Economic Appraisal

Techniques
Rate of Return Method
 The rate of return is a percentage that indicates the relative yield
on different uses of investment.
 RoR=((Beginning Value-Ending Value)/Beginning Value​)×100
 Three types of rates of return are;
 Minimum Acceptable Rate of Return (MARR)
 Internal Rate of Return (IRR)
 External Rate of Return (ERR)
 MARR: The rate set by an organization to designate the lowest
level of return that makes an investment acceptable.
 IRR: A discount rate at which NPW equals to zero.
 ERR: It is the rate of return that is possible to obtain for an
investment under the current conditions.
 Internal Rate of Return
 The rate of return of a cash f low pattern is the interest
rate at which the present worth of that cash flow pattern
reduces to zero.
 Since it is very difficult to find the exact value of i at which
the present worth function reduces to zero, we have to
start with an intuitive value of i and check whether the
present worth function is positive. If so, increase the value
of i until the present worth becomes negative.
 Then the rate of return is determined by interpolation
method in the range of values of i for which the sign of
the present worth function changes from positive to
negative.
 The first step is to find the net present worth of the
cash flow

 The above function is to be evaluated for different

values of i until the present worth function reduces to
zero.
 IRR = i1 +
 In this method of comparison, the rate of return for
each alternative is computed.
 The alternative which has the highest rate of return is
selected as the best alternative.
Example-1
 A company is trying to diversify its business in a new
product line. The life of the project is 10 years with no
salvage value at the end of its life. The initial outlay of
the project is Rs. 20,00,000. The annual net profit is Rs.
3,50,000. Find the rate of return for the new business.
Solution

 Net Present Worth (NPW) (i =10%) = Rs. 1,50,610.

 Net Present Worth (NPW) (i =12%) = Rs. –22,430.

 IRR=
Example-2
 A firm has identified three mutually exclusive
investment proposals whose details are given below.
The life of all the three alternatives is estimated to be
five years with negligible salvage value.
Solution
Example-3
 A Company is planning to expand its present business
activity. It has two alterna tive s for th e e xp a ns i on
programme and the corresponding cash f lows are
tabulated below. Each alternative has a life of five years and
a negligible salvage value. The minimum attractive rate of
return for the company is 12%. Suggest the best alternative
to the company.

Alternative Initial Investment Yearly Revenue (Rs.)

(Rs.)
Alternative 1 500000 170000
Alternative 2 800000 270000
Solution
 Payback Period
 Payback period is the time in which the initial cash
outf low of an investment is expected to be recovered
from the cash inflows generated by the investment. It
is one of the simplest investment appraisal techniques.
 The formula to calculate payback period of a project
depends on whether the cash flow per period from the
project is even or uneven.
 In case they are even, the formula to calculate payback
period is:
Initial Investment
Payback Period =
Cash Inflow per Period
 Payback Period Contd..
 When cash inflows are uneven, we need to calculate the
cumulative net cash flow for each period and then use
the following formula for payback period:
B
Payback Period = A +
C

In the above formula,

 A is the last period with a negative cumulative cash flow;
 B is the absolute value of cumulative cash flow at the end
of the period A;
 C is the total cash flow during the period after A

Decision Rule:
 Accept the project only if its payback period is LESS than
the target payback period.
Example 1: Even Cash Flows
 Example-1

 Company C is planning to undertake a project

requiring initial investment of $105 million. The
project is expected to generate $25 million per
year for 7 years. Calculate the payback period of
the project.
Solution
 Payback Period = Initial Investment ÷ Annual Cash
Flow = $105M ÷ $25M = 4.2 years
Example 2: Uneven Cash Flows
 Company C is planning to undertake another project
requiring initial investment of $50 million and is
expected to generate $10 million in Year 1, $13 million
in Year 2, $16 million in year 3, $19 million in Year 4 and
$22 million in Year 5. Calculate the payback value of
the project.
Soln.
(cash flows in millions) Cumulative Cash Flow
Year Cash Flow
0 - 50 - 50
1 10 - 40
2 13 - 27
3 16 - 11
4 19 8
5 22 30

Payback Period
= 3 + (|-$11M| ÷ $19M)
= 3 + ($11M ÷ $19M)
≈ 3 + 0.58 ≈ 3.58 years
 Cost-Benefit Analysis
 Cost-Benefit Analysis helps us to infer whether it is socially desirable to
undertake a number of investment Projects.

 The main objective of any public alternative (Constructing Bridges, Roads,

Dams, Establishing Public Utilities. etc.) is to provide goods/services to the
public at the minimum cost.

 Any public activity can be undertaken for implementation, if benefits of the

public activity are at least equal to its cost.

 This is nothing but making a decision based on Benefit-Cost ratio given by;
BC Ratio = Equivalent Benefits/Equivalent Cost

 Benefits may occur at different time periods of the Public Activity and costs
may consist of initial investment, yearly operation and maintenance cost.
Therefore both Benefits and Costs need to be converted to a common time
base (Present Worth, Future Worth or Annual Equivalent)
Cost-Benefit Analysis
 Notations & Formula:
BP = Present Worth of the total Benefits
P = Initial Investment
C = Yearly cost of operation and maintenance
CP = Present worth of Yearly cost of operation and
maintenance
BC Ratio =
Example-1
 In a particular locality of a state, the vehicle users take a roundabout
route to reach certain places because of the presence of a river. This
results in excessive travel time and increased fuel cost. So, the state
govt. is planning to construct a bridge across the river. The estimated
initial investment for constructing the bridge is Rs. 4000000. The
estimated life of the bridge is 15 years. The annual operation and
maintenance cost is Rs. 150000. The value of fuel savings due to
construction of the bridge is Rs. 600000 in the first year and it
increases by Rs. 50000 every year thereafter till the end of the life of the
bridge. Check whether the project is justified based on BC ratio by
assuming an interest rate of 12%, compounded annually.
 Example-2
 Two mutually exclusive projects are being considered for
investment. Project A1 requires an initial outlay of Rs.
3000000 with the net receipts estimated as Rs. 900000 per
year for the next five years. The initial outlay for Project A2 is
Rs. 6000000, and the net receipts have been estimated at Rs.
1500000 per year for the next seven years. There is no salvage
value associated with either of the Projects. Using Benefit-
Cost ratio, which project would you select? Assume an
interest rate of 10%.
 Example-3
 A State govt. is planning a hydroelectric Project for a river basin. In
addition to the production of electric power, this project will provide
f lood control, irrigation and recreation benefits. The estimated
benefits and costs that are expected to be derived from this project
are as follows.
Particulars Amount (in Rs.)
Initial Cost 80000000
Annual Power Sales 6000000
Annual flood control savings 3000000
Annual irrigation benefits 5000000
Annual recreation benefits 2000000
Annual operating and maintenance costs 3000000
Life of the Project 50 Years

Check whether the State govt. should implement the Project (assume i
= 12%)
Short Question
1. For a accepting a project proposal on the basis of Net
Present Value (NPV) and Internal Rate of Return (IRR)
which of the following statements is true
 (i) IRR should be equal to the discount rate used for
calculating NPV
 (ii) IRR should be less than the discount rate used for
calculating NPV
 (iii) IRR should be greater than the discount rate used
for calculating NPV
 (iv) All of these
Long Question
Question 1.1
Given the cash flows of a company about an investment proposal in
the following table
Time period 0 1 2 3 4 5
Cash Flows -500000 200000 100000 200000 100000 200000

(i) Calculate the Net Present Value (NPV) for the proposal at 4% cost of
money.
(ii) Is the proposal acceptable on the basis of NPV value?
(iii) How do you interpret the estimated NPV if you are the finance manager
of the company?
Question- 1.2
(b) Consider the following particulars about an alternative
 Initial cost = $420000
 Equivalent annual benefit = $116520
 Life (years) = 5
(i) Draw a cash flow diagram for the alternative.
(ii) Find the Interest Rate of Return of the alternative.
If the MARR (Minimum Attractive Rate of Return) is 14%,
should the alternative be accepted? Why?
Question- 1.3
A machine has the following particulars
Initial Cost = $800000
Annual Operation/Maintenance cost = $20000
Cost at the end of 4th year to maintain the efficiency = $50000
Cost at the end of 6th year to maintain efficiency = $50000
Salvage value = $300000
Life (year) = 12
Interest rate = 12% compounded annually
(i)Write a cash flow diagram.
(ii)Do an Annual Worth analysis for the machine.
Question 2.1
 Your friend has decided to start a transportation business after
his B.Tech. He needs to buy a lorry at the cost of Rs.4000000.
The life of this lorry is 20 years. This will produce income of
Rs.300000 each year for first 9 years. At the end of 10th year
the estimated income is Rs.200000. For each of the remaining
period of its life the lorry is expected to earn Rs.340000. The
Minimum Attractive Rate of Return (MARR) of your friend is
14% compounded annually. You want to help your friend in
deciding about the acceptance of this proposal by calculating
the Net Present Value (NPV) of the proposal.
 (i)Calculate the NPV of this proposal.
 (ii)How do you explain the NPV you find?
 (iii)Will you advise your friend to accept this proposal?
Question 2.2
Following particulars are available about a new automatic
machine of the surgery department in a medical college.
Particulars Amount ($)
Initial Cost 500000
Annual O/M cost 850
Cost at the end of 12th year for technical update 50000
Annual income from the machine 60000
Salvage value of the machine 40000
Life of the machine (years) 20

(i) Write a cash flow diagram.

(ii) Find the Annual Worth amount of costs and benefits
separately at the MARR of 9% set by the medical college.
(iii) Write your impression about purchasing this machine.
Question 2.3
Sudarshan wants to start a small bakery. The Cash flows of his
dream project are summerised in the following table.
End of 0 1 2 3 4 5
year
C a s h -12750 1500 3000 4500 6000 7500
flows ($)
(i) Draw a cash flow diagram of the above cash flows.
(ii) Find the internal rate of return of the proposal by Hit
and Trial method (Use the Uniform Gradient Series Annual
Equivalent Factor).
(iii) If Sudarshan calculates the Net Present Value (NPV)
of this project proposal, at 13.75% compounded annually
will it be positive or negative? Why?
Question 2.4
The state government is planning to provide public access to a wild
life sanctuary. For this the government has to create the required
facilities with the help of the US government. The government will
generate good amount of income from tourism if the project is
implemented. The costs and benefits associated with this proposal
are given in the following table
Particulars Amounts ($)
First cost 2400000
Annual O/M cost 160000
Annual income 500000
Additional Income at the end 10 th year because of 200000
increased tourism
Life (years) 20
(i) Calculate the Benefit Cost ratio (B/C ratio) by using the Annual
Worth method at the interest rate 12% annual compounding.
(ii) Will the government invest in this project? Why?
Question 3.1
Consider the following table which summarizes data for two
alternatives.
Particulars First cost Annual return Life
Alternative 1 ₹ 5,00,000 ₹ 1,50,000 10 years
Alternative 2 ₹ 8,00,000 ₹ 2,50,000 10 years

Find the best alternative based on the basis of Net Present

value method if i = 15% compounded annually.
QUestion 3.2
A producer wants to purchase a machine. There are two machines
available in the market whose initial cost is ₹ 10,00,000 each.
From the following information find out which machine will be
selected on the basis of Pay-back period method.

End of Cash inflow Cash inflow from

year from machine machine B(in ₹)
A(in ₹)
1 50,000 90,000
2 2,50,000 1,20,000
3 4,00,000 3,50,000
4 6,00,000 7,00,000
5 8,50,000 9,00,000
Question 3.3
A government is planning a hydroelectric project for a river basin. Besides
the production of electric power, this project will provide flood control,
irrigation and recreation benefits. The estimated benefits and costs
expected form the three alternatives under consideration are listed in the
following table:
Particulars A B
Initial cost(in ₹) 10,00,00,000 15,00,00,000
Annual equivalent benefits and cost
(i) Operating and maintenance cost 20,00,000 30,00,000
(ii) Power sales/year 1,00,00,000 1,50,00,000
(iii) Flood control savings 30,00,000 40,00,000
(iv) Irrigation benefits
40,00,000 55,00,000
(v) Recreation benefits
15,00,000 35,00,000

If the interest rate is 10% and the life of the projects is estimated to be 40 years,
by comparing thee BC ratios, determine which project should be selected.
 Question 4.1
The initial investment on a project is Rs.10,00,000. The project will
generate the following cash flows during its life period.

Year 1 3 5 7 9 11
C a s h 250000 250000 250000 250000 250000 250000
Flow ($)

The salvage value of the project is $50000. Find the Net Present
value of the project if the Minimum Attractive Rate of Return is
14 percent compounded annually. Should the project be
implemented?
Question 4.2
The details of an investment proposal are given below

Year 0 1 2 3 4 5
C a s h -150000 45570 45570 45570 45570 45570
flow ($)

Calculate the Internal Rate of Return (IRR) of the project. If your

personal MARR is 14%, should you go with the project?
Question 4.3
Government of Odisha is planning to invest Rs.50,00,00,000
in the ring road project around Bhubaneswar city for better
communication facilities. Further, the government has to
provide another financial support of Rs.10,00,00,000 at the
end of 5th year. The project will generate benefit of
Rs.5,00,00,000 each year for 20 years first phase of life after
which it needs resurfacing. Current rate of interest is 5%
yearly compounding. Do a Benefit-cost ratio analysis on the
project using present worth method. Should the government
go ahead with the proposal?
Question 5.1
 KASIA DAS and BABY DAS are two contractors. Both
of them want to take one project in which an initial
investment of Rs.8,00,00,000 is required. An annual
benefit of Rs.2,70,00,000 can be received from the project
for 5 years. The personal MARR (Minimum Attractive
Rate of Return) of KASIA is 25% and that of BABY DAS
is 17.5% percent. Find the Rate of Return (ROR) of the
project. Between KASIA and BABY who should not take
the project?
Question 5.2
The Hanging Bridge of Gujurat state collapsed recently. The Government of
Gujurat has decided to construct another bridge in its place with latest
technology. The initial cost of the bridge is Rs.50,00,00,000. The annual
maintenance cost of the bridge is Rs.20,00,000 during the first phase of the
life of 20 years. At the end of 12th year the Government has to incur an
additional cost of Rs.5,00,00,000 to increase the strength of the bridge. The
annual public benefit from the use of the bridge is estimated to be
Rs.4,50,00,000. An additional benefit of Rs.5,00,00,000 will be received at
the end of 10th year because of festive season. Determine the Benefit-Cost
ratio of this proposal at the interest rate of 8% compounded annually.
Should the bridge be constructed? (Use PW analysis)