Notes of

Lecture one----- ‘Introduction to Project Appraisal’

of the Program on
Project Appraisal [Financial Aspect] and introduction to
Risk Analysis

Conducted by
Project Appraisal Consultants
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What is Project Appraisal?
Project appraisal is a structured and Systematic process to examine and assess:
 Financial viability
 Economic viability
 Social viability
 Technological suitability and
 Environment sustainability of Projects

Project appraisal helps in

• weeding out unviable projects
• ranking of projects
• expediting the financial closure of projects
• timely completion of projects

World Bank reports have brought out that poorly appraised projects have seven
times more probability of failure within three years of their implementation as
compared to well appraised projects.
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 VARIOUS STAGES OF PROJECT FORMULATION

Inception of Project Idea

↓

Pre Feasibility Study

↓

Feasibility Study
↓

Detailed Design of project

↓

Detailed Project Report

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 WHAT ARE DIFFERENT STAGES / MUDULES ?

Analysis Module.

Financing Module.

Project Investment Stage.

Project Operation Stage.

Post Completion appraisal.

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 PROJECT ANALYSIS / APPRAISAL MODULES
Project has following analysis / appraisal modules:
• Financial Analysis/Appraisal

• Economic Analysis/Appraisal

• Distributive/ Social appraisal

• Sensitivity Analysis

• Scenario Analysis

• Risk Analysis (use of Simulation)

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FINANCIAL ANALYSIS / APPRAISAL MODULES
- The Financial appraisal is most widely used in State Government Projects and
Programme as well as by the Lenders / Banks.

- Financial analysis is done in different ways for different stakeholders such as:
• Project promoters
• Banks / Lenders to Project
• Government Budget
• Economy

Broad frame work for financial appraisal is done as follows:

• Prepare Cash inflows, Cash outflows and Net Cash flows profile over the life of
the project.
Where
the revenue / Benefit is taken as ‘Inflow’ to the project and
the expenditure / cost is taken as ‘Outflow’ to the project

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 For any year in the life of the project (say ̔t’ year)
Net Cash Flow = Cash Receipt – Cash Expenditure of year ‘t’

Similarly,
Net Benefit = Benefit – Cost of year ‘ t ‘
 in initial years ̔Net Cash flow ̓is negative because of investments [Investment Stage]
 As Project Operations stage comes, the Net Cash flow becomes positive.

Operation Stage
Cash
flow 0
→Years

Investment Stage
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- If additional Investments are made on technology up gradation or
renovation during Project Operation Stage, then the Net Cash Flow
profile could also be as follows:
Selling plant

← Salvage Value

Net Cash Operation Operation

Flow
→ Years

Additional Investment
↑ or

Investment Replacement

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-In some projects there may not be any positive salvage
value at the end. In fact, in some cases, decommissioning of
project may require funds. Example Nuclear plants; Mines.

Operation

Net Cash
Flow → Years

↑
Cost of decommissioning
↑
Investment

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 INVESTMENT PHASE IN A PROJECT

- Timing of Investment : When to make investment in a project and start a

project.

- This depends on:-

• When the demand for output of a project is large enough to support the
project.

• Is technology needed for the project available.

• Is project financially viable?

• Financial closure of the project should take place.

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 ONE WEEK PROGRAMME COVERAGE
Real
• Financial
Costs Nominal
or Prices Real
Economic
Nominal
• Costs are given in the account books or estimated by Accounting Officers
• One has to be careful in their use and should know fully about them.

• ACCOUNTING SYSTEMS
There are two accounting systems in use.
Accounting Systems

Cash based System Accrual System

• Use of these systems, advantages / disadvantages

• Mixture of both also used.
• Cash based System : Immediate survival / short term viability
• Accrual based system : Long term survival.
• Examples

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 PRO FORMA CASH FLOW STATEMENTS

• Investments in one, two, three …..years

• Operation and Maintenance expenditure
• All Revenues receipts from sales, services and miscellaneous
• Salvage value (At the end)

Different perspectives for Cash Flow Statements:

Pro forma Cash Flow Statement are prepared for following different
perspectives:
• Project promoters’ – Equity holders’ perspective
• Lender’s / Banker’s perspective
• Government budget perspective
• Economy perspective

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PROCEDURE FOLLOWED FOR PREPARATION OF
PRO FORMA CASH FLOW STATEMENTS:

Cash out flows (from project)

• Investment
•Operation and maintenance costs
•Materials/salaries etc.

Cash In flows (to project)

• Sale of goods/products/services
•Miscellaneous revenue
• Salvage value

• Net Cash Flows (NCF). This is calculated for each year

Net Cash Flow = Total Cash Inflow – Total Cash Out Flow

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 OPPORTUNITY COST OF FUNDS
• Different sources used to fund a project
• Government
• Bankers
• Public
• How to find out opportunity cost of Public fund?
• Discount Rates, Discount factors
• Discounting/Compounding
• Inflation
• Weighted Average
• Price Increase in basket of goods
• On annual basis
• Inflating/Deflating
• Annual Inflows/ Outflows
• Annuity – Perpetual inflows cases
• Weighted Average Cost of Public Funds (WACC)
• Calculation of Real or Nominal interest Rates/Discount Rates
• What should be the base year for real values ?

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 ALTERNATE INVESTMENT CRITERIA
- What are different criteria used for finding out a project viability?
- Why these are needed?
- Different Methods used for Project / Programme or Scheme appraisal
• Net Present Value (NPV) Method
• Internal Rate of Return (IRR) Method
• Benefit Cost Ratio (B/C) Method
• Pay Back Period / Pay Out Period Method
• Cost Effective Method
- Which Method to use and Where?
- Financial Appraisal and Economic Appraisal.

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- Mutually Exclusive and Mutually non-Exclusive projects.
- Weakness of IRR Method

- Typical cases where B/C Ratio and IRR Methods give opposite ranking of projects
as compared to NPV Method
- Why and when to use Pay Back Period Method? Who generally uses this?
- Cost effective Method – Measureable units of output and inputs not in
monetary units ( Input can be given in Rupees but output is non monetary units
such as control of Malaria, improvement in adult literacy etc.)

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DISTRIBUTIVE / SOCIAL APPRAISAL
- What is Distributive OR Social appraisal?
- Poor, Rich, middle class – value money differently.
- Poor incur more expenditure on essentials (as a proportion of their income)
- Rich incur less expenditure on essentials.
- Middle class – in between Rich and Poor.
- What are distributional weights. How to calculate and assign weights in appraisal?
- Segregation of Benefits / Costs of all sections as far as possible.
- Assigning weights to the costs/benefits of Rich, Middle and Poor.
- Do Appraisal of project, with weighted Benefits / Costs.
- Caution – Assignment of weights to be done carefully.
- Examples: Rural Road and Urban Flyover projects. Cheese project in urban area and milk
project in rural area.

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EFFECTS OF INFLATION ON PROJECT VIABILTY
 What is Inflation? Weighted average increase in prices of a basket of goods.
 How does it affect project inputs / outputs / taxes / subsidies?
 Inflation effects on project viability in following six different ways.

- Cost of Goods Sold (COGS) (FIFO – LIFO)

- Project Financing
- Loan and Interest Payments
- Taxes Payment [ Higher inflation makes you pay more taxes]
- Depreciation expenses and taxes
- Inflationary tax on ‘Desired Cash Balance’.

 Integration of all effects of Inflation

 Does project viability deteriorate with Inflation? Why? And How?

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 INCREMENTAL / SCALE ANALYSIS
- What is Incremental OR Scale Analysis?
- Economies of Scale
- Law of Diminishing Returns
- Increase scale size of project or scheme and find out

- NPV of each scale

- Incremental NPV (∆ NPV)
(NPV of incremental Net Cash Flow)
- IRR
- Marginal IRR (MIRR)
(IRR of incremental Net Cash Flow)

- Draw Scale or size versus NPV, ∆ NPV, IRR, MIRR

- Select a scale at which the NPV is maximum
- IRR is Maximum when IRR and MIRR meet but MIRR is reducing
- Maximum addition to welfare of the Society when NPV is maximum
- Why is this analysis not done?
- Dibang Hydro power Project
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INTRODUCTION TO RISK ANALYSIS PART I
Introduction to Risk Analysis Part I will cover followings:
- What is Risk Analysis ?

- Characteristics of probability distributions.

- What are Mean, median and mode values in project data and how to calculate them?
- Different types of probability distributions ?

- Probability distribution versus cumulative probability distributions.

- Significance of Variance, Standard Deviation and Coefficient of Variation.

- How and why the project appraisal with mode or best values of inputs will not give the

most probable solution?

- What are stochastic and deterministic values ?

- Risk lover versus Risk Adverse

- Risk Analysis useful in marginal projects

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 INTRODUCTION TO RISK ANALYSIS PART II
The Introduction to Risk Analysis Part II will cover the followings

- Illustration explaining the use of simulation in Project appraisal.

- Application of different probability distributions on different inputs or

outputs.
- Typical graph depicting expected project return [NPV]

- When to select or reject a project on the basis of simulated results.

- How the Risk Averse and Risk Lovers select projects ?

- Case when one project clearly dominates the other.

- When not to do any project?

- Usefulness and limitations of Risk Analysis.

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 RISK MANAGEMENT
- How to Quantify Risks?

- Monte Carlo Simulation.

- Expected Loss/Gains Ratios.

- How to Reduce Risks?

- Link input prices and output prices.

- What are positive negative correlations between input and output.

- Passing on risks through Contracts.

- Hedging Risks.

- What is Efficient Risk Management - Ratio of resources (money, time and

manpower) used to reduce Risk should be maximum.

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Remember :
If you hear
You may will forget

If you see,
You may remember

If you do yourself,
You will remember

Hence please attempt all the assignments

which I will give.

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