Financial Anaysis Of Project

FINANCIAL ANALYSIS OF PROJECTS

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5.1 OVERVIEW seeks to ascertain whether the proposed project will be financially

viable in the sense of  

being able to meet the burden of servicing debt whether the proposed project will satisfy the return expectations of those who provide the capital.

Comparing the monetary costs and benefits over time to determine

whether a project is profitable or not. The objective and significance of financial analysis differs when it is applied to privately financed projects and public financed projects In case of such publicly financed projects financial analysis may aim at   

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Measuring the extent of subsidies required Identifying the project that is least cost alternative Establishing cost-recovery schemes project A & E

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5.2 Technical Aspects of Financial Analysis A. Projection of cash inflows and outflows of the project Cash flows, and not accounting estimates, are used Why Cash Flows? They measure actual economic wealth. They occur at identifiable time points. Cash is used to pay dividends, interest and other fixed obligations They are free of accounting definitional problems.

B. Estimating cost of capital C. Discounting cash flows of the project 12/19/2011

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5.3 Determining Relevant Cash Flows A relevant cash flow is one which will change as a direct

result of the decision about a project. A relevant cash flow is one which will occur in the future. A relevant cash flow is the difference in the firm’s cash flows with the project, and without the project. Relevant cash flows are also known as: Marginal

cash flows.  Incremental cash flows.  Changing cash flows.  Project cash flows.

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5. 3 Determining Relevant Cash Flows A. Cash inflows – may result from Sales of the products or services - It represents the dominant source of cash flow and is termed as cash flows from operations. 2. Sales of by products - some projects may have byproducts that are salable and serve as source of cash inflows. 3. Recovery of net working capital 4. Other miscellaneous sources – E.g. investment of idle cash temporarily or sale of old assets. 1.

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5. 3 Determining Relevant Cash Flows

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5.3 Determining Relevant Cash Flows b) Pre-Production capital costs: costs incurred prior to commercial production. These include:  Preliminary capital – issue expenditure: during the registration and formation of the company  Expenditures for Preparatory Studies: There are three types of expenditures for preparatory studies. 





Expenditures for pre – investment studies (opportunity, pre – feasibility, feasibility and support or functional studies) Consultant fees for preparing studies, engineering and supervision of erection and construction Other expenses for planning the project

 Other pre – production Expenditures are:     

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Salaries & fringe benefit for project implementation team Travel expenses Preparatory installation (workers camps, temporary houses and stores) Pre – production marketing costs Training costs (fees, travel, living expenses) project A & E

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5.3 Determining Relevant Cash Flows ii) Net Working Capital:  Indicates financial means required to operate the project according to

its production program.  defined as current assets minus current liabilities.  represents the liquid assets which will be tied up in the project.   The reason why we treat net working capital as an investment cost is without them, the project will not function.

2. Investments during production – additional investments to be made during commercial production • Expansion costs • Replacement of fixed assets • etc 12/19/2011

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5.3 Determining Relevant Cash Flows II. Production costs: Production costs should be calculated as total annual costs and preferably also as cost per unit produced.  Material costs  Labor costs  Factory overhead costs

III. Other Costs: included in this category are costs incurred in the process of producing and selling goods and services but other than production department costs  Administrative costs  Sales and distribution costs (marketing costs)

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Special issues in the determination of relevant cash flows  Sunk costs money already spent or committed is irrelevant to the decision

Opportunity costs is the cost incurred as a result of diverting the resource from its next best available use to the project under review  Relevant

Financing flows interest paid on debt, and dividends paid on equity, are NOT relevant cash flows of the project.  Why?

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Special issues in the determination of relevant cash flows Tax payments  these are cash outflows when they are paid.

Terminal cash flows – When the project is completed 

Relevant

Non-cash outlay expenses Depreciation, amortization, etc

They are simply the accounting allocation of an initial capital cost. 

