Assignment for PGPM 21

1.

INTRODUCTION Project Formulation and Appraisal play a critical role in entrepreneurship development and enterprise creation. Most rejections and failures of project proposals are due to improper business planning. Varying appraisal methods and project formats (varying from bank to bank and financial institution to financial institution) compound the complexity. Formulating viable project reports for small, micro, village and cottage industry is a fine art requiring skills different from what is needed in case of large and medium enterprises. Though a good project report is the heart of entrepreneurship, potential entrepreneurs lack formulating skills and their trainerpromoters, knowledge of training/consulting methods. Even experienced trainers/consultants are often unclear on the treatment required for different projects: industry, service or business. Project Analysis is done to Estimate, Compare, and Rank the project net benefits among different alternatives with budget constraints. Project appraisal is a generic term that refers to the process of assessing, in a structured way, the case for proceeding with a project or proposal. In short, project appraisal is the effort of calculating a project's viability. It often involves comparing various options, using economic appraisal or some other decision analysis technique. The economic and financial appraisals (ex-anti evaluation) are considered to be the most important tools for helping decision maker to choose or select.

2.

WHAT IS A PROJECT? "A project is a group of activities which can be planned, financed (funded), implemented, and analyzed as a unit". In project management, a project consists of a temporary endeavor undertaken to create a unique product, service or result. Another definition is a management environment that is created for the purpose of delivering one or more business products according to a specified business case. Project objectives define target status at the end of the project, reaching of which is considered necessary for the achievement of planned benefits. They can be formulated as SMART criteria: Specific, Measurable (or at least evaluable) achievement, Achievable (recently Agreed-to or Acceptable are used regularly as

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well), Realistic (given the current state of organizational resources) and Time terminated (bounded). The evaluation (measurement) occurs at the project closure. However a continuous guard on the project progress should be kept by monitoring and evaluating. It is also worth noting that SMART is best applied for incremental type innovation projects. For radical type projects it does not apply as well. Goals for such projects tend to be broad, qualitative, stretch/unrealistic and success driven.

The project in general includes the following factors (a) (b) (c) Outflows Also known as; inputs, resources, costs or investments Inflows Also known as: output, production, benefits or revenues. Life span of the project The time or the life of the project. It is a specific activity(ies) with a specific starting point and specific ending point intended to accomplish a specific objective(s). A space A geographical location or a place with a boundary forming the project space The management The administrative structure, the individuals (coop., corp., entities) and the participants.

(d) (e)

It is better to keep the project close to the minimum size that is economically, technically, and administratively feasible 3. THE PROJECT CYCLE The project cycle comprises of (i) Project Identification, (ii) Project Preparation or Formulation (feasibility studies), (iii) Project Appraisal (Ex-ante Evaluation), (iv) Project Implementation, and (v) Project Evaluation (Ex-post Evaluation). (i) Project Identification

Any project starts with an idea, which leads the identification of the relationship between the idea and the sector plan, then with the national plan as a whole which also includes the identification of the opportunity cost of the alternative investments

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(ii)

Project Preparation or Formulation (feasibility studies)

This stage includes the different feasibility studies such as: (a) Technical feasibility (b) Commercial feasibility (marketing study) (c) Financial feasibility (d) Economic feasibility, and etc. This stage ends with a project report (iii) Project Appraisal (Ex-ante Evaluation)

It includes economic, financial, and social evaluation for the project before its implementation to have enough understanding whether the project is feasible or not. (iv) Project Implementation

This stage includes observing the project scheduling, supervising, and control the different stages. Also to record what has happened in each stage of the project implementation (project reporting, or sometime known as follow up reports). (v) Project Evaluation (Ex-post Evaluation)

It includes the financial, economic, and social evaluation after the project is implemented. The difference between Stages 3 and 5 (even the used measures are the same) is that: in stage 3 (the Appraisal stage) is estimated but stage 4 is what actually happened (The Evaluation Stage).

4.

