1.

ALL THE PROJECTS NEED TO BE APPRAISED, FROM TECHNICAL AND

FINANCIAL POINT VIEW. WHICH FEASIBILITY (TECHNICAL OR
FINANCIAL) IS MORE IMPORTANT FOR A FINANCIAL ANALYST SITTING
IN A BANK AND WHY?

And. FEASIBILITY MEANS:-Feasible means practical, possible or plausible.

Feasibility means able to be achieved within the given constraints. A feasible solution is a
solution, which is reasonable under the circumstances. There can be many feasible
solutions to any one problem.

FEASIBILITY ANALYSIS

The feasibility of a project can be ascertained in terms of technical factors, economic

factors, or both. A feasibility study is documented with a report showing all the
ramifications of the project. In project finance, the pre-financing work (sometimes
referred to as due diligence) is to make sure there is no "dry rot" in the project and to
identify project risks to ensure they can be mitigated and managed in addition to
ascertaining "debt service" capability.

o Technical Feasibility. Technical feasibility refers to the ability of the process to

take advantage of the current state of the technology in pursuing further
improvement. The technical capability of the personnel as well as the capability
of the available technology should be considered. Technology transfer between
geographical areas and cultures needs to be analyzed to understand productivity
loss (or gain) due to differences.
o Financial Feasibility. The ability to raise money to implement the project is of
paramount importance. The promoter should be capable of raising funds either
from his own sources or from banks and institutions. One area that often gets
overlooked is contingency planning. Financial feasibility should be distinguished
from economic feasibility. Financial feasibility involves the capability of the
project organization to raise the appropriate funds needed to implement the
proposed project. Project financing can be a major obstacle in large multi-party
projects because of the level of capital required. Loan availability, credit
worthiness, equity, and loan schedule are important aspects of financial feasibility
analysis.

FROM THE VIEW POINT OF FINANCIAL ANALYST FINANCIAL

FEASIBILITY IS MORE IMPORTANT THEN TECHNICAL FEASIBILITY: -

This involves an analysis of the cash flow profile of the project. The analysis should
consider rates of return, inflation, sources of capital, payback periods, breakeven point,
residual values, and sensitivity. This is a critical analysis since it determines whether or
not and when funds will be available to the project. The project cash flow profile helps to
support the economic and financial feasibility of the project.
A benefit-cost analysis and a breakeven analysis are important aspects of evaluating the
economic feasibility of new industrial projects.
Project must be financially viable BECAUSE: -

• The finances projects whose projected cash flow will be sufficient at all times to
service the loan and other debt.
• All key risks must be identified and the project should be robust to changes in key
assumptions for quantifiable risks such as foreign exchange and energy prices, as
shown by a Sensitivity Analysis. Alternatively, it should be possible to mitigate
risks, for example through a completion guarantee or manufacturer's warranty.
• Loans are provided to public or private creditworthy entities.
• For projects whose cash flow primarily relies on an off-take agreement, the
creditworthiness of the off-taker and validity and enforceability of the contract
will be ascertained.
• Tariffs must remain affordable or a social safety net will be set up to protect lower
income groups. The Affordability Ratio - the total heat bill/average household
income in city, region or country - varies between countries. For heat, it should
normally not exceed 8%.

This portion of the feasibility study provides an assessment of the impact of the proposed
project. The value added potential of the project should also be assessed. A value added
tax may be assessed based on the price of a product and the cost of the raw material used
in making the product. The tax so collected may be viewed as a contribution to
government offers.

Technical feasibility is also important because: - Project must be technically feasible,

make economic sense and be the least-cost solution.

Technology must be well proven, can be physically implemented, and is well adapted to
the region/country. The Financial Internal Rate of Return of the project - with savings
valued at current prices or future prices if these can be reasonably predicted - should be in
excess of 10% over the life of the project.

