PROJECT FINANCE

MODULE - I

[Link]
SCHOOL OF MANAGEMENT STUDIES
KONGU ENGINEERING COLLEGE
Introduction to Projects:
Part of human scene since civilization.
‘Special’ and ‘One-off’
Situation involves capital expenditure decision
Opportunity for investing resources after analyzing
and appraised.
Outlay of funds with the expectation of future stream
of cash flows.
Examples of project
GOI thinking of an ambitious plan to link the Ganges
and Cauvery rivers.

Dhabhol power house.

Recently constructed Terminal 3, Airport in New

Delhi.
Project – Definition:
Project is a complex, non-routine, one time
effort limited by time, budget, resources and
performance specifications designed to
meet customer needs.
Objectives of a Project/Project
Management
Timescale
- Management techniques
- Delays on large project
- Critical tasks & Control techniques
Project costs
- Budget
- Pure research projects
Performance
- Project success
Characteristics of a project
A start and end date.
Resources – Time, Money, People and Equipment
An Outcome – New highway, Satellite, Software etc.,
Time

Quality

Scope Cost
Project Life Cycle
1. Defining/Initiating – Goals, Specifications, Tasks and
Responsibilities.

2. Planning – Schedules, Budget, Resources, Risks and staffing.

3. Executing – Status report, Changes and Quality forecasts.

4. Delivering/Closing – Train the customer, Transfer the

documents and Release resources.
Project - Classification
 Manufacturing Projects:
- Specially designed & built as per customer specification.
- Involves designing, prototype testing, manufacturing, Delivery
and installation at customer’s premises.
- Usually job is sold for fixed price with target profit in mind.
- Management techniques – cost estimation, Timescale etc.,
- Application of network analysis, resource scheduling.

 Construction Projects:
- Bigger and expensive than manufacturing project.
- Need expert professional attention for flow of funds.
- Contracts between participating companies.
Cont…
 Management Projects:
- Helps to manage changes of premises, new installations or
maintenance of existing place and facilities.

 Research projects:
- Produce knowledge.

 Reengineering projects:
- Brings change in an existing system or knowledge.
- eg., Computerized land records, Improved production process.
Project Management – Meaning:

Project management is all about “Creating an

environment and conditions in which a defined goal or
objective can be achieved in a controlled manner by a
team of people”.
Why Organizations use project management?
 Competitive environment – Quality products: Lower cost: Lesser time.

 Techniques - Allows to plan and organize resources to achieve a

specified outcome.

 Helps to manage and anticipate risks in a structured manner.

 Surveys indicates PM allows for better utilization of resources,

synergies and focus on results and quality.
Role of Project Managers
- Assumes great responsibility.

- To direct, supervise and control.

- Define the project and reduce it to manageable task.

- Obtain appropriate resources and build a team.

- set the goal & motivate his team.

- Access and monitor risks and mitigate them.

- Adapt and manage change.

Project Manager - Skills

 Leadership  Planning

 People management  Estimating

 Effective communication  Problem solving

 Influencing  Creative thinking

 Negotiation  Time management

 Conflict management
Possible barriers for PM
Poor communication Union Strikes

Disagreement Personality conflicts

Misunderstanding Poor management

Bad weather Poorly defined Goals &

Objectives
Varying Rolls of PM – Illustrated with construction project.

Architectural/Consulting
PM-B
B organization plans & designs the
project
Supervision
of the
project
Monitors project
progress

A PM-A
PM-C Project
Customer –
wants the Builder
project carries out
construction
of the project

Contractual relationship
Illustration – Cont…
- Org. A is a customer, who wants the project.

- Org. A do not have the resource & expertise to carry feasibility

study, Planning, Design, Preparation of the contract documents &
supervision of project execution, then it engages Org. B to undertake
these activities for a fee.

- Org. B may be architectural, consultant or PM firm.

- Org. C is appointed for executing the project.

- Org. B acts on behalf of Org. A to supervise the project to be

carried out by Org. C.
Illustration – Cont…
Project manager A’s role:
- more of monitor, progress finder, reporter and expediter.
- to keep the top management informed on progress, expenditure and possible
delays in completion.

Project manager B’s role:

- Involves in feasibility study, advising the customer on best choice, planning,
design, contract document preparation, checking quality & progress, exercising
supervision, contacting & negotiating with local authorities.

Project manager C’s role:

- Directly involved in execution of the project.
- Involves in detailed planning, daily decision making, organizing, coordinating,
directing, supervising personnel and controlling material resources.
Organizational structure for the projects:
- Project is a non-routine undertaking often plagued with many
uncertainties.

- Relationships in project are dynamic, temporary and flexible.

- Project requires a coordination of efforts of people from different

functional areas and contributions of external agencies.

FORMS OF PROJECT ORGANISATION

Functional organization structure.

Project (Divisional)organization structure.

Matrix organization structure.

Functional organization structure.
 Hierarchical structure with Clearly GM
defined role.
AGM
 A separate project coordinator is
appointed with the primary
responsibility of coordinating the
work of functional department. Production Manager
PM
 Emphasis may be more on its own Production supervisor
specialty than on project goal.
PE 1 PE2 PE3
 Lack of motivation & difficult to
extent leadership.

 Poor communication between

departments.
Project organization structure
 Resources separated from functional structure.
 Common for large scale building and construction projects.
 Duties & responsibilities comes under separate project manager.
 Singleness of purpose & Unity of command.
 Resources are under direct control of project manager.
 Not suitable for all projects.
 Facilities might be used inefficiently.
 Job security in question.

PM APM Civil Dsg. Eng Mech. Eng Constr. Eng

Accountant Pur. Officer Trans. Mgr Qlty. Supervisor

Matrix organization structure
- Combination of functional & project organization.
- It minimizes the drawback & maximizes the benefit of both
organization structures.
- Each staff has to report to two bosses.

ABBREVATIONS:
EM – Engineering Manager
PM – Production Manager
QM – Quality Manager
SM – Supply Manager
MM – Marketing Manager
HRM – HR Manager
FM – Finance Manager
 GM
AGM

CHIEF EM PM QM SM MM HRM FM
[Link]

[Link] I X
A D G

[Link] II Y
B E H

[Link] III Z
C F I
 Project Finance - Rationale
 Continues need of large projects for economic growth.

 Large projects – 20% in number but 80% in value.

 Studies reveals, Infrastructure investment is associated with one to

one percentage increase in GDP.

 A study by IFC (International Finance Corporation) shows that

insufficient/irregular power supply reduces India’s GDP by 0.5% to 1%.

 Traditionally, Public sector/Government financed large projects.

 Government finances are increasingly under pressure – leads to private

participation – reduces the public expenditure.
Cont…
 Risks in large projects are quite different.

 Sustain till positive cash flow generation is challenging.

 Risks – Construction, Operating, Financial, Political, Time period risks

with no certainties on cash inflow.

So what will be the ideal mode of financing for the

large, Risky projects?

PROJECT FINANCING
Project Finance - Definition
 PF involves the creation of legally independent project company with
equity from one or more sponsoring firms and non or limited
recourse debt for the purpose of investing in a single industrial asset.

 Project financing may be defined as the raising of funds on a ‘limited

– recourse’ or ‘non – recourse’ basis to finance an economically
separable capital investment project in which the providers of the
funds look primarily to the cash flow from the project as the source
of funds to service their loans and provide the return of, and a return
on their equity invested in the project.
Types of Project financing
1. Non-recourse project finance:
- Financed completely based on the merit of the project rather than the
credit of the project sponsor.

- No direct legal obligation for sponsor to repay the project debt or

interest, if project cash inflows proves inadequate.

- Attempted only if the lender has utmost confidence in the project.

2. Limited–recourse project finance:

- Lenders retain some of support or recourse to the project promoters.

- Nature of recourse is clearly established at the outset itself, through

documentation.
Distinctive Features of PF (PF vs. Other fin)
- Risky & requires special knowledge.

1. Only source of repayment – future internal cash inflow.

2. Mostly for new business venture – no track record – Disadvantage

creditors.

3. Technical evaluation – key element – PF lenders (SIDBI, IDBI) have

own team.

4. PF is only for the project which is legally & economically self contained
through SPV whose only business is the project.
Cont…
5. High ratio of debt to equity, 70% to 90% of project cost.

6. Main security for lenders are project contracts, licenses or ownership of

rights to natural resources; physical assets are likely to be less worthy.

7. MBO’s/LBO’s may seem to be similar to PF due to high risk level but

they may not consist single purpose industrial asset.

8. Closer control is possible since assets and cash flows are segregated.

9. Risk allocation is an imp. advantage of PF; Conventional – sponsor.

10. More expensive due to its non-recourse nature.

Project Finance – Gaining growth
- Preferred alterative to conventional financing method.

