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:
- Revenue expenditure under erstwhile Demands Nos 1 to 15
- Unavoidable expenditure on considerations of Safety
- Passenger amenity works
- 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:
- New Lines
- 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
- Yard remodeling and terminal facilities
- Microwave & other telecommunication works
- Change of Traction & provision of Loco Sheds there for
- Introduction of New services – Passenger trains, container services, street delivery & collection, outagencies
- 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
- Existing optimum capacity
- The extent to which it is presently utilized
- The capacity expected to be available after provision of proposed facilities.
Average Annual Cost consists of
- Average Annual Cost of Operations – erstwhile Demands 8, 9 & 10
- Average Annual Cost of Repairs & Maintenance – erstwhile Demands 4, 5, 6 & 7
- 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 % |
|||