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:
- New
Lines
- 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
- Existing
optimum capacity
- QA
The extent to which it is presently utilized
- 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
|
****
