In very simple words, project appraisal means the assessment of a project. Project appraisal is done both for proposed and executed projects. In case of former, project appraisal is called Ex-ante analysis’ and in case of later ‘Post ante analysis’.
Project appraisal is a cost and benefits analysis of different aspects of proposed project with an objective to adjudge its viability. A project involves employment of scarce resources. An entrepreneur needs to appraise various alternative projects before allocating the scarce resources for the best project. Project appraisal has the aim of assuring a rational allocation of limited funds among alternative investment opportunities in view of achieving certain specified goals. It helps in selecting the best project among available alternative projects. Thus, project appraisal is necessary as the number of projects to satisfy the identified needs always exceed the availability of resources and a choice among alternative project is to be made.
Financial institutions do the project appraisal to assess the project credit worthiness before giving finance to an entrepreneur. For a financial institution, project appraisal is a process whereby a leading financial institution makes an independent and objective assessment of the various aspects of an investment proposition for arriving at a financial decision and is aimed at determining the viability of a project and sometimes in modifying its scope and content so as to improve its viability. However, sometimes, project appraisal and project evaluation are used interchangeably.
Methods of Project Appraisal
Keeping the overall objectives of the enterprise in view and all those of the project, a number of methods are suggested for project appraisal. Commonly suggested methods are discussed in detail as follows:
(1) Payback Period Method – The payback period is the length of the time required to recover the initial outlay on the project. This period is usually expressed in years. This method recognises the need for the recovery of the original capital invested in the project. The basic element of this method is the calculation of a recovery time, by accumulation of cash in flow year by year, until the cash inflows equal the amount of the original investment. The length of time this process takes gives the pay back period for the project. When deciding between two or more competing projects, the usual decision is to accept the one with the shortest payback. The formula for calculating payback period is :
Pay Back Period = Original cost of investment / Actual cash inflow
(2) Discounted Pay Back Period Method – A serious limitation of pay back method is that it | ignores the time value of money. Discounted pay back period method overcomes this limitation as in this method, the cash flows involved in a project are discounted back to present value terms. The pay back period is calculated in the same way as in the previous method except that the cash flows accumulated are the base year value cash flows which have been discounted at the discount rate i.e. the required rate of return on investment.
Thus, in addition to the recovery of the cash investment, the cost of financing the investment during the time that part of the investment remains uncovered is also provided for. However, this method also does not take into account the cash flows which occur subsequent to the pay back period, which may be substantial.
(3) Average Rate of Return Method – ARR method is considered to be an improvement over the payback period method since it considers the earnings of the project during its entire economic life. The ARR method also known as the Accounting Rate of Return method, is a measure of profitability which relates income to investment, both measured in accounting terms. ARR method employs the normal accounting technique to measure the increase in profit expected to result from an investment by expressing the net accounting profit arising from the investment as a percentage of that capital investment. In this method, the following formula can be used to arrive at the average rate of return :
ARR = ( Average annual profit after tax / Average amount invested ) *100
Average Investment = ( Initial Investment + Salvage Value ) / 2
(4) Net Present Value Method – The objective of every business in wealth maximisation. To create wealth, inflows must exceed the present value of all anticipated cash outflows. Net present value (NPV) is obtained by discounting all cash outflows and inflows attributable to a project by a chosen percentage e.g. the project’s weighted average cost of capital. The NPV method discounts the net cash flows from investment by the minimum required rate of return and deducts the initial investment to give the yield from the funds invested. If yield is positive the project is acceptable. If yield is negative, if means that the project is unable to pay for itself and is thus unacceptable.
(5) Benefit / Cost Ration Method – BCR method is the ratio of gross discounted benefits to gross discounted costs. This method may be used as an extension of NPV method and expressed in coefficients or in percentage. There are two ways of defining the relationship between benefits and costs.
(6) Internal Rate of Return Method – Internal rate of return is a discount rate used in project appraisals which brings the cost of a project and its future cash inflows into equality. It is the rate of return which equates the present value of anticipated net cash flows with the initial cash outlay. The IRR is also defined as the rate at which the net present value is zero. This method is used when the cost of capital and the annual cash inflows are known and the unknown rate of return is to be calculated.