The project evaluation process involves more than just determining a project's expected revenues and profitability; it also involves a study of the key factors that affect a project and their financial impact on the project. In addition, a project evaluation includes strategic evaluation, economic evaluation and social impact evaluation (Refer Exhibit I).
While the financial evaluation of a project aims at ascertaining the most efficient strategy for delivering the desired output, the strategic evaluation ensures that the project is consistent with the output objectives of the firm. The economic evaluation of the project, however, seeks to ensure that the delivered output is benefiting the public at large. The evaluation of social impact aims at ensuring that the consequences of a project (in terms of employment, output, savings and so on) are beneficial to the public. The financial appraisal is the most important part of the evaluation because the project cannot be successful if it is financially unviable, even though it may be technically and commercially feasible.
DEFINING THE TERMS
Projects, by their definition, have a defined start and end date. A project is defined as "a collection of linked activities, carried out in an organized manner with a clearly defined start point and finish point, to achieve some specific results that satisfy the needs of an organization as derived from the current business plans."
Projects are characterized by pre-determined goals, defined scope, limited resources, sequenced activities and a specific end result. While discussing the evaluation of a project, it is important to understand some other terms that are often used.
Cost of capital refers to the rate of return which must be earned by a firm in order to satisfy the expectations of the investors who provide the funds for the firm.
It is measured as the weighted arithmetic average of the cost of various sources of finance obtained by the firm. Expected return is the arithmetic mean or average of all possible outcomes where those outcomes are weighted by the probability of their occurrence. The legal, printing, postage, underwriting brokerage costs, and other costs of issuing securities, are known as floatation costs. Incremental cash flow is the difference in cash flows of a firm with and without a project. It can also be defined as the change in the future cash flows of a firm as a direct consequence of undertaking a project. The value of a future stream of payments or receipts from a project when discounted at a given rate to the present time it is known as the present value of a project. Projects are said to be mutually exclusive when the acceptance of one will necessarily mean the rejection of others.
The net present value of a project is the present value of future payments reduced by the present value of costs. The rate of discount at which the net present value of an investment is zero is called the internal rate of return. Benefit cost ratio measures the present value of returns per rupee of investment. Sensitivity analysis is a risk analysis technique used for studying the responsiveness of net present value to changing a variable in the profitability equation. It is akin to 'what if'analysis. For example, we can know the impact of reduction in the costs of raw materials by 10 % on NPV of a project.