Definition of Project Appraisal – Market, Technical, Financial, Commercial, Managerial and Social Aspects

Introduction

The exercise of project appraisal simply means the assessment of a project in terms of its economic, social and financial viability. This exercise basically aimed at determining the viability of a project and sometimes also in reshaping the project so as to upgrade its viability i.e. it aims at sizing up the quality of projects and their long-term profitability.

Appraisal of term loan proposals (projects) is an important exercise for the financial institutions and investing companies in credit decisions. The art of project appraisal puts more emphasis on the economic and technical soundness of the project and it earning potential than on the adequacy and liquidity of the security offered. Hence, the process of appraisal should require more dynamic approach as it is linked with a sense of uncertainty.

Appraisal Process

Project appraisal is a scientific tool. It follows specific pattern. This process usually involves six areas of appraisal such as market appraisal, technical appraisal, financial appraisal, profitability appraisal, managerial, and social appraisal.

Market and Demand Appraisal

Appraisal of commercial viability means assessment of marketability of the end-product. Therefore, at the time of assessment of commercial viability, the following points require careful consideration.

Size and prospective growth of the market which the unit is required to cater like nature of population, their purchasing power, their educational background, fashion etc.

Demand and supply position of the product in the national and international market

Nature of competition

Pricing policy including prospective prices vis-a-vis the quality of the product

Marketing strategy and selling arrangements made by the unit adequacy of sales fore:

Export potential

If the product is an important-substitute, the position regarding existing imports in the country along with the C.I.F value of the imported goods, vis-a-vis cost of product of the unit.

Technical Appraisal

A project is considered to be technically feasible, if it is found to be ‘sound’ from technical and engineering point of view. It is an attempt to find out how well the technical requirements of the unit can be met, which location would be most suitable and what the size of plant and machinery should be.

Objectives of Technological Appraisal

The fundamental objective of appraising a project from the technology point of view is to justify the present choice and provide an insight into future technological developments. Other objectives are:

To justify the goal compatibility of a project with the preferred technology;

To seek a better available alternative technology which is both cost effective and efficiently manageable;

To seek such a technology that can go with existing skill levels of team members or requires little orientation and training programmes;

To seek a better technology that is not detrimental to the overall environment.

The technology that is used in projects can be classified on the basis of:

Purpose for which it is applied;

Level at which it is used;

Nature of skills applied while using the technology. On the basis of purpose, the technology can be:

Manufacturing technology which is generally used in manufacturing industries like textiles industries like textile industries, steel industries, etc.,

Extraction technology which is used in extraction of basic raw materials such as oils, petroleum products, coal and pig iron, etc.,

Conversion technology which is used in process industries like cement, sugar, etc.

Pre-fabricated technology which is used in construction industries like roads, bridges, and buildings, sheds etc., On the basis of the level at which technology is used the classification is as follows:

Core technology which is a base for any industrial activity like basic plant and machinery that is erected. For example, Lakshmi Machine works textile machine installed in a textile firm.

Engineering and design technology which supports the core technology by providing basic layouts and helps in erecting the plant at the required site. Considering the above example, the machine has to be linked with essential spindless and spools through which the yarn is supplied to the machine on which the yarn will be warped and weft.

Intermediate technology which supports both core technology and engineering and design program with sufficient intermediaries such as heavy machine tools and devices to mobilize input and output and output of firm and continue to operate the machinery.

Component technology which is labelled as supplied or consumable for the core, engineering and even intermediate technology. For example, spare parts of a machine, screws lubricating oil, belts, electrical connections and other engineering fittings, etc.,

Appraisal of Managerial Competence

This is the most difficult job to evaluate the “ MAN or MEN” behind the project. It has been the practical experience of the bank/ financial institutions that even the most technically feasible and financially/commercially viable project has been a total failure because of lack of management experience. The problem may become all the more serious if the management is dishonest/delinquent rather than inefficient and ineffective. Unfortunately, there is no scientific yardstick by which managerial competence can be judged objectively. For an established group of industrialists floating a new company unit, the banker can have at least, an idea of the background of the promoters. Much also depends whether the existing promoters belong to the ‘Blue Chip’ group or not. But, in case of a new promoter floating a new project, the problem of judging managerial competence induces some kind of subjectivity in the decision of the banks/financial institutions. In appraisal parlance, such evaluation is known as ‘Principle of three Cs’ i.e. Character, Capacity and Credit worthiness. The following table will show some principles of credit evaluation in terms of Cs of credit.

Financial Appraisal

The basic purpose of financial appraisal is to assess whether the unit will generate sufficient surplus so as to meet the outside obligations. Financial appraisal usually examines two aspects of finance:

The cost of the project i.e., the amount required to complete the project and bring it to normal operation

The means of financing the cost i.e. the sources from which the required funds are to be raised.

After computing the cost of the project and means of finance, the various factors required for assessment of financial viability which a banker should carefully examine, are as under:

Reasonableness of Cost of Project

The project cost should be reasonable: However, assessing reasonableness of the project cost is a very difficult and delicate task. Here, generally, the technique of inter-firm comparison is used which compares the project cost estimates with the cost of comparable units in the same industry.

Debt-Equity ratio: This is a very important consideration as there should not be mismatch between the external debt (long-term) and the equity of the enterprise.

Long Term Debt

Sensitivity Study: This is carried out to see that the unit would be able to serve its debts & give reasonable return under less optimistic conditions. For determining, profitability of the project generally projections are obtained over the entire repayment period (say 7 to 10 years) in the following functional areas:

Cost of Production

Profitability

Cash flow

Debt service coverage ratio

Break even point

The appraiser should satisfy himself about the reasonableness of the basic assumption on which the above projections are made The important assumptions generally looked into are:

Capacity build up

Cost of raw materials

Estimates of salaries & wages

Estimates of administrative expenses

Expected selling price

Provisions made for depreciation

Provisions for various taxation liabilities

The assumptions should be reasonable and realistic. In case, the assumption are not pragmatic, the same can be got changed by the bank and fresh figures can be compiled. But the basic consideration the banker should have it that the cash generation position of the unit should be quite comfortable throughout the repayment period. An ideal debt service coverage aimed at is 2:1.

A model problem for ascertaining cash flow projection and the financial viability of the project are given below:

Illustration

Sai enterprises is interested in assessing the cash flows associated with replacement of an old machine by a new machine. The old machine has a book value of ` 90,000 and it can be sold for ` 90,000. It has a remaining life of 5 years after which the salvage value is expected to be nil. It is being depreciated annually at the rate of 10% using written down value method. The new machine costs ` 4 lakhs. It is expected to fetch 2.5 lakhs after 5 years when it will no longer be required. It will also be depreciated annually @ 10% using W.d.v method. The new machine is expected to save ` 1 lakh in manufacturing costs. Investment in working capital would remain unaffected. The tax rate applicable to the firm is 50%.

You as a project analyst are required to work out the incremental cash flows associated with the replacement of old machine and prepare a statement to be presented to the management for consideration.

Answer

The above case refers to a replacement project. In such cases, one must take the following points into consideration:

comparison of new machine with the old machine from the overall cash flows point of view;

comparison of net impact of the ‘replacement’ or ‘retaining the old machine’ over the cash flows;

financing mix used for the replacement and its impact on the interest rates to observe the effect on the profit after interest and tax.

At least two of the above factors should be applied here to analyse the position and present the analysis for managerial consideration. The following cash flow statement will help present the situation better.

Cash flows for the Replacement of machinery of Sai Enterprises (Rs in crores)

Working Notes:

Net investment (` 4 lakhs less ` 90,000) = ` 3.1 lakhs

Savings of the new machine are given in the problem, i.e. 1 lakh

Incremental depreciation is derived by considering depreciation of the new machine less depreciation of the old machine.

Operating cash flows = Incremental depreciation + Incremental profit after tax.

Profitability Analysis

The financial projection such as profitability estimates, cashflow estimates and projected balance sheets are the basis for assessing the viability of the project. Therefore, verification of profitability estimates is highly important for the proper appraisal of a term loan proposal.

The profitability estimate should always accompany the assumptions based on which the profitability estimates have been prepared.

Ratio Analysis

Many important parameters such as sales, operating profit, net profit, equity, debt, current assets. Current liabilities, etc. do not give much information if figure is studied in isolation. If a ratio is calculated between related items, the ratio indicates the relationship between two or more than two variable, thus giving meaningful information for taking decision. Some of the ratio useful for banks are discussed below.

Loan Safety Ratio

This indicates the relationship between term liabilities and owned funds and helps in assessing the capital gearing. The debt shall include long term loans, debentures, deferred payment preference shares due for redemption between 1 to 3 years. The equity includes ordinary share capital, preference share capital due for redemption after 3 years, investment subsidy, unsecured loans subordinated to the term loan, internal accruals, non refundable deposits in the case of cooperatives.

Current Ratio

(Current assets to current liabilities)

The ratio indicates the liquidity position of the company. Current assets should be more than current liabilities. The acceptable ratio should be between 1.5 to 2.1. The ratio beyond 2.1 will indicate that either the inventories are stocked unnecessarily or the products produced are not sold. The current ratio will indicate the necessity for proper inventory control.

Debt Service Coverage Ratio(dscr)

The ratio indicates the capacity of the unit to repay the term loan liabilities and interest thereon. It is important ratio for lending institution as the repayment period has to be suitably fixed based on this ratio. This ratio indicates the cash generation the term liabilities to be paid out of this and balance left for the company’s use. Repayment of term loan without generating sufficient cash will lead to reduction in working in the working capital, tight liquidity position and further deterioration in the working of the unit. The acceptable ratio should not be less than 1.5: 1 which indicates that 1.5 times cash is generated to pay the term, loan liabilities of one time. The formula calculation of the DSCR is given below.

The DSCR should be calculated for each year of operation and also for the entire repayment period as an advance.

Margin of Security

The term loans are generally sanctioned against the security of fixed assets. The excess of fixed assets over the term loans provides margin for the term loans.

Productivity Ratio are:

Capital employed to Value of output sales

Capital employed to Net value added

Investment per worker

Productivity per worker

Profitability Ratio are:

percentage of raw material to value of output

percentage of wages and salaries to value of output

Percentage of interest to value of output

Percentage of operating profit to sales

Percentage of profit after tax equity

A list showing the method of calculation of above ratios and their usefulness is given separately.

Break Even Point (Bep)

The manufacturing cost consists of two costs viz. fixed costs and variable costs. Certain type costs viz. depreciation, interest on term loan, repair and maintenance, rent and insurance, wages and salaries, administrative expenses etc. has to be incurred by the unit irrespective of the level of operation. This cost will not change with the level of operation and they are called fixed costs. All the other costs viz. cost of raw material consumables, power, water, stores, packing charges, selling expenses etc. which vary with the level of operation is called variable cost. The BEP is the level at which the unit should operate to meet the fixed costs. It is level of operation, where there is no profit or loss for the unit. The BEP is calculated using the following formula

The appraising officer should follow uniform policy to divide the total cost into fixed cost and variable cost as certain cost neither remain fixed nor changed in the same proportion in which the level of production changes.

Discounted Cash Flow Techniques

A project should earn sufficient return which should be at least equal to the cost of capital invested in it. The following evaluation techniques helps to identify the best investment proposal amongst the available.

Pay back method

Average Rate of Return Method

Net present value method

Internal rate of return

Pay Back Method

The period required for recovering the entire investment made the project is calculated. The shorter is the period better return. The cash flow (operating profit + depreciation + other non cash write off-tax) is accumulated year by year until it equals the original investment. However, this method ignores the cash inflow received after crossing the pay back period. This method is best suited where the emphasis is on avoidance of long term risk.

Average Rate of Return

Unlike the pay back period method, the entire life of the project is taken into account. The average annual net operating profit (after depreciation) for the entire life of the project is calculated and the rate of return of original investment in an year is calculated by taking the average of opening and closing book values of the investment in the year. The grand average of such average investment of all years is obtained to know the average investment of the project gives the average rate of return. This method does not give any importance to the time value of the money and also the life differential of the projects.

Net Present Value Method (NPV)

Pay back method and average rate of return method does not give importance to the time value of money. The money invested today will not be equal to the money received in the future. Therefore, the time value of the money also should be taken into account while determining the return for the present investment.

Under this method, the future cashflow of all the years during the expected life of the project are discounted at a predetermined cut-off rate and the net present value is obtained. The cut-off rate should be either equal to or more than the cost of the funds. The present investment is an outflow of funds and hence treated as having minus value. If the difference between the present investment and the net present value of cash inflow is positive than it indicates that the profit is greater than the cost of the capital.

Internal Rate of Return (IRR)

NPV method indicates, the net present value of the future cash flows at a predetermined discount rate and the project is accepted for investment if the return of a project, the net cashflow in each year are discounted at various discounting rates till the sum of net present value of cashflow equal the cash outflow. Such a rate of discount which would equate the present value of investments to the present value of future benefits over the life of the projects.

Problem 1

NMH Industries is considering proposal involving procurement of a special machine to produce a new product. The technical team furnished two alternative machines whose investment costs are ` 50,000 each and life span is 4 years. After the expire of its useful life, the vendors guaranteed to buy back at ` 5,000 each. The management of the company uses certainly equivalent approach to evaluate risky investments. The company’s risk adjusted discount rate is 16% and the risk-free rate is 10%. The expected values of net cash flows (CFAT) with their respective certainly equivalents are as follows:

Which machine should be purchased, out of the above, by the company?

Answer

NPV Under Certainly Equivalent Approach:

The above analysis clears the fog surrounding investment possibilities.

Machine A is resulting in higher NPV compared to Machine B. Therefore, machine A should be purchased having the highest NPV at risk free rate.

Problem 2

Sastha Ltd is considering a project with the following cash flows.

The costs of capital is 8%. Measure the sensitivity of the project to changes in the levels of plant value, running costs and savings (considering each factor at a time) so that NPV becomes zero. Which factor is most sensitive to affect the acceptability of the project.

The PV factors at 8% discount rate are:

0 1.000

1 0.926

2 0.857

Answer

The Net present value of Cashflows:

The project a may be accepted as it is having a positive NPV of 560.5.

The sensitivity of project towards various costs can be performed as under.

Sensitivity Analysis

       (1) Plant costs may need to be increased by a PV of 560.

             i.e. 560.5

            7,000 x 5 = 8.007% or by 8%

       (2) Running Costs may need to increased by

            i.e. 560.5

            3,994.5 x 100 = 14.03% or by 14%

       (3) Savings may be reduced by

            i.e. 560.5

            11,555 x 100 = 4.85%

According to this analysis, it is clear that savings having a lowest sensitivity ratio gets affected most while accepting the project.

Social Cost Benefit Analysis (SCBA)

It is a methodology for evaluating investment projects from social point of view.

SCBA seeks to assess the utility of a project to society as a whole. It attempts to separate all the expected changes viz. economic, social and environmental likely to arise as a result of implementing the project. These can be represented as inputs and outputs of a project and a price can be put to each of these input an output. Since both inputs and outputs are spread over a number of years, it is necessary to combine the costs and benefits stream that arise over the economic life of the project.

ORIGIN: Methodological guidelines of SCBA have been developed by international agencies like OECD AND UNIDO. India, Planning commission issued in 1975 guidelines for the preparation of feasibility reports for industrial reports.

Socio-Economic Appraisal

Social cost benefit analysis (SCBA) is a perfect necropsy where the identification and determinatio of the best among project alternatives is made with reference to a country’s economic and social prerogatives. It is a systematic procedure for comprehensive review of all the costs, benefits, and effects of a project. Such appraisal is performed for development and infrastructure projects usually by emphasizing the economic, technical, operational, institutional, and financial factors to ensure that the selected project meets all necessary requirements and is implementable.

SCBA focuses on the following objectives:

to contribute effectively to GDP of an economy;

to aid in economic development;

to justify the utilisation of economy’s scarce of growth;

to maintain and protect environment from pollution;

to educate new lines of functioning that are simple and cost effective;

to benefit the rural poor and reduce regional imbalances;

to justify the risks undertaken to implement and the sacrifices made in the process.

Therefore, it is important to identify the major economic, environmental, social and other factors a project may influence directly or indirectly.

Few notable contributions towards social-cost-benefit approach are:

UNIDO — Guidelines for Project Evaluations released during early 70s

M.D.Little, J.A.Mirrlees —Appraisal and Planning for Developing Countries

Limitations of SCBA

No standard method or technique applicable to all types of investment projects.

Quantification and measurement of social cost and benefits are formidable.

However these limitations can be rectified by removing subjectivity in it.

Summary

Thus the project has to be appraised to ensure that the project will generate sufficient return on the resources invested in it. The viability of the project depends on technical feasibility, marketability of the products at a profitable price, availability of financial resources in time and proper management of the unit. It should be also within the framework of national priorities bases on social cost benefit analysis.

In brief, a project should satisfy the tests of technical, commercial, financial and managerial feasibilities as given above.