A Note On The Financial Evaluation Of Projects

CHOICE OF DISCOUNT RATE

The next step in the financial evaluation phase is the determination of an appropriate discount rate. The determination of an appropriate discount rate is necessary for establishing the financial feasibility of a project. Most of the appraisal criteria used these days are time adjusted or discounted criteria, like net present value (NPV), benefit cost ratio (BCR) and internal rate of return (IRR). All these require the use of a risk-adjusted discount rate to determine the actual returns from the project (Refer Exhibit II). The most commonly used method for determining the discount rate makes use of theoretical models like the capital asset pricing model (CAPM)^[6] and the weighted-average cost of capital (WACC) model. The CAPM is used to ascertain the relevant cost of equity for a given level of risk. This is then combined with the cost of debt funds in proportion to their respective weights in the total funds used to finance the project. This combined approach is known as the WACC.

APPRAISAL CRITERIA

After determining the cash flows of a project, one must assess its viability. This can be achieved through the use of discounted criteria or non-discounted criteria.

Time adjusted or discounted criteria include

•Net present value.
•Internal rate of return.
•Benefit-cost ratio or profitability index.

Traditional or Non-discounted criteria include

•Accounting rate of return.
•Payback period.

Certain assumptions are made when appraising projects using the criteria given above. They are:

•The risk of all project proposals under consideration does not differ from the risk of the existing projects of the firm.

•The firm has certain criteria for evaluating the projects. Based on the criteria, the investment decision will be either to accept or to reject the proposal.

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

^[6] A model describing the relationship between risk and expected return. It serves as a model for the pricing of risky securities. According to CAPM, the expected return of a security or a portfolio equals the rate on a risk-free security (Rf) plus a risk premium. If this expected return does not meet the required return, then the investment should not be undertaken. Hence, the Expected Return = Rf + Beta * (Market return – Rf).

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