CHAPTER 7 Financial Analysis Abbbb

Chapter seven:
Financial Analysis of
Project
5.1. Financial analysis basic
• To judge a project from the financial angle,

we need information about the following:
1. Cost of project
2. Means of financing
3. Estimates of sales and production
4. Cost of production
5. Working capital requirement and its financing
6. Estimates of working results
7. Break-even point
8. Projected cash flow statements
9. Projected balance sheets
1. Cost of project
Initial Investment Costs

• Initial investment costs are defined as
– the sum of fixed assets (fixed investment
costs plus pre-production expenditures) and
investment in networking capital.
• Fixed assets
– constitute the resources required for
construction and equipping an investment
project
• Networking capital
– corresponds to resources needed to operate
the project totally or partially.
1. Cost of project
• At the pre-investment stage, in this regard, the

following two mistakes are frequently made:
1. Networking capital, meaning current assets
minus current liabilities, is either excluded at all
or included in insufficient amount
– that, in turn, might be causing liquidity problems for
projects.
2. Total investment costs are sometimes confused
with total assets, the latter constituting fixed
assets plus pre-production expenditures plus
current assets.
1. Cost of project
• the components of the total investment

cost.
i. Fixed Investment Cost
ii. Pre-Production Expenditures
iii. Working Capital (WC) Requirements
iv. Provision for Contingencies
A) Land and Site Development
B) Buildings and Civil Works
C) Cost of Plant & Machinery
D) Technical Know-how and Engineering
Fees
E) Expenses on Foreign Technicians and
Training of Local Technicians Abroad
F) Miscellaneous Fixed Assets and
Expenditures
• The cost of land & site development is the
sum of broad range of costs, the following
being the major ones:
– Basic cost of land including conveyance
(transfer) and other allied charges,
– Premium payable on leasehold,
– Cost of leveling and site preparation,
– Cost of laying approach roads and internal
roads,
– Cost of gate ways,
– Cost of tube wells, etc.
• The cost of buildings & civil works depends on the
following two basic factors:
– The kind of structures required, and
– The specific requirements of the manufacturing
process
• It covers the costs of the following major items:
• Buildings for the main manufacturing plant;
• Buildings for auxiliary services like steam supply,
workshops, etc;
• Laboratory, water supply, etc;
• Warehouses, open yard facilities, etc;
• Non-factory buildings (e.g. guesthouse, cafeteria, clinics,
etc);
• Garages, sewage, drainage, and other civil engineering
works.
• It is fundamental component of the project cost.
• Costs of Imported Machineries and Equipments:
– CIF import value (including shipping, freight, and
insurance costs)
– Import duty (if any),
– Clearing, loading & unloading, and local transportation &
insurance charges
• Costs of Indigenous Machineries and Equipments:
– FOR (Free on Rail ) costs (in other words, purchase price
plus freight charges),
– Sales taxes (if any),
– Rail way freights and transportation charges up to the site
• Cost of stores and spares acquired with machineries
and equipments
• Foundation & Installation charges (depending on
the specific requirements of the project)
D) Technical Know-how and
Engineering Fees
• Technical consultants or collaborators, (local or
foreign), may involve for making:
I. Project preparation report,
II. Choice of technology,
III. Selection of the plant machinery and equipments,
IV. Detailed engineering services, etc
• The cost paid for these services in setting up the
project is a component of the project cost.
– However, any royalty payable (annually) on transfer of
technology, which is typically a percentage of sales, is an
operating expense and hence, accounted in the projected
profitability statement.
• Travel expenses of technicians to- and -

