Course: project economics and evaluation

Course: project economics and evaluation Course code: C11PV Coursework title: Project Appraisal Student Number: H00152083 Lecturer: Dr. Esinath Ndiweni 1. Introduction The work is centred on the importance of project appraisal therefore emphasising on the financial and non-financial techniques of appraisal. The object and, therefore, the importance of a project appraisal is making an analysis to see whether the project is viable. It is vital to know whether a project is technically feasible and whether it is going to be an economic liability or not.

A project appraisal is an important part of any project and should be taken seriously because a lot rests on it. The effects of a project appraisal are long reaching and have very definite long term effects because of the capital investment that is always required in any project. Once a decision has been made to go ahead with a project, it is irreversible. Even if, through some catastrophic event, the project has to come to an unpredicted halt, the investment has been made so all could be lost. These high expenditures can be critical, not just for that particular project but for the health and survival of the entire business.

As such, this paper combines the importance of both methods in order to help in assessment of project performance. 2. Literature review Recent literature has been emphasising on the need to consider the use of both financial and non-financial methods when dealing with project decisions. It is fundamental for a project to consider these techniques in order to measure a success of a project. This part of the paper is focused on critically analysing and evaluating these techniques and justifying why both are important. Some of these methods are very simple (e. g. payback period) while others are particularly sophisticated and complex (e. . Net Present Value, Real Options Reasoning). Simpler methods do not take into account the time value of the money and do not include the risk dimension. All these methods are well documented and explained in the literature. However, there is little empirical evidence on the factors that explain the use of the different techniques by firms. Thus, this paper is focused on the use of capital investment appraisal methods (CIAM) in practice. Particularly, it analyses whether there are specific contingencies that explain why firms use and do not use specific capital investment appraisal methods. . Financial method of appraisal The decision making in projects are not difficult when we only use financial knowledge. Financial techniques use NPV, IRR, Payback Period techniques in appraising a project as well as making investment decisions. Through this technique, a firm can also analyse a project’s tendency to risk by using sensitivity analysis and risk analysis. Project managers often concentrate on establishing the financial visibility of their projects through reasonable economics.

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Traditionally, the Net Present Value, the Internal Rate of Return and Payback Period techniques have formed a major component of the financial techniques of investment. They are often based on the time value of money methods to forecast the expected monetary returns of a given project. The reliability of these techniques however depends on the accuracy of the given cash flows and the time frame as planned by the organisation. A major drawback to the financial method of appraisal is the fact that it cannot be practically assumed with a high degree of certainty.

The value of all the factors is affected by numerous risks and unforeseen events which are often difficult to tell. Based on an article by S. Mohammed under project certainty (2001) he argued that the financial factors like the net present value, internal rate of return and payback period do not allow for non-financial aspects to be considered in assessing investment option. Non-financial methods such as political, legal and social factors are believed to be essential but rather, firms count them outside the normal appraisal process. These non-financial factors require careful knowledge in order to be managed.

In major cases, the neglect of these aspects may result in failure of the project despite having favourable financial components. a. Types of financial techniques of appraisal There different types of techniques in the financial aspects of appraisal. The first to be considered is the Net present Value (NPV). This method enables the firm to determine how much value a project can add. It determines the acceptability of the project. Before taking any step to in a project, the NPV must be considered. If the NPV is positive, then the project can be accepted, whereas if it is negative, the project should be rejected.

It determines the stance of the firm in the project and enables organisations to know the end product of the project in terms of cash. The limitation however is the fact that NPV does not accurately forecast future costs and benefits. Another technique is discounted cash flow method which provides approach for evaluating proposed investment project because they recognise the importance of the concepts of time value of money and the cost of capital, and stress the need for forecasting. It can be applied for valuing business as a whole and also for valuing individual business components of a company or firm.

Also it can be used by both equity shareholders because on the basis of DCF valuation they can compare two companies and take decision whether to invest or not, and also debt holders can use DCF method to take decision regarding the company. The problem with DCF is that since it is a valuation tool it is dependent heavily on the inputs used for valuation purpose, so if inputs are changed slightly there can be large change in the value of a company. Payback period is another important technique which refers to the period of time a project can cover for the investment made by the company.

For example if the initial project cost is ? 50000 and the annual cash flow is ? 10000, it implies that the payback period would be 5 years. It is also beneficial for those companies who are recently established and want to know the time frame in which they would recover their original investment, therefore those companies which do not want to take risk and want quick return on their investments can select those projects which have low payback period and ignore those projects which require long gestation projects.