- Demand for infrastructure investment is staggering.

- Funding vehicle for large projects.

- Attracting a great deal of academic interest.

- Promoters often lack enough capital to put the whole venture together.

- PF brings promoters & financiers together

- Considerable risks in PF prompts the promoters to share them

with several project lenders. (Failure of one big project funded by single sponsor can
bankrupt the sponsor).

- In 2001, Kuwait’s equate petrochemical company financed its expansion by way of

PF of 10 year term loan of $400m from a syndication of loans.
Parties involved in PF
1. Sponsors:
- Undertakes the project & carry much of responsibility to ensure its
success.

- Look after project management, project scheduling and co-ordination.

- Main beneficiaries of the project.

- can be a Government/Government entity or an individual or a group

of individuals coming together for a common purpose.

Example: Nedumbassery Airport project in Cochin was undertaken by

a group of non-resident keralites with the support of the kerala
government and partly financed by leading project lenders in India
including HUDCO.
Cont…
2. Project lenders
- In PF, usually there are multiple lenders – advantage of risk sharing.
- Through a syndication or a consortium of lenders, who come together
and share the risk on pari-pasu basis.
- one of the main lender acts as financial advisor and undertakes
preparation of the credit memorandum, which project credit analysis.

3. Technical consultants/Lawyers/Accountants
- Projects are not only massive but also complicated.

4. Government
- Co-operation and willingness to provide an investment friendly climate
is essential for any project.
- Infrastructure projects such as roads, railways, hospitals and airports are
of direct interest to any government.
Cont…
5. Multi-lateral Agencies
- Some mega projects involves participation of agencies across the
globe for financing.
* ADB
* Commonwealth development bank
* IBRD (World bank)
* International Finance organization

6. Contractors
- Large projects may enter in to hundred’s of contract.
- Off-take contract.
Why investors use project finance? (Advantages)
1. High Leverage
- Venture such as power generation or road building - long term – no
high return; high leverage improves investors return. PF takes
advantage of the fact debt is cheaper.
- Particulars Low leverage High leverage

PROJECT COST 1000 1000

a). Debt 300 800
b). Equity 700 200
c). Revenue from project 100 100
d). Interest rate of debt (p.a.) 5% 7%
e). Interest payable (a * d) 15 56
f). Profit (c - e) 85 44
RETURN ON EQUITY (f/b) 12.14% 22%
Cont…
2. Tax benefit
- Another factor which makes high leverage more attractive is that
interest amount is tax deductable where as dividends to share holders
are not, which makes debt even cheaper than equity.

3. Off – balance sheet financing

- If the investor has to raise the debt and then inject into the project,
this will clearly appear on the balance sheet. A project finance structure
may allow the investor to keep the debt off the consolidated balance
sheet. This may be seen beneficial to a company’s financial position.

4. Borrowing capacity
- PF increases the level of debt that can be borrowed against a project.
Non-recourse finance raised by the project company is not normally
counted against corporate credit lines. It may increase an investor’s
overall borrowing capacity.
Cont…
5. Risk limitation
- Raising funds through PF does not normally guarantee the repayment
of debt. This means that the risk is therefore limited to the amount of
the equity investment.
- A companies credit rating is also less likely to be down graded if its
risks on project investments are limited through a project finance
structure.

6. Long-term finance
- PF typically have longer term than corporate finance.
- Necessary if the assets financed normally have a high capital cost that
can not be recovered over a short term.
- Loans of power projects often run for nearly 20 years and for
infrastructural projects (oil, gas & minerals) even longer.
Disadvantages of PF
1. Complexity in Risk allocation:
- For successful project, risks must be allocated in an economically
efficient manner among the project participants which is a complex
task as many participants are involved with diverse interest.
- Risk allocation tension exists between project sponsor and lender
regarding the degree of recourse to the loan.
2. Increased lender risk & Higher interest rates:
- The high risk scenario in PF results in higher fees charged by
lenders which leads to expensive mode of financing.
3. Lender supervision:
- Lender will impose greater level of supervision on management &
operations of the project. This makes project companies not to
amend project contracts without lender supervision.
- The higher degree of lender supervision results in possible delays
and high cost that are typically borne by the project company.
Cont…
4. Requires more time & effort:
- Longer time is required than conventional financing due to higher
complexity.