from abroad,
• Boarding and lodging,
• Salaries and allowances, etc
F) Miscellaneous Fixed Assets
and Expenditures
• These are not parts of the direct manufacturing
process but necessary to run the organization as an
entity.
• For instance, the following costs are classified under
this major group:
• Furniture and office equipments;
• Tools, vehicles, railway siding, diesel generators;
• Transformers, boilers, piping system;
• Laboratory and workshop equipments;
• Effluent treatment plants and firefighting equipment;
• Expenses for procurement (acquisition) of patents, licenses,
trademarks, and copyrights (for using a given technological
package);
• Deposits made with the electricity board, and so on.
D) Technical Know-how and Engineering
Fees
F) Miscellaneous Fixed Assets and
Expenditures
• Pre-production capital expenditures
include the following:
A. Establishment and Capital Issue
Expenses
B. Pre-Operative Expenses
A. Establishment and Capital Issue Expenses
• Establishment Expenses:
– These are expenditures incurred during the
registration and formation of the company,
including:
• Legal fees for preparation of the memorandum & articles
of association, similar documents, capital issues and
Expenses for incorporating the company
• Capital Issue Expenses include:
– Underwriting commission and brokerage fees,
– Fees to managers and registrars,
– Printing and postage expenses,
– Advertising and public announcements,
– Listing fees and stamp duty expenses for
processing of share applications and allotment, etc
B. Pre-Operative Expenses
• Expenditures for pre-investment studies such as
opportunity, pre-feasibility, feasibility, and
support or functional studies
• Consultant fees while project preparation, Pre-
production marketing costs and promotional
activities and Training costs (fees, travel, and
living expenses);
• also , preliminary expenses for identifying the
project, conducting the market survey, and
preparing the feasibility report can be presented
under this heading as well.
• In estimating the working capital requirement
and planning for its financing, the following points
have to be born in mind:
• The WC requirement consists of the following:
– Raw materials & components ( indigenous as well
as imported)
– Stocks of goods in process (WIP)
– Stocks of finished goods
– Debtors (receivables)
– Operating expenses (prepaid insurances, prepaid
rents, etc)
– Consumable stocks (supplies)
• Provisions should also be made for physical
contingencies as an allowance, which is providing a
safety factor to cover unforeseen or forgotten minor
costs.
– Contingency allowance is an amount included in a project
account to allow for adverse conditions that will add to
baseline costs.
– These are:
• Physical Contingencies: Allow for physical events such as
the effects of adverse weather condition during
construction, etc.
– They are included in both Financial and Economic analysis
• Price Contingencies:
– Allow for general inflation.
– In project analysis, they are omitted both from financial and
economic analysis when the analysis is done in constant prices.
– Constant price is a value, most often a price, from which the overall
effect of general price increase (inflation) has been removed.
1. Cost of project summary
• the components of the total investment cost.

– A) Land and Site Development:
– B) Buildings and Civil Works:
– C) Cost of Plant & Machinery:
– D) Technical Know-how and Engineering Fees
– E) Expenses on Foreign Technicians and Training Abroad
– F) Miscellaneous Fixed Assets and Expenditures:
– A. Establishment and Capital Issue Expenses
– B. Pre-Operative Expenses
2. Means of financing
• To meet the cost of project the following

means of finance are available:
– Share capital
– Term loans
– Debenture capital
– Deferred credit
– Incentive sources
– Miscellaneous sources
3. Estimates of sales and production
• Typically, the starting point for profitability

projections is the forecast for sales revenues.
• In estimating sales revenues, the following
considerations should be borne in mind:
1.It is not advisable to assume a high capacity
utilization level in the first year of operation.
2.It is not necessary to make adjustments for stocks
of finished goods. For practical purposes, it may be
assumed that production would be equal to sales.
3.The selling price considered should be the price
realizable by the company net of excise duty.
• It shall, however, include dealers' commission which is shown
as an item of expense (as part of sales expenses).
4.The selling price used may be the present selling
price
4. Cost of production
• Given the estimated production, the cost