NOT cash flows.

measured in project analysis only because they reduces taxes. 

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Their tax savings are considered

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5.4 Project Appraisal Techniques Investment project appraisal methods are classified

into two basic categories non discounted cash flow methods discounted cash flow methods

A. Non Discounted Cash Flow Methods Do not consider time value of money two types of methods are considered in this category pay back method average accounting rate of return 12/19/2011

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Payback Period  is the number of years required to return the original investment from

the net cash flows (net operating income after taxes plus depreciation).  Shorter payback period is preferred  commonly used as a first screening method  

If payback < acceptable time limit, accept project If payback > acceptable time limit, reject project

 For uniform net cash flows:  PBP = Original investment ÷ annual NCF

 For non uniform cash flows:  PBP is the period at which cumulative NCF is equal to zero

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Advantages & disadvantages of PBP

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Average accounting rate of return also known as accrual accounting rate of return,

unadjusted rate of return model, etc It uses data from income statement  ARR (based on total org. inv) = average net profit

÷ org. inv’t

 AARR (based on average org. inv) = average net profit ÷ average org. inv’t  average org. inv’t = (org. inv’t + salvage value) ÷ 2

 Advantages:  

simple to calculate using accounting data Project profitability is considered

 Disadvantages  

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is inconsistent with wealth maximization as the objective of the firm ignores the time value of money

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Illustration Example 1 The company is to invest in business machine whose investment cost is Br.500,000, useful life is 4 years & estimated disposal value is zero. The expected annual NCF is Br200,000. Required: i) calculate the PBP & make a decision if ATL is 3 years ii) calculate the ARR & AARR

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Illustration Example 2  A project with initial investment cost of Br200,000 will have the following expected

NCF:

Year

NCF

1

40,000

2

50,000

3

90,000

4

60,000

5

70,000

 Required:  i) calculate the PBP

 ii) calculate the AARR if the annual depreciation is Br30,000 & disposal value is

Br20,000 & make a decision if the required AARR is 25% 12/19/2011

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B: Discounted Cash Flow Methods They recognize the fact that a Birr received today is

preferable to a Birr received at some future date. There are three main discounting methods used in practice for appraisal of investment projects. The net-present-value method (NPV), Benefit – cost ratio or profitability Index and The internal-rate of return (IRR)

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1. Net Present Value (NPV) NPV = PV of cash inflows – PV of cash outflows Or = PV of net cash flows – Initial investment NPV decision rules: For independent projects: accept all projects where NPV > 0 For mutually exclusive projects: accept a project with highest positive NPV

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Advantages & disadvantages of NPV Advantages:  Tells

whether the investment will increase the firm's value  Considers all the cash flows  Considers the time value of money

Disadvantages:  Requires

an estimate of the cost of capital in order to calculate the net present

value  Expressed in terms of Birr, not as a percentage  difficult to explain to non-finance people

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2. Internal Rate of Return (IRR) is the estimated rate of return for a proposed project, given

its incremental cash flows. is the discount rate at which the present value of cash inflows is

equal to the present value of cash outflows (NPV = 0). is the maximum rate of interest that can be paid to finance

for a project without making a loss. IRR decision rules:  Set the Hurdle Rate (HR)  For independent projects: accept all projects where IRR ≥ HR  For mutually exclusive projects: Compute (IRR less hurdle rate) for each

project, rank from highest to lowest and accept the highest ranking project. 12/19/2011

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Advantages & disadvantages of IRR Advantages:  Tells

whether the investment will increase the firm's value  Considers all the cash flows  Considers the time value of money  Comparable with hurdle rate

Disadvantages: 

May not give the value-maximizing decision when used to compare mutually exclusive projects - does not show Birr improvement in value

 

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IRR can be affected by the scale (size) of the project initial investment There will be possibility of existence of multiple IRRs – when the sign of the cash flows of a project change more than once during the project's life

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Conflicting results between NPV & IRR When one project is to be selected out of two or more

projects (Mutually exclusive projects), NPV and IRR may give conflicting recommendations. Generally the project with the highest NPV is selected if all projects required the same investment. Why?

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3. Profitability Index (PI) sometimes called Benefit Cost Ratio or present value index is calculated by taking the  

PV of cash inflows divided by the present value of cash outflows, or PV of net cash flows divided by the initial investment

PI decision rules: For independent projects: accept all projects where PI >1 For mutually exclusive projects: accept a project with highest PI (PI > 1)

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Advantages & disadvantages of PI Advantages:  Tells

whether the investment will increase the firm's value  Considers all the cash flows  Considers the time value of money  PI makes the right decision in the case of different amount of cash outlay of different project. (when capital is rationed)

Disadvantages: It is difficult to calculate profitability index if two projects having different useful life.  May not give the correct decision when used to compare mutually exclusive projects  Requires an estimate of the cost of capital in order to calculate the net present value 

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Illustration Example 1  A project with initial investment cost of Br1,000,000 produces the following expected net cash flows over 5 years:

Year

NCF ( in thousands)

1

200

2

200

3

300

4

300

 The project’s cost of capital is 10%

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Required: calculate the following amounts & make a decision

550

 NPV  IRR  PI

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Illustration Example 2 Consider the following data summarized from four hypothetical projects and evaluate which project shall be undertaken. Assume that the company has only Br 50,000 capital to finance a project (s).

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Projects

A

B

C

D

PV of net cash flows in thousands

90

60

84

45

Cash flow at time zero

50

15

35

15

Profitability Index

1.8

4

2.4

3

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Comprehensive Problem  BERI Chemical PLC is presently paying an outside firm Br 1 per kilogram to dispose of waste material resulting 







from its manufacturing operations. At normal operating capacity the waste is about 40,000 kgs per year. After spending Br 40,000 on research, the company discovered that the waste could be sold for Br15 per kilogram if it was processed further. Additional processing would, however, require an investment of Br 610,000 in new equipment, which would have an estimated life of 5 years and no salvage value. Depreciation would be computed by double declining balance method. Additional net working capital of Br25,000 is required. Except for the costs incurred in advertising of Br 20,000 per year, no change in the present selling and administrative expenses is expected if the processed waste (new product) is sold. The details of additional processing costs are as follows: variable, Br5 per kilogram of waste put into process; fixed (excluding depreciation), Br 30,000 per year. There will be no losses in processing, and it is assumed that all of the waste processed in a given year will be sold in that year. Waste that is not processed further will have to be disposed off at the present rate of Br 1 per kilogram. Estimates indicate that 30,000 kilograms of the new product could be sold each year. The management is confronted with the choice of disposing off the waste, or processing it further and selling it. Hence, it seeks your advice. Assume that the firm’s cost of capital is 15% and it pays 30% tax on its income.

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Comprehensive Problem Required:  Calculate the investment cost  Calculate the net cash flow of the project (processing the waste and selling it) for each year (year 1 – 5).  Calculate the payback period for the project and make a decision if the acceptable time limit is 3 years.  Calculate the accounting rate of return (on average investment) of the project and make a decision if the acceptable AARR is 25%.  Calculate the net present value of the project and make a decision  Calculate the IRR of the project and make a decision

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Solution 1. Inv’t cost = 610,000 + 25,000 = 635,000 2.