ASSESSMENT AND APPRAISAL OF A PROJECT The following are the common steps for the Assessment and Appraisal of any project Identify the project costs and benefits Quantify the project costs and benefits Conduct a cost-benefit analysis Assess the economic and financial feasibility of the project by estimating the various profitability indicators of the project

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Conduct sensitivity analysis scenarios, whenever needed. Accept or reject a project or a set of project according to a set of choice criteria

The two techniques for the assessment and appraisal of the projects are (i) NonDiscounted Technique and (ii) Discounted Technique. (i) Non-Discounted Technique

Non-discounted technique of Capital Budgeting refers to the technique or method of investment decision where it is considered that there is no change in the price level between the initial investment made and the date of last return from the investment. Under this technique, the future value of money is considered at the current value. The non-discounted techniques are as follows:(a) Pay Back Period (PBP) Method

Pay Back Period refers to the period (generally number of years) of an investment project proposal at which the firm expects to recover its initial investment to the project proposal. Alternatively the PBP is the period at which the total cash inflow from a project equals to the initial investment (i.e. cash outflows) made to the project. Computation of PBP (i) When the Cash Inflows After Tax (CFAT) are constant every year PBP = Initial Investment / Constant CFAT per annum (ii) When CFAT are not constant every year, the following steps are to be followed : Step 1:- Calculate the CFAT of each year Step 2:- Compute the cumulative CFAT Step 3:- The time (i.e. year) when the cumulative CFAT becomes equal to the initial investment would be the PBP or else, use the method of interpolation. Under this method, the project having the shortest PBP should be undertaken

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(b)

Pay Back Profitability Method

Pay Back Profitability is the amount of cash flows earned from a project after its Pay Back Period. Alternatively, it is the excess of cash inflows from a project over the initial investment into the project. It represents the net cash inflows from the project proposal. Computation of Pay Back Profitability (i) When (CFAT) are constant every year Pay Back Profitability = (Expected life of the project PBP) x CFAT (ii) When CFAT are not constant every year Pay Back Profitability = Total CFAT Initial Investment (c) Average Rate of Return (ARR) Method ARR is the method of investment appraisal which determines return on investment by totaling the cash flows (over the years for which the money was invested) and dividing that amount by the number of years. The average rate of return does not assure that the cash inflows are the same in a given year; it simply guarantees that the return averages out to the average rate of return.

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This method is based on accounting information rather than cash flows. There are various ways of calculating Average Rate of Return. It can be

ARR =

Average annual Profit after Tax x 100 Average Investment

Average Annual Profit =

Total of after Tax Profit of all the year x 100 No. of years

Average Investment =

Original Investment + Salvage Value 2

Average Investment =

Original Investment - Salvage Value 2

+ Salvage Value

calculated as:-

If working Capital is also required in the initial year of the project, the average investment will be= Net working Capital + Salvage value + (initial cost of Machine- Salvage Value). In another method instead of average investment original cost is used. In this method, to evaluate the project all those projects are accepted on which average rate of return is more than the predetermined rate. Thus, the

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project is given more significant on which the average rate of return is the highest. Acceptance Rule Accept if ARR > minimum rate. Merits 1) 2) Easy to understand. Necessary information to calculate average rate of return are available easy. This method takes into account all the profits during the life time of the project, whereas pay back period ignores the profits accruing after the pay back period. 3) 4) 5) Give more weightage to future receipts. Easy to understand and calculate. Uses accounting data with which executives are familiar.

Demerits 1) 2) 3) 4) 5) Ignore the time value of money. Does not use cash flow. No objective way to determine the minimum acceptable rate of return. This method does not account for the profits arising on sale of profit on old machinery on replacement. ARR method does not consider the size of investment for each project. It may be time that the competing ARR of two projects may be the same but they may require different average investments. It becomes difficult for the management to decide which project should be implemented. (ii) Discounted Technique

Discounted Technique is a method of investment analysis in which anticipated future cash income from the investment is estimated and converted into a rate of return on initial investment based on the time value of money. In addition, when a required rate of return is specified, a net present value of the investment can be estimated.

