Feasibility Study

Project Appraisal 7.4.1 Introduction After estimating capital and operating costs; modelling and forecasting cash flows for the project, the next stage is appraising the project to determine whether it is financially feasible. Before setting out on this, one must make sure that the project cash flow is correctly projected as elaborated in the previous section. The criteria on which the project acceptance will be based should have been stipulated. In the present “dotcom” age, project appraisal would appear to be a simple exercise of selecting the correct functions from Excel application, plunging in the data by simply highlighting them, and you are done. True, that is what differentiates project analysis in the present digital age compared to three decades ago. But there is still more to it than that. Each analysis result have to be subjected to a more critical assessment in order to ascertain that it represents the reality on the ground. For example, if during sensitivity analysis, sales appears to be insensitive to the project profitability even up to 40% decrease, from which the market share was derived, need to be scrutinized once more. The same approach should be used for other variables. Remember the maxim : when it is too good, think twice! In this Guide, commercial appraisal is based on a greenfield and stand-alone project, and not two or more projects competing for resources from the same sponsor. Furthermore, the purpose of the appraisal is to determine (1) project profitability, or its potential to earn a decent return to the investors and (2) financial viability and sustainability, or the ability of the project to finance its operations from internally generated cash flow. 7.4.2 Appraisal methods and criteria Many investment decisions involve costs and benefits that are spread over a period of time. Construction and setting up of a production facility for SME project, for instance, may take anything from 6 months up to a year, before cash will start flowing in after the commencement of production. In order to ascertain whether the future cash inflows will justify the present investment outlay, the money spent today should be compared with the money expected to be received in the future. The comparison is effected by discounting the future streams to the present value. This will be elaborated more in later sections. So It is against this background that projects appraisal methods are divided into two main categories: discounting and non-discounting, the principal difference being that the latter does not take the time value of money into account, while the former does. Non-discounted methods Simple Payback Accounting Rate of Return (ARR) Discounted methods Net Present Value (NPV) Internal Rate of Return (IRR) Modified Internal Rate of Return (MIIR) Discounted Cash Payback Period (DPB) Payback Period is the time it will take for the business to recoup the amount of capital it has invested in the project, from the generated cash flows. To use this as criteria, a basis must be established for the maximum payback time required for accepting the project; which may be arbitrarily selected, depending on the scale of investment or an industry standard, typically about 2 to 3 years. The variables that goes into the calculation relationship are connected as follows: Payback period=(Initial investment outlay)/(Annual cash flow receipts) Example 7.2 Payback calculation A project with a total investment of TZS 20,000,000 is expected to generate the following cash flows over a six year period. Table 7.4 Cash flow data for calculation of payback period (TZS x 1000) The cumulative cash flow in the third row indicates that by the end of the second year there is only TZS 6,000,000 left to recoup the investment. The cash flow in the following year (Year 3) is TZS 8,000,000. If this cash flow is spread evenly throughout the year, the payback will occur in another 6,000,000 ÷8,000,000 = 0,75 years, giving a payback period of 2,75 years. The decision rule then is : accept the project if the payback period is above the cut-off rate, reject it otherwise. Thus, if the adopted cut-off payback period was 2 years, this project would be rejected. The payback method is sometimes dubbed as the “rule of thumb” on account of its simplicity, which is probably its only advantage; but as an appraisal tool it has several flaws. First, it ignores the timing of cash flow, which is so important to the opportunity cost of capital. Second, it does not take into account the cash flow occurring after the payback period. For the previous example, a total of TZS 29,000,000 is expected to be generated from year 3 to the end of the project. With a cut-off period of two years, this amount is disregarded in evaluating the project. The implication of this is that the payback method discriminates against projects with longer economic lives. It is concerned more with attaining a quick payback; and if it does not occur, the project will be rejected out of hand. The payback method is not suitable for appraising a project, save as an initial indication to an entrepreneur for an investment made in a risky country where an early recovery of the investment is important, in case anything may go wrong. Accounting Rate of Return (ARR), also referred to as the average return on investment (ROI), is defined as the ratio of average after-tax accounting profit to the investment outlay made for the project, normally expressed as a percentage. It utilizes financial accounting result figures, and not cash flow. As for the payback period, the resulting ARR is then compared to an arbitrarily chosen cut-off rate. ARR=(Average profit after tax)/(Investment outlay) Note that the there are two definitions (another weakness for the method) for the denominator. In one definition, the denominator is the average investment, calculated as the initial investment plus the final investment in that period, divided by two. In this Guide, the definition given in the preceding equation will be used.