Defining Costs and Benefits

Before evaluating the projects it is necessary to idetify the costs and benefits associated with the project. Cost of the project includes all cash outflows and benefits include all cash inflows and non-cash expenses like depreciation, amortization etc. The following points are to be kept in mind while measuring costs and benefits.
1. All costs and benefits must be measured in terms of cash flows and non cash charges must be added back.
2. All cash flows must be defined in post-tax terms
3. Usually the net cash flows are defined from the point of view of the suppliers of long term funds (i.e. suppliers of equity capital plus long term loans).
4. Interest on long term loans must not be included while determining the net cash flows.
5. The cash flows must be measured in incremental terms. In other words, the increments in the present levels of costs and benefits that occur on account of the adoption of the projects alone are relevant for the purpose of determining the net cash flows. Some implications of this principle are as follows:

If the proposed project has a relative impact on the existing product lines of the firm, then such impact must be quantified and considered for ascertaining the net cash flows. For example, if the project is for the manufacture of an improved version of the company’s existing product the new product’s sales will bring down the sales of the existing product. This decrease in sales has to be considered.

Sunk costs must be ignored. For example, the cost of existing land must be ignored because money has already been sunk in it and no additional or incremental money is spent on it or the purpose of this project.

Opportunity costs associated with the utilization of the sources available with the firm must be considered even though such utilization does not entail cash outflows. Example while the sunk cost of land is ignored, its opportunity cost i.e. the income it would have generated if it had been utilized for some other purpose or project must be considered.

The share of the existing overhead costs which is to be borne by the end product (s) of the proposed project must be ignored.

Appraisal Criteria:

Having defined the costs and benefits associated with a project, and converted it into a stream of cash flows i.e. cash outflows (costs) and cash inflows (benefits), one has to examine whether the project is financially feasible or not. A number of criteria have been evolved for evaluating the financial desirability of a project. These criteria can be classified as

1. Non Discounting
2. Discounting Techniques

Non-discounting techniques do not consider the time value of money, whereas discounting techniques evaluate the project by considering the time value of money.

Evaluation Criteria:

*Pay back period
* Average Rate of Return
*Net Present Value
* Benefit Cost Ratio
* Internal Rate of Return

Payback Period: This is one of the non-discounting evaluation techniques to evaluate the desirability of the project. It is the simplest, and perhaps the most widely employed quantitative method for appraising the capital expenditure decision. Pay back period is defined as the number of years required to recover the original cash outlay invested in a project.

There are two ways of calculating the payback period:

Case I: When the project generated cash flows are constant i.e. flow stream is in the nature of annuity
Payback period: Investment/constant annual cash flow
Payback period is obtained by dividing the investment i.e cash outlay by the annual cash inflow. Annual cash inflows represent cash flows after payment of tax.

For example an investment of Rs 50,000 in a machine is expected to produce cash flow after tax (CFAT) of Rs 10,000 for 6 years then

Payback period = 50,000 /10,000 = 5 years.

Case II: When a project’s cash flows are not equal i.e. cash flows vary from year to year.

Here, payback period is calculated by the process of cumulating the cash flows till the time when cumulative cash flows become equal to the original cash outlay.

Consider a project which involves initial cash outlay of Rs 10,000. The pattern inflows from the project are as follows:

Year Inflow in Rs Cumulative of inflow Rs

1 2,000 2,000
2 3,000 5,000
3 3,000 8,000
4 2,000 10,000*
5 2,000 12,000

By observing the cumulative inflows the reader can find the payback period of the project as 4 years.