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Project Appraisal

An important step in capital budgeting is to determine which investment opportunity is most profitable. The procedure adopted for this is known as project appraisal. Project appraisal is a tool to examine as to whether, in the given situation it would be more realistic, reliable and reasonable to invest resources or not.

In short project appraisal is the assessment of a project to know, whether it is worthwhile to invest money in it.


Methods of project appraisal or Capital budgeting techniques.

The important and popular methods of Capital budgeting are-

I. Non - discounting techniques or Traditional methods.

1. Payback period method
2. Post payback profitability method 3. Average rate of return method


II. Discounting techniques or modern methods

1. Discounted payback method.
2. Net Present Value method.
3. Internal rate of return method.
4. Net terminal Value method.

I. Non discounting techniques or traditional methods.

1. Payback period method

The Payback period refers to the minimum period required to recover the amount invested in a project.
This method is based on the assumption that every capital expenditure pays itself back within a certain period out of the earnings generated from the investment. Payback period is expressed in years. Under payback period method, different projects are ranked on the basis of length of their payback period and the one with the shortest Payback period is selected.

Payback period under different situations can be calculated as under,

A. Payback period when cash inflows are equal or even

If the cash inflows are even or equal, payback period is obtained as follows.

Payback period = Initial investment / Annual cash inflow

Here, annual cash inflow means profit after tax but the before depreciation. The accounting profit and the depreciation are given depreciation must be added to the profit to arrive at an annual cash flow.


B. Payback period when cash inflows are Unequal or uneven.

If the expected cash inflows are uneven or unequal, then cumulative cash inflows should be calculated. The year in which the cumulative cash inflow equals the initial investment is the payback period. In some cases fraction of the years will have to be taken into account to determine payback period.

In such cases the following equation can be used

Payback period = E+(C/ B)

Where E = number of years immediately preceding the year of final recovery.
B = Balance amount still to be recovered.

C = cash inflow during the year of final recovery.

Under the payback method, the cash inflow means operating profit before depreciation but after tax.



Advantages of payback method

1. It is simple to understand and easy to apply.

2. It is very important for cash forecasting, budgeting and cash flow analysis.

3.This method can be used profitably for short-term capital projects, which start yielding returns in the initial years.

4. It minimises the possibility of losses through obsolescence.

5. It takes into account liquidity.



Disadvantages of Payback method


1. It ignores the time value of money.

2. It completely ignores cash inflows after the payback period.

3. Sometimes a project is having higher payback period may be better than lower payback period owing to higher return after payback period. This is true in the case of long-term projects.

4. This method does not measure profitability of the project.

5. It does not measure the rate of return.