A Note On The Financial Evaluation Of Projects
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FINANCIAL EVALUATION Contd..OPPORTUNITY COSTS
Each and every resource utilized by a project entails a cost, irrespective
of whether the resource is purchased for the project or already owned by the
firm. If the resource is already owned by the firm, the opportunity cost of
the resource must be charged to the project. The opportunity cost of a
resource is the present value of net cash flows that can be derived from it
if it were to be put to its best alternative use. Suppose a project requires
land that is already owned by the firm. Though the cost of the land is a
sunk cost and needs to be ignored, its opportunity cost, i.e., the income it
would have generated had it been put to its next best use must be
considered.
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ACCRUAL ACCOUNTING AND CASH FLOWS
All costs and benefits are to be measured in terms of cash flows than in
terms of accrual accounting whereby income and expenditure are
recognized when the transaction is entered into rather than when payment
or receipt takes place. This implies that all non-cash charges like
depreciation and provisions that are deducted for the purpose of
determining profit after tax must be added back to profit after tax to
arrive at the net cash flow. |
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INCIDENTAL EFFECTSAll incidental
effects of a project on the rest of the firm's activities must be
considered. The proposed project may have a beneficial or detrimental effect
on the revenue stream of other product lines of the firm. Such impact must
be quantified and considered when ascertaining the net cash flows.
POST TAX PRINCIPLE
For the purpose of appraisal, the cash flows of a project must be defined in
post tax terms. Cash flows can be defined in three ways. Each of the methods
of cash flow estimation depends on different viewpoints regarding who
provides the capital for a project whether it is only equity shareholders or
both equity shareholders and long term lenders or the total fund providers
(including long term and short term). The post tax cash flows under the
three viewpoints would be different.
CASH FLOWS FROM LONG TERM FUNDS POINT OF VIEW
This method is based on the assumption that funds invested in a project come
from both equity shareholders and long term lenders. When calculating net
cash flows using this method, the interest paid on long term loans is
excluded. The rationale for this approach is that the net cash flows are
defined from the viewpoint of suppliers of long term funds. Hence, the post
tax cost of funds is used as the interest rate for discounting. The post tax
cost of long term funds obviously includes the post tax cost of long term
debt. Therefore, if the interest on long-term debt is considered for the
purpose of determining net cash flows, an error due to double counting would
occur. The following illustration shows how the error occurs.
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CASH FLOWS FROM EQUITY FUNDS POINT OF VIEW
CASH FLOWS FROM TOTAL FUNDS POINT OF VIEW
CHOICE OF DISCOUNT RATE
APPRAISAL CRITERIA
DISCOUNTED CASH FLOW/TIME ADJUSTED TECHNIQUES
NET PRESENT VALUE
APPRAISAL TECHNIQUES IN PRACTICE FOR VARIOUS TYPES OF PROJECTS
CONCLUSION
EXHIBIT I ASPECTS OF PROJECT APPRAISAL
EXHIBIT II PROJECT EVALUATION TECHNIQUES
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