Project Formulation & Appraisal

Capital Budgeting

Project Formulation & Appraisal

 Capital Budget
Capital budget is the budget of capital expenditures.
Capital Expenditures are those expenditures whose
benefit spread in number of years e.g., purchase of
Plant and Machinery , Land and building and starting a
new factory plant etc.

Project Formulation & Appraisal

 CAPITAL BUDGETING
Capital budgeting: is the planning process for allocating
all expenditures that will have an expected benefit to the
firm for more than one year.

Project Formulation & Appraisal

 Investment Appraisal
Firms normally place projects in the following categories:
 Replacement and maintenance of old or damaged
equipment.
 Investments to upgrade or replace existing equipment
 Marketing investments to expand product lines or
distribution facilities.
 Investments for complying with government

Project Formulation & Appraisal

 OVERALL AIM
To maximise shareholders wealth..
Projects should give a return over and above the marginal
weighted average cost of capital.

Projects can be;

Mutually exclusive
Independent

Project Formulation & Appraisal

 IDEAL SELECTION METHOD
 Select the project that maximises shareholders wealth

 Consider all cash flows

 Discount the cash flows at the appropriate market

determined opportunity cost of capital

Project Formulation & Appraisal

 Need for Investment Appraisal
 Large amount of resources are involved and wrong
decisions could be costly
 Difficult and expensive to reverse
 Investment decisions can have a direct impact on the
ability of the organisation to meet its objectives

Project Formulation & Appraisal

 Investment Appraisal Process
Stages:
 identify objectives. What is it? Within the corporate
objectives?
 Identify alternatives.

 Collect and analyse data. Examine the technical and

economic feasibility of the project, cash flows etc.

Project Formulation & Appraisal

 Investment Appraisal Process
Stages:
 decide which one to undertake

 authorisation and implementation

 review and monitor: learn from its experience and try to

improve future decision - making

Project Formulation & Appraisal

 The following are the difficulty involved in capital
expenditure decisions:
o Measurement problems

o Uncertainty

o Temporal spread

Project Formulation & Appraisal

 Capital budgeting is a complex process which may be
divided into five phases:

Planning

Analysis

Selection

Implementation

Review

Project Formulation & Appraisal

 Planning
 Articulation of firms broad investment strategy
 Type of investment
 Identification of individual project opportunities
 Generation and screening of project proposals
 Prima facie worthwhile to justify feasibility study
 What aspects of project are critical to study

Project Formulation & Appraisal

 Analysis
 A detailed analysis of the marketing, technical,
financial, economical, and ecological aspects
 Focuses on gathering, preparing and summarizing
relevant information
 The stream of cost and benefits can be defined

Project Formulation & Appraisal

 Selection
 Is the project worthwhile?
 Wide range of appraisal criteria is used to judge the
worthiness of a project
 Such criteria are divided into non-discounting and
discounting technique

Project Formulation & Appraisal

 Selection Criteria
Criterion Accept

Payback Period (PBP) PBP < Target Period

Accounting Rate of Return (ARR) ARR > Target Rate

Net Present Value (NPV) NPV > 0

Internal Rate of Return (IRR) IRR > Cost of Capital

Benefit Cost Ratio (BCR) BCR > 1

Project Formulation & Appraisal

 Implementation
 Refers to conversion of blue print into reality
 In case of industrial project, implementation involves setting of
manufacturing facilities
 Project and engineering design
 Negotiations and contracting
 Construction
 Training
 Plant commissioning (starting up the plant)
 Translating an investment proposal into a concrete project is a
complex, time-consuming and risky task
 For expeditious implementation at a reasonable cost, the
following are helpful:
 Adequate formulation of Project
 Use of the principles of Responsibility Accounting
 Use of Network Techniques

Project Formulation & Appraisal

 Review
 Performance review should be done periodically to compare
actual performance with the projected performance
 Feedback device is useful in in several way:
 How realistic were the assumptions
 Provides a documented log of experience that is highly valuable in
future decision making
 Suggests corrective action to be taken in the light of actual
performance
 Helps in uncovering judgemental biases
 Induces a desired caution among project sponsors

