Sound Feasibility Study And Technical Analysis
In our numerous article where we discussed some of the business plans that can help you easily to set, we also have an article listing at least top 10 of the best businesses with their business plans to go with. We have as well established that the whole purpose of evaluating businesses as business projects is to be able to determine the profitability and desirability for the commitment of resources.
Project evaluation is an exercise that entails using the present to predict the future. In doing this a sound feasibility study or report is always an option and it is prepared.
What Is A Sound Feasibility Study
A sound feasibility study is an empirical investigation and analysis of a proposed desirability, its financial implications, technical feasibility and commercial viability. It involves the collection, collation, processing and analysis of both primary nature secondary data, which are then used to examine the nature of an industry as well as highlight the essential features of the project to enable a potential investors take a sound investment decision.
Methods Of Investment Appraisal
1) Pay Back Period (PBP)
2) Accounting Rate Of Return (ARR)
3) Discounted Cash Flow Methods
- Net present value
- Internal Rate Of Return (IRR)
- Profitability Index (PI)
4) Cost – Benefit Analysis
Pay Back Period –
The payback period methods measures the length to time it takes project cash inflow to replay its initial capital outlay. We can redefine payback period as the period which it takes cash inflows from a capital investment project to equal the cash outflows of the business. Payback commonly used as a first screen method for evaluating projects. It is rough measure of liquidity and not profitability.
Measurement usually established the firm’s maximum payback period target for planned investment projects and then provides operational guidelines such that only investment resulting in pay back periods which are less or equal to the policy determined payback would be accepted. For instance if the policy determined expected payback period is 5 years, then any project with payback period greater than 5 years is deemed to be too risky and hence rejected.
It is assumed that the shorter the payback period the lower the chance of making for project. The payback period can be calculated in two different ways depending on the type of investment cash flow.
Merits Of Payback Period
- Easy to understand and compute, also it is inexpensive to use
- Emphasizes liquidity
- Uses cash flows information
Demerits Of Payback Period
- Ignores the times value of money and ignores cash flows occurring after the payback period.
- Not a measure of profitability
- No objective way to determine the standard payback
- No relation with wealth maximization principle.
Accounting Rate Of Return
The accounting rate of return (ARR) method of evaluating proposed capital expenditure is also known as the average rate of return method. It is based on accounting information rather than cash flow. This method tends to express the returns of a project to the cost of such a project. There is no unanimity regarding the definition of the rate of return. there is a number of alternative methods for calculating the ARR, but the most commonly used of ARR is expressed as follows ARR = Average Annual Profit/Average Investment x 100.
Average annual profit is defined as the average annual profit after deduction of taxation. However, in a situation where tax information is not given, we will take average annual profits as average profit before tax. Average profits are found by first adding the total profits over the duration of the business or project as the case maybe and then divide by the number of years of project’s life.
Merits Of Accounting Rate Of Return
- Uses Accounting data with which the executives are familiar with.
- Easy to understand and calculate
- Gives weights to future receipts
Demerits Of Accounting Rate Of Return
- Ignores the time value of money
- It does not use cash flows
- No objective way to determine the minimum acceptable rate of return.
Discounted Cash Flow Method
The accounting rate of return of project evaluation as discuss earlier ignores the timing of cash flows and the opportunity cost of capital tied up. The payback period considers the time it takes to recover the original cost of the project, but ignores total to recover the original cost of the project, but ignores total profits over a project life.
The discounted cash flow (DCF) method is a project evaluation technique which into account both the time value money and total profits over a project life. The Discounted Cash Flow is therefore more superior to both ARR and payback period for a capital investment appraisal.
The Discounted Cash Flow like the payback period examines the cash flows of a project, not the accounting projects. Cash flows are considered because they show the cost and benefits when they occur. The timing of cash flows is taken into account by discounting them. The DCF method also looks at the relevant cash flows from the project.
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