Key Steps in Project Appraisal

Performance Review: Performance review, or post completion audit, is a feedback device. It is a means of comparing actual performance with projected performance. It is conducted most appropriately when the operations of a project have stabilized and is useful in several ways: (1) It throws light on how realistic were the assumptions underlying the project. (2) It provides a documented log of experience that is highly valuable for decision making (3) It helps in uncovering judgmental biases (4) It induces a much needed caution amongst project sponsors.

Project appraisal involves six broad steps as shown. A brief description of these steps are as follows:

Forecast the costs and benefit: A capital project involves costs and benefits extending over a period of time. Typically, costs are incurred in the form of initial cash outlays on fixed assets and net current assets. Benefits are derived in the form of cash inflows from the operations of the project over its economic life, plus terminal cash inflow from the liquidation of the project at the end of its economic life.

Apply suitable investment criteria: The stream of costs and benefits of the project has to be converted into a measure indicating how worth while is the Project. For this purpose, several investment criteria are used. They fall into two broad categories: discounted cash flow criteria and non-discounted cash flow criteria.

Keys Steps in project Appraisal
Forecast costs and benefits
Select appraisal criteria
Assess risk
Estimate the cost of capital
Value the options
Consider the overall corporate perspective

While the former calls for discounting the future benefits using an appropriate discount rate, the latter does not involve any discounting.

Assess the risk of the project: Costs and benefits associated with a capital project are almost invariably subject to risk. There may be a lot of variability characterizing factors like project cost, sales quantity, selling price, material cost, energy cost, project life, and salvage value. The actual values of these variables often turn out to be different from their forecast values. Hence, you should try to get a handle over how the variability in these factors can affect the attractiveness of the project.

Estimate the cost of capital: The cost of capital is the discount rate used for evaluating a capital project. Under appropriate conditions, it is measured as the weighted average cost of different sources of capital employed for financing the project. The cost of a specific source of finance is defined as the rate of discount that equates the present value of the expected post tax payments to that source of finance, with the net funds received from that source.

Value the options: The traditional approach to project appraisal calls for judging a project on the basis of its net present value, obtained by discounting the project cash flow stream using an appropriate cost of capital. This approach however, is incomplete as it fails to capture the value of real options embedded in the project. Hence, the traditional Net Present Value analysis needs to be expanded to include the value of real options inherent in the project.

Consider the overall corporate perspective: Capital investments in plant, machinery, buildings, research, facilities, product development, marketing programs, and so on are tangible expressions of a company’s strategy. Hence, capital investment decisions must be evaluated from the overall perspective of the firm. In such an evaluation, due consideration should be given to general economic outlook, prospects of industries in which the firm operates, and the competitive position and core competencies of the firm.