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PROJECT FINANCE
Main Activity
1. Financial Evaluation of Project
Other Activities
2. Cost of Project
3. Decision about Sources of Finance
o Cost of Capital
o Capital Structure
4. Working Capital Requirement
Inflows are provided by market & demand analysis by calculating forecasted demand and price.
Outflows are provided by Technical analysis (Operational Cost) and Financial Analysis (Financial
Cost). On the basis of cash inflows and cash outflows, net cash inflows are calculated. Finally,
project is evaluated by applying various techniques of capital budgeting on net cash inflows.
(2)
The difference in two methods is of ‘Time Value of Money’. +TMV means that the value of a unit
of money is different in different time pe4riods. “Rs.100 not today is having more worth than Rs.
100 note tomorrow”. Conversely, the sum of money received in future is less valuable than it is
today. The main reason for time value of money is to be found in the reinvestment opportunities for
funds which are received early. The funds so invested will earn a rate of return; this would not be
possible if the funds are received at a later time. The time value of money is therefore, expressed
generally in terms of a rate of return or discounting rate.
NON-DISCOUNTING TECHNIQUES
The average profit after taxes are determined by adding up the after-tax profits expected for each
year of project’s life and dividing the result by the number of years. The initial investment is the
total investment in the business at the time of starting it. Some experts suggest to take average
investment instead of initial investment, as charging of depreciation against profit is regularly
reducing the investment is business. Such average investment will be calculated by dividing the
total investment by two (assuming scrap value as zero)
(3)
Merits:
1. It is very easy to understand and to calculate
2. It uses readily available accounting information.
Demerits:
1. It ignores the time value of money. Yearly inflows of (Rs.10000, 20000 & 30000) and
(Rs.3000, Rs.20000 and Rs.10000) will be treated as same.
2. It uses accounting profits, which takes into account the non-cash expenditures.
Initial Investment
PBP (in years )
Annual Cash Inflow
Balance R emaining
PBP CompleteYears 12
Cash Inflow for the year months
First formula is used in case of annuity of cash inflows and second one is used when cash
flows are not uniform (mixed stream).
Accept Reject Criterion: The actual pay back is compared with predetermined or desired
pay back, that is, the pay back set up by the management in terms of the maximum period
during which the initial investment must be recovered. If the actual pay back period is less
than the predetermined pay back, the project would be accepted; if not, it would be rejected.
When there are alternative projects, they may be ranked according to the length of the pay
back period. Thus, the project with shorter pay back period will be selected.
Merits:
1. It is easy to calculate and simple to understand.
2. It is based on cash inflows and not on accounting profit.
3. It favors the project with larger cash inflows in earlier years (although do not consider
time value of money).
Demerits:
1. It ignores the time value of money
(4)
2. It do not consider the cash flows beyond the pay-back period. Project A – Rs.5000,
Rs.6000 and Project B – Rs.5000, Rs.6000, Rs.8000, Rs.10000 with initial investment
of Rs.10000 are same for this method.
DISCOUNTING TECHNIQUES
The discounting techniques take into consideration the time value of money while evaluating the
costs and benefits of a project. These methods require cash flows to be discounted at a certain rate.
Frequently used discounting techniques of project evaluation are:
FV
PV t
(1 r )
Where: PV = Present Value of Cash Flow
FV = Future Value of Cash Flow
r = Rate of Discounting (can be the cost of capital, or desired rate of return)
t = Time i.e. year of the cash flow to be discounted
CI1 CI 2 CI 3 CI n
NPV 1
2
3
............. (1 r ) n COo
(1 r ) (1 r ) (1 r )
Accept-Reject Criteria: If the NPV is positive, the project should be selected and if it is
negative, project should be rejected. Zero NPV implies that the firm is indifferent to accepting or
rejecting the project. In case of many alternative projects, the various projects would be ranked in
order of the NPV. The project with the highest NPV would be assigned the first rank, followed
by others in the descending order.
Merits:
1. It considers the Time Value of Money
2. It also considers the all cash flows while evaluating the project
(5)
Demerits:
1. It is difficult to calculate in comparison to non-discounting techniques.
2. May not give correct result when initial investments are different in two projects, as it is an
ABSOLUTE MEASURE only.
3. Deciding about the appropriate discounting rate is very difficult, it can be different for
different persons.
