A Note On The Financial Evaluation Of Projects

FINANCIAL EVALUATION

The financial evaluation of a commercial project mainly involves estimating the return on investment and the profitability of the project. However, the financial evaluation of non-commercial projects involve the identification of the most efficient way of delivering the desired project outputs and ensuring that the project outputs result in significant benefits to the community.

Financial appraisal includes the compilation of the list of alternative projects and the associated streams of costs and benefits. The financial evaluation is conducted using the cash flow rather than accounting profits method^[2]. The accuracy of the evaluation will ultimately depend on:

According to this principle, the cash flows have to be measured in incremental terms. Only those revenues or expenditures that are likely to occur as a direct result of the project should be included when determining the cash flows. A project's incremental cash flows should be ascertained through the ‘with and without^[3]'principle, i.e. to determine the cash flows of the firm including and excluding the project.
Project Cash Flow Cash flow for the firm Cash flow for the firm
for year (T) = with the project for year (T)  without the project for the year (T)

The idea behind the incremental analysis concept is to illustrate only the additional impact created by a project. Cash flows that would have occurred irrespective of the project are extraneous to the analysis and should be excluded.

If a department currently owns a vehicle fleet and is considering selling it and leasing vehicles instead, the incremental costs and benefits of doing so can be compared. If the net present value of the proposal is positive, then the proposal should be accepted. If the current situation is being compared with more than one alternative, the proposals can be ranked by dividing the net present value by the initial investment. The proposal which should be accepted is that with the highest ratio of net present value to Investment.

Sunk costs refer to non-recoverable costs incurred in the past or committed before the evaluation of a project. These costs have to be ignored when conducting a financial evaluation of a project.

Firm A has hired a consultant to assess the viability of outsourcing its credit collections and to list the possible agencies to which it can outsource its collections. Firm A spent $121,000 on consultant's fees prior to the evaluation of proposals. It further estimated that other costs like legal fees, stamp duty etc. for setting up an outsourcing contract would be $240,500 and the present value of cost savings from outsourcing will be $320,450. On the basis of the available information, the management of the company argued that since it had already incurred $121,000 for assessing the viability of the project, it would be a waste not to proceed with outsourcing, while the staff argued that the firm should not proceed further because the project would never recover the initial outlay of $121,000. In this case, both the arguments are invalid, as $121,000 is the sunk cost and thus irrelevant for calculating the project costs. The outsourcing project will have an NPV of $79,950 ($320,450 – $240,500).

^[2] The accounting profit method ignores the time value of money. Under this method, revenue is recognized as being generated when the product is sold and not when cash is collected from the sale of the product.

^[3] A common mistake is to select cash flows on a ‘before and after'basis (the ‘after'cash flows incorporate the effects of the project and other unrelated initiatives).

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