5. Higher transaction cost:

- Due to the legal expense involved in designing the project structure,
legal issues, documentation and other contracts.

6. Extensive risk appraisal:

- A detailed risk appraisal is absolutely necessary to assume other
parties, including passive lenders and investors, that the project makes
sound economic and commercial sense.
A Schematic Diagram – The Basis elements of
project finance:
Lenders
Loan funds Debt Repayment

Input – Raw material Purchase contract(s)

ASSETS COMPRISING THE

Supplier Purchaser
PROJECT

Supply contract(s) Output

Equity Funds Returns Forms of credit support

Equity Investors
International Project Finance
- Also known as Global Project finance or Transnational project finance.

 It is the financing technique of bringing together development,

construction, operation, financing and investment capabilities from
throughout the world for developing a project in particular country.

 - Technology licensing, knowledge know-how and Cross border

financing are very much involved in International project finance.

 - Purchase contractor / Supply contractor may belongs to different

countries.
Examples of facilities developed with project finance
 Energy generation

 Pipelines, Storage facilities and Refineries

 Airports & seaports

 Mining – Copper, Iron ore…

 Toll roads

 Waste disposal

 Telecommunications

 Leisure & Sports stadium.

Project lenders
1. Commercial lenders
- Includes banks, insurance companies, credit corporations and
other lenders who provide debt financing for projects.

- These institutions may be based on host country or other country.

- Lenders might provide different types of debt to the project.

a. Arranging bank
b. Managing bank
c. Agent bank
d. Engineering bank
e. Security agent
Cont…
2. Bond holders
- Bond holders purchase project debt in the form of bonds.

- Bond holders are represented by bond trustee, a financial Institution

that acts as the representative for the bond holders in managing the
debt transaction.

- Key difference between bonds & loans are bonds is liquidity.

- Bonds are purchased by the investors looking for long term, fixed –
rate income – LIC & Pension funds.

- PF bonds provide an alternative to buying government or corporate

bonds, since return is higher.
Cont…
S&P and Moody’s are the leaders in the field as far as PF bonds are concerned.

Investment Grade Ratings

S&P Moody’s
AAA Aaa
AA+ Aa1
AA Aa2
AA- Aa3
A+ A1
A A2
A- A3
BBB+ Baa1
BBB Baa2
BBB- Baa3
Cont…
- Bonds may either be public issues or Private placement.
- Under the normal Securities Exchange Contracts (SECs), Bonds on
private placement cannot sold to another party for two years, This lack
of liquidity is generally not acceptable to U.S. bond investors.
- Rule 144a allows secondary trading (i.e. reselling) of private
placements of debt securities, provided sales are to QIBs.

Bonds vs. Loans for Project financing:

 Bonds are tradable & liquefiable.
 Bonds are suitable for developed markets and “Standard Projects”.
 Bonds are especially suitable if a project is being refinanced after it has
been built and operated successfully for a period.
 Greater flexibility of bank loans tends to make them more suitable for
the construction & early operation phases of a project.
Project Finance structures
- Project finance structure have been the subject of substantial
research during the last decade or so.

- Although the project finance structures share certain common

features, every project is unique and requires tailoring the financial
package to the particular circumstances & features of the project.

Structural attributes of Project Finance:

1. Organizational structure
2. Capital structure
3. Ownership structure
4. Board structure and
5. Contractual structure
Common Models in Project Finance
 Build-Operate-Transfer (BOT)

 Build-Own-Operate-Transfer (BOOT)

 Build-Own-Operate (BOO)

 Build-Transfer-Operate (BTO)

 Buy-Build-Operate (BBO)

 Lease-Develop-Operate (LDO)

 Wraparound Addition
Capital Budgeting
Outline
Capital investments: Meaning, Importance and difficulties
Types of capital investments
Phases of capital budgeting
Levels of decision making
Objectives of capital budgeting
Common weaknesses in capital budgeting
Capital Budgeting - Meaning
- Capital Budgeting is the process of making investment decisions
regarding capital expenditure.

- Capital expenditure involves non-flexible long term commitment of

funds.

- Capital Budgeting is also known as long term planning for investment

decisions.

Definition:

“A long term planning for making and financing proposed capital

outlay”
- Charles T. Horngreen
Nature of Capital Investment Decisions
 The investment decisions of a firm are generally known as the capital
budgeting, or capital expenditure decisions.

 The firm’s investment decisions would generally include expansion,

acquisition, modernisation and replacement of the long-term assets. Sale
of a division or business (divestment) is also as an investment decision.

 Decisions like the change in the methods of sales distribution, or an

advertisement campaign or a research and development programme
have long-term implications for the firm’s expenditures and benefits, and
therefore, they should also be evaluated as investment decisions.
Features of Capital Investment Decisions

The exchange of current funds for future benefits.

The funds are invested in long-term assets.

The future benefits will occur to the firm over a series

of years.
Importance of capital Investments
- Capital investment decisions are most important decision taken by a
firm.
- Importance depends up on 3 inter related reasons.

1. Long-term effects: Capital expenditure decisions provide

framework for future activities.
2. Irreversibility:
- Market for used capital equipment is ill organized.
- Custom made
- Reversal of decision may mean scrapping of the capital decision.
3. Substantial Outlays:
- An integrated steel plant involves an outlay of sevaral thousand
million.
- Capital costs tend to increase with the advanced technology.
Difficulties in capital investments
1. Measurement problems:
- Identifying & Measuring the costs & benefits of a capital
expenditure proposals are difficult.
- Problems are more on the scenario like intangible consequences like
improving the morale of the workers.

2. Uncertainty:
- Benefits are extended far into the future. Difficult to predict what
will happen in future.

3. Temporal spread:
- As the benefits are spread out over a long period of time say 20 years
or more. Estimating discount rates and establishing equivalences
becomes difficult.
Types of capital investments -1

Capital Investment

Physical Monetary Intangible

Financial claims, Training, Market

Land, Building,
Deposits, Bonds, Development etc.
Machinery etc
Equity shares etc.
Types of capital investments -2
Capital Investment

Strategic Investment Tactical Investment

To implement a current
Investment that has strategy as efficiently or as
significant impact on the profitably as possible
direction of the firm
Ex: An investment by TATA
Ex: Reliance decision to enter motors to replace an old
in retail business – machine to improve
‘Reliance Fresh’ productivity represents a
tactical investment
 Types of capital investments -3
Capital Investment

Mandatory Replacement Expansion Diversificati R&D Miscellan

Investment Investment Investment on invest. Investment eous
Ex: Aimed Investmen
To comply at ts
with To replace To increase producing
statutory worn out capacity to new - To develop
requiremen equipment cater growing products/se new
ts. with new demands rvices or product &
equipment entering Process.
Ex: in order to Ex: HUL’s into new Items like
Pollution reduce decision to geographic interior
control operating increase the al areas decoratio
equip, Fire costs & variance in Ex: n, Land
fighting increase Detergent McDonalds Ex: Bramos scapping
equip yield RIN missile etc
Types of capital investments -4
Capital Investments

Mutually exclusive Independent Contingent

Investment Investment Investment
 Levels of Decision Making

Operating Administrative Strategic

decisions decisions decisions

 Where is the decision taken Lower level Middle level Top level
management management management

 How structured is the decision Routine Semi – structured Unstructured

 What is the level of resource Minor resource Moderate resource Major resource
commitment commitment commitment commitment

 What is the time horizon Short – term Medium – term Long – term
Phases of capital budgeting
PLANNING

ANALYSIS
Capital Budgeting
SELECTION is a very complex
process which is
divided in to six
FINANCING broad phases

IMPLEMENTATION

REVIEW

Represents the sequence

Indicates phases of capital budgeting are interactive in nature
Cont…
1. Planning:
- Expression of idea.
- Provides framework which shapes and guides the idea.
- Preliminary project analysis need to be done – feasibility study.

2. Analysis:
- Detailed analysis of marketing, technical, financial, economic &
ecological aspects is undertaken.
- This phase includes gathering, preparing and summarizing relevant
information for the project proposal.

3. Selection:
- Techniques Discounting & Non-Discounting.
Cont…
4. Financing:
- Equity
- Debt

5. Implementation:
- Implementation of industrial projects involves several stages
* Project & Engineering review
* Negotiations & Contracting
* Construction
* Training
* Plant commissioning

6. Review:
Basic Considerations: Risk and Return

INVESTMENT RETURN
DECISIONS

MARKET VALUE
OF THE FIRM

FINANCING RISK
DECISIONS

Higher the return, higher the risk – Trade-off should be carefully analyzed.
Investment Evaluation Criteria

Three steps are involved in the evaluation of an

investment:

Estimation of cash flows

Estimation of the required rate of return (the

opportunity cost of capital)

Application of a decision rule for making the choice

Investment Decision Rule
 It should maximise the shareholders’ wealth.
 It should consider all cash flows to determine the true
profitability of the project.
 It should provide for an objective and unambiguous way of
separating good projects from bad projects.
 It should help ranking of projects according to their true
profitability.
 It should recognise the fact that bigger cash flows are preferable
to smaller ones and early cash flows are preferable to later ones.
 It should help to choose among mutually exclusive projects that
project which maximises the shareholders’ wealth.
 It should be a criterion which is applicable to any conceivable
investment project independent of others.
Evaluation Criteria

1. Discounted Cash Flow (DCF) Criteria

  Net Present Value (NPV)
  Internal Rate of Return (IRR)
  Profitability Index (PI)

2. Non-discounted Cash Flow Criteria

  Payback Period (PB)
  Accounting Rate of Return (ARR)
Payback period
Payback is the number of years required to recover the original cash
outlay invested in a project.
If the project generates constant annual cash inflows, the payback
period can be computed by dividing cash outlay by the annual cash
inflow. That is:
Initial Investment C
Payback = = 0
Annual Cash Inflow C

Assume that a project requires an outlay of Rs 50,000 and yields

annual cash inflow of Rs 12,500 for 7 years. The payback period for
the project is:
Rs 50,000
PB = = 4 years
Rs 12,000

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Payback
Unequal cash flows In case of unequal cash inflows, the payback
period can be found out by adding up the cash inflows (Cumulative)
until the total is equal to the initial cash outlay.

Suppose that a project requires a cash outlay of Rs 20,000, and

generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000
during the next 4 years. What is the project’s payback?

= 3 years + 12 × (1,000/3,000) months

= 3 years + 4 months
Acceptance Rule

 The project would be accepted if its payback period is less than the
maximum or standard payback period set by management.

 As a ranking method, it gives highest ranking to the project, which

has the shortest payback period and lowest ranking to the project
with highest payback period.

67
Evaluation of Payback
Certain virtues:
 Easy to calculate & simple to understand.
 Cost effective method.
 Useful where the business is suffering from shortage of funds
as quick recovery is essential for repayment.
 Useful where profitability is not important.
 Liquidity

Serious limitations:
 Ignores cash flows after payback, depreciation, scrap value,
interest factor etc.
 Time value of money ignored.
 Profitability of the project is completely ignored.
 Gives more importance to liquidity as a goal of capital
expenditure decision which is not justifiable.

68
Accounting Rate of Return Method

 The accounting rate of return is the ratio of the average after-tax profit
divided by the average investment. The average investment would be equal
to half of the original investment if it were depreciated constantly.

Average income
ARR =
Average investment
 A variation of the ARR method is to divide average earnings after taxes by
the original cost of the project instead of the average cost.

69
Acceptance Rule

This method will accept all those projects whose ARR is

higher than the minimum rate established by the
management and reject those projects which have ARR
less than the minimum rate.

This method would rank a project as number one if it

has highest ARR and lowest rank would be assigned to
the project with lowest ARR.

70
Evaluation of ARR Method
The ARR method may claim some merits

 Simple & Easy

 Considers total lifetime earnings
 Accounting data
 Accounting profitability (profit after depreciation and tax)

Serious shortcoming

 Cash flows ignored

 Time value ignored
 Ignores the fact that profits can be reinvested

71
ARR - Illustrated
Capital Outlay: Rs. 2,00,000
Depreciation: 20% p.a. on WDV basis
Forecasted annual income before depreciation for the 1st five years are
Rs.1,00,000; Rs. 1,00,000; Rs. 80,000; Rs. 80,000 and Rs. 40,000
respectively. Calculate ARR.
Year Earnings before Depreciation @ Earnings after
depreciation (Rs.) 20% (Rs.) Depreciation
(Rs.)
1 100000 40000 60000
2 100000 32000 68000
3 80000 25600 54400
4 80000 20480 59520
5 40000 16384 23616
Total profits for 5 years 2,65,536
Cont…
Average Profits = 2,65,536/5 = Rs. 53,107

ARR on original investment: 53,107/2,00,000 x 100 = 26.55%

ARR on average investment: 53,107/1.00.000 = 53.11%

Acceptance rule:

If ARR > Hurdle rate, accept the project otherwise reject the
project.
Net Present Value Method

 Cash flows of the investment project should be forecasted based on

realistic assumptions.