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The discounted techniques are as follows:(a) Discounted Pay Back Period (PBP) Method The discounted payback period is the amount of time that it takes to cover the cost of a project, by adding positive discounted cash flowcoming from the profits of the project. In investment decisions, the number of years it takes for an investment to recover its initial cost after accounting for inflation, interest, and other matters affected by the time value of money, in order to be worthwhile to the investor. It differs slightly from the payback period rule, which only accounts for cash flows resulting from an investment and does not take into account the time value of money. Each investor determines his/her own discounted payback period rule and, as such, it is a highly subjective rule. In general, however, short-term investors use a short number of years, or even months, for their discounted payback period rules, while long-term investors measure their rules in years or even decades. (b) Profitability Index (PI) Method Profitability Index (PI) is the ratio of the Present Value (PV) of the total cash inflows from a project and the PV of the total cash outflows for the project. PI is also called the benefit-cost ratio. PI = PV of total cash inflows PV of total cash outflows If PI is less than 1, accept the project proposal, If PI is greater than 1, reject the project proposal If PI is equal to 1, the management may be indifferent in accepting or rejecting the project proposal. Generally the project proposal is rejected in such a case as the firm does not get the net benefit from it. (c) Net Present Value (NPV) Method

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Net Present Value (NPV) is the difference between the PV of the total cash inflows from a project and the PV of the total cash outflows for the project. NPV = Total of PV of cash Inflows - Total of PV of cash outflows (i.e., the total of discounted cash inflows - the total of discounted cash outflows Following steps are to be followed for determining the NPV: Step 1: Calculate the CFAT of each year Step 2: Multiply the CFAT of each year by the respective PV factor and get the discounted CFAT or PV of CFAT. Step 3: Compute the cumulative discounted CFAT Step 4: Compute the PV of cash outflows. Step 5: Calculate the NPV by deducting the PV of the total cash outflows from the PV of the total cash inflows. Decision-Making Criterion i. ii. In case of a single project proposal, accept it if NPV > 0; else In case of two mutually exclusive project proposals, accept the reject it. project having the higher NPV. (d) Internal Rate of Return (IRR) Method Internal Rate of Return (IRR) is the rate of return which equates the PV of the total cash inflows with the PV of the total cash outflows. Therefore, IRR is the rate of return (i.e. the discounting factor) which makes the NPV zero. At the IRR, PV of total cash inflows = PV of total cash outflows Hence, PI = 1.

Decision-Making Criterion iii. In case of a single project proposal, accept it if the IRR exceeds the cost of capital.

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Assignment for PGPM 21

iv.

In case of two mutually exclusive project proposals, accept the

project having the higher IRR. ASSUMING THE FOLLOWING HYPOTHETICAL WATER RESERVOIR PROJECT A water reservoir project to irrigate agricultural land that used to be in rain fed was designed. The estimated costs and benefits of the project in millions of US $ are displayed in Table 1. The task is to calculate the project NPV, BCR at 10% Discounted rate. In addition, we need to determine the project IRR. Table 1: The annual estimated costs and benefits for the project Year 1 2 3 4 5 6 7 8 9 10 Total Investment ($) 15.00 10.00 10.00 0.00 0.00 12.00 0.00 0.00 0.00 0.00 47.00 O&M ($) 2.00 2.50 3.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 42.50 Total Cost ($) 17.00 12.50 13.00 5.00 5.00 17.00 5.00 5.00 5.00 5.00 89.50 Benefits ($) 5.00 8.00 11.00 15.00 15.00 10.00 15.00 15.00 15.00 15.00 124.00

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Solution :Table 2: The Project NPC and BCR as 10% Discount Rate
Year Investment ($) 1 2 3 4 5 6 7 8 9 10 Tot al 15.00 10.00 10.00 0.00 0.00 12.00 0.00 0.00 0.00 0.00 47.00 O&M ($) 2.00 2.50 3.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 42.50 Total Cost ($) 17.00 12.50 13.00 5.00 5.00 17.00 5.00 5.00 5.00 5.00 89.5 Benefits ($) 5.00 8.00 11.00 15.00 15.00 10.00 15.00 15.00 15.00 15.00 124.00 DF 10% 0.909091 0.826446 0.751315 0.683013 0.620921 0.564474 0.513158 0.466507 0.424098 0.385543 D Cost ($) 15.45 10.33 9.77 3.42 3.1 9.6 2.57 2.33 2.12 1.93 60.62 D Benefit ($) 4.55 6.61 8.26 10.25 9.31 5.64 7.70 7.00 6.36 5.78 71.46 NPV ($) 10.9 0 -3.72 -1.51 6.83 6.21 -3.96 5.13 4.67 4.24 3.85 10.8 4