Year 1

increase in sales rev (30000x15)

Year 2

Year 3

Year 4

Year 5

450000

450000

450000

450000

450000

30000

30000

30000

30000

30000

480000

480000

480000

480000

480000

150000

150000

150000

150000

150000

Fixed, manufacturing

30000

30000

30000

30000

30000

Advertising

20000

20000

20000

20000

20000

Total cash operating costs

200000

200000

200000

200000

200000

Net cash flow before tax & tax savings

280000

280000

280000

280000

280000

84000

84000

84000

84000

84000

196000

196000

196000

196000

196000

73200

43920

26352

15811

9487

cost saving: reduction in disposal cost Sub total less: cash operating costs: Variable (30000x5)

Less: taxes Net cash flow before tax savings Add: Tax savings from depreciation Tax savings from loss on disposal

14230

Recovery of NWC

25,000

Net cash flow

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269200

239920

222352

211811

244717 30

Solution 3) PBP = 2.57 years

Year

NCF

Cumulative NCF

0

(635000)

(635000)

1

269200

(365800)

2

239920

(125880)

3

222352

96,472

4) AARR Year 1 Year 2 Net cash flow Average annual net profit = 110,600 Average Investment = 317,500 Less: Depreciation expense Loss on disposal of AARR = 34.83%

Year 3

Year 4

269200

239920

222352

211811

219717

244000

146400

87840

52704

31622

equipment

Net profit

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Year 5

47434 25200

93520

134512

159107

140661

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Solution 5) NPV Year 1 Net cash flow

Year 4

Year 5

239920

222352

211811

244717

0.8696

0.7561

0.6575

0.5718

0.4972

234096.3

181403.5

146196.44

121113.5

121,643.3

804,483.1

Less: Initial investment NPV

Year 3

269200

x PVIF PV of net cash flows Total PV of net cash flows

Year 2

635,000 169,483.1

6) IRR Try 27%; NPV at 27% = (10,240) Try 26%; NPV at 26% = 2,020 IRR = 26.16% 12/19/2011

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5.5 Financial Evaluation conditions of uncertainty

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Scenario Analysis What happens to the NPV or IRR under different

cash flow scenarios? At the very least, look at: Base case – Most likely outcomes Best case – high revenues, low costs Worst case – low revenues, high costs

Best case and worst case are not necessarily

probable, but they can still be possible

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Summary of Scenario Analysis

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Scenario

Net Income

Cash Flow

NPV

IRR

Base case

19,800

59,800

15,567

15.1%

Worst Case

-15,510

24,490

-111,719

-14.4%

Best Case

59,730

99,730

159,504

40.9%

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Sensitivity Analysis What happens to NPV when we change one

variable at a time This is a subset of scenario analysis where we are looking at the effect of specific variables on NPV The greater the volatility in NPV in relation to a specific variable, the larger the forecasting risk associated with that variable, and the more attention we want to pay to its estimation In sensitivity analysis only one variable is changed at a time. In the real world, however, variables tend to move together. 12/19/2011

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Break-Even Analysis Common tool for analyzing the relationship between sales

volume and profitability There are three common break-even measures  Accounting break-even – sales volume at which NI = 0  Cash break-even – sales volume at which OCF = 0  Financial break-even – sales volume at which NPV = 0

Accounting Break-even 

Q = (FC + D)/(P – v)

Cash Break-even 

Q = FC/(P – v) (ignoring taxes)

Financial Break-even 

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PV of cash inflows = PV of cash outflows project A & E

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5.6. Project Financing The allocation of financial resources to a project prerequisite for   

investment decisions pre-investment analysis determining the cost of capital

Main types of financing   

Equity Debt Grant

When making financing decision, the major concern is

creating optimal capital structure. 12/19/2011

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5.6.1 Equity Financing Equity is invested capital that creates ownership in the project. It is more expensive than debt because  Equity investor accepts more risk than lender  Dividends distributed are not tax deductible

 Professional sources:    

Institutional risk takers Groups of wealthy individuals Government-assisted sources Major financial institutions, etc

 Non-professional sources:     

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Friends Relatives Employees Customers industry colleagues, etc project A & E

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Advantages & disadvantages of equity financing Advantages:  No compulsion to pay dividends  Equity capital has no maturity date  The larger the equity base, the greater the financial flexibility  Easy exit: easy for the promoter to offload his holdings to any other interested investor and quit the company without closing down the business.