Project Formulation & Appraisal

 Capital Budgeting - Methods

1. Accounting Rate of return

2. Payback

3. Net Present Value

4. Internal Rate of Return

Project Formulation & Appraisal

 Petroleum Project Economics

Petroleum Project Appraisal and Screening

19
Project Formulation & Appraisal
 Accounting Rate of Return (ARR)

Accounting Rate of Return method relates average annual profit to either the amount
initially invested or the average investment, as a percentage.
Formulae:
ARR = Average annual accounting profit x 100
Average investment
Where:
 Average annual profit = Total profit/Number of years
 Average investment = (initial capital investment + scrap value) / 2

Project Formulation & Appraisal

 Accounting Rate of Return (ARR)

ARR = Avg. Net Income Per Year

X 100
Avg. Investment

Project Formulation & Appraisal

 Payback
 This measures the length of time required for
the net cash flows generated during production
to cover the cash outflows during exploration
and development.
 This occurs where the cumulative cash flow is
zero.
 The option with the shortest payback is most
preferred.

Project Formulation & Appraisal 22

 Discounted Cash Flow

Discounted cash flows refers to the conversion of

estimated future cash flows to present values

using an interest rate known as “Discount rate”

Project Formulation & Appraisal 23

 Net Present Value

 Uses the present value factors from: 1/(1+r)n

 The sum of all discounted cash flows at a given
interest rate

 The investment with the highest present worth is

selected

Project Formulation & Appraisal 24

 Net Present Value
n CFt
NPV  
t  0 1  d 
Formula: t

Where:
CFt = Cash Flow of a period “t”
dt = Discount rate for period “t”
n = Last period of economic horizon

Investment Decision:
NPV > 0 Project accepted
NPV < 0 Project rejected

Project Formulation & Appraisal 25

 Internal Rate of Return

 Discount rate which gives a net present value of zero.

 Manually calculate via a trial and error approach.

 Software to calculate such as Microsoft excel.

Project Formulation & Appraisal 26

 Internal Rate of Return
Manual calculation steps

1. Use an interest rate which gives a slightly positive

present worth

2. Use an interest rate which gives a slightly negative

present worth

3. Apply rate of return formula

Project Formulation & Appraisal 27

 Discount rate and Net Present Value

Net
Present
Value

PW+ve

0
IR+ve IR-ve Discount
Rate
PW-ve

Internal Rate of
Return

Project Formulation & Appraisal 28

 Internal Rate of Return

 IRve  IRve PW ve 

Internal Rate of return  IRve   
 PW  ve  PW  ve 

IR+ve = Interest rate with positive present worth

IR-ve = Interest rate with negative present worth
PW+ve = Positive present worth
PW-ve = Negative present worth

Project Formulation & Appraisal 29

 Calculations

 Using the information in the following slide, calculate

total cash inflow and total cash outflow.

 Using the cash flows determine: Payback, NPV and

IRR.

Project Formulation & Appraisal 30

 Oil Price
No. Year Oil Production MMbbls Total Capex $m Total Opex $m
($/BBL)
1 2014 0 15 -30 0
2 2015 0 19.2 -22 0
3 2016 0 16 -112 0
4 2017 0 19.6 -110 0
5 2018 0 24.5 -77 0
6 2019 2 21.5 -10 -1.4
7 2020 4 20.6 -7 -2.8
8 2021 12 18.5 -4 -8.4
9 2022 15 17.2 0 -19.6
10 2023 14 18.4 0 -15.7
11 2024 14 22.2 0 -13.3
12 2025 12 20.6 0 -11.3
13 2026 10 14.4 0 -9.6
14 2027 8 19.3 0 -8.2
15 2028 5 30.3 0 -7
16 2029 6 25.9 0 -5.8
17 2030 8 26.1 0 -4.8
18 2031 6 31.1 0 -2.7
19 2032 5 41.4 0 -1.3
20 2033 1 56.5 0 0
Project Formulation & Appraisal 31
 Further Reading
 Projects: Planning, Analysis, Financing, Implementation
& Review – Dr. Prasanna Chandra, Tata McGraw Hill
 Practical Techniques of Effective Project investment
Appraisal: Tiffin – Viva Books 2007
 Project Finance – Appraisal & Followup: Sarda – ADB
Publishers 2007
 Project Reports & Appraisal: Pahwa – Bharat Law 2007

Project Formulation & Appraisal