of production may be worked out.
• The major components of cost of
production are:
1. Material cost
2. Utilities cost
3. Labor cost
4. Factory overhead cost
1. Material cost
• the material cost comprises the cost of raw
materials, chemicals, components, and consumable
stores required for production.
• While estimating the material cost, the following
points should be borne in mind:
– 1.The requirements of various material inputs per
unit of output may be established on the basis of
one or more of the following:
• (a) theoretical consumption norms
• (b) experience of the industry
• (c) performance guarantees, and
• (d) specification of machinery suppliers.
1. Material cost
• While estimating the material cost, the following
points should be borne in mind:
– 2. The total requirements of various material
inputs can be obtained by multiplying the
requirements per unit of output with the
expected output during the year.
– 3. The prices of material inputs are defined in CIF
(cost/ insurance, and freight) terms.
– 4. The present cost of various material inputs is
considered. In other words, the factor of inflation
is ignored.
– 5. If seasonal fluctuations in prices are regular,
the same must be considered in estimating the
cost of material inputs.
2. Utilities cost
• Utilities consist of power, water, and fuel.
• The requirements of power, water, and fuel may be
determined on
– the basis of the norms specified by the
collaborators, consultants, etc. or
– the consumption standards in the industry,
whichever is higher.
• The cost of fuel (furnace oil, coal, firewood,
biogases, etc.) often an important item, is
somewhat more difficult to estimate.
3. Labor cost
• Labor cost is the cost of all manpower employed in
the factory.
• Labor cost naturally is a function of the number of
employees and the rate of remuneration.
• The requirement of workers depends on
– the number of operators/helpers required for
operating various machines and manning various
services.
• The number of supervisory personnel and
administrative staff may be calculated on
– the basis of the general norms prevailing in the
industry.
•
3. Labor cost
• In estimating remuneration rates, the prevailing
rates in the industry/area should be taken into
account.
• The remuneration should include, besides basic pay,
dearness allowance, house rent allowance,
conveyance allowance, medical reimbursement,
leave travel concession, provident fund contribution,
gratuity contribution, and bonus payments.
• In addition, account should be taken of vacations,
overtime work, night work, work on holidays, etc.
• Sometimes labor cost is estimated by adding a
certain percentage, on a global basis, to the basic
pay.
• It is, however, advisable to make a detailed
analysis, at least in the beginning.
4.Factory overhead cost
• The expenses on repairs and maintenance, rent,
taxes, insurance on factory assets, and so on are
collectively referred to as factory overheads.
• Repairs and maintenance expense depends on the
state of the machinery-this expense tends to be
lower in the initial years and higher in the later
years.
• Rent, taxes, insurance, etc. may be calculated at the
existing rates.
• A provision should be made for meeting
miscellaneous factory expenses.
• In addition, a contingency margin may be provided
on the items of factory overheads.
5.Working capital requirement and its financing
• The working capital requirement consists

of the following:
– (i) raw materials and components (indigenous
as well as imported), (ii) stocks of goods-in-
process (iii) stocks of finished goods, (iv)
debtors, and (v) operating expenses.
• The principal sources of working capital
finance are:
– (i) working capital advances provided by
commercial banks, (ii) trade credit, (ill)
accruals and provisions, and (iv) long term
sources of financing.
5.Working capital requirement and its financing
• There are limits to obtaining working

capital advances from commercial banks.
• They are in two forms:
– (i) the aggregate permissible bank finance is
specified as per the norms of lending
– (ii) against each current asset a certain amount
of margin money has to be provided by the
firm.
6.Estimates of working results
• Given the estimates of sales revenues and cost of

production, the next step is to prepare the
profitability projections or estimates of working
results.
• The estimates of working results may be prepared

along the following lines:
• A Cost of production
• B Total administrative expenses
• C Total sales expenses
• D Royalty and know-how payable
• E Total cost of production (A + B + C + D)
• F Expected sales
• G Gross profit before interest
• H Total financial expenses
• I Depreciation
• J Operating profit (G - H - I )
• K Other income
• L Preliminary expenses written off
• M Profit/loss before taxation (J + K - L)
• N Provision for taxation
• O Profit after tax (M - N)
• Less Dividend on
• - Preference capital
• - Equity capital
• P Retained profit
• Q Net cash accrual (P + I + L)
• The estimates of working results may be prepared along the

following lines:
• A. Cost of Production
– This represents the cost of materials, labor,
utilities, and factory overheads.
• B.Total Administrative Expenses
– This consists of (i) administrative salaries, (ii)
remuneration to directors, (iii) professional
fees, (iv) light, postage, telegrams, and
telephones, and office supplies (stationery,
printing, etc.), (v) insurance and taxes on
office property, and (vi) miscellaneous items.
• C. Total Sales Expenses
– The expenses included under this head are: (i)

