Project Appraisal and Investment Analysis
Core concepts
Project appraisal assesses whether an investment is worthwhile before funds are committed. Candidates must understand cash-flow forecasting, discounting, NPV, IRR, payback, discounted payback, and the profitability index. Know how to handle inflation (use nominal cash flows with nominal rates, real with real), risk adjustment through scenario and sensitivity analysis, and the treatment of working capital and terminal value. Social cost-benefit analysis extends this to public projects, valuing externalities and using shadow prices.
Common traps
A common trap is mixing nominal cash flows with a real discount rate, which distorts NPV. Another is ignoring working capital: an initial investment in inventory and receivables must be recovered at project end. Watch for the payback period ignoring cash flows after the cutoff and the time value of money (unless discounted). Also, do not include financing costs in project cash flows when the discount rate already reflects the cost of capital, as this double counts.
Worked rule of thumb
A project costs 1,000 now and returns 600 in each of years one and two, with a 10 percent discount rate. PV = 600/1.1 + 600/1.21 = 545.45 + 495.87 = 1,041.32. NPV = 1,041.32 - 1,000 = 41.32, so accept. Rule of thumb: if NPV is positive at the required rate, the project adds value; use IRR only as a cross-check.