Benefit Cost Ratio = 71.46 / 60.62 = 1.179 NPV = 10.84

Table 3: The Project NPC and BCR as 20% Discount Rate

Year Investment ($) 1 2 3 4 5 6 7 8 9 10 Tot al O&M ($) Total Cost ($) Benefits ($) DF 20% D Cost ($) 14.17 8.68 7.52 2.41 2.01 5.69 1.40 1.16 0.97 0.81 44.82 D Benefit ($) 4.17 5.56 6.37 7.23 6.03 3.35 4.19 3.49 2.91 2.42 45.72 NPV ($) 10.0 0 -3.12 -1.15 4.82 4.02 -2.34 2.79 2.33 1.94 1.61 0.90

15.00 10.00 10.00 0.00 0.00 12.00 0.00 0.00 0.00 0.00 47.00

2.00 2.50 3.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 42.50

17.00 12.50 13.00 5.00 5.00 17.00 5.00 5.00 5.00 5.00 89.5

5.00 8.00 11.00 15.00 15.00 10.00 15.00 15.00 15.00 15.00 124.00

0.833333 0.694444 0.578704 0.482253 0.401878 0.334898 0.279082 0.232568 0.193807 0.161506

Benefit Cost Ratio = 45.72 / 44.82 = 1.020 NPV = 0.90

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Table 4: The Project NPC and BCR as 30% Discount Rate

Year Investment ($) 15.00 10.00 10.00 0.00 0.00 12.00 0.00 0.00 0.00 0.00 47.00 O&M ($) 2.00 2.50 3.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 42.50 Total Cost ($) 17.00 12.50 13.00 5.00 5.00 17.00 5.00 5.00 5.00 5.00 89.5 Benefits ($) 5.00 8.00 11.00 15.00 15.00 10.00 15.00 15.00 15.00 15.00 124.00 DF 30% 0.769231 0.591716 0.455166 0.350128 0.269329 0.207176 0.159366 0.122589 0.094300 0.072538 D Cost ($) 13.08 7.4 5.92 1.75 1.35 3.52 0.8 0.61 0.47 0.36 35.26 D Benefit ($) 3.85 4.73 5.01 5.25 4.04 2.07 2.39 1.84 1.41 1.09 31.68 NPV ($) -9.23 -2.67 -0.91 3.50 2.69 -1.45 1.59 1.23 0.94 0.73 3.58

1 2 3 4 5 6 7 8 9 10 Tot al

Benefit Cost Ratio = 31.68 / 35.26 = 0.8985 NPV = -3.58

Table 5: INTERNAL RATE OF RETURN

Year Investment ($) 15.00 10.00 10.00 0.00 0.00 12.00 0.00 0.00 0.00 0.00 47.00 O&M ($) 2.00 2.50 3.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 42.50 Total Cost ($) 17.00 12.50 13.00 5.00 5.00 17.00 5.00 5.00 5.00 5.00 89.5 Benefits ($) 5.00 8.00 11.00 15.00 15.00 10.00 15.00 15.00 15.00 15.00 124.00 DF 21.40% 0.823723 0.67852 0.558913 0.460389 0.379233 0.312383 0.257317 0.211958 0.174595 0.143818 D Cost ($) 14 8.48 7.27 2.3 1.9 5.31 1.29 1.06 0.87 0.72 43.20 D Benefit ($) 4.12 5.43 6.15 6.91 5.69 3.12 3.86 3.18 2.62 2.16 43.24 NPV ($) -9.88 -3.05 -1.12 4.61 3.79 -2.19 2.57 2.12 1.75 1.44 0.04

1 2 3 4 5 6 7 8 9 10 Tot al

Benefit Cost Ratio = 43.24 / 43.20 = 1.0009 NPV = 0.04

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Assignment for PGPM 21

INCREASING THE DIMENSIONS OF PROJECTS FEASIBILITY AND APPRAISAL The following issues are becoming increasingly crucial factors in assessing and determining the feasibility of a project or a set of projects 1. The environmental impact of the project 2. The interdependencies among projects 3. Fund limitations (Capital Constraint)

