Given a range of project options, which one best utilises the available resources
Suitability in meeting the stakeholders’ requirements, e.g. lenders of funds
There are various procedures and techniques to perform such appraisal. These are outlined below:
1. Net present value (NPV): Assume the initial investment for a project is 1,000,000. The rate that the borrower will incur as cost of capital is 5%. Also the cash flows received from the project are 200,000, 250,000, 300,000 & 500,000. Then the NPV of this project (as on today) is:
Since the net value of this project, the project is acceptable. In case of multiple projects, the highest positive value is the most preferred.
2. Internal Rate of Return (IRR): This method determines the minimum rate of return required from the project for zero net present value. Only if the IRR is greater than the cost of capital, the project will be profitable. For the earlier cash flows, we have:
Since IRR > cost of capital (5%), the project is feasible.
3. Break-even period (BEP): This is a relatively crude method which does not account for the time value of money as NPV and IRR does. Still, it gives a rough idea of when the project will begin to yield net benefit after having recovered its cost. For example, for the above cash flows, break-even year is calculated as: