Project appraisal and Implementation- Module 3
Project appraisal is a process that evaluates a project's feasibility and
viability before committing resources. It's a key part of project
management.
Purpose
To determine if the project will meet its objectives
To ensure the project is sustainable
To ensure the project provides the expected returns or benefits
To compare different projects that compete for resources
Appraisal methods
Economic appraisal: Compares costs and benefits that can be valued in money
terms
Financial appraisal: Assesses the cost and profitability of a project
Technical appraisal: Ensures that a project is designed, engineered, and follows
accepted standards
Environmental appraisal: Includes initial environmental examination (IEE) and
Environment Impact Assessment (EIA)
Steps in the process
Identify the project and define its scope
Identify the goals, objectives, and expected outcomes of the project
Evaluate the project's viability and feasibility
Determinants of cost of project
The cost of a project in project management is determined by many factors,
including the resources required, the nature of the project, and the market
conditions.
Factors that affect project cost
Resources: The cost of labor, materials, equipment, facilities, and third-party
vendors
Project nature: The type of project, such as construction, and the client's priorities
Market conditions: The economic conditions that affect the cost of materials, labor,
and other resources
Procurement options: The choice of how to acquire resources, such as through
purchasing or contracting
Legislative constraints: Laws and regulations that may affect the cost of the project
Cost estimation
• Cost estimation is the process of calculating the costs of all
the resources required for a project. This can be done in the
form of an itemized budget or a cash-flow plan.
Cost control
• Cost control is the process of measuring and taking action to
correct cost variances from the baseline. This can include
increasing the budget or reducing the scope of work.
Cash flows
In project management, "cash flows" refers to the movement of money
in and out of a specific project over its lifecycle, including incoming
revenue from deliverables and outgoing expenses like labor costs,
materials, and other project expenditures, essentially tracking the
project's financial status at different stages.
Cash flows in project management:
Components:
Incoming cash: Revenue generated from delivering project milestones,
client payments, etc.
Outgoing cash: Costs associated with project execution like salaries,
equipment rentals, material purchases, and other operational
expenses.
Cash flows
Importance:
Financial health monitoring: Tracking cashflows allows project managers to identify
potential financial issues early on, like cash shortages or overspending.
Decision-making: Analyzing cashflow data helps in making informed decisions
regarding resource allocation, budget adjustments, and project phasing.
Risk mitigation: By forecasting future cash inflows and outflows, project teams can
proactively address potential financial risks.
Analyzing Cashflow:
Cashflow projections: Creating a detailed forecast of expected cash inflows and
outflows throughout the project timeline.
Cashflow statement: A financial document that summarizes the cash generated and
used by a project, typically categorized as operating, investing, and financing activities.
Types of Cashflows in Project Management:
Operating Cashflow:
Cash generated from the core operations of the project, including
revenue from deliverables and direct project expenses.
Investing Cashflow:
Cash related to purchasing or selling long-term assets needed for the
project, like equipment or software licenses.
Financing Cashflow:
Cash related to funding the project, including loans, equity
investments, and debt repayments.
Review of Net Present Value method
The Net Present Value (NPV) method is a widely used financial analysis
tool that evaluates the profitability of a project by calculating the
present value of all future cash inflows and outflows, effectively taking
into account the "time value of money" principle, where a dollar today
is worth more than a dollar in the future; a positive NPV indicates a
profitable, project, while a negative NPV indicates a loss-making one.
NPV calculates the difference between the present value of all future
cash inflows from a project and the initial investment required.
NPV Decision Rule
The following NPV signs explain whether the investment is good or bad.
NPV > 0 - The present value of cash inflows is more than the present value of
cash outflows. The money earned on the investment is more than the money
invested. Hence, it is a good investment.
NPV = 0 - The present value of cash flows is more than the present value of cash
outflows. The money earned on the investment is equal to the money invested.
Therefore, there is no difference between cash inflows and cash outflows.
NPV < 0 - The present value of cash inflows is less than the present value of
cash outflows. The money earned on the investment is less than the money
invested. Hence, it is not a fruitful investment.
Role of NPV
Net present value (NPV) is the difference between the present value of
an investment and the cost resulting from an investment. The points
given below define the role of NPV accurately.
• A positive NPV indicates that the investor’s financial position will be
improved by undertaking a project.
• A negative NPV indicates the financial loss of an investor.
• Null or zero NPV indicates that the present value of all the benefits
over useful time is equivalent to the present value of cost.
Benefit-Cost Ratio Method
To calculate a benefit-cost ratio (BCR), you can divide the total present
value of benefits by the total present value of costs. The formula is:
BCR = Present value of benefits / Present value of costs
Example of the Benefit-Cost Ratio
Cash flow projections for a project are provided below. The relevant
discount rate is 10%.
Interpretation
The benefit-cost ratio would be calculated as $97,670.72 / $33,625.09
= 2.90.
• The higher the BCR, the more attractive the risk-return profile of the
project/asset. The value generated by the BCR indicates the dollar
value generated per dollar cost.
• For example, the BCR of 2.90 in the preceding example can be
interpreted as “For each $1 of cost in the project, the expected dollar
benefits generated is $2.90.”
Merits and demerits
Key advantages of the benefit-cost ratio include:
It is a useful starting point in determining a project’s feasibility and
whether it can generate incremental value.
If the inputs are known (cash flows, discount rate), the ratio is relatively
easy to calculate.
The ratio considers the time value of money through the discount rate.
The ratio indicates the value generated per dollar of costs.
Key limitations of the benefit-cost ratio include:
• The reliability of the BCR depends heavily on assumptions. Poor cash
flow forecasting or an incorrect discount rate would lead to a flawed
ratio.
• The ratio itself does not indicate the project’s size or provide a specific
value on what the asset/project will generate.