 Appropriate discount rate should be identified to discount the

forecasted cash flows. The appropriate discount rate is the project’s
opportunity cost of capital.

 Present value of cash flows should be calculated using the

opportunity cost of capital as the discount rate.

 The project should be accepted if NPV is positive (i.e., NPV > 0).

74
Net Present Value Method

Net present value should be found out by subtracting present value

of cash outflows from present value of cash inflows. The formula
for the net present value can be written as follows:

 C1 C2 C3 Cn 
NPV      n 
 C0
 (1  k ) (1  k ) (1  k ) (1  k ) 
2 3

n
Ct
NPV    C0
t 1 (1  k )
t

75
Calculating Net Present Value
Assume that Project X costs Rs 2,500 now and is expected
to generate year-end cash inflows of Rs 900, Rs 800, Rs
700, Rs 600 and Rs 500 in years 1 through 5. The
opportunity cost of the capital may be assumed to be 10
per cent.

 Rs 900 Rs 800 Rs 700 Rs 600 Rs 500 

NPV    2
 3
 4
 5
 Rs 2,500
 (1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10) 
NPV  [Rs 900(PVF1, 0.10 ) + Rs 800(PVF2, 0.10) + Rs 700(PVF3, 0.10 )
+ Rs 600(PVF4, 0.10 ) + Rs 500(PVF5, 0.10)]  Rs 2,500
NPV  [Rs 9000.909 + Rs 8000.826 + Rs 700 0.751 + Rs 6000.683
+ Rs 5000.620]  Rs 2,500
NPV  Rs 2,725  Rs 2,500 = + Rs 225
76
Acceptance Rule

 Accept the project when NPV is positive NPV > 0

 Reject the project when NPV is negative NPV < 0

  May accept the project when NPV is zero NPV = 0

 The NPV method can be used to select between mutually exclusive

projects; the one with the higher NPV should be selected.

77
Evaluation of the NPV Method

NPV is most acceptable investment rule for the following reasons:

 Time value
 Measure of true profitability
 Value-additivity

Limitations:

 Involved cash flow estimation

 Discount rate difficult to determine
 Mutually exclusive projects

78
Internal Rate of Return Method
The internal rate of return (IRR) is the rate that equates the
investment outlay with the present value of cash inflow received
after one period. This also implies that the rate of return is the
discount rate which makes NPV = 0.

C1 C2 C3 Cn
C0    
(1  r ) (1  r ) (1  r )
2 3
(1  r )n
n
Ct
C0  
t 1 (1  r )t
n
Ct

t 1 (1  r ) t
 C0  0

79
Calculation of IRR
Uneven Cash Flows: Calculating IRR by Trial and
Error

The approach is to select any discount rate to compute

the present value of cash inflows. If the calculated
present value of the expected cash inflow is lower than
the present value of cash outflows, a lower rate should
be tried. On the other hand, a higher value should be
tried if the present value of inflows is higher than the
present value of outflows. This process will be repeated
unless the net present value becomes zero.

80
Calculation of IRR
Level Cash Flows
Let us assume that an investment would cost
Rs 20,000 and provide annual cash inflow of Rs
5,430 for 6 years.

The IRR of the investment can be found out as

follows:
NPV  Rs 20,000 + Rs 5,430(PVAF6,r ) = 0
Rs 20,000  Rs 5,430(PVAF6, r )
Rs 20,000
PVAF6, r   3.683
Rs 5,430

81
NPV Profile and IRR
A B C D E F G H
1 NPV Profile
Discount
2 Cash Flow rate NPV
3 -20000 0% 12,580
IR
4 5430 5% 7,561
R
5 5430 10% 3,649
6 5430 15% 550
7 5430 16% 0
8 5430 20% (1,942)
9 5430 25% (3,974)
Figure 8.1 NPV Profile

82
Acceptance Rule
 Accept the project when r > k.
 Reject the project when r < k.
 May accept the project when r = k.
 In case of independent projects, IRR and NPV rules will give the same results.

Evaluation of IRR Method

 IRR method has following merits:
 Time value
 Profitability measure
 IRR method may suffer from:
 Multiple rates
 Mutually exclusive projects

83
Profitability Index
 Profitability index is the ratio of the present value of cash inflows, at the
required rate of return, to the initial cash outflow of the investment.