• The project should be the least-cost solution, which is the most cost-effective
option for the end-consumers based on a comparison of long-run costs at user
level for different, feasible and competitive heating sources. This analysis should
be part of the feasibility study which should also: Identify and evaluate project's
main components: location, volume, foreign and local cost.
• Calculate the expected savings from each component.
• Assess the duration of implementation of each component. Physical
implementation period should not be longer than four years for the entire project.
• Provide all inputs needed for the financial analysis: amortization and replacement
of assets, operating and maintenance costs, changes in company
structure/ownership, forecasted energy prices, etc.
The feasibility study should end with the overall outcome of the project analysis. This
may indicate an endorsement or disapproval of the project. Recommendations on what
should be done should be included in this section of the feasibility report.

2. ASSESS VARIOUS APPRAISAL CRITERIA FOR PROJECTS ON THE BASIS

OF CERTAIN THEORETICAL AND PRACTICAL CONSIDERATIONS.

Ans. As the project takes shape and studies near completion, the project is scheduled for
appraisal. Appraisal, perhaps the best known phase of project work (in part, because it is
the culmination of preparatory work), provides a comprehensive review of all aspects of
the project and lays the foundation for implementing the project and evaluating it when
completed.

APPRAISAL COVERS FOUR MAJOR ASPECTS OF THE PROJECT:

• TECHNICAL
• INSTITUTIONAL
• ECONOMIC
• FINANCIAL.

TECHNICAL APPRAISAL:-

Is concerned with questions of physical scale, layout, and location of facilities; what
technology is to be used, including types of equipment or processes and their
appropriateness to local conditions; what approach will be followed for the provision of
services; how realistic implementation schedules are; and what the likelihood is of
achieving expected levels of output. A critical part of technical appraisal is a review of
the cost estimates and the engineering or other data on which they are based to determine
whether they are accurate within an acceptable margin and whether allowances for
physical contingencies and expected price increases during implementation are adequate.

The technical appraisal also reviews proposed procurement arrangements. Procedures for
obtaining engineering, architectural, or other professional services are examined. In
addition, technical appraisal is concerned with estimating the costs of operating project
facilities and services and with the availability of necessary raw materials or other inputs.
The potential impact of the project on the human and physical environment is examined
to make sure that any adverse effects will be controlled or minimized.

INSTITUTIONAL:-

This means that the transfer of financial resources and the construction of physical
facilities, however valuable in their own right, are less important in the long run than the
creation of a sound and viable local "institution," interpreted in its broadest sense to cover
not only the borrowing entity itself, its organization, management, staffing, policies, and
procedures, but also the whole array of government policies that conditions the
environment in which the institution operates.

Experience indicates that insufficient attention to the institutional aspects of a project

leads to problems during its implementation and operation. Institutional appraisal is
concerned with a host of questions, such as whether the entity is properly organized and
its management adequate to do the job, whether local capabilities and initiative are being
used effectively, and whether policy or institutional changes are required outside the
entity to achieve project objectives.

These questions are important for traditional project entities; they are even more
important (and difficult to answer) for the entities charged with preparing and carrying
out the new-style projects intended to benefit the rural and urban poor, where there may
be no established institutional pattern to follow.

Of all the aspects of a project, institution building is perhaps the most difficult to come to
grips with. In part, this is because its success depends so much on an understanding of the
cultural environment. One has come to recognize the need for a continuing re-
examination of institutional arrangements, openness to new ideas, and a willingness to
adopt a long-term approach that may extend over several projects.

ECONOMIC:-

Through cost-benefit analysis of alternative project designs, the one that contributes most
to the development objectives of the country may be selected. This analysis is normally
done in successive stages during project preparation, but appraisal is the point at which
the final review and assessment are made.

During economic appraisal, the project is studied in its sectoral setting. The investment
program for the sector, the strengths and weaknesses of public and private sectoral
institutions, and key government policies are all examined.

In transportation, each appraisal considers the transportation system as a whole and its
contribution to the country's economic development. A highway appraisal examines the
relationship with competing modes of transport such as railways. Transport policies
throughout the sector are reviewed and changes recommended, for example, in any
regulatory practices that distort the allocation of traffic. Whenever the current state of the
art permits, projects are subjected to a detailed analysis of their costs and benefits to the
country, the result of which is usually expressed as an economic rate of return. This
analysis often requires the solution of difficult problems, such as how to determine the
physical consequences of the project and how to value them in terms of the development
objectives of the country.

The distribution of the benefits of a project and its fiscal impact are considered carefully,
and the use of "social" prices to give proper weight in the cost-benefit analysis to the
government's objectives of improved income distribution and increased public savings is
passing through an experimental phase. Since the estimates of future costs and benefits
are subject to substantial margins of error, an analysis is always made of the sensitivity of
the return on the project to variations in some of the key assumptions.

Some of the elements of project costs and benefits, such as pollution control, better health
or education, or manpower training, may defy quantification; in other projects, for
example electric power or telecommunications, it may be necessary to use proxies, such
as revenues, that do not fully measure the value of the service to the economy. In some
cases, it is possible to assess alternative solutions that have the same benefits and to select
the least-cost solution. In other cases, for example education, alternatives are likely to
involve different benefits as well as different costs, and a qualitative assessment must
suffice.

Whether qualitative or quantitative, the economic analysis always aims at assessing the
contribution of the project to the development objectives of the country; this remains the
basic criterion for project selection and appraisal.

FINANCIAL:-

Financial appraisal has several purposes. One is to ensure that there are sufficient funds
to cover the costs of implementing the project. Therefore, an important aspect of
appraisal is to ensure that there is a financing plan that will make funds available to
implement the project on schedule. When funds are to be provided by a government
known to have difficulty in raising local revenues, special arrangements may be
proposed, such as advance appropriations to a revolving fund or the earmarking of tax
proceeds.

For a revenue-producing enterprise, financial appraisal is also concerned with financial

viability. Will it be able to meet all its financial obligations, including debt service to the
Bank? Will it be able to generate enough funds from internal resources to earn a
reasonable rate of return on its assets and make a satisfactory contribution to its future
capital requirements? The finances of the enterprise are closely reviewed through
projections of the balance sheet, income statement, and cash flow. Where financial
accounts are inadequate, a new accounting system may be established with technical
assistance financed out of the loan. Additional safeguards of financial integrity may
include establishing suitable debt-to-equity ratios or limitations on additional long-term
borrowing.

Financial project appraisal and evaluation requires the following:

• Detailed statement giving the expected cash inflows and outflows to be assigned
to the investment those relevant cash flows.
• Assessment of the impact of taxation
• Discount rate to account for the time value of money
 • Add level rate to account for the risk associated with the investment that the risk
of use of project cash flows.

The techniques of project appraisal can be discussed under two heads:-

(i) Undiscounted and
(ii) Discounted.

A. NON DISCOUNTED CASH FLOW METHODS

1. Payback method (or Payback Period)

The payback period is the number of years required to return the original investment from
the net cash flows (net operating income after taxes plus depreciation).

Example
Assume the firm is considering two projects; project A and project B, each requires an
investment of $100 millions. The cost of capital is 10%. Below is the summary of
expected net cash flows in millions.

The payback from the two projects is

Project A: 2 and1/3 years

Project B: 4 years

If the firm has the policy of employing three years payback period, project A will be
accepted but project B will be rejected.

Decision Rule
• If payback > acceptable time limit, accept project
• If payback < acceptable time limit, reject project
Advantages of PB method.
• It is very easy to calculate, but it can lead to wrong decision
• Put more emphasis to quick return of the invested fund so that they may be put to use in
other places or in meeting other needs.
• Easy to apply (Simple to understand

Problems with the Payback Method

• Does not consider post-payback cash flows
• Does not consider time value of money
• Does not explicitly consider risk
• The "acceptable" time period is arbitrary

Example

In case two projects need initial outflow of $30m and have the following expected net
cash inflows

ARR is also known as accrual accounting rate of return unadjusted rate of return model
and the book value model.
Its compilations is related with
- Conventional accounting models of calculating income and required investment
- Shows the effect of an investment on project’s financial statement.

Advantages of using ARR

• It is simple to calculate using accounting data
• Earning of each year is included in the calculating the profitability of the project

Disadvantages of using ARR

• It is inconsistency with wealth maximization as the objective of the firm
• since it uses the accounting data it includes the amount of accruals in calculating the
earnings “net profit”.
• It is based on the familiar accrual accounting.
• It ignores the time value of money i.e. expected future dollars are erroneously regarded
as equal to present dollars.

B: DISCOUNTED CASH FLOW METHODS

1. Net Present Value Method (NPV)

It is the method of evaluating project that recognizes that the dollar received immediately
is preferable to a dollar received at some future date. It discounts the cash flow to take
into the account the time value of money.

This approach finds the present value of expected net cash flows of an investment,
discounted at cost of capital and subtract from it the initial cash outlay of the project.
In case the present value is positive, the project will be accepted; if negative, it should be
rejected. If the projects under consideration are mutually exclusive the one with the
highest net present value should be chosen.

Problems with NPV

• Difficult to explain to non-finance people

• Solution is in dollars, not percentage rates of return
Some value of R will cause the sum of the discounted receipts to the equal the initial cost
of the project, making the equation equal to zero, and that value R will be the project’s
internal rate of return.

From the above calculation, when rate is 15% the PV of investment A is zero, which
indicates that its internal rate of return is 15%. The IRR for project B is approximately to
20%.

IRR Decision Rules

Independent Projects: Accept all as long as the IRR hurdle rate
Mutually Exclusive Projects: Compute (IRR - hurdle rate) for each project, rank from
highest to lowest and accept the highest ranking project [assuming the computation (IRR
- hurdle rate) > 0]
IRR--Advantages/Disadvantages

1) Advantages

• Considers all cash flows

• Considers time value of money
• Comparable with hurdle rate

2) Disadvantages
• Does not show dollar improvement in value of firm if project is accepted
• IRR can be affected by the scale (size) of the project, i.e., Io
• Possible existence of multiple IRRs

Relationship between IRR and the NPV Profile

1) When the IRR = the firm's hurdle rate, NPV = 0

2) When the IRR < the firm's hurdle rate, NPV < 0
3) When the IRR > the firm's hurdle rate, NPV > 0

3. Profitability index
It is sometimes called Benefit Cost Ratio or present value index. It is calculated by taking
the present value of cash inflows divided by the present value of cash outflows. The
decision criteria is to accept project with a Profitability Index (PI) greater than one.

This ratio gives the return in the present terms per unit invested. Using this criterion,
projects will be ranked from the one with highest PI down to one with the lowest, and
then project would be selected in the order of ranking up to the point where the budget is
exhausted.

This criterion is simple but suffers from two basic limitations.

It cannot be used to except in cases where there is only a single constraint. In case where
the capital is rationed in more that one period or where the capital is not the only
constraint, the criteria will not provide the best solution.
It looks projects individually and does not take into account the overall portfolio where
correlation of projects’ returns is important

3. CAN NPV AND IRR AS METHODS OF PROJECT APPRAISAL GIVE

CONTRADICTORY RESULTS? YES OR NO AND WHY? ALSO EXPLAIN
HOW YOU PROPOSE TO RESOLVE SUCH CONTRADICTION.

ANS.

YES , NPV and IRR give contradictory results. An accept/reject "conflict" occurs when
NPV says "accept" and IRR says "reject" or NPV says "reject" and IRR says "accept"

NPV and IRR Methods: Possible Decision Conflicts

• When projects are independent, no accept/reject conflict will arise

• A ranking conflict occurs when one project has a higher NPV than another while
the lower NPV project has a higher IRR.
• Ranking conflicts are unusual but can occur. These conflicts are relevant only
when there are multiple acceptable mutually exclusive projects

For example:-

Required: i) estimate the net present value (NPV) of the Project `P' and `J' using 15 per
cent as the hurdle rate; ii) estimate the internal rate of return (IRR) of the Project `P' and
`J'; Initial investment 40,000 and 20,000 respectively.

