Financial and Strategic Management

What is Project Appraisal Under Inflationary Conditions?

Timing for project appraisal is the most important consideration for all types of appraisers. A project under normal circumstances is appraised from different angles viz. technical feasibility, managerial aspects, commercial aspects, financial viability, and economic and social aspects.

Under the normal conditions when prices are generally stable, the demand pattern as projected in the project report is unchangeable, the project cost described in the project report remains unchanged at current prices and as such, there is not much danger of any sudden escalation in project cost or overrun in the projected resources.

There is practically no risk involved of either business or financial nature and evaluation of the project could be done from different angles without providing for any change in project cost and planning for additional financial resources to meet the overrun or escalations.

Nevertheless, project appraisal can’t be devoid of inflationary pressures as normal conditions for a project do not exist. Because the project is to be implemented over a period of time ranging upon the size and magnitude of the project, i.e. it could be six months or beyond to run or two or more years. During such a period, it can’t be predicted as and when the trade cycles set in and the up-turn in the economy is generated.

In a developing economy like India, inflation grows at a planned steady rate because of the economic development activities, and as such provision for a probable escalation in the project, the cost is generally provided as a cushion to inflationary pressures.

However, during inflationary conditions, the project cost is affected by the magnitude of parameters. Cost of the project on all heads viz. labor wage, raw material, fixed assets, equipment, plant and machinery, building material, remuneration of technicians, and managerial personnel undergo a shift change. Besides, inflationary conditions place constraints on the resources of the consumers of the product and affect the demand pattern. Thus, cost at production is affected besides the projected statements of profitability and cash flow by the change in the demand pattern and market forecasting figures. The inflationary pressures alone do not stop here. The financial institution and banks revise their rate of lending and their financing cost further escalate during inflationary conditions. Under such conditions, the appraisal of the project generally be done keeping in view the following guidelines which are usually followed by the Government agencies, banks, and financial institutions:

1. Make provisions for the delay in project implementation, escalation in project cost as per the forecasted rate of inflation in the economy particularly on all heads of cost.

2. Sources of finance should be carefully scrutinized with reference to revision in the rate of interest to be made by the lender and the revision which could be followed in the interest-bearing securities. All these factors will push up the cost of financial resources for the corporate unit.

3. Profitability and cash flow projections as made in the project report require revision and adjustment should be made to take care of the inflationary pressures affecting adversely future projections.

4. Explain fully the criteria followed in adjusting the inflationary pressures viz. there are two criteria followed given as under:-

a. take inflationary rate at an average rate and escalate the total cost at that rate;

b. adjust each cost item against the inflationary rate. This would make adjustments for inflationary pressures in the cost elements responsible for outflows and the revenue elements in the cash. Both cash inflows and outflows will accordingly adjust to inflationary changes at the appropriate rate applicable to each of them respectively.

5. Examine the financial viability of the project at the revised rates and assess the same with reference to the economic justification of the project. The appropriate measure for this aspect is the economic rate of return for the project which will equate the present value of the capital expenditure to net cash flows over the life of the project. The rate of return should be acceptable which accommodates the rate of inflation per annum.

6. In inflationary times, early payback projects should be prepared. Because projects with long payback are more subjected to inflationary pressures and the cash flow generated by the project will bear high risk.

About the author

Shreya Kushwaha

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