Disadvantages  Loss of decision making powers & control  Regulatory compliance  Equity dividends are paid out of profit after tax  Taking in investors is a permanent obligation, and the investors have a right to stay

put and take their cut of profits forever.  Cost of issuing equity shares is generally higher than the cost of issuing other types of securities 12/19/2011

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5.6.2. Debt Financing Is the ability to use other people’s and institutions’ money

without giving up ownership control. Sources:  Banks  Savings and loans  Micro finance institutions  State and local governments  Family members  Friends  International agencies  etc 12/19/2011

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Types of debt financing Loan Financing Short and medium term borrowings from commercial bank for working capital or suppliers credit and  Long-term borrowings from national or international development finance institutions 

Suppliers Credit 

Long-term loans provided by project equipment suppliers to cover purchase of their equipment by the project company. Particularly important in projects where capital equipment is intensive.

Bonds 

are long-term debt securities generally purchased by institutional investors and sometimes individuals through public markets

Leasing 

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to lease plant equipment or borrow the entire productive assets project A & E

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Advantages & disadvantages of debt financing Advantages:  Because the lender does not have a claim to equity in the business, debt does not

dilute the owner's ownership interest in the company.  Interest on debt is tax deductible lowering the actual cost of the loan to the company.  Except in the case of variable rate loans, principal and interest obligations are known amounts which can be forecasted and planned for.  Raising debt capital is less complicated because the company is not required to comply with state and federal securities laws and regulations.

 Disadvantages  Unlike equity, debt must at some point be repaid.  Increases financial leverage which raises cost of equity to the firm  Debt instruments often contain restrictions on the company's activities, preventing

management from pursuing alternative financing options and non-core business opportunities.  The larger a company's debt-equity ratio, the more risky the company is considered by lenders and investors. Accordingly, a business is limited as to the amount of debt it can carry. 12/19/2011

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ECONOMIC EVALUATION

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OVERVIEW Financial evaluation aims at assessing the financial &

commercial viability of a project from point of a point of view of investors and financiers. Economic evaluation is the assessment or justification of project idea within the wider context of national economic & social environment. To make corporate objectives & investment policies determined by investors in harmony with national socio-economic policies of the country.  Focuses on the social costs & benefits of the project. 

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Principal sources of differences between economic evaluation & financial analysis A. Market Imperfection  Market prices are used in financial analysis.  But may not show true value of the product or factor due to

market imperfection resulting from •

Rationing (price control by government) 

•

Description of minimum wage rates 

•

Wages paid may exceed the labor rate in competitive market.

Foreign exchange regulation 

•

Price paid by consumer may be less than that in competitive market.

Regulated forex rate may be less than the one to be in absence of regulation

Shadow prices are used in economic evaluation

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Principal sources of differences between economic evaluation & financial analysis B. Externalities  Beneficial & harmful external effects  Not considered in financial analysis unless they result in monetary

benefits & costs to the investor.  But they are always considered in economic evaluation

C. Taxes and Subsidies  From financial analysis point of view, they are definite monetary costs and

benefits  But in economic evaluation, they are transfer payments and are ignored

D. Concern for savings  High concern for savings in economic evaluation (benefit saved is more valuable than benefit consumed)  In financial analysis, there is no division between consumption & savings. 12/19/2011

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Principal sources of differences between economic evaluation & financial analysis E. Concern for income redistribution  A private firm doesn’t bother about how its benefits are distributed across

various groups in the society  But there is high concern from society point of view (benefit going to economically poor section is considered more valuable than benefit going to affluent section)

F. Merit wants  Are goals & preferences not expressed in the market place but believed by

policy makers to be in the larger interest  Goods are divided in to merit goods and demerit goods in economic evaluation.  Merit good: the one for which the social value exceeds the economic value  Demerit good: the one for which the social value is less than the economic value 12/19/2011

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