Project Evaluation Appraisal; Payback Period
Table of Contents
PROJECT EVALUATION APPRAISAL; PAYBACK PERIOD
PROJECT:
“Any proposal made for capital investment is called project.” Or; It is a way of using the resource. The projects are launched for the development of society.
EVALUATION:
“Evaluation is a process for determining systematically and objectively the relevance, efficiency, effectiveness, and impact of activities have to be performed or have been performed” Or;
Evaluation means the establishment of admissibility of a project and if there are more than one project, then the selection of the projects which is the best.
In simple word, “It is the process of determining the viability and feasibility of a project.”
For the determination of the admissibility of a project, there are certain yard-sticks or techniques which are to be employed for evaluation. Most important evaluation techniques are:
- Un-discounted rate or return
- Pay-back method
- Present value method
- Benefit-cost ratio
- Inter rate of return (IRR)
Un-discounted rate or return:
In this method, the time value of money is not considered. It is one of the oldest methods of evaluation.
Example: If a person wants to set up a sawmill with the following costs:
- Capital investment = 50, 000
- Annual rent = 1000
- Useful life = 5 years
- Annual running cost:
- Cost of power
- Taxes 3000
- Worker charges
Thus, Total Annual Cost = Running cost + Annual Rent
4000 = 3000 + 1000
The revenue is Rs 12000 / annum, and 16000 / annum. If we prepare a balance sheet of this investment:
No of Years | Running Cost + Rent | Revenue (i) | Revenue (ii) |
1 | 4000 | 12000 | 16000 |
2 | 4000 | 12000 | 16000 |
3 | 4000 | 12000 | 16000 |
4 | 4000 | 12000 | 16000 |
5 | 4000 | 12000 | 16000 |
Total | 20,000 | 60,000 | 80,000 |
Net Revenue = (i) 60,000 – 20,000 and (ii) 80000 – 20,000
= (i) 40,000 and (ii) 60,000
- If the net revenue is less than the capital invested in the project is not feasible
- If the net revenue is greater than the capital invested in the project is feasible.
Merits:
- Simple to calculate
- It does not take into account the time value of money
- It gives equal weight to the payments made today and payments made afterward.
Pay-back method:
It is the period of time over which the capital invested will be recovered back or it refers to that period of time during which initial outlay of the project is recovered. For this purpose, a balance sheet is drawn. Those costs are taken into accounts which are direct costs or running costs. The net gross revenue is considered for drawing a balance sheet. The businessmen or investor fix payback period according to their experience. If it is less than the calculated period, the project is feasible and if more it is not feasible.
Payback Period = Capital investment / Average annual revenue
= CI / AAR
Merits:
- It is simple
- It provides a measure of risk
- No calculations are involved
Demerits:
- It does not take into account the benefits which can be derived from the project after the payback period is over.
- It does not give the magnitude of profitability.
- It does not help in the ranking of the project
- Its basis is not scientific
- It doesn’t take into account not tangible benefits.
We cannot use the payback period method in forestry due to a long rotation. It is confined to industry and business. Presently the use of this method has been discontinued.
Present value method
Net present values is defined as the present value of expected future returns minus the present value of expected future cost, with costs and returns discontinued at the appropriate interest rate.
NPV = ΣR – ΣC / (1 + ґ)^{n}
While evaluating the project, the corps to be incurred on the projects is discounted to the base year. Similarly, the amount realized on revenue during the project period is also discounted back to the base year. The net present value method provides a ‘pass-fail’ test for deciding whether or not to undertake a particular project.
- If the net NPV of the project at the appropriate discount rate is positive then the project is acceptable.
- If the NPV is negative than the project is not acceptable.
For example, A poplar plantation is to be grown and the following costs are incurred during different years with revenue obtained at the end of 5^{th} year.
Year | Cost / ha | Factor | Disc: cost @ 10% | Revenue Factor | P.V @ 10% |
1 | 1050 | 1.10 | 954.55 | — | — |
2 | 300 | 1.21 | 247.93 | — | — |
3 | 200 | 1.331 | 150.26 | — | — |
4 | 200 | 1.4641 | 136.60 | — | — |
5 | 700 | 1.6103 | 436.65 | 5000 | 3104.63 |
Total | 1925.99 | 3104.63 |
NPV = ΣR – ΣC
= 3104.63 – 1925.99
= 1178.64
Merits:
- Takes into account the time value of money
Demerits:
- It does not help very much to determine the most suitable process.
- If we have a large project it will have larger present value and smaller will have a small value. The returns economic efficiency may be less in the first case.
- It does not help in the selection of the projects.
Benefit-cost ratio:
It is of American origin, firstly used for evaluating watershed development projects. Later on, it has been used almost exclusively as a measure of social measure ie for economic and social analysis. Nowadays it is being applied to all and particularly suited to afforestation projects in special areas.
The BCR can be defined as follows:
BCR = Present value of benefits / Present value of costs
The higher the discount rate the smaller the resulting benefits cost ratio. If BCR is more than one (ie BCR > 1), then the project is acceptable and if less than one (ie BCR < 1), then rejected.
For evaluation purposes, we determine the value of benefits derived by the society on account of such public projects and make a balance sheet of benefits and costs. Then, these values are discounted. The ratio b/w discounted benefits and discounted cost values will give us an idea about the feasibility of values will give us an idea about the feasibility of the project. For each project, this ratio can be easily worked out and easily be related accordingly to the highest ratio obtained. The allocation of funds will be made to that project first which has the highest ratios and go on allocating funds respectively until you reach the end. Thus the project has a ratio less than 1: 1 which is not accepted. This process is called “budget planning”.
Merits:
- It can easily be carried out.
- It is superior in the case where the constant budget is involved.
Demerits:
- How to choose the correct rate of interest?. It is better to use 2-3 rates of interest for discounting.
- It is difficult to estimate the prices of those goods and services which are not purchased in the market.
Sensitivity Analysis:
In order to overcome the selections of the appropriate rate of interest. This analysis has been evolved. Apply different rates of interest from 10 – 20% and similarly change the prices of goods and services granted by the project. If B / C ratio (ie benefit-cost ratio) is still more than one, the project is feasible.
The internal rate of return (IRR)
It is the discount rate at which the discounted project cost, including investment costs, is just equal to discounted project benefits.
The IRR can also be defined as that rate of discount if applied reduces NPV of the project to zero.
In Forestry, IRR may be defined as the average rate earned on all costs made prior to the time of timber harvest.
The terms financial yield and the marginal efficiency of capital used in literature signify the IRR. The IRR is greater than the actual rate of return the project will be feasible.
Merits:
- It does not require the selection of the appropriate rate of interest.
- It takes into account the scale of initial investment.
- It is also easy to use in considering project risk.
- No availability assumption or rate of return is used.
- It is used by private individuals.
The following steps are to be taken while calculating IRR:
- Formulation of the cash flow statement including yearly estimates of cost and revenue.
- Application of different discount rates and try to find out what rate of interest which equates both sides of revenue and costs and brings present worth of the project equal to zero. This process is known as Reiteration.
Returns must be greater than that of the cost of the project of any investment has to be made. Thus every method of evaluation concentrates on the benefit to be derived and costs to be made during the project period to determine the feasibility of the project.
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