From scenic beauty and recreational opportunities to direct inputs into the production process, environmental resources provide a complex set of values to individuals and benefits to society. Coastal areas, for example, offer scenic panoramas and radiant sunsets. Fish and other edible sea life caught in coastal areas provide a rich and nutritious source of food to consumers. Beaches are also excellent recreation areas, used for relaxation, exercise, or bird watching. These are only the direct benefits. There are also values that are not directly tied to use, such as climate modulation, physical protection, and stewardship for future generations. All of these benefits are relevant in environmental valuation. Environmental Values Use values, such as fishing and hiking, are the more direct and quantifiable category of environmental values, but they capture only a portion of the total economic value of an environmental asset. Indirect-use values, non-use values, and intrinsic values are also associated with preserving environmental resources. Total economic value is represented by the following equation: Total economic value = direct-use value + indirect-use value + non-use value + intrinsic value Indirect-use values associated with coastal areas include biological support, physical protection, climate modulation, and global life support. Non-use values are less direct, less tangible benefits to society and include option and existence values. The option value is the value an individual places on the potential future use of the resource, for example, benefits a beach would offer during future trips to the coastal area. Existence values

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include bequest, stewardship, and benevolence motives. Bequest value is the satisfaction gained through the ability to endow a natural resource on future generations. The stewardship motive is derived from an altruistic sense of responsibility toward the preservation of the environment and a desire to reduce environmental degradation. The benevolence motive reflects the desire to conserve an environmental resource for potential use by others. Finally, the intrinsic value of nature reflects the belief that all living organisms are valuable regardless of the monetary value placed on them by society. It is important to note that there are certain environmental assets that are absolutely essential to the support of animal life, and that the total value of these assets is not definable. Marginal changes, however, in the productivity and security of even irreplaceable environmental assets (e.g., the degradation of part of a large ecosystem or environmental resources essential to human life) can be captured in terms of total economic value. For example, the total economic value of air and water quality are immeasurably large because extreme degradation of either would result in irreversible and catastrophic damage to the capacity of this planet to support human and other life. However, we can observe the finite value that society places on small losses of even those assets that are absolutely essential for sustaining life. For instance, society has proven willing to accept some degradation of air quality to improve the efficiency and convenience of transportation. In this particular example, individual choices are not a good indicator of the value of air quality since most of the costs of reduced air quality are externalized or passed on to others Methods for Valuing the Environment Environmental valuation is largely based on the assumption that individuals are willing to pay for environmental gains and, conversely, are willing to accept compensation for some environmental losses. The individual demonstrates preferences, which, in turn, place values on environmental resources. That society values environmental resources is certain; monetizing the value placed on changes in environmental assets such as coastal areas and water quality is far more complex. Environmental economists have developed a number of market and non-market-based techniques to value the environment. Figure 2 presents some of these techniques and classifies them according to the basis of the monetary valuation, either market-based, surrogate market, or non-market-based.

