Chapter 2 – Project / Term Loan Appraisal

Aspects of Project Appraisal

1. Technical Appraisal

2. Commercial / Market Appraisal

3. Managerial Appraisal

4. Financial Appraisal

1. Analysis of past working results in case of existing concerns

2. Cost of Project and Means of Finance

3. Financial Projections – Cash flow and Profitability estimates

4. Ratio Analysis

5. Break even Points analysis

6. NPV, IRR analysis

7. Benefit Cost Ratio (BCR)

1. Technical Appraisal

Technical appraisal by the bank involves a study of :-

• Location

• Technology adopted Manufacturing process

• Size of the plant

• Product mix / Product range

• Selection of Plant & Machinery

• Plant lay out

• Raw Materials

• Labour

• Utilities

• Implementation Schedule

• Licenses & Statutory requirement

2. Commercial / Market Appraisal

Information should collect of:-

• Demand

• Supply

• Distribution

• Pricing

• External

Technique used for forecasting aggregate demand are:-

• • Import substitution

  • Past trend method

  • End use method

  • Correlation and Regression

  • Export market

3. Managerial Appraisal

Management appraisal is nothing but appraising of the persons behind the enterprise. The basic of this confidence is generally derived from the 5 C’s of the borrower

• Character

• Capacity

• Capital

• Collateral

• Conditions

Management appraisal involves the assessment of:-

• The Entrepreneur

• The Board of Directors

• The Chief Executive

• The Departmental Heads

4. Financial Appraisal

1. Analysis of past working results in case of existing concerns

• Assessment of latest financial position by audited B/s and P&L of last 3 year

2. Cost of Project and Means of Finance

Cost of projects includes:

• Land & Site Development

• Building

• Plant & Machinery

• Technical known-how and Engineering fees

• Expenses on engaging foreign technicians and training of indian technicians

• Miscellaneous assets

• Preliminary & pre-operative expenses

• Contingencies

• Margin for working capital

• Initial cash losses

Source of Finance

Source of finance includes:

• • • • Share Capital

      • Term Loan

      • Debenture Capital

      • Deferred Credit

      • Incentive Sources

      • Miscellaneous Sources

3. Financial Projections – Cash flow and Profitability estimates

The aim of estimation of profitability are:

• The Earning Capacity of the Project

• The Capacity of the Unit to Service the Loan

• The Capability of the Unit to Service the Share Capital

• Surplus Available with the Unit for Finance its Future Growth

4. Ratio Analysis

Debt Service Coverage Ratio (DSCR)

• DSCR indiactes the ability of a concern to service its term liabilities

• DSCR = (Net Profit + Depreciation + Other Non Cash Expenses + Interest on Term Loan) / (Interest on Term Loan + Instalment of Term Loan)

• The Average DSCR of 1.50 is considered reasonable

5. Break even Points analysis

• Break Even Analysis if often used in appraising the profitability

• Break Even Point in terms of unit is = Fixed Cost / Contribution

• Contribution = Sales price per unit – Variable cost per unit

Capital Budgeting

1. Pay Back Period

It is commonly used method of investment appraisal in view of the simple mode of its calculation. The payback period represents the number of years it takes for the operating earnings from a project to recoup the total investment on the project and is computed taking into account:

Net investment / Profit before depreciation and tax = Payback period (years).

The method is useful both for firms with plenty of investment opportunities but limited financial resources and for those projects which have obsolescence risk i.e. larger wear and tear.

Pay Back Period method has following limitations:

• It can lead to incorrect ranking of industrial projects as the method ignores return of the project after the payback period.

• The method does not give us any objective cut-off criterion. What should be the minimum or maximum payback ?

• The projects which have low return initially but a longer economic life may be preferable to

• those projects which have high earning capacity initially but have shorter life span.

• This method like return on investment ignores the time value of money.

• This method attaches undue importance to the quick yield and gives the impression that the projects have little or no development significant. It is a not enough to recoup the investment. The principal concern of the investor is to optimise the return/benefits. In view of the aforesaid limitations, the payback method is better accepted as a secondary method of investment appraisal rather than the final criterion for investment.

2. Average Rate of Return

Under this method, the entire life of a project is taken into account, unlike the payback period. An average of the annual net operating profits (After Depreciation) for the entire life of the project is taken and rate of return on original investment and average investment calculated.

Average Rate of Return method has following limitations:

• This method like return on investment ignores the time value of money.

• This method does not take into account the life differential of projects

3. Net Present Value (NPV)

NPV is the difference between cash outflows at base period and present value of future cash inflows. It helps the bank to ascertain, whether a oroject should be taken up for financing or not

Profitability Index = Present Value of Cash Inflows / Present Value of Cash Outflows

4. Internal Rate of Return (IRR)

The internal rate of return is the discount rate at which the total discounted value of future drawls from the unit is equal to the initial investment in to the unit. It is the discount rate that makes the net present value (NPV) of the project equal to zero. An investment to be accepted if it’s IRR is higher than its cost of capital and should be rejected if lower

5. Benefit Cost Ratio (BCR)

Benefit Cost Ratio (BCR) = PVB/I

Net Benefit Cost Ratio (NBCR) = (PVB – I) / I = BCR – I