PV of all CI
PI or BCR
PV of all CO
Let us see with the help of illustration:
If future Cash Inflows are given as - CI1, CI2, CI3, ……………, CIn and Initial Cash Outflows
(investment) is given as: - CO0,Than PI can be Calculated as:
CI1 CI 2 CI 3 CI n
(1 r )1 (1 r )2 (1 r )3 ............. (1 r ) n
PI
COo
Accept-Reject Criteria: A project will qualify for acceptance if its PI exceeds one and rejected if
it is less than one. When PI equals 1, the firm remains indifferent to the project. When PI is
greater than, equal to or less than 1, the net present value is greater than, equal to or less than
zero respectively. Selection of projects with PI method can be done on the basis of ranking. The
highest rank will be given to the project with the highest PI, followed by others in the same order.
Merits:
1. It considers the Time Value of Money
2. It considers all the inflows from the project
3. It is a Relative Measure, can be used in all cases
Demerits
1. This method is difficult to use in comparison to traditional methods
2. Deciding about the appropriate discounting rate is very difficult, it can be different for
different persons.
return is usually the rate of return that a project earns. It is defined as the discount rate ® which
equates the aggregate present value of the net cash inflows with the aggregate present value of
cash outflows of a project. In other words, it is that rate which gives the project NPV as zero.
Symbolically, it can be shown as follows:
CI1 CI 2 CI 3 CI n
(1 r )1 (1 r )2 (1 r )3 ............. (1 r ) n COo 0
Unlike the NPV method of calculating the value of IRR is more difficult. The procedure is
based on ‘hit & trial’. We try different rates for discounting the cash flows and find out the
NPV and try the same till we get a discounting rate at which NPV becomes zero. That
discounting rate is the IRR for the project. We can also use following steps and formula to have
some approximation regarding the zero NPV discounting rate i.e. IRR.
Find fake PBP (as discounting factor)
Search nearby value (rates) from the table
Put the value in formula to make NPV zero
If not getting zero, try some other nearby rate
Get two rates - one negative and one positive NPV
Put the Figures in formula to get IRR
PV of CI rL PV of COrL
IRR rL r
PV of CI rL PV of CI rH
Accept-Reject Criteria: The project would qualify to be accepted if the IRR exceeds the cut-off
rate or desired rate. If the IRR is less than the required rate it would be rejected. Ranking
method can also be used in case of multiple projects. Ranking is done in descending order from
high IRR project to low IRR project and select from top.
Merits:
1. It considers the Time Value of Money
2. It considers all the inflows from the project
3. It do not require any discounting rate
4. It indicates the real profitability of the business
Demerits:
1. It is very difficult to calculate (Hit & Trial)
OTHER ACTIVITIES:
Apart from project evaluation there are some other activities which comes under financial analysis:
Estimating the Cost of Project
Decision about Sources of Finance
Working Capital Requirement
(7)
All above sources are having some merits as well as some demerits; therefore, a proper
combination out of above sources has to be formed keeping following factors in mind:
Cost of Capital
Risk Bearing Capacity
Duration
Willingness to loose control over business
Trading on Equity etc.
As we know that debt capital is a cheaper source of finance, but it is risky because of its fixed legal
obligation of paying interest and capital repayment. Therefore, while deciding about the capital
structure proper use of debt capital should be made to minimize the cost of capital but at the same
time risk should be checked.
Trading on Equity can be defined as using more and more debt capital in capital structure of a firm
for increasing the value of shareholders.
Investment 10,00,000
ROI 20%
Tax Rate 50%
Items Option A Option B
Sources of Finance
No. of Equity Shares of Rs.10 100000 50000
Equity Capital / Funding 1000000 500000
Term Loan @12% Interest 0 500000
Total Capital Employed 1000000 1000000
It is clear from the above illustration that under option A (100% equity financing) earning per
share is Re.1 where as by using 50% debt of 12% rate of interest it has increased to Rs.1.4. It is
because of ‘trading on equity’.
(9)
But trading on equity is a two edge sword. The way it is providing benefit to the shareholder can
reverse also i.e. it can give loss also to shareholders, if rate of return from the business becomes
less than the rate of interest on the loan. Again changing the above example we can see this:
Investment 10,00,000
ROI 10%
Tax Rate 50%
Items Option A Option B
Sources of Finance
No. of Equity Shares of Rs.10 100000 50000
Equity Capital / Funding 1000000 500000
Term Loan @12% Interest 0 500000
Total Capital Employed 1000000 1000000
We can see that when rate of return is less than rate of interest on debt using more debt in capital
structure is harmful for shareholders. Therefore:
More of Debt Capital is used when Expected ROI > Interest on Debt
Less of Debt Capital is used when Expected ROI < Interest on Debt