A major disadvantage of payback period is that it does not show a true picture when it comes to evaluating cash flows of a project. b. Advantages and disadvantages of different financial methods of appraisal The payback period is based on the idea of how much time is needed for the project to generate cash flows sufficient to recover the initial amount invested. It can be also used as a criterion for acceptance or rejection of projects in the case that the payback period is above or below a certain number of years previously defined.

The main advantages of this method are: ease of understanding; simplicity of implementation; provides an idea of the degree of liquidity and risk of the project; and in times of huge instability, the use of this method is a way to increase the security of investments. Despite these advantages, the payback method has two important drawbacks. First, it ignores the cash flows occurring after the payback time, which can lead to the rejection of profitable projects that require a longer recovery period. Second, the payback period, in its original version, does not consider the time value of money in calculating the cash flows.

This is inconsistent with the basic principles of financial mathematics. One way of overcoming this problem is to calculate the payback period by discounting (at the appropriate discounting rate) the expected future cash flows, as proposed by Longmore (1989). The accounting average rate of return (ARR) is computed as the ratio between the project’s estimated average profit and the average accounting value of the investment (Brealey and Myers, 1998). This ratio is compared with the firm’s accounting rate of return or other benchmark external to the firm (e. . the industry average value). The main advantages of this method are its simplicity of understanding and usage, given that the figures used in calculations are those provided by accounting reports. However, this method presents some important weaknesses. First, it does not take into account the time value of money. Second, being based on accounting earnings and not on the project’s cash flows, it is conceptually incorrect. Finally, there is the need to set a target rate of return as a prerequisite to apply ARR as an appraisal method (Akalu, 2001). c.

Benefits and importance of financial techniques of Appraisal The object and, therefore, the importance of a project appraisal is making an analysis to see whether the project is viable. It is vital to know whether a project is technically feasible and whether it is going to be an economic liability or not. A project appraisal is an important part of any project and should be taken seriously because a lot rests on it. The effects of a project appraisal are long reaching and have very definite long term effects because of the capital investment that is always required in any project.

Financial techniques are essential methods in determining the acceptability of the project. Financial method of appraisal is often regarded as the aspect of project appraisal, however, in order for a project to be successful non-financial aspects must also be considered. A major significance of financial method of approval is that it partially justifies spending money on a project. This means that it enquires whether a project gives good value for the budget of the project. It also gives confidence through its several tools that money is being put to good use.

Financial techniques are also important decision making tools in which they involve comprehensive analysis of a wide range of data and judgement. This is to enable projects managers to ensure that the selected project is sustainable and it also guarantees sensible ways of managing risk. Furthermore, financial method helps to confirm that projects will be managed properly, by ensuring the calculations are accurate, that there are contingency plans to handle risks and setting milestones against which progress can be judged. 4.

NON-FINANCIAL METHODS OF APPRAISAL Project appraisal is not all about financial methods. There are non-financial aspects of appraisal that play an important role in helping firms make decisions on projects. As a matter of fact, non-financial factors are considered as the backbones of a project that will either make or break a project. A very important factor that requires consideration is meeting the requirements of current and future legislation. In most cases it is regarded more important than any method of appraisal because it is uncertain.

Every country belongs to a system of government that it is accountable to, in an event where every calculations and evaluations have been completed to determine the acceptability of a certain project, and then along the line the government in power brought a rather abrupt end to the given project. The logic in this implies financial techniques of appraisal are very significant to a project, however, they must go hand-in-hand with the non-financial factors and it is paramount for any management to consider meeting the requirements of the legislation first.

Other important factors of non-financial methods are matching the standards of the industry, improving staff morale and improving relationships with clients. In most cases, it is fundamental to balance non-financial and financial techniques. The firm may need to decide how important each factor is to the project. An appraisal choice in this way can take into consideration how well the project fits with the techniques. d. Analysis of non-financial factors of appraisal

There are different factors to be considered in the appraisal of projects. In most cases some of these factors are neglected in the event of appraisal and it does not reduce the profitability of the project, and on the other hand it renders the project non-profitable. First of all, the political factors must be considered. This is an obvious factor which its omission could result into the end of the project in the sense that the project manager or the firm must meet the requirements of the legislation.

For example some governments could ban the use of some web-based advertisements due to political reasons definitely, and the project could sometime require the use of the web-based sites to create awareness of the project to the general public. Due to the actions of the government, the project consequently faces a setback. The advantage of this factor however is that, it does not occur often and it has a low probability of failing a project if it does not occur. A good example of this factor is when 2011, the Egyptian president decided to ban the access of YouTube, a video site that is known worldwide for its ease of video coverage.

If the company decides to advertise the project through this means and along the way the decision is taken, the company will definitely face a setback. Another factor to be considered is the environmental factor. Green activities have recently gained popularity to the extent that companies not investing in equipment that preserve the environment are seen as non-responsive by the general public who are the customers. It is also important for a project to be aware of the resources in the area where the project would be launched.

For example, in Nigeria, projects that are based on construction are usually suitable for the soils of the northern part because they are arable and fine. If a company decides to launch a project in the southern part there is possibility of failing to get the perfect soil due to large number of oil fields. Also the process of land acquisition is complex. It requires the company to follow a long process in order to acquire a large piece of land. Furthermore for short term projects it would be of immense advantage if the country is blessed with favourable weather conditions and a vast number of skilled labours.

Furthermore in addition to the analysis of non-financial methods of appraisal, it is paramount to bring the usefulness of risk into the picture. It enhances decision making on marginal projects. A project whose single-value NPV is small may still be accepted following risk analysis on the grounds that its overall chances for yielding a satisfactory return are greater than is the probability of making an unacceptable loss. Likewise, a marginally positive project could be rejected on the basis of being excessively risky, or one with a lower NPV may be preferred to another with a higher NPV because of a better risk/return profile.

However an area for caution is Risk analysis amplifies the predictive ability of sound models of reality. The accuracy of its predictions therefore can only be as good as the predictive capacity of the model employed. Lastly the company or the firm must consider the availability of manpower. In order to ensure the success of a project there must be a high concentration of skilled workers to handle the activities of the project. The higher the number of skilled workers will create a better chance for the project to be launched and completed in a good way.

There must be individuals who will handle the financial methods as well and to ensure the project will be favourable or not. e. Limitations of non-financial methods The appraisal of projects in most cases requires the incorporation of the effects of both financial and non-financial methods of appraisal and ensures that these methods are appropriately represented. The main drawback to the non-financial methods of appraisal is that they cannot be used alone to determine the acceptability of a project. Also due to its intangible nature it brings limitation when using probability analysis.

This is due to the fact that non-financial factors on projects are often difficult to quantify. As a result of this, current models often ignore this method because of the lack of knowledge of the qualitative and strategic benefit costs. Non-financial have an intangible nature, are difficult to estimate, and cause a subjective analysis to project evaluators. Therefore, the investment decision should rely not only on the traditional evaluation criteria, but also on non-financial factors, through the use of tools and methods that incorporate and quantify non-financial aspects in project evaluation. f.

Comparison between financial and non-financial techniques of project appraisal The prominent issue about the financial and non-financial methods of appraisal is the fact both concepts are essential to the success of a project. The neglecting of one aspect of either of the concepts may result in the failure of the project because they work hand-in-hand. In other comments it was understood that the non-financial factors are not instrumental in the appraisal of a project due to their qualitative nature. On other hand, financial methods like the payback period do not give a true picture of what exactly is required in the investment.

However in my view the financial techniques are better in showing the benefits of a project. 5. Conclusion The paper is centred on the importance of the techniques of project appraisal. Due to the mutual nature of both the financial and non-financial methods of appraisal, I believe they are both crucial factors to be considered in the appraisal of a project. The two methods complement each other. These methods are not only crucial for project use only but also for students and researchers as well, and hopefully upcoming innovation from researchers could bring adjustments to the financial methods to be simpler. . REFERENCES Akalu, M. (2001). “Re-examining project appraisal and control: developing a focus on wealth creation. ” International Journal of Project Management 19: 375-383. Hermes, N. , P. Smid and L. Yao (2006). “Capital Budgeting Practices: A Comparative Study of the Netherlands and China”, Working Paper, University of Groningen, p. 36. Hawkins, C. J. , and D. W. Pearce (1971), “Capital Investment Appraisal” (MacMillan Press). Jones, C. , Software Assessments, Benchmarks, and Best Practices, Information Technology Series, Addison Wesley, 2000 Verbeeten, F. (1993). Do organizations adopt sophisticated capital budgeting practices to deal with uncertainty in the investment decision? A research note. " Management Accounting Research 17: 106-120. http://www. nibusinessinfo. co. uk/content/strategic-issues-investment-appraisal (accessed on March 24, 2013) http://www. accountantnextdoor. com/investment-appraisal-8-non-financial-factors-that-every-accountants-and-managers-should-consider/ (accessed on 22nd march, 2013) http://www. letslearnfinance. com/advantages-and-disadvantages-of-payback-period. html (accessed on March 23rd, 2013)

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