Answer: The statement of NPV and the IRR of Project P are shown in Tables 1 and 2
respectively.

NPV OF PROJECT “P” AND “J”

project P project J
year cash discoun PV year cash discoun PV
t (Rs) t (Rs)
interest interest
at 15% at 15%
1. 1300 0.8690 11305 1. 7000 0.8690 6087
0
2. 8000 0.7561 6048 2. 1300 0.7561 9829
0
3. 1400 0.6575 9235 3. 1200 0.6575 7890
0 0
4. 1200 0.5718 6882
0
5. 1100 0.4972 5483
0
 6. 1500 0.4325 6484
0
TOTAL TOTAL
less 7300 4,537 less 3200 23,806
Investment 0 4 Investment 0 20,000
40,00
0
NPV 5374 NPV 3806

IRR of Project “P” lies between 18 per cent and 20 per cent in table 2.0. Actual IRR
can be ascertained by way of interpolation as follows:

Table 2.0

year cash discoun PV year cash discoun PV

project P t factor (Rs) project J t factor (Rs)
at 18% at 20%
1. 1300 0.8475 11018 1. 13000 0.8333 10833
0
2. 8000 0.7182 5745 2. 8000 0.8944 5555
3. 1400 0.5086 8620 3. 14000 0.5787 8102
0
4. 1200 0.5158 6190 4. 12000 0.4823 5788
0
5. 1100 0.4371 4809 5. 11000 0.4319 4421
0
6. 1500 0.3709 5556 6. 15000 0.3349 5023
0
TOTAL TOTAL
less 7300 4,183 less 73000 39722
Investment 0 8 Investment 40,000
40,00
0
NPV 1838 NPV - 278

18 + (41,838 - 40,000 / 41,838 - 39,722) x 2 = 18 + 1.74 = 19.74 per cent

The IRR of Project J is given in Table 3.0

project P project J
year cash discoun PV year cash discoun PV
t factor (Rs) t factor (Rs)
 at 24% at 26%
1. 7000 0.8066 5846 1. 7000 0.7687 5556
2. 1300 0.6504 8455 2. 1300 0.6899 8189
0 0
3. 1200 0.5245 6291 3. 1200 0.4999 5899
0 0
TOTAL TOTAL 19744
less 3200 20039 less 3200
Investment 0 5 Investment 0 20,000
20000
NPV 395 NPV - 266

IRR of Project J lies between 24 per cent and 26 per cent. Actual IRR can be
ascertained by way of interpolation as follows:

24 + (20,395 - 20,000 / 20,395 - 19,744) x 2 = 24 + 1.21 = 25.21 per cent

Conflict: These two methods may often give contradictory results in case of alternative
proposals that are mutually exclusive

NPV METHOD IRR METHOD

PROJECT “P” NPV Rs 5374 I RANK IRR 19.74% II RANK
PROJECT “J” NPV Rs 3806 II RANK IRR 25.21% I RANK

Reason: The IRR method assumes that funds are invested at the internal rate of return
over the balance life of the proposal whereas the NPV method assumes that investment
rate is equal to the cost of capital which is the minimum required rate for a company.
Because of the above different assumptions, the results of both the methods are
contradictory.

In addition, the IRR method favours short-lived project such as Project J in this
case, whereas the NPV method favours long-life projects (that is, Project P).

Ranking conflicts arise because of:

1) Timing differences in incremental cash flows
2) Magnitude differences in incremental cash flows
3) When a conflict arises among mutually exclusive projects, pick the one with the
highest NPV
. In case of unequal lives of projects, the choice can be made by comparing their
annual equivalent value (AEV) as follows:

Formula: AEV = NPV / Annuity factor (addition of all the annuity factors)

Project P: 5374 / 3.7845 = Rs 1,420

Project J: 3806 / 2.2832 = Rs 1,667

Higher AEV is better. Project J should be selected.