on
savings?
2. What is the value of such savings to the society?
 The savings impact of the project = Yi MPSi
Where: Yi = Change in income of group ‘i’ as result of the project
MPSi = Marginal propensity to save of group ‘i’.
For example, as a result of a project, the income gained by group ‘i’ is 20,000.
The marginal propensity to save of this group is 10%.
 The impact on savings of the project is 2,000.
 Value of Savings: The value of a Birr of savings is the present value of the additional
consumption stream produced when that Birr is invested. The additional stream of
consumption generated by a Birr of investment depends on the marginal productivity
of capital and the rate of reinvestment from additional income.

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 Income Distribution Impact: Many governments regard redistribution of income
in favor of economically weaker sections or economically backward regions as a socially
desirable objective. Due to practical difficulties in pursuing the objectives or
redistribution entirely through the tax, subsidy etc, investment projects are also
considered as investments for income redistribution and their contribution towards this
goal is considered in their evaluation.

This calls for suitably weighing the net gain or loss by each group, measured earlier, to
reflect the relative value of income for different groups and summing them. In order to
decide the relative weights, the best single factor, the elasticity of marginal utility of
income, is used. The marginal utility of income is the value derived from one more unit
of income.
 Adjustment for Merit and Demerit Goods
In some cases, the analysis has to extend to reflect the difference between the economic
value and social value of resources. This difference exists in case of merit goods and
demerit goods. A merit good is one for which the social value exceeds the economic
value. For example, the country may place a higher social value than economic value of
creation of employment. In the case of a demerit good, the social value of the good is
less than its economic value. For example, a country may regard cigarettes as having
social value less than the economic value.
 The procedure for adjusting for the difference between social value and economic
value is as follows:
a) Estimate the economic value
b) Calculate the adjustment factor as the difference between the ratio of social value to
economic value.
c) Multiply the economic value by the adjustment factor to obtain the adjustment
d) Add the adjustment to the net present value of the project.
 Example:
The present economic value of the output of the project is 25 million.
The social value of the project is 20% greater than the economic value.
The adjustment factor would be, 0.2(or 120/100 – 1).
 Multiplying the present economic value by 0.2, we get an adjustment of 5 million.
This, then, is added to the present economic value of 25 million.
Where the socially valuable output of the project doesn’t appear as an output in the
economic analysis (exam: employment generated by the project), the output is treated
like an externality and its valuation in social terms is the adjustment.

4.4.2.2 Little-Mirrlees Approach

 Shadow Price of Traded Goods: The shadow price of a traded good is simply its
Border Price. If a good is exported, its shadow price is FOB price and if a good is
imported its shadow price is its CIF price. The logic for using border prices is fair
because it represents the correct social opportunity costs or benefits of producing or
using a good.

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 Accounting price of non-traded goods: Accounting prices for non-traded items are
defined in terms of marginal social cost and marginal social benefit. The marginal
social cost of a good is the value in terms of accounting prices of the resources
required to produce an extra unit of the good. The social marginal benefit is the value
of an extra unit of the good from the social point of view.
 Use of Conversion Factors: The accounting price of non-traded items is defined in
terms of marginal social cost and marginal social benefit. In practice, the calculation
of these costs and benefits is a difficult task. LM Suggests that the monetary cost of a
non-traded item be broken into tradeable, labour and residual components. The
tradeable and residual components may be converted into social cost by applying
suitable social conversion factors. The labour component’s social cost can be
obtained by using social wage rate.
A conversion factor is a factor by which we multiply the price of an input or output in the
domestic market to obtain its accounting price, when the factor cannot be observed or
estimated directly, a conversion factor for each homogeneous group of non-traded
commodities should be estimated. However, since it is difficult, we may resort to a
standard conversion factor for the aggregates. For example the SCF of Ethiopia,
calculated by the central planners is 0.75 and this figure should be used in project
analysis.
 Shadow Wage Rate: The SWR is a function of:
(1) the marginal productivity of labour,
(2) the costs associated with urbanization, and
(3) the cost of having an additional amount committed to consumption when the
consumption of worker increases as a result of the higher income he enjoys in
urban employment.
Under Ethiopian conditions, a single shadow wage should be used until detailed
information is made available. The planners have estimated the SWR of Ethiopia as 0.90
per day, using average agricultural labour productivity.
 National Parameters: A parameter is defined as ‘a quantity or constant whose value
varies with the circumstances of its application.’ Accounting prices are parameters
which could take different values in different projects. These values are determined
by the cost and production structures of the project and the economic conditions in
the area of the project. However, there are some shadow prices that due to their
nature or aggregation procedures are estimated on an economy-wide basis. They will
have general acceptability and be used in all projects on the country. They are called
Key Shadow Prices or more commonly National Parameters. They are (1) SWR,
(2) SCF, and (3) ARI-Accounting Rate of Interest or Opportunity Cost of Capital
(OCC) or Discount Rate of Interest (ARI).
 Accounting Rate of Interest (ARI) = Account Rate of Return (ARR)
The ARI is the rate used for discounting social profit. Experience is the best guide to the
choice of ARI. If the investment requirement of acceptable projects exceeds the
availability of visible funds, increase the accounting rate of interest. If it is less than the
availability of funds, decrease the rate.

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