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Figure 2. Environmental Valuation Methods Market-Based Methods Economists generally prefer to rely on direct, observable market interactions to place monetary values on goods and services. Markets enable economists to measure an individual's willingness to pay to acquire or preserve environmental services. In turn, consumers reveal their preferences through the choices they make in allocating scarce resources among competing alternatives. There are a number of marketbased methods of environmental valuation. This article identifies and discusses three market-based techniques: a) factor of production approach, b) change in producer/consumer surplus, and c) examination of defensive expenditures. The value of a natural resource can be monetized based on its value as a factor of production. An Economic View of the Environment notes that the output of any firm is a function of several important inputs (e.g., land, capital, natural resources), which are collectively known as "factors of production." In their role as factors of production, raw materials and environmental inputs are used in the production of other goods. When a natural resource has direct value as a factor of production and the impact of environmental degradation on future output of that resource can be accurately measured, the resultant monetary value of the decline in production or higher cost of production can be measured. For example, a decline in water quality could have a direct and detrimental impact on the productivity and health of shellfish beds. This technique is methodologically straightforward; however, it is limited to those resources that are used in the production process of goods and services sold in markets. Because many goods and services produced by the environment are not sold in markets, the factor of production method generally fails to capture the total value of the resource to society. A final market-based valuation method is that of defensive expenditures, which are made on the part of industry and the public either to prevent or counteract the adverse effects of pollution (Feather 1995) or other environmental stressors. The defensive
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expenditures method, also known as the averting behavior approach, monetizes an environmental externality by measuring the resources expended to avoid its negative impacts on a surrounding community. Types of defensive expenditures include water purification devices, beach nourishment, and replanting seagrasses. Surrogate Market Methods. In the absence of clearly defined markets, the value of environmental resources can be derived from information acquired through surrogate markets. The most common markets used as surrogates when monetizing environmental resources are those for property and labor. The surrogate market methods discussed below are the hedonic price method and the travel cost method, with a brief look at the use of random utility models for environmental valuation. The hedonic price method of environmental valuation uses surrogate markets for placing a value on environmental quality. The real estate market is the most commonly used surrogate in hedonic pricing of environmental values. Air, water, and noise pollution have a direct impact on property values. By comparing properties with otherwise similar characteristics or by examining the price of a property over time as environmental conditions change and correcting for all non-environmental factors, information in the housing market can be used to estimate people's willingness to pay for environmental quality. The travel cost method is employed to measure the value of a recreational site by surveying travelers on the economic costs they incur (e.g., time and out-of-pocket travel expenses) when visiting the site from some distance away. These expenditures are considered an indicator of society's willingness to pay for access to the recreational benefits provided by the site. Non-Market Methods. The Contingent Valuation Method (CVM) is a non-market-based technique that elicits information concerning environmental preferences from individuals through the use of surveys, questionnaires, and interviews. When deploying the contingent valuation method, the examiner constructs a scenario or hypothetical market involving an improvement or decline in environmental quality. The scenario is then posed to a random sample of the population to estimate their willingness to pay (e.g., through local property taxes or utility fees) for the improvement or their willingness to accept monetary compensation for the decline in environmental quality. The questionnaire may
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take the form of a simple open-ended question (e.g., how much would you be willing to pay) or may involve a bidding process (e.g., would you accept $10, would you accept $20) or take-it-or-leave-it propositions. Based on survey responses, examiners estimate the mean and median willingness to pay for an environmental improvement or willingness to accept compensation for a decline in environmental quality. Conclusion Environmental valuation techniques are primarily driven by the principle that individuals are self-interested and demonstrate preferences that form the basis of market interactions. These market interactions demonstrate how individuals value environmental goods and services. The market-based nature of economic theory emphasizes the maximization of human welfare. The market, in turn, determines resource allocation based on the forces of supply and demand. The environment, thus, is used as an instrument to achieve human satisfaction. In turn, the environment can be treated like any other commodity and its associated value can be broken down into many elements. For example, the value of coastal areas could be theoretically quantified based on the value of the products it offers (e.g., fish, crabs, clams, recreation, and bird watching). In this manner, environmental valuation can be viewed as a mechanistic approach in which the total value of an environmental system is assessed in terms of the value of its individual parts. Existence values are not demonstrated in the marketplace and are at least somewhat based on unselfish motives making them problematic to environmental analysts. To quantify existence values accurately within the framework of environmental valuation is difficult. Revealed preference methods (e.g., travel cost method and hedonic pricing methods) measure the demand for the environmental resource by measuring the demand for associated market goods. Existence values are not adequately captured using these methods. Existence values are only revealed through surveys of individual willingness to pay for the environmental resource or willingness to accept compensation for environmental losses.

THE FINANCIAL \ ECONOMIC ACCEPTANCE CRITERIA

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1) Net Present Value (NPV): One project accept if NPV >= 0 Many project (set of projects) Most to least NPV values to rank project choose until budget is exhausted. 2) Benefit to Cost Ratio (BCR) One project accept if BCR >= 1 Many project (set of projects) Most to least BCR values to rank project choose until budget is exhausted.

FORMAL DECISION TREE FOR ACCEPTING PROJECTS (INDEPENDENT Vs. DEPENDENT) Decision Accept One Project Accept One of Several Projects Accept few of many projects State of Dependence Constraint Criterion NPV > 0 Maximize NPV Independent Capital Constraint No Capital Constraint Dependent Capital Constraint No Capital Constraint Rank by BCR Rank by NPV > 0 Find feasible sets maximize NPV given your budget constraint Find possible sets maximize NPV (all projects with NBV >= Zero)

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