• C. Total Sales Expenses
– The expenses included under this head are: (i)
commission payable to dealers, (ii) packing and
forwarding charges, (iii) salary of sales staff
(iv) sales promotion and advertising expenses,
and. (v) other miscellaneous expenses.
• D.Royalty and Know-how Payable
– The royalty rate is usually 2-5 per cent of sales.
– Further, royalty is payable often for a limited
number of years, say 5 to 10 years.

• E.Total Cost of Production
– This is simply the sum of cost of production;
total administrative expenses, total sales
expenses, and royalty and know-how payable.
– (A + B + C + D)
• F. Expected Sales
– The figures of expected sales are drawn from the
estimates of sales and production prepared earlier in the
financial analysis and projection exercise.
• G. Gross Profit Before interest
– This represents the difference between expected sales
and total cost of production.

• H.Total Financial Expenses
– consist of interest on term loans, interest on
bank borrowings, commitment charges on term
loans, and commission for bank guarantees.
• I. Depreciation
– This is an important item, particularly for
capital-intensive projects.
• J .Operating profit (G - H - I )
– Is amount after deductions total financial expenses and
depreciation from Gross profit before interest.
– G-H-I

• K. Other Income
– This represents income arising from
transactions not part of the normal operations
of the firm.
• Examples : sale of machinery, disposal of
scrap, etc.
• L. Write-off of Preliminary Expenses
– Preliminary expenses up to 2.5 per cent of the
cost of project or capital employed, whichever
is higher, can be amortized in ten equal annual
installments.

• M. Profit/ Loss Before Taxation
• This is equal to:
– operating profit + other income- write-off of preliminary
expenses.
– (J + K - L)
• N.Provision for Taxation
– While calculating the taxable income, a variety of incentives
and concessions has to be taken into account.
– The tax burden can be figured out fairly easily by applying
the appropriate tax rates.
• O.Profit After Taxation =(M - N)

– This is simply profit/loss before taxation minus
provision for taxation.
– A part of profit after tax is usually paid out as
dividend - dividend on preference capital and
dividend on equity capital.
• P. Retained Profit
– The difference between profit after tax and dividend
payment is referred to as retained profit.
• Q. Net Cash Accrual = (P + I + L)
– The net cash accrual from operations is equal to:
retained profit + depreciation + write-off of
preliminary expenses + other non-cash charges.

• A Cost of production
• B Total administrative expenses
• C Total sales expenses
• D Royalty and know-how payable
• E Total cost of production (A + B + C + D)
• F Expected sales
• G Gross profit before interest
• H Total financial expenses
• I Depreciation
• J Operating profit (G - H - I )
• K Other income
• L Preliminary expenses written off
• M Profit/loss before taxation (J + K - L)
• N Provision for taxation
• O Profit after tax (M - N)
• Less Dividend on
• - Preference capital
• - Equity capital
• P Retained profit
• Q Net cash accrual (P + I + L)
7.Break-even point
• It is also helpful to know what the level of

operation should be to avoid losses.
• For this purpose, the break-even point, this refers
to the level of operation at which the project
neither makes profit nor incurs loss, is calculated.
• Steps of computing the break-even point,
1. the costs are divided into two broad categories
A. Fixed Costs Almost every business incurs
certain costs which are fixed in nature.
B. Variable Costs Several important elements of
costs vary directly with output.
7.Break-even point
• Steps of computing the break-even point,