 Profitability Index = P.V of cash inflows / P.V of cash outflows

 The initial cash outlay of a project is Rs 100,000 and it can generate cash
inflow of Rs 40,000, Rs 30,000, Rs 50,000 and Rs 20,000 in year 1 through
4. Assume a 10 per cent rate of discount. The PV of cash inflows at 10 per
cent discount rate is:

84
Cont…
Year Cash inflows Discount rate @ Net cash inflows
10%
1 40,000 0.909 36,360
2 30,000 0.826 24,780
3 50,000 0.751 37,550
4 20,000 0.683 13,660
Total present value 1,12,350

PI = TPV of Cash Inflow/Cash outflow

= Rs. 1,12,350/Rs. 1,00,000
Þ 1.1235
Þ As PI > 1, Accept the project.
Acceptance Rule

The following are the PI acceptance rules:

 Accept the project when PI is greater than one. PI > 1

 Reject the project when PI is less than one. PI < 1

 May accept the project when PI is equal to one. PI = 1

The project with positive NPV will have PI greater than one.

Lesser PI means that the project’s NPV is negative.

86
 Evaluation of PI Method
 It recognises the time value of money.

 It is consistent with the shareholder value maximisation

principle. A project with PI greater than one will have positive
NPV and if accepted, it will increase shareholders’ wealth.

 In the PI method, since the present value of cash inflows is

divided by the initial cash outflow, it is a relative measure of a
project’s profitability.

 Like NPV method, PI criterion also requires calculation of cash

flows and estimate of the discount rate. In practice, estimation
of cash flows and discount rate pose problems.

87
Conventional and Non-conventional Cash Flows

A conventional investment has cash flows the pattern of an

initial cash outlay followed by cash inflows. Conventional
projects have only one change in the sign of cash flows; for
example, the initial outflow followed by inflows, i.e., – + + +.

A non-conventional investment, on the other hand, has cash

outflows mingled with cash inflows throughout the life of the
project. Non-conventional investments have more than one
change in the signs of cash flows; for example, – + + + – ++ – +.

88
NPV Versus IRR
Conventional Independent Projects:

In case of conventional investments, which are

economically independent of each other, NPV and IRR
methods result in same accept-or-reject decision if the
firm is not constrained for funds in accepting all
profitable projects.

89
Case of Ranking Mutually Exclusive Projects
Investment projects are said to be mutually exclusive when
only one investment could be accepted and others would
have to be excluded.

Two independent projects may also be mutually exclusive if

a financial constraint is imposed.

The NPV and IRR rules give conflicting ranking to the

projects under the following conditions:

 The cash flow pattern of the projects may differ. That is, the cash
flows of one project may increase over time, while those of others
may decrease or vice-versa.
 The cash outlays of the projects may differ.
 The projects may have different expected lives.
90
Reinvestment Assumption

The IRR method is assumed to imply that the cash

flows generated by the project can be reinvested at its
internal rate of return, whereas the NPV method is
thought to assume that the cash flows are reinvested
at the opportunity cost of capital.

91
NPV Versus PI
A conflict may arise between the two methods if a
choice between mutually exclusive projects has to be
made. Follow NPV method:

Project C Project D
PV of cash inflows 100,000 50,000
Initial cash outflow 50,000 20,000
NPV 50,000 30,000
PI 2.00 2.50

92
Risk management in PF: Introduction
- High Risk is an integral part of any project.

- Risk emanates due to uncertainty about the realization of estimated return.

- Risk involves when actual returns may vary from the estimate. Ex:
Post office deposit & Share market return

- Risk exists whenever the decision maker is in a position to assign probabilities

to various outcomes.

- Applicable when historical data is available. E.g: Insurance premium Risk

coverage based on mortality rates over the period of time.

- The factors influencing the returns is so complex that it is not possible to

eliminate the risk inherent in any project.

- Yet, what can be done is to minimize it or to manage it.

 Nature of Risk:
- Any project is undertaken with clear objective (i.e.) to provide reasonable
return to the capital invested.

- To meet this, the project undertaken is subjected to the process of a rigorous

appraisal and assessment of the following related aspects;

1. Promoters resourcefulness, track record and commitment to the project.

2. Management quality and proposed organizational setup

3. Marketing aspects – Ascertainment of the aggregate demand of the proposed

product, Market share, Marketing plan, Pricing policies etc.

4. Technical feasibility – Collaboration & Choice of technology.

5. Financial viability – Cost, Financing structure, Profitability estimates.