Project appraisal test for business take-off

Usually, in a business environment, a lot of decision-making comes into play before the money is invested in any project at all. Sometimes, the decisions taken reflect all considerations, both qualitative and quantitative. Quantitative decisions are those that do not necessarily conform with measurement in terms of naira and kobo. Such decisions look critically at the economic climate, availability of personnel, the effect of government policy, the market environment in the usual demand and supply interplay, and others not easily quantifiable. Quantitative decisions, on the other hand, are those based on the amount of money that will be required to start, the returns expected from such operations, and the returns from other available projects measured in terms of opportunity costs.

The sum total of quantitative and qualitative decisions finally culminates into embarking on a particular project as against the other. Therefore, it behooves the decision-makers to ensure that they are satisfied with the line of action they finally take. This exercise is often regarded as project appraisal.

Project appraisal entails subjecting project opportunities to laid down criteria set by an organization to select those that best satisfy such criteria. To this end, a ranking method is employed by which projects are ranked in descending order, with the best project coming first and following in that order. In the end, the best projects will be selected subject, however, to availability of funds as in capital rationing situation.

Briefly stated, capital rationing occurs in a situation whereby suitable investments exist but without sufficient funds to carry them out. It could be one-period capital rationing, not lasting for more than one accounting period or multi-period capital rationing that extends beyond one accounting period and may even occur intermittently.

Of course, it is not easy to determine which project best satisfies criteria until some analysis is carried out. As a result of the appreciation of this uneasiness, some techniques have evolved which greatly assist in quantifying the financial effect of embarking on any project. These techniques will be briefly looked into in turn. The techniques that will be discussed are Accounting Rate of Return (ARR) or Return on Investment (ROI) or Return on Capital Employed (ROCE), payback period, and discounted cash flow techniques.

Accounting Rate Of Return (ARR)
The accounting rate of return on investment or return on capital employed measures the accounting profit a particular project generates over its entire life. An average of this project is found and compared with the initial sums invested; the percentage so derived will be to determine the profitability of such investment (project) or not.

The Accounting rate of return is usually calculated as follows:
(a) Average Accounting Return / Average Investment X 100 or
(b) Average Accounting return / Average Investment X 100
While Average investment return = Initial Investment + Residual value / 2

The residual value is the amount that will be recoupable at the completion of the project. It may, for instance, be the amount that machines used in the project will be sold as scrap at the
completion of the project.

The accounting rate of return is easy to calculate and understand even by a layperson. For instance, a company’s cost of capital is known; this is compared with ARR to determine profitability. In a situation where the cost of capital is higher than the ARR, that project is not profitable. For instance, a project with an APR of 10% as against a cost of capital of 12% points to unprofitability. The fact that should be noted here is that accounting profit does not include the cost of obtaining the funds.

Another advantage of using ARR is that information is readily available since it draws from the accounting records kept by the business. Even where estimates will be made, it is much easier to use the basic concept of price minus cost to arrive at a profit.

However, ARR has some shortcomings despite its simplicity, APR though it also considers projects throughout its entire life, does not take into consideration the time value of money. Since future occurrence can hardly be predicted with certainty coupled with rapid inflation time value of money becomes very relevant.

The expected profits to be earned in the future are mere projections which perchance may come to be. This is a limitation of forecasting. All the same, ARR provides an acid test in project appraisal

Payback Period
The payback period is when a project will be required to pay back or recoup its initial outlay or investment to be regarded as profitable. Using accounting profit and the returns or profit recorded in each year is used to reduce the amount initially invested until such amount is completely recovered. For instance, a project that costs ₦100,000 to execute with profit in the year (1) one ₦30,000, year two ₦25,000, year three, ₦25,000, year four ₦20,000, year five ₦17,500 and year six ₦15,000, will have four years as payback period.

To be continued tomorrow

Oluwadele is a chartered accountant and public policy Scholar based in Canada.

He is the author of “Thoughts of A Village Boy.” Email: bolutife.oluwadele@gmail.com