2. the break-even point is calculated as follows:
Break-even point =
Fixed costs
Unit selling price – Unit variable cost
8. Projected cash flow statements
• The cash flow statement shows the

movement of cash into and out of the firm
and its net impact on the cash balance
with the firm.
 Investing fixed asset creation
 Financing inv’t and drawing
 Terminal liquidation
9.Projected balance sheets
• The balance sheet, showing the balances

in various asset and liability accounts,
reflects the financial condition of the firm
at a given point of time.
• The liabilities side shows the sources of finance

employed by the business.
• Shared capital consists of paid-up equity and
preference capital.
• Reserves and supplies represent mainly the
accumulated retained earnings.
– They are shown in different accounts like the
capital reserve, the investment allowance
reserve, and the general reserve.
• Secured loans represent the borrowings of the

firm against which security has been provided.
– The important components of secured loans
are debentures, term loans from financial
institutions, and loans from commercial banks.
• Unsecured loans represent borrowings against
which no specific security has been provided.
– The important constituents are: fixed deposits
from public and unsecured loans from
promoters.
• Current liabilities are obligations which

mature in the near future, usually a year.
– These obligations arise mainly from items
which enter the operating cycle:
• payables from acquiring materials and supplies used
in production, and accruals of wages, salaries, and
rentals.
• Provisions:
– include mainly tax provision, provision for
provident fund, provision for pension and
gratuity, and provision for proposed dividends.
• The assets side of the balance sheet shows how

funds have been used in the business.
• The major asset components may be described
briefly.
– Fixed assets are tangible long-lived sources ordinarily used
for producing goods and services. They are shown at original
cost depreciation.
– Investments represent financial securities owned by the
firm.
– Current assets and advances consist of cash, debtors,
inventories of different kinds, and loans and advances made
by the firm.
• Miscellaneous expenditures and losses represent
outlays not covered by the previously described
asset accounts and accumulated losses, if any.
Contents of chapter 5

5.2. Measuring Project cash flows
5.3. Non-discounted cash flow
approaches
5.4. Discounted cash flow
approaches
5.5. Project financing alternatives
• A cash flow statement contains information

regarding the movement and availability of
physical cash within the project.
– The movement of cash refers to cash inflow
and cash outflow.
– The sources of cash inflow are
• equity capital, loan, and sales
– The sources of cash outflow are
• expenditures like investment, incremental
working capital, operating costs, loan on
interest, loan repayment, and tax.
• This enables the project appraiser to see whether

there is enough cash available to meet the project’s
expenditure requirements at any particular moment
in time.
– If any time periods of cash shortage are identified then the
cash flow statement can be utilized to find ways of
overcoming such shortfalls.
• The key point to remember when assessing the
liquidity of a project is that the cumulative cash flow
must remain positive.
– A negative figure indicates the project lack sufficient fund to
cover its expenditure and as a result the project should be
ceased.
A. Basic principles of measuring project cash

flows:
B. Components of the cash flow estimation

flows:
B. Components of the cash flow estimation:
A. Basic principles of measuring project cash flows:
– The following principles should be

followed while estimating the cash flows
of a project:
• A. Separation principle
• B. Incremental principle
• C. Post-tax principle
A. Basic principles of measuring project cash flows:
– The following principles should be

followed while estimating the cash flows
of a project:
• A. Separation principle
• B. Incremental principle
• C. Post-tax principle
A. Separation principle
• There are two sides of a project;

– the investment (or asset) side and
– financing side
• the cash flow associated with these sides should be
separated.
– Suppose, a firm is considering a one year project
that requires an investment of Birr 1,000 in fixed
assets and working capital at time 0. The project is
expected to generate a cash inflow of Birr 1,200 at
the end of year 1-this is the only cash inflow
expected from the project.
• The project will be financed entirely y debt carrying an
interest rate of 15% and maturing after 1 year.
• Assuming that there are no taxes, the cash flows
associated with the investment side of the project,
– the rate of return on the investment side of the
project,
• the cash flows associated with the financing side of the
project, and the cost of capital on the financing are as
follows. Project
Financing Investment
Time Side Cash flow Time Cash flow

0 +1,000 0 -1,000
1 -1,150 1 +1,200
Cost of capital 15% Rate of return 20%
Project

0 +1,000 0 -1,000
1 -1,150 1 +1,200
• Note that the cash flows on the investment

side of the project do not reflect financing
costs (interest in our example).
Project

0 +1,000 0 -1,000
1 -1,150 1 +1,200
• The financing costs • The cost of capital is

are included in the used as the hurdle rate
cash flows on the against which the rate
financing side and of return on the
reflected in the cost investment side (which
of capital figure is 20%) is judged.
(which is 15%).
B. Incremental principle
-(4.1)
• The cash flow of a project must be measured in

incremental term.
• To ascertain a project’s incremental cash flows you
have to look at what happens to the cash flow of
the firm with the project and without the project.
• The difference between the two reflects the
incremental cash flows attributable in the project.
That is:
 project cash flow   cashflow for firm with   cashflow for firm without 
       
 for year t   project for year t   project for year t 
C. Post-tax principle
• Cash flow should be measured on an after-tax basis.

• Some firms may ignore tax payments and try to
compensate this mistake by discounting the pre-tax
cash flows at a rate higher than the cost of capital of
the firm.
• Since there is no reliable way of adjusting the discount
rate, you should always use the after-tax cash flow
along with after-tax discount rate to assess the impact
of taxes.
• The important issues in assessing the impact of taxes
are:
– What tax rate should be used to assess tax liability?
– What is the effect of non-cash charges?
• In response to the above issues, the marginal tax rate

(the tax rate applicable to the income at margin) of the
firm than average tax rate is suggested as relevant rate
for estimating tax liability of the project.
• Non-cash charges can have an impact on the cash
flows if they affect the tax liability.
– The most important non-cash charge is depreciation.
– The tax benefit of depreciation is depreciation
multiplied by marginal tax rate.
• For example, if the initial investment (BV0) is 100

and depreciation rate (r) is 40 percent, the book
value and depreciation charge will be as follows for
the first three years.
Year Beginning book value Depreciation charge

1 100 100 (0.4)=40
1
2 60 100 (1-0.4) 0.4=24
2
3 40
36 100 (1- 0.4) 0.4=14.4

flows:
B. Components of the cash flow estimation:
• To evaluate a project, you should determine the
relevant cash flows, which are the incremental after-tax
cash flows with the project.
• The cash flow stream of a conventional project-a
project that involves cash outflows followed by cash
inflows-comprises three basic components. These are
1. Initial investment: It is the after-tax cash outlay
(outflow) on capital expenditure and networking
capital when the project is set.
2. Operating cash inflows: These refer to the after-tax
cash inflows resulting from the operation of the
project during its economic life.
3. Terminal cash inflow: It is the after-tax cash flow
resulting from the liquidation of the project at the
end of its economic life.
• Figure 1 below depicts on a time line the cash flows for an
illustrative project, with each of the cash flow components
labeled.
Fig 1: Cash flow components
Terminal Cash Inflow
Operating Cash inflow 50,000
10,000 15,000 30,000 50,000 50,000 40,000 30,000 20,000
0
1 2 3 4 5 6 7 8
150,000
Initial Investment End of year

Contents of chapter 5

approaches
5.4. Discounted cash flow
approaches
approaches
• There are two main methods of non-
discounted measures of project
worth:
– the simple rate of return and
– the Payback Period (PBP).
– These methods are commonly used by
small businesses but they are not
reliable and should not be used for
making judgments on the desirability of
medium to large-scale projects.
approaches
• There are two main methods of non-
discounted measures of project
worth:
– 1. the simple rate of return and
– 2. the Payback Period (PBP).
1.simple rate of return
• The simple rate of return or ARR is the ratio of net
benefit after depreciation and taxes in a normal
year to the initial investment in terms of fixed and
working capital.
• Normal year is a representative year in which
capacity utilization is at technically maximum
feasible level and debt repayment is still
underway.
• The return on total capital is computed by
deducting/excluding interest from the net profit
and including loan capital in total capital
invested. The simple rate of return can be
expressed by the following formula:
• The simple rate of return can be expressed by the
following formula:
Where,
F Y R = Simple rate of return on total investment;
R or Re= Simple rate of return on equity capital;
I F =Net profