FINANCIAL EVALUATION

MEANING: Financial evaluation of a project is analysis of a project for checking

whether project is profitable or not before taking project in hand. We also review the
project by investigating its cost, risk and return. If we have lots of alternatives projects,
then we select best project on the basis of financial evaluation. In simple words, we uses
following tools for financial evaluating of a project.

1. Evaluate the Cost of Project

First thing which we see before take the any project from financial point of view is to
evaluate the cost of project. Whether cost of project is good according to its quality or
not?

2. Time Value of Investment in Money

Time value of investment in money is the importance factor which affects the decisions
of financial evaluation of any capital investment because we check the profitability of
project according to time. Today earned one rupee from any project is better than one
rupee earned after one year because we can get interest one rupee which has earned
today.

3. NPV
NPV is also good tool of financial evaluation. If we have two project and we have to
choose any one best project, then we will check NPV of each project. We will accept that
project whose NPV will higher. NPV means net present value. It is excess of present
value of cash inflows over present value of cash outflow.

4. IRR
IRR is internal rate of return. It is that rate where the total present value of cash inflow is
equal to the present value of cash outflow. So, if any project gives use this earning rate,
we will accept that project.

5. Pay back period

Pay back period is not non-discounting technique of financial evaluation. In payback
period, we find the total time in which our project will give use profit equal to our initial
cost. If payback period of one project is less that payback period of second project, then
we will select first project instead of accepting second project because less payback
period will be better than longer payback period for financial evaluating of any project.

6. Risk Evaluating
We also analyze different risks relating to financial evaluation of any project. Risk may
be liquidity, solvency or interest or any other. After this, we see whether we have ability
to manage these risks, if not, then, we leave that project for projecting our business.
METHODS OF FINANCIAL EVALUATION

1. Net Present Value Method: Net Present Value (NPV), defined as

the present value of the future net cash flows from an investment project, is one of
the main ways to evaluate an investment. Net present value is one of the most
used techniques and is a common term in the mind of any
experienced business person. To improve the value of your company, identify and
find solutions to those “destroyers” of value.
When choosing between competing investments using the net present
value calculation you should select the one with the highest present value.
If :

NPV > 0, accept the investment.

NPV < 0, reject the investment.
NPV = 0, the investment is marginal

FORMULA
NPV = (Cash inflows from investment) – (cash outflows or costs of investment)

MERITS

1. It is based on the time value of money.

2. It considers the earnings or savings over the entire life of the project. These earnings or
savings are converted into the present value of money.

3. It helps to make a comparative assessment of different projects.

4. Under this method, the highest net present value project is recommended for
implementation. It leads to maximization of profits to the organization.

DEMERITS
1. This method does not indicate the rate of return which is expected to be earned.

2. This method may fail to give satisfactory answer when the projects are requiring
different levels of amount of investment and with different economic life of the projects.

3. The application or usage of this method requires the knowledge of rate of cost of
capital. If cost of capital is unknown, this method cannot be used.

4. The NPV method leads to confusing and contradictory answers in ranking of

complicated projects.

2. Internal Rate Of Return method: Internal rate of return (IRR) method also
takes into account the time value of money. It analyzes an investment project by
comparing the internal rate of return to the minimum required rate of return of the
company. The internal rate of return sometime known as yield on project is the rate at
which an investment project promises to generate a return during its useful life. It is the
discount rate at which the present value of a project’s net cash inflows becomes equal to
the present value of its net cash outflows. In other words, internal rate of return is the
discount rate at which a project’s net present value becomes equal to zero.

FORMULA
Internal rate of return = Net initial investment
Annual cash inflows
MERITS
1. It considers the time value of money even though the annual cash inflow is even and
uneven.

2. The profitability of the project is considered over the entire economic life of the
project. In this way, a true profitability of the project is evaluated.

3. There is no need of the pre-determination of cost of capital or cut off rate. Hence,
Internal Rate of Return method is better than Net Present Value method.
4. Sometimes, the pre-determination of cost of capital is very difficult. At that time,
Internal Rate of Return can be used to evaluate the project.

DEMERITS

1. This method assumed that the earnings are reinvested at the internal rate of return for
the remaining life of the project. If the average rate of return earned by the firm is not
close to the internal rate of return, the profitability of the project is not justifiable.

2. It involves tedious calculations.

3. This method gives importance only to the profitability but not consider the earliest
recouping of capital expenditure. The reason is that sometimes Internal Rate of Return
method favors a project which comparatively requires a longer period for recouping the
capital expenditure. Under the conditions of future is uncertainty, sometimes the full
capital expenditure can not be recouped if Internal Rate of Return followed.

4. The results of Net Present Value method and Internal Rate of Return method may differ
when the projects under evaluation differ in their size, life and timings of cash inflows.

3. Average Rate Of Return Method: Average rate of return is a method of

evaluating capital investment proposals that measures the expected profitability of an
investment in plant assets. This method is also known as accounting rate of return
method. Average rate of return method is one of the methods of evaluating capital
investment proposals that does not consider present values.

FORMULA
Average rate of return = Average annual incremental income / Average investment
4. Payback Period Method: