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

 

Financial Justification / Appraisal of Railway Projects

 

Source: Chapter II of IR Financial Code Volume I

• Capital is scarce and investment is irreversible and many projects will be competing for getting acceptance; hence need for project appraisal. 
• What is Justification? Justification means the action of showing something to be right or reasonable.
• What is Financial?  Financial means money, investment, etc.
• Is the proposed expenditure worth the money ? 
• In simple words, Financial Justification means examining whether the money proposed to be spent or invested is reasonable, necessary, and likely to provide adequate benefits or returns. 
• 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 capital expenditure incurred on New Assets/Improvement of existing Assets should be financially justified and sanctioned before it is actually incurred.   
• Net financial gain (earnings – working expenses) may either be an increase in earnings or reduction in expenditure or both. 
• Interest and depreciation are considered in orthodox methods, but not in Discounted Cash Flow (DCF) methods of financial evaluation of a project.

Exceptions to Financial Justification: 

A.                     Revenue expenditure under erstwhile Demands Numbers 1 to 15

B.                     Safety works - DF IV

C.                    Passenger amenity works   DF I

D.                    Labour welfare works (however in the case of Residential Buildings i.e., Railway quarters – 6 % Assessed Rent is required) - DF II

E.                      Statutory obligations

Note: However if the above items i.e., 1 to 5 form a part of the whole scheme  - The total cost of the whole scheme inclusive of the above works should be financially justified. 

• Savings of one Zonal Railway at the expense/loss of another Zonal Railway – In such cases, the 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.
• Intangible benefits such as social benefits, environmental benefits, economical benefits  etc., are essential criteria for social projects like infrastructure is upliftment of weaker sections. In the case of major projects such as new line constructions, or changes of traction from steam to diesel/electric, the benefits likely to be realized by the economy as a whole are assessed by the Economic Adviser to the Railway Board

Scrutiny by the 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 the Railway Board from time to time.
• Even in cases, where the Rate of Return is not a determining factor, he/she (Financial Adviser) can offer advice on the general merits of the 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.  (Initially, it was 14 %, then revised as 12%)
• Exceptions are Assisted Sidings & Residential Buildings (for which separate rules exist)
• Savings in expenditure or increase in net earnings or a 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 – is ignored as an element of working expenses in Annual Cash flow under the DCF Method. 

Test of Remunerativeness must be for the following ones: 

1. New Lines
2.  Line Capacity Works 

• Gauge conversions
• Doubling
• Signaling schemes
• Provision of Addl Loops / Lengthening of Loops
• Crossing Stations
• 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, out agencies

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.

Meaning in Simple Words

Normally, the alternative giving the higher Rate of Return (ROR) should be selected because it provides better financial benefits.

However, the highest ROR cannot always be the only deciding factor. Some benefits or disadvantages cannot be measured accurately in money, such as:

• Passenger safety
• Environmental protection
• Public convenience
• Reliability of operations
• Reduction in accidents
• Better service to remote or weaker sections
• Future operational flexibility

Therefore, an alternative giving 16% ROR may sometimes be preferred over another alternative giving 20% ROR, provided there are strong non-financial reasons. Such reasons must be clearly examined and recorded in the proposal.

 Practical Example – Construction of a Railway Overbridge

A Railway is considering two alternatives to eliminate a busy level crossing.

Alternative A – Limited improvement to the existing level crossing

• Additional gates and signalling arrangements are provided.
• Estimated ROR: 20%
• Lower investment is required.
• Road traffic will still be stopped whenever trains pass.
• Possibility of accidents and traffic congestion continues.

Alternative B – Construction of a Railway Overbridge

• Estimated ROR: 16%
• Higher investment is required.
• Road and rail traffic can move without interruption.
• Risk of accidents at the level crossing is substantially reduced.
• Ambulances, school buses and other vehicles are not detained.
• Fuel wastage, pollution and public inconvenience are reduced.

Decision

On financial grounds alone, Alternative A, with 20% ROR, appears more economical. However, Alternative B, with 16% ROR, may be selected because it provides substantial benefits relating to safety, public convenience, uninterrupted traffic and environmental protection. It is difficult to assign an exact monetary value to all these benefits.

The proposal should therefore record reasons such as:

“Although the Railway Overbridge alternative has a lower ROR of 16% compared with 20% for the limited-improvement alternative, it is recommended in view of the significant improvement in public safety, elimination of road-traffic detention, reduction in accident risk and long-term operational benefits.”

Examination Point

A less economical alternative may be accepted when important intangible or non-monetisable considerations justify it. However, the reasons for rejecting the more economical alternative must be specifically recorded and approved by the competent authority.

• The Accounts Officer can offer his remarks, if not accept the above proposal.
• Sanctioning authorities must pay due consideration to remarks of the Accounts Officer before sanctioning such a proposal. 

Provision of Rolling Stock:

• In New Line constructions & Line Capacity works – Rolling stock
• Investment is also added to the Initial cost of the Project before measuring the 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 with those anticipated to improve the return further. 

Meaning of Sub-optimization

Sub-optimization means improving the overall return of a project by reviewing its individual sub-works.

A large project may contain several smaller components. Some components may give good financial or operational benefits, while others may contribute very little.

 

Instead of rejecting the entire project, the less useful or less remunerative sub-work may be:

• dropped,
• reduced in scope, or
• replaced with a more beneficial sub-work.

This helps the project achieve a better overall Rate of Return (ROR).

Practical Example – Railway Yard Remodelling Project

A Railway proposes a yard remodelling project costing ₹100 crore, consisting of:

Additional loop line – ₹30 crore

New signalling system – ₹25 crore

Construction of a large administrative building – ₹20 crore

Additional goods-handling line – ₹25 crore

The overall ROR of the project is only 9%.

On detailed review, it is found that:

The administrative building gives very little direct operational benefit.

The goods-handling line is expected to increase freight loading and reduce wagon detention.

The Railway therefore decides to:

reduce the administrative building cost from ₹20 crore to ₹5 crore, and

use the remaining ₹15 crore for improved goods-handling facilities.

After this substitution, the revised project gives an ROR of 13%.

Conclusion

The entire yard remodelling project was not abandoned. Instead, a less remunerative sub-work—the large administrative building—was reduced and replaced by a more beneficial sub-work—better goods-handling facilities.

This process is called sub-optimization

Examination Point

Sub-optimization is the process of improving the overall viability of a project by replacing, reducing or deleting less remunerative sub-works and including works that are expected to increase the project’s return.

Line Capacity works: Master charts should be prepared for 

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

Average Annual Cost consists of 

A.                     Average Annual Cost of Operations – erstwhile Demands 8, 9 & 10

B.                     Average Annual Cost of Repairs & Maintenance – erstwhile Demands 4, 5, 6 & 7

C.                    Annual Depreciation charge – erstwhile Demand No. 14

Financial Appraisal Techniques

Financial Statements Methods: (without considering time value of money) 1. ARR - Accounting Rate of Return method. 2. Pay Back Period Method

Present Value Method: (considering time value of money) - DCF - Discounted Cash Flow method. 

       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 thousand
• 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 of this method is that it ignores the cash inflows of the Total period. If considering, Total period, Project B is having more returns than Project .A

Salient features:

