Financial Appraisal of Railway Projects - DCF - Discounted Cash Flow Method

 

Financial Appraisal of Railway Projects

By M. Nageswara Rao, www.appendix3exam.com

 

Source: Chapter II of IR Finance Code Volume I

❖      What is Justification? Justification means the action of showing something to be right or reasonable.

❖      What is Financial?  Financial means money, investment etc.

❖      In simple Financial Justification means the money invested should be reasonable or right.

❖      Investment decisions   - Most Interesting and most difficult decisions to be made by the Management – for erstwhile Demand No. 16

❖      Fundamental to the Railway system as a commercial undertaking that expenditure incurred on New Assets/Improvement of existing Assets should be financially justified and sanctioned before it is actually incurred.

Exceptions to Financial Justification:

1. Revenue expenditure under erstwhile Demands Nos 1 to 15
2. Unavoidable expenditure on considerations of Safety
3. Passenger amenity works
4. Labour welfare works (however in case of Residential Buildings i.e., Railway quarters – 6 % Assessed Rent is required)

Note: However if the above items i.e., 1 to 4 forms a part of the whole scheme  - The total cost of the whole scheme inclusive of above works should be financially justified.

❖      Savings of one Zonal Railway at the expense/loss of another Zonal Railway – In such cases, interest of Railways as a whole should be considered for assessment of Financial justification.

❖      No credit should be given to a proposed scheme for saving, which can be achieved regardless of whether the proposed scheme is or is not embarked upon,

Scrutiny by Accounts Officer:

❖      As a Financial Adviser to the Administration, should carefully scrutinize the justification for proposed expenditure.

❖      While scrutinizing, he/she should refer to Chapter II of Finance Code Volume One, Canons of Financial Propriety and other related instructions received from Railway Board from time to time.

❖      Even in cases, where Rate of Return is not a determining factor, he/she (Financial Adviser) can offer advice on the general merits of proposal in the spirit of a prudent individual spending his/her own money (one of the canons of financial propriety)

 

Test of Remunerativeness: (Rate of Return)

❖      Minimum of 10 % on Initial Estimated cost.

❖      Exceptions are Assisted Sidings & Residential Buildings (for which separate rules are existed)

❖      Savings in expenditure or increase in net earnings or combination of both.

❖      Interest during construction – should be added to the cost (subject to construction of which is likely to last for more than one year)

❖      Depreciation – ignored as an element of working expenses in Annual Cash flow under DCF Method.

Test of Remunerativeness must for the following ones:

1. New Lines
2.  Line Capacity Works

A.      Gauge conversions

B.      Doubling

C.      Signaling schemes

D.      Provision of Addl Loops / Lengthening of Loops

E.       Crossing Stations

F.       Strengthening electrical Substations

3. Yard remodeling and terminal facilities
4. Microwave & other telecommunication works
5. Change of Traction & provision of Loco Sheds there for
6. Introduction of New services – Passenger trains, container services, street delivery & collection, outagencies
7. Workshops (Production Units & Repair Workshops)

 

❖      Sometimes, it is necessary to reject more economical alternatives (say 20% ROR), because of consideration on which it is difficult to put a precise money value & choose less economical (say 16%) .  But reasons should be recorded for resorting to a less economical one.

❖      The Accounts Officer can offer his remarks, if not accept the above proposal.

❖      Sanctioning authorities must pay due consideration of remarks of Accounts Officer before sanctioning such a proposal.

Provision of Rolling Stock:

❖      In New Line constructions & Line Capacity works – Rolling stock investment also added to the Initial cost of the Project before measuring Financial Rate of Return.

❖      Assessed by the Planning Directorate of Railway Board.

 

Sub-optimization: To realize the optimum benefits for the project by substituting the less remunerative sub works by those anticipated to improve the return further.

Line Capacity works: Master charts should be prepared for

1. Existing optimum capacity
2. The extent to which it is presently utilized
3. The capacity expected to be available after provision of proposed facilities.

 

Average Annual Cost consists of

1. Average Annual Cost of Operations – erstwhile Demands 8, 9 & 10
2. Average Annual Cost of Repairs & Maintenance – erstwhile Demands 4, 5, 6 & 7
3. Annual Depreciation charge – erstwhile Demand No. 14

 

Financial Appraisal Techniques

 

 

 

                         

                       Financial Statements                                                Present Value

(Without considering Time value of Money)                     (Considering Time value of Money)

            

                               

                                                                                                                                DCF – Discounted Cash Flow

                                                                                                                 

Accounting Rate of Return             Payback Period

 

Accounting Rate of Return: (Considering No time value)

❖      ROR is worked out by arriving at % ratio of Net gain over the initial estimated cost

❖      Net gain =     Earnings minus expenses

 

Example: Calculate Net gain from the following information.

❖      Proposed Building Cost – Rs. 10 Lakhs

❖      At present, Annual rent paying  - Rs. 1.5 Lakhs

❖      Annual Maintenance of the Proposed Building – Rs. 50 thousands

❖      Life of the Building – 50 years

❖      Residual/Scrap value at the end of 50 years – Rs. One Lakh

❖      Rate of Depreciation – 3%

Calculation of Net Gain is:

Depreciation = (Rs.10 Lakhs – 1 Lakh) x 3 %  = Rs. 9 Lakhs x 3 % = Rs.27000

Maintenance =Rs. 50000

Average Annual Cost = Maintenance plus Depreciation

Average Annual Cost = Rs.50000 + Rs.27000 = Rs. 77000

Net Gain = Annual Rent – Annual Cost

Net Gain = Rs. 150000 – Rs. 77000  = Rs. 73000

Net Gain percentage is 7.3 %  (Rs. 73000 on Rs. 10 Lakhs)

   Payback Period Method

❖      Recoupment of the Original investment is an important consideration in appraising a capital investment.

Example: Project Investment is Rs. 1 Lakh

	Project A – Inflows		Project B – Inflows		Remarks
Year	Each year	Cumulative	Each year	Cumulative
1	10000	10000	15000	15000
2	12000	22000	16000	31000
3	22000	44000	12000	43000
4	30000	74000	15000	58000
5	20000	94000	16000	74000
6	10000	104000	12000	86000	Project A takes 6 years to Get back its investment
7	10000	114000	10000	96000
8	8000	122000	10000	106000	Project B takes 8 years to Get back its investment
9	5000	127000	15000	121000
10	5000	132000	18000	139000
11	6000	138000	22000	161000
12	12000	150000	19000	180000

 

Outcome:

❖      Compared to Project B, Project A gets back its investment in 6 years. So Project A is selected.

❖      But the drawback in this method is, it ignores the cash inflows of the Total period. If considered, Total period, Project B is having more returns than Project B.

 

Salient features:

❖      Not considering Time Value of Money

❖      Basis is Payback period.

❖      Rate of Return is not important.

❖      Presently not in vogue in Indian Railways

❖      However there is no bar to application of this method to evaluation of Railway Projects in consultation with PFA.

❖      Suitable in the following cases.

A.      Plant & Machinery, where processes or products are likely to be replaced by technological changes within a few years.

B.      Single purpose New line where the known reserves of coal, Iron ore etc are expected to be depleted/exhausted after a specified number of years.

 

  Discount Cash Flow Method:

❖      Considers Time value of Money

●        Helps determine the value of an investment based on its future cash flows.

●        The present value of expected future cash flows is arrived at by using a discount rate to calculate the DCF.

●        If the DCF is above the current cost of the investment, the opportunity could result in positive returns.

●        Rs.100 receivable today is more than Rs.100 receivable a year later.

●        Hence Rs. 100 received today will earn interest or profits and shall accumulate to more than Rs. 100 in a year's time.

●        NPV (Net Present Value) or NPW (Net Present Worth) Method

●        Assuming that the Railways' cost of finance say 6% per annum, Rs. 106 received a year hence should be worth Rs.100 today and

●        Rs.100 which may be received in a year's time is worth about Rs. 94 today (actually it is worth Rs.94.34).

●        Discounted cash flow (DCF) helps determine the value of an investment based on its future cash flows.

●        The present value of expected future cash flows is arrived at by using a discount rate to calculate DCF.

●        If the (DCF is above the current cost of the investment, the opportunity could result in positive returns.

 

DCF Method   example

 

 

Year	Outflow	Inflow	Factor@10%	NPV At 10%	Net flow @ 10%		Factor@15%	NPV At 15%	Net flow @ 15%
0	100		1	100	-100		1	100	-100
1	100		0.9091	90.91	-90.91		0.8696	86.96	-86.96
2	100		0.8264	82.64	-82.64		0.7561	75.61	-75.61
3		80	0.7513	60.104	60.104		0.6575	52.6	52.6
4		100	0.683	68.3	68.3		0.5718	57.18	57.18
5		90	0.6209	55.881	55.881		0.4972	44.748	44.748
6		130	0.5645	73.385	73.385		0.4323	56.199	56.199
7		110	0.5132	56.452	56.452		0.3759	41.349	41.349
				NPV - Net Present Value	40.572			NPV - Net Present Value	-10.494

 

 

 

Lower Interest Rate			10
Higher Interest Rate			15
Difference in Interest Rates  (15-10)			5
Net cash flow at Lower interest Rate i.e.,10%			40.572
Net cash flow at Higher interest Rate i.e., 15 %			-10.494
ROR formulae  =  Lower Rate of Interest + (Higher interest - Lower Interest x Cash flow at Lower Interest/Cash flow at lower interest - Cash flow at higher interest)
ROR = 10 + (5 x 40.572 / 40.572  - ( -10.494)
ROR = 10 + 3.97		=	13.97%
ROR = 13.97 %