FIN 650: Project Appraisal
Lecture 1
Introduction
Course Overview
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

Prerequisites
 Bus635 and/or EMB 510
Requirements and Grading
 1 Paper (40%)
 One Midterm Examination (20%)
 Final Examination (40%)
Class Materials
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2
Web-page: http://fkk.weebly.com
Office: NAC 751
Office hours: Tuesday, 5pm-6:30 pm
Activity Schedule: FIN650
Class
Date
Exams
Paper
1
24 May
2
31 May
3
7 June
4
14 June
5
21 June
Guest Lecturer
Lab class
6
28 June
Guest Lecturer
Lab class
7
5 July
Mid 1
8
12 July
9
19 July
10
26 July
11
9 Aug
12
16 Aug
Guest Lecturer
13
13 Aug-23
Aug.
Final
Paper
Project Appraisal
Nature
of project appraisal
Given the limitation of resources, choices must
be made among the competing uses, and project
appraisal is one method of evaluating
alternatives in a convenient and comprehensive
fashion
Project appraisal assesses the benefits and cost
of a project and reduces them to a common
yardstick. If benefits exceed costs, the project is
acceptable; if not the project should be rejected
 Society’s objective
Growth:
to increase total national income
Equity: to improve the distribution of national income
Projects should be assessed in relation to their
net contribution to both of these objectives

Project and Program Appraisal

Project and program sometimes used
interchangeably
Project:
Jamuna Bridge Project, Square Pharmaceuticals
Program:

Literacy Program
Analysis by whom?
Private

Investor

Lender
Government

Public-private partnership
Donor

agency
agency
Tools for analysis will vary
Private
investor-capital budgeting
Government/donor
agency- cost benefit analysis
CBA and Capital Budgeting

Cost-Benefit Analysis
Cost benefit analysis is a program/project
assessment method that quantifies in monetary
terms the value, net social benefits, of all
program /project consequences for all members of
the society

Capital Budgeting
Is the process of evaluating and selecting long-term
investments consistent with the firm’s goal of
owner wealth maximization
Major Steps in CBA









Specify the set of alternative projects
Decide whose benefits and costs counts(standing)
Catalogue the impacts and select measurement
indicators (units)
Predict the impacts quantitatively over the life of the
project
Monetize (attach dollar/taka values to) all impacts
Discount benefits and costs to obtain present values
Compute the NPV of each alternative
Perform sensitivity analysis
Make a recommendation based on the NPV and
sensitivity analysis
7
Capital Budgeting

Capital budgeting is primarily concerned with
sizeable investments in
long-term assets.



Different from recurring expenditure in two
aspects:



Tangible: property, plant or equipment
Intangible: R&D, Patents or trademarks
Projects are significantly large
Long-lived projects with their benefits or cash
flows spreading over many years.
Capital budgeting decisions have significant
impact on firm’s performance and they are
critical to the firms success or failure
Capital Budgeting



Capital budgeting is one of the most
significant financial activity of the
firm.
Capital budgeting determines the core
activities of the firm over a long term
future.
Capital budgeting decisions must be
made carefully and rationally.
Capital Budgeting Within the Firm
The Position of Capital Budgeting
Financial Goal of the Firm:
Wealth Maximisation
Investment Decison
Long Term Assets
Capital Budgeting
Short Term Assets
Financing Decision
Dividend Decision
Debt/Equity Mix
Dividend Payout Ratio
Examples of “Long Term Assets”
• Real Estates
• Aircrafts, Ships
• Forest
• Plant and Machineries
Aspects of Capital Budgeting
Capital Budgeting involves:
 Committing significant resources.
 Planning for the long term: 5 to 50
years.
 Decision making by senior management.
 Forecasting long term cash flows.
 Estimating long term discount rates.
 Analyzing risk.
Aspects of Capital Budgeting
Capital Budgeting:
• Emphasizes the firm’s goal of
wealth maximization, which is
expressed as maximizing an
investment’s Net Present Value
• Requires calculation of a project’s
relevant cash flows
Aspects of Capital Budgeting
Capital Budgeting Uses:
• Sophisticated forecasting techniques:-
• Time series analysis by the application of
simple and multiple regression, and moving
averages
•Qualitative forecasting by the application of
various techniques, such as the Delphi
method
Aspects of Capital Budgeting
Capital Budgeting requires:
Application of time value of money
formulae.
 Application of NPV analysis to forecasted
cash flows.
 Risk Analysis – Risk Adjusted Discount
Rate(RADR) and Certainty Equivalent
 Application of Sensitivity and Break Even
analyses to analyze risk.

Aspects of Capital Budgeting
•Application of Simulation and Monte Carlo
Analysis as extra risk analysis.
•Application of long term forecasting and risk
analysis to projects with very long lives.
•Application of optimization techniques to projects
which have constrained resources.
•Development and application of generic and
specific financial models
•Application of cash flow forecasting, and NPV
analysis to all aspects of property investment
projects.
•Application of NPV analysis under the additional
risks associated with international investments
Shareholder Wealth Maximization and NPV
• The shareholder wealth maximization goal
requires that management should endeavor to
maximize net present value (NPV) of expected
future cash flows to the shareholders of the
firm.
•NPV represents discounted sum of the
expected net cash flows.
•Cash outflows: capital outlays
•Cash inflows: proceeds from sales
• Net cash flows are determined by subtracting
a given period’s cash outflows from that
period’s cash inflows.
Shareholder Wealth Maximization and NPV
•The discount rate takes into account the timing
and risk of the future cash flows resulting from the
investment.
•The longer it takes to receive a cash flow, the
lower the present value to the investor.
•The greater the risk associated with receiving a
future cash flow, the lower the value investors
place on that cash flow.
•Shareholder wealth depends on magnitude,
timing and risk associated with the cash flows
expected to be received in future by the
shareholders
Class Exercise
Project Alpha requires an initial capital
outlay of Tk. 45,000 and will have net
cash inflows of Tk. 15,000, Tk. 20,000 and
Tk. 30,000 at the end of years 1,2, and 3
respectively. The discount rate is 8% per
annum.
 How much project Alpha will add to the
firm’s value?

19
Classification of Investment Projects



An independent project is one the acceptance
or rejection of which does not directly eliminate
other projects from consideration or affect
likelihood of their selection
Mutually exclusive projects- cannot be
pursued simultaneously-the acceptance of one
prevents the acceptance of the alternative
proposal
A contingent project is one the acceptance or
rejection of which is dependent on the decision to
accept or reject one or more other projects


Complementary projects, pharmacy and doctor’s clinic
Substitute projects, Thai or Chinese restaurant
20
The Capital Budgeting Process
Corporate goal
 Strategic planning
 Identification of investment opportunities
 Preliminary screening of projects
 Financial appraisal of projects
 Qualitative factors in project evaluation
 The accept/reject decision
 Project implementation and monitoring
 Post-implementation audit

21
The Capital Budgeting Process
`
Corporate goal
Strategic Planning
Investment opportunities
Preliminary Screening
Financial Appraisal
Qualitative factors, Judgments
Accept/Reject Decision on the project
Accept
Reject
Implementation
Monitoring
Post implementation audit
22
Why Cash Flows?

Cash flows, and not accounting
estimates, are used in project
analysis because:




They measure actual economic wealth.
They occur at identifiable time points.
They have identifiable directional flow:
inflow and outflow.
They are free of accounting definitional
problems.
23
The Meaning of RELEVANT Cash Flows.
A relevant cash flow is one which will
change as a direct result of the
decision about a project.
 A relevant cash flow is one which will
occur in the future. A cash flow
incurred in the past is irrelevant. It is
sunk.
 A relevant cash flow is the difference
in the firm’s cash flows with the
project, and without the project.

24
Cash Flows: A Rose by Any Other Name Is Just as
Sweet.
 Relevant
cash flows are also
known as: Marginal
cash flows.
 Incremental cash flows.
 Changing cash flows.
 Project cash flows.
25
Categories of Cash Flows

Project cash flows may be separated into
two categories:

Capital cash flows

The initial investment
 Outflows, purchasing assets and initial working capital


Additional middle-way investments such as upgrades
and increases in working capital investments
Terminal cash flows
 Inflows, proceeds from sale, salvage value of the asset net
of tax, recovery of remaining working capital
 Outflows, cost of asset disposal, environmental
rehabilitation, redundancy payment to employees

Operating cash flows: cash inflows from sales,
cash outflows for marketing and advertising,
payments for wages, utilities, raw materials
26
Essentials in Cash Flow Identification

Principle of the stand-alone project


Indirect of synergistic effects



Evaluation of the proposed project purely on its own
merits, in isolation from any other activities or the
projects of the firm
Negative effects, new model of car, lower sales of
existing model, must be deducted from future cash flows
Positive effects, pharmacy adjacent to doctor’s clinic,
favorable impact on clinics cash flows to be added to
pharmacy project’s cash flows
Opportunity cost principle: the most valuable
alternative that is given up if the proposed
investment project is undertaken

Use of existing resources, space, building, rental value,
market value
27
Essentials in Cash Flow Identification

Sunk cost, is an amount spent in the past in
relation to the project, but which cannot now be
recovered or offset by the current decision


Overhead costs



Past consulting expenses
Utilities, executive salaries
With or without the project, incremental costs to be
included
Treatment of working capital



Current assets (inventories, accounts receivables)
minus current liabilities (accounts, wages payable)
Increases in working capital is treated as cash outflows
even though there is no actual cash outflow, opportunity
cost
Capital flows, not operational flows, it is a fund
28
Essentials in Cash Flow Identification

After-tax cash flows


Must be accounted for as a cash outflow, not
based on net cash flow but on taxable income
Treatment of depreciation


Is not a cash flow
In project appraisal, what is relevant is not the
accounting depreciation but tax allowable
depreciation to measure the tax effect
Investment allowance, enhances NPV
 Financing flows, excluded. double
counting, included in the discount rate

29
Essentials in Cash Flow Identification

Within-year timing of cash flows




Occurs at various points of time in a year
Standard practice is to assume that capital expenditure
occur at the beginning of the year and all other cash
flows occur at the end of the year
Points in cash flow timing is are set at the end of each
year. An initial outlay of Tk. 50,000 at the start of year
1will be timed as occurring at the end of year zero.
Inflation and consistent treatment of cash flows
and discount rates



Nominal returns, incorporating the inflationary effect is
preferred over cash flow forecasts in real terms,
excluding the inflationary effects
Fisher effect
Consistency, cash flow in nominal terms- use nominal
discount rate; cash flow in real terms- use real discount
rate
30
Project Cash Flows: Yes and No.
 YES:-
these are relevant cash flows:
Incremental future sales revenue.
 Incremental initial outlay.
 Incremental future salvage value.
 Incremental working capital outlay.
 Incremental future taxes.
31
Project Cash Flows: Yes and No.

NO:- these are not relevant cash flows:
Changed future depreciation.
 Reallocated overhead costs.
 Adjusted future accounting profit.
 The cost of unused idle capacity.
 Outlays incurred in the past.

32
Cash Flows and Depreciation: Always a Problem.
Depreciation is NOT a cash flow.
 Depreciation is simply the accounting
amortization of an initial capital cost.
 Depreciation amounts are only
accounting journal entries.
 Depreciation is measured in project
analysis only because it reduces taxes.

33
Other Cash Flow Issues.
Tax payable: if the project changes
tax liabilities, those changed taxes are
a flow of the project.
 Investment allowance: if a taxing
authority offers this ‘extra
depreciation’ concession, then its tax
savings are included.
 Financing flows: interest paid on debt,
and dividends paid on equity, are NOT
cash flows of the project.

34
Other Cash Flow Issues.
 In property investment, ‘property’
cash flows may be distinguished from
‘equity’ cash flows.
 In project analysis, cash inflows are
timed as at the end of a year, and
capital outlays are timed as at the start
of a year.
 Forecast inflated cash flows must be
discounted at the nominal discount
rate, not the real discount rate.
35
Using Cash Flows
All relevant project cash flows are set out
in a table.

The cash flow table usually reads across in
End of Years, starting at EOY 0 (now) and
ending at the project’s last year.
 The cash flow table usually reads down in
cash flow elements, resulting in a Net
Annual Cash Flow. This flow will have a
positive or negative sign.

36
Delta Project Cash Flows










Project start date 2001
Capital outlay in year 1 is $ 1 million; year 3 is
$0.5 million
Economic life 8 years
Working capital Y0-2000; Y1-2500; Y2-3100; Y33600; Y4-4000; Y5-4300;Y6-4500; Y7-3000, Y80.
Salvage value in Y8: $16,000
Depreciation on initial investment is 12.5% p.a.
upgrade depreciates @$100,000 for years 4-8.
Sales forecasts
After tax salvage value
Accounting income
Workbook 2.1
37
Asset expansion project cash flows

Initial investment


Net operating cash flows




Initial investment in plants and working capital
Add back depreciation
Exclude depreciation from costs
Add tax shield of depreciation (tax rate x
depreciation)
Terminal cash flows

Proceeds from sale of assets minus taxes on
sale of an assets plus recovery of working
capital
38
Asset replacement project cash flows

Initial investment


Incremental operating cash flows


Initial investment in plants and working capital
minus proceeds from sale of old asset plus
taxes on sale of old assets
Operating cash flow of new assets minus
operating cash flow of old assets
Terminal cash flow

Proceeds from sale of new asset- proceeds
from sale of old asset - taxes on sale of old
assets- taxes on sale of an assets-taxes on
sale of old assets plus recovery of working
capital
39
Project Cash Flows: Summary
Only
future, incremental,
cash flows are Relevant.
Relevant Cash Flows are
entered into a yearly cash
flow table.
Net Annual Cash Flows are
discounted to give the
project’s Net Present Value.
40
Project Cash Flows: Summary
Overarching principles:

We only need to estimate cash flows
that change as a result of accepting
the project (incremental cash flows).

The amount of, and the timing of the
cash flow must be estimated, not the
accounting profit/loss by ordinary
accounting methods.
41
Project Cash Flows: Summary
There are generally three kinds of
cash flows that can be affected by
a capital budgeting project:
1) Initial period cash flow
2) Operating cash flow
3) Terminal year cash flow
42
Since taxes are cash flows,
we must include taxes in
our cash flow estimates.
All estimated cash flows
should be after-tax cash
flow estimates!
43
Cash flow type #1: Initial period cash flows



These are simply any cash flows that occur in
the initial period of the project’s life (period
0).
For example, assume that a new investment
project would require spending $20 million for
new capital machines, plus $3 million for
additions to working capital (increases in cash
balances, inventory, and accounts receivable).
The initial period cash flow = -$20 + -$3
= -$23 million.
44
Cash flow type #2: Operating cash flow

Accounting income for a period could be
a measure of cash flow, except that
depreciation (an expense, but not a
cash flow) was subtracted in calculating
it.

Operating cash flow equals
Net Income + Depreciation
45
Operating cash flow
Operating cash flow will be affected
whenever a revenue or expense is
changed on the income statement.
For example, operating cash flow is
increased/decreased if a project results
in increased/decreased sales revenues.
 Operating cash flow is
decreased/increased if a project results
in increased/decreased expense of
some kind.

46
Continuing with the example project:




Assume the business currently has sales of
$95 million and cash operating expenses of
$65 million, plus $15 million of depreciation
expense.
Assume the tax rate = 30%.
Net income = ($95 - $65 - $15) x (1 - .3)
= $10.5 million.
Operating cash flow = Net income +
depreciation = $10.5 + $15 = $25.5 million
per year.
47
Class exercise
Assume that accepting the new
investment project would increase the
business sales by $10 million, and
increase the operating costs by $4
million, plus increase depreciation
expense by $2 million. What is the
incremental operating cash flow for
the project?
48
Answer
Operating cash flow with the new
project = ($105 - $69 - $17) x (1.3) + $17 = $30.3 million.

The incremental operating cash flow
for the project equals the change in
cash flows from before accepting the
project to after accepting it = $30.3 $25.5 = $4.8 million per year.
(Assume these benefits continue the
same each year for 10 years.)
49
An alternative way
It is usually easiest to compute this
incremental cash flow by just using the
incremental numbers themselves. Thus,

The relevant incremental operating cash flow
for the example project =
+ Inc. in sales revenue ……… $10 million
- Inc. in op. costs (expenses) ….. 4 million
- Inc. in depreciation expense … 2 million
= Inc. in EBT …………………. 4 million
- Inc. in taxes (@ 30%) …..…... 1.2 million
= Inc. in EAT …………….…..
2.8 million
+ Inc. in depreciation expense … 2 million
= Inc. in operating cash flow ….. $ 4.8 million
50
Operating cash flow
Notice that this method of calculating the
incremental operating cash flow requires
you to simply identify every item in the
company’s income statement that changes,
and then to calculate the change in net
income that results. Finally, the operating
cash flow equals the change in net
income plus the change in
depreciation.
51
Cash flow type #3: Terminal year cash flows
These cash flows consist of any residual
values (salvage values) recovered from
the project at the end of its useful life.
 For our example, assume that at the
end of the
project’s life, the machines
could be sold to net $100,000 after
taxes, and that the working capital ($3
million) is recovered in full.
 Thus, the terminal year cash flow (year
10) for the project = $3.1 million.

52
Total cash flows
The complete cash flows for the
example project are:
Periods:
0
1-10
10
- $23
+ $ 4.8
+ $ 3.1
Assume that the cost of capital for
the project equals 10%, the NPV is
calculated to be $7.69 million.
53
What to do with the project?
Since the NPV > 0 we know the project is a good
one.

We could alternatively have made the decision
using the IRR method. IRR of the project can
be calculated to be 17%. Since this is > the
10% cost of capital, the project should be
accepted.

We could also have (alternatively) made the
decision using the PI method. PI = 1.33,
which is > 1.00.
54
Class Exercise 2
Consider another example:




Assume the Widget Company is considering an
investment to replace a production machine with
a more efficient one.
Assume the new machine costs $100,000, and
the old machine has a book value of $15,000 and
a current salvage value of $25,000.
Assume the tax rate is 30%.
What are the relevant cash flows for the project
analysis, and should the replacement be
accepted?
55
Initial period cash flows
First, determine the initial period
cash flows:



The $100,000 purchase price of the new machine
is an immediate cash outflow.
The $25,000 salvage value of the old asset would
be an immediate cash inflow.
Taxes on the gain from sale of the old asset is
also an immediate cash outflow.
Taxes = 30% x (SV-BV) = .3 x (25,000-15,000)
= $3,000.
56
Initial period cash flows
The total initial period (period 0)
incremental cash flows for the
replacement project are:

-$100,000 + $25,000 - $3,000 = $78,000.
57
Operating cash flows
Next, we calculate the operating
cash flows:




Assume the new machine would reduce
operating costs by $35,000 per year for the
next 8 years, compared to using the old
machine. Depreciation expense would also
increase by $12,500 per year for 8 years.
Net income will increase by ($35,000 12,500) x (1-.3) = $15,750.
Op. CF = Net Income + Depreciation =
$15,750 + $12,500 = $28,250 per year, for
8 years.
Note that this is an annuity of benefits.
58
Calculation of Taxes
Assume that both the old machine and
the new one would be fully depreciated
after 8 years.


With the new machine, sale in year 8 for
$5,000 => taxable gain on the sale equal to
the salvage value minus the book value =
($5,000 – 0) = $5,000. Tax on this gain =
$5,000 x .3 = $1,500.
With the old machine, sale in year 8 for $500
=> taxable gain on the sale equal to the
salvage value minus the book value = ($500
– 0) = $500.Tax on this gain = $500 x .3 =
$150.
59
Terminal year cash flows
Altogether, then, the total terminal
year cash flow equals
= incremental salvage value of $4,500 incremental taxes of $1,350
 = $4,500 - $1,350 = $3,150.
 This cash flow in year 8 is in addition
to the regular $28,250 operating cash
flow
of that year (already
computed).

60
Important:
While in general, any cash flow affected
by a project is relevant, we do not
include any cash flows that are
financing costs.
 For example, we do not include interest
expense or lease payments.
 The reason for this is that all financial
cash flows are implicitly included in the
cost of capital used to find NPV (or used
to compare to IRR). To include the
financial cash flows and then discount
them to PV would be to double count
their impact.

61