• Not considering the Time Value of Money
• The basis is the Payback period.
• The rate of Return is not important.
• Presently not in vogue in Indian Railways
• However, there is no bar to the application of this method to the 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 the 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 says 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 formulae  =                                                        (Diff.bet. 2 interest rates x Cash flow at                                                                              lower)                            Lower rate of interest        +   —-------------------------------------------------                                                     Cash flow at lower - cash flow at higher
ROR = 10 + (5 x 40.572 / 40.572  - ( -10.494)
ROR = 10 + 3.97		=	13.97%
ROR = 13.97 % FIRR, EIRR AND MEIRR Differences in Railway Project Appraisal Source: Indian Railway Finance Code, Volume I, Chapter II; Annexure I — Railway Project Economic Appraisal Framework Note. In simple terms: FIRR examines the return to the Railways, EIRR examines the return to the economy, and MEIRR extends economic appraisal to capture wider economic, social and Railway-network effects more comprehensively.                                     Differences between Comparison FIRR EIRR MEIRR Full form Financial Internal Rate of Return Economic Internal Rate of Return Modified Economic Internal Rate of Return Basic question Is the project financially remunerative to Indian Railways? Is the project beneficial to the economy and society as a whole? What is the comprehensive economic return after considering wider economic, social and Railway-network effects? Viewpoint Railway administration / project entity National economy and society National economy, society and the Railway network Nature of appraisal Financial appraisal Economic appraisal Broader and modified economic appraisal Main cash inflows / benefits Fare and freight earnings, non-fare revenue, expenditure savings and other direct financial gains Quantifiable economic benefits such as travel-time savings, freight-time savings, vehicle-operating-cost savings, accident reduction, infrastructure-maintenance savings, employment and emission benefits  EIRR benefits plus wider network effects such as Railway-network decongestion, reduction in delays, better travel-time reliability and increase in Railway throughput Costs considered Actual project investment, operation and maintenance expenditure and other financial cash outflows Economic cost of resources used, after applying prescribed economic conversion factors where required Economic costs together with a more comprehensive assessment of economic, social and network consequences Treatment of taxes, subsidies and market distortions Generally reflected in the actual financial cash flows of the project Financial prices may be adjusted to represent the real cost to the economy Follows economic-cost principles and additionally captures wider network and social impacts Main output Financial IRR — the discount rate at which the financial Net Present Value becomes zero Economic IRR — the discount rate at which the Economic Net Present Value becomes zero A modified economic return measure used for comparing wider impacts at different levels before an investment decision Typical interpretation A higher FIRR indicates a financially stronger project for the Railways A project may have a low FIRR but a satisfactory EIRR because society receives benefits beyond Railway earnings A project may gain additional justification when benefits spread across the Railway network, regions and users beyond the immediate project corridor Illustrative example Additional freight earnings and savings in train-operation costs from a doubling project Savings in passenger time, road vehicle costs, accidents, fuel use and emissions due to diversion from road to rail EIRR benefits plus decongestion of connected routes, increased network throughput and improved reliability across adjoining sections Keyword Return to Railways Return to economy Comprehensive economic, social and network return   Important Examination Note FIRR and EIRR are distinct measures: FIRR is based on the project’s financial cash flows, whereas EIRR is based on economic costs and benefits to society. The Railway Project Economic Appraisal Framework states that Indian Railways is shifting from the existing EIRR-based assessment to the more comprehensive MEIRR approach to capture economic and social network impacts. MEIRR in this Railway context should not be confused with MIRR — Modified Internal Rate of Return — used in general corporate finance. One-line Memory Aid    Acronym Expansion Explanation FIRR Financial Internal Rate of Return Railway’s financial return EIRR Economic Internal Rate of Return Economy’s return   MEIRR  Modified Economic Internal Rate of Return Wider economic + social + network return (Railway) Practical Interpretation A commercially strong project normally shows a satisfactory FIRR because direct Railway earnings and savings are adequate. A socially desirable project may have a weak FIRR but a satisfactory EIRR when benefits to passengers, freight users and the economy are counted. MEIRR is intended to avoid viewing a project in isolation; it also examines how the intervention affects connected routes, network capacity, reliability and wider development. Likely Examination Questions 1. Which measure examines direct financial return to Indian Railways? Answer: FIRR. 2. At what discount rate does Economic Net Present Value become zero? Answer: EIRR. 3. Which approach captures economic, social and Railway-network impacts more comprehensively? Answer: MEIRR. Key Takeaways for MCQ DCF stands for Discounted Cash Flow  Test of remunerativeness or Rate of Return - Minimum 10% on the initial estimated cost 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) Traditional methods are ARR - Average Rate of Return and Payback Period  - Both not considering Time Value DCF Method - Considering Time Value 6.                       Exceptions to Financial Justification:  A.                     Revenue expenditure under erstwhile Demands Numbers 1 to 15 B.                     Safety works C.                    Passenger amenity works D.                    Labour welfare works (however in the case of Residential Buildings i.e., Railway quarters – 6 % Assessed Rent is required) E.                      Statutory obligations Note: However if the above items i.e., 1 to 5 form a part of the whole scheme  - The total cost of the whole scheme inclusive of the above works should be financially justified.  7. FIRR stands for Financial Internal Rate of Return 8. EIRR stands for Economic Internal Rate of Return 9. MEIRR stands for Modified Economic Internal Rate of Return

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