Chapter Five

Financial Analysis and Project Financing

The main objective of financial analysis is to measure the financial viability of a project under prevailing
market conditions. The basic question to be addressed is whether the project can survive financially if it is left
to the forces of the market. The objective and significance of financial analysis differs when it is applied to
privately financed projects and public financed projects. Financial analysis may not have direct application in
the case of some of public financed projects such infrastructural project (so it requires modification)

In case of such publicly financed projects financial analysis may aim at

 Measuring the extent of subsidies required

 Identifying the project that is least cost alternative (for example, different designs) - a project with least life
time costs is desired.
 Establishing cost-recovery schemes – cost recovery scheme is a very popular issue nowadays. Some of the
cost should be recovered from the community and used for expansion purpose. The idea is users should
contribute to the cost otherwise expansion of the project will not be possible. It is became important issue for
donors and government.

Determining Relevant Cash Flows

Cash inflows- project cash inflows are expected to appear from the following sources:

 Sales of the products or services- these are the principal sources of income for the project for which it has
been established. It represents the dominant source of cash flow and is termed as cash flows from
operations.
 Sales of by products- some projects may have byproducts that are salable and serve as source of cash
inflows. For example, in a sugar factory, the molasses is a salable byproduct.
 Recovery of net working capital- by the end of the planning horizon of the project the initial working
capital of the project is expected to be recovered and represents another inflow of cash.
 Other miscellaneous sources- a project may have inflow of cash from other minor sources such as
investment of idle cash temporarily or sale of old assets.

Cash Outflows- the project will have the following major categories of cash outflows:

 Initial investment costs

These are defined as the sum of fixed assets (fixed investment costs plus pre-production expenditures) and net
working capital. Expenditures for fixed assets constitute the resources required for constructing and equipping
an investment project. Net working capital requirement corresponds to the resources needed to operate the
project totally or partially. Their break down is stated as follows:

 Investment costs = fixed capital + Net working capital

 Fixed capital = fixed investment + pre-production capital costs

Hence, Investment costs = fixed investment + pre-production capital costs+ Net working capital.

1. Fixed Capital costs- are the costs of fixed investments such as the costs of the following:

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 Land acquisition and site preparation costs
 Building and civil work costs
 Plant, machineries and equipment costs
 Patent acquisition costs etc

2. Pre-Production capital costs- costs incurred prior to commercial production. These costs need to be
capitalized.

 Expenditures for pre-investment studies such as opportunity study, pre-feasibility and feasibility study
and support and functional studies,
 Preproduction manpower cost
 Consultant fees for preparing studies, engineering, and supervision of erection and construction
 Trail run, start up and commissioning expenditures,
 Other expenses preproduction costs such as preproduction marketing, know how and patent fees, training
costs etc,

3. Net Working capital requirement- is computed as current assets less current liabilities in operating the
project during the planning horizon.

Net working capital 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. So it is part of the
investment costs. It forms essential part of the initial capital outlays required for an investment project,
because it is required to finance the operation of the plant. Any change in current assets or liabilities has an
impact on the financial requirements. Networking capital is partly inflow because, at the time when the
project is over, it will be realized in the form of cash and will be treated as an inflow. Net working capital
amount fluctuates as there is a change in capacity utilization. We have to focus on the additional working
capital requirement each year. The amount of working capital invested should be optimal, that is neither too
large nor too small, to avoid penalties for the project. Working capital should be carefully estimated and
adequately controlled and monitored.

 Production costs- Production costs include the following three main categories of costs:

a. Material costs (direct) - as were discussed previously, various types of materials and parts are
consumed in running the project.
b. Labor costs (direct) – represent the costs incurred in relation to the human resource of the
organization.
c. Factory overhead costs- represent indirect materials and parts, indirect labor and other overhead
costs such as depreciation of facilities and equipments etc.

 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. These represent operating and other expenses of
the company.

1. Administrative costs
2. Sales and distribution costs (marketing costs)

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Two approaches of determining the projected cash flows of a project:

 A cash flow forecast based on the income statement, in which the statement is adjusted for non-cash
items. The resulting figure refers to funds provided by operations. Considering cash flows not recognized
in the income statement leads to the final funds position of the project.
 A cash receipts and disbursement statement, or the cash budget, reflecting the initial cash balance, the
receipt for the period, the expected disbursements and the ending cash balance.

Supporting schedules for financial analysis are the following:

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 Investment cost schedule  Working capital schedule
 Production costs schedule  Loan repayment schedule

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Once, the above analysis is made, the next tasks are going directly to the project appraisal techniques. Investment
project appraisal methods are classified into two basic categories. These are non discounted cash flow methods
and discounted cash flow methods. Non discounted methods will be observed first followed by those using
discounted cash flows.

A. Non Discounted Cash Flow Methods

There are two types of methods considered in this category: the pay back method and the average accounting rate
of return which will be discussed in brief next.

1. Payback method (or Payback Period)

The 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). When deciding between two or more competing projects the
usual decision is to accept the one with the shortest payback.

Payback is commonly used as a first screening method. It is more popular and easy to apply. The decision rules
are:
 If payback < acceptable time limit, accept project
 If payback > acceptable time limit, reject project

In the simplified case of a project with equal annual cash inflows, it is easy to find the payback period. Example if
a Birr 2 million is invested to earn Birr 500,000 per annum for 7 years, the pay back period is computed as
follows:

Pay back period = Br 2million/500,000= 4years

However, if cash inflows are uneven (a more likely state of affairs), the payback has to be calculated by working
out the cumulative cash flow over the life of a project.

The shorter the payback period is the better the project. However, the limitations of the technique can be seen
when it is used to appraise several projects together and hence compare them.

Merits of payback period as an investment appraisal technique

a. Simplicity- as a concept it is easily understood and is easily calculated,

b. Rapidly changing technology, If new plant is likely to be scrapped in a shorter period because of
obsolescence, a quick payback is essential,
c. Improving investment conditions, When investment conditions are expected to improve in the near future,
attention is directed to those projects which will release funds soonest, to take advantage of the improved
climate,
d. Payback favors projects with a quick return, It is often argued that these are to be preferred for three reasons
1. Rapid project payback leads to rapid company growth- but in fact such a policy will lead to many
profitable investment opportunities being overlooked because their payback period does not happen to be
particularly swift,
2. Rapid payback minimizes risk (the logic being that the shorter the payback period, the less there is that
can go wrong), Not all risks are related to time, but payback is able to provide a useful means of assuring
time risks (and only time risk), It is likely that earlier cash flows can be estimated with greater certainty,

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 3. Rapid paybacks maximize liquidity, But liquidity problems are best dealt with separately, through cash
forecasting,
Critics of payback period as an investment appraisal technique include the following:
a. Project return may be ignored- in particular, cash flows arising after the payback period are ignored.
b. Timing is ignored-Cash flows are effectively categorized as pre-payback and post payback- but no more
accurate measures is made. In particular, the time value of money is ignored.
c. Lack of objectivity-There is no objective measures as to what length of time should be set as the minimum
payback period, Investment decisions are therefore subjective.
d. Project profitability is ignored-Payback takes no account of the effects on business profits and periodic
performance of the project, as evidenced in the financial statement. This is critical if the business is to be
reasonably viewed by users of the accounts.

Example: Assume that there are two projects that need initial outflow of Br30 million each and having the
following expected net cash inflows to be evaluated using the payback technique. Required: which project shall
be undertaken if a) They may be undertaken together b) They are mutually exclusive.

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ARR is also known as accrual accounting rate of return, unadjusted rate of return model and the book value
model. Its compilations is related with conventional accounting models of calculating income and required
investment It also shows the effect of an investment on project’s financial statement.

Advantages of using ARR include the following:

 It is simple to calculate using accounting data

 Earning of each year is included in the calculating the profitability of the project

Disadvantages of using ARR include the following:

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 It is inconsistent with wealth maximization as the objective of the firm
 Since it uses the accounting data it includes the amount of accruals in calculating the earnings “net profit”.

 It is based on the familiar accrual accounting.

 It ignores the time value of money i.e. expected future dollars are erroneously regarded as equal to present
dollars.

B: Discounted Cash Flow Methods

Three types of methods will be considered in here. These are the net present value, the internal rate of return and
the profitability index. All of them have advantages over the payback period method because they recognize the
time value of money. Reasons for time preference are because of consumption, risk preference and investment
preference. Each of them will be considered next.

1. Net Present Value Method (NPV)

It is the method of evaluating projects that recognizes that the Birr received immediately is preferable to a Birr
received at some future date. It discounts the cash flows to take into the account the time value of money. This
approach finds the present value of expected net cash flows of an investment, discounted at cost of capital and
subtract from it the initial cash outlay of the project. In case the present value is positive, the project will be
accepted; if negative, it should be rejected. If the projects under consideration are mutually exclusive the one with
the highest net present value should be chosen. The formula to compute NPV and examples are given below:

Problems with NPV are it is difficult to explain to non-finance people and solution is in Birr amounts, not in
percentage rates of return.

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Some value of R will cause the sum of the discounted receipts to equal the initial cost of the project, making the
equation equal to zero, and that value R will be the project’s internal rate of return. It is thought as the maximum
rate of interest that can be paid to finance for a project without making a loss. Projects with costs of capital lower
than the IRR are acceptable.

Generally it is necessary to compute the IRR by trail and error (i.e. to compute the NPVs at various discount rates
until the discount rate is found which gives an NPV of zero. A computer program can automatically produce the
IRR of project cash flows. As an example, consider the following computations:

From the above calculation, when rate is 15% the PV of investment A is zero, which indicates that its internal rate
of return is 15%. The IRR for project B is approximately to 20%.

IRR Decision Rules

Independent Projects: Accept all as long as the IR > hurdle rate
Mutually Exclusive Projects: Compute (IRR less hurdle rate) for each project, rank from highest to lowest and
accept the highest ranking project [assuming the computation (IRR less hurdle rate) > 0]

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Advantages of using IRR include the following:

 Considers all cash flows

 Considers time value of money

 Comparable with hurdle rate

Disadvantages of using IRR include the following:

 It does not show Birr improvement in value of firm if a project is accepted

 IRR can be affected by the scale (size) of the project, i.e. Io (initial investment)

 There will be possibility of existence of multiple IRRs

The relationship Between IRR and the NPV Profile can be shown as follows:

1) When the IRR = the firm's hurdle rate, NPV = 0

2) When the IRR < the firm's hurdle rate, NPV < 0
3) When the IRR > the firm's hurdle rate, NPV > 0

NPV and IRR methods may result in possible decision conflicts. An accept/reject conflict occurs when NPV says
"accept" and IRR says "reject" or NPV says "reject" and IRR says "accept". The decision then will depend on
whether the projects are mutually exclusive or there is only a single investment project.

Single Investment Decision

When deciding whether or not to accept a single project both methods give the same result. A project will be
accepted if it has a positive NPV at the required rate of return and if it has a positive NPV then it will have an IRR
that is greater than the required rate of return.

Mutually Exclusive Investments

When one project is to be selected out of two or more projects, NPV and IRR may give conflicting
recommendations. Generally the project with the highest NPV is selected if all projects required the same
investment. IRR may be confusing under such a case because more than two or more projects may have the same
IRR which is greater than the required rate of return and it is not necessarily the project with the highest IRR
which should be selected, provided that the IRR is greater than the costs of capital for at least two of the projects.

When projects are independent, no accept/reject conflict will arise. A ranking conflict occurs when one project
has a higher NPV than another while the lower NPV project has a higher IRR. Ranking conflicts are unusual but
can occur. These conflicts are relevant only when there are multiple acceptable mutually exclusive projects. When
a conflict arises among mutually exclusive projects, pick the one with the highest NPV.

3. Profitability Index

It is sometimes called Benefit Cost Ratio or present value index. It is calculated by taking the present value of
cash inflows divided by the present value of cash outflows.

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Due to shortage of funds, a company may not always be able to undertake all of the attractive projects available to
it. In this case a choice must be made from the projects under consideration. For divisible projects, where it is
possible to invest only a proportion of the total funds and get a proportion of the NPV, we can use a profitability
index (PI).

The decision criteria are to accept project with a Profitability Index (PI) greater than one.

This ratio gives the return in the present terms per unit invested. Using this criterion, projects will be ranked from
the one with highest PI down to one with the lowest, and then project would be selected in the order of ranking up
to the point where the budget is exhausted.

Example: 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).

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
Based on the above analysis, projects B and D can be undertaken for a total financial outlay of Br 30,000 instead
of project A or C because the two projects have better profitability indexes than the others. No other project will
be considered because the remaining fund is not enough (though there is unused fund of Br 20,000 i.e. Br 50,000-
Br 30,000= Br 20,000).
This criterion is simple but suffers from two basic limitations:
1. It cannot be used to except in cases where there is only a single constraint. In case where the capital is
rationed in more that one period or where the capital is not the only constraint, the criteria will not provide the
best solution.
2. It looks projects individually and does not take into account the overall portfolio where correlation of
projects’ returns is important

Financial Evaluation under Conditions of Uncertainty

Forecasts of the future business environment concerning demand, production and sales can be only an
approximation, because it is not possible, on the basis of past data to determine more than a past trend, which may
be extrapolated into uncertain future.

Of primary importance in the appraisal of an investment project is the reliability of the data assessed and of the
project design in terms of sales programme, selection of project inputs and location, choice of technology,
engineering design, management, personnel, as well as implementation of the project.

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 To minimize uncertainty with regard to the reliability of project data and design, the financial analyst should
check whether the feasibility study covers all aspects relevant to the investment and financing decisions. Only
when the feasibility study fulfils these basic requirements should the analysis of the business risks begin. The
most basic reasons for uncertainty are inflation, changes in technology, false estimates of the rated capacity, and
the length of the construction and running-in periods.

The problem of uncertainty is aggravated by phasing of the project over time. Investments also underlie many
developments and changes in the political social, commercial and business environment as well as changes in
technology, productivity and prices. To cope with the risks involved in any significant investment, management
has basically the following two options with regard to a policy on risks:

 To acquire insurance against various risks identified for an investment project

 To identify the possibilities for active risk control or risk management.

The main instrument of the insurance strategy is to invest only when the expected returns are higher than the cost
of capital plus the risk margin. But this concept can be successful only when the investor has an investment
portfolio. In this case the risks are spread over a number of carefully selected investments (possible only for large
firms but not by small ones).

As an alternative, when deciding about the desirability of a project, all the elements of uncertainty have to be
taken into account by evaluating any foreseeable risks that could have significant impacts on its feasibility and the
possible means of control of the risks. The allowance to be provided for such risks may have a decisive impact on
the profitability of the project and in the case of a marginal proposal make project implementation impossible.
When the aspects of uncertainty are to be included in the financial evaluation, three variables in particular should
be examined:

 Investment costs- investment costs of the project may increase extremely making the profitability of the
project difficult or impossible. This may arise due to wastage and consumption of much resources or
increase in their costs.
 Sales revenue- the doubt with revenues is that they may be below what was estimated at the time of the
feasibility study. This may be due to failure to achieve sales quota or inability to charge the estimated
prices.
 Costs of products- these costs are similar to that of investment costs and increases in them will affect the
profitability of the project significantly.
 Operating and other expenses- these categories of expenses are not exceptions. They may increase and
make the project’s success questionable.

A host of individual items enters into these variables, all of which are composed of a price and quantity factors.
Sensitivity analysis is a proper instrument for identifying these critical variables and the extent to which they could
affect the financial feasibility of the project. Sensitivity analysis is what if analysis changing the amount of the above
critical variables towards the worst situations i.e. decreasing revenues and increasing the various costs and expenses
of the project depending on different levels of certainty. It may be used together with the equation or using break even
analysis.

Exercise: Assume that Mina PLC, a financial analyst, is doing a consulting work for evaluating the two projects given
below. The projects costs Br 500 million each and the required rate of return for each of the projects is 12%. The
projects’ expected net cash flows are as follows:

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 Calculate each of the project's payback, net present value (NPV) and internal rate of return.
 Which project or projects should be accepted if they are independent?

 Which project should be accepted if they are mutually exclusive?

 How might a change in the required rate of return produce a conflict between NPV and IRR rankings of the
two projects? Would this conflict exist if k is 5%?

 Why does the conflict exist?

Project Financing

There are two types of project financing: equity and debt financing. When looking for money, you must consider
your company's debt-to-equity ratio - the relation between amounts borrowed and amounts invested to the
business by the owners. The more money owners have invested in their business, the easier it is to attract
financing.

The proportion of debt to equity depends of how well the financial market is organized and the availability of debt
financing. In addition, the existence of capital markets and the legal environment governing it will have a critical
impact. However, shortage of financial resources will be a critical constraint of implementing feasible investment
projects.

Equity Financing- most small or growth-stage businesses use limited equity financing. As with debt financing,
additional equity often comes from non-professional investors such as friends, relatives, employees, customers, or
industry colleagues.

However, the most common source of professional equity funding comes from venture capitalists. These are
institutional risk takers and may be groups of wealthy individuals, government-assisted sources, or major
financial institutions. Most specialize in one or a few closely related industries.

Venture capitalists may scrutinize thousands of potential investments annually, but only invest in a handful. The
possibility of a public stock offering is critical to venture capitalists. Quality management, a competitive or
innovative advantage, and industry growth are also major concerns.

Debt Financing

There are many sources for debt financing: banks, savings and loans, commercial finance companies, and the
microfinance institutions. State and local governments have developed many programs in recent years to
encourage the growth of small businesses in recognition of their positive effects on the economy.

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Family members, friends, and former associates are all potential sources, especially when capital requirements are
smaller. Traditionally, banks have been the major source of small business funding. Their principal role has been
as a short-term lender offering demand loans, seasonal lines of credit, and single-purpose loans for machinery and
equipment.

In addition to equity considerations, lenders commonly require the borrower's personal guarantees in case of
default. This ensures that the borrower has a sufficient personal interest at stake to give paramount attention to the
business. For most borrowers this is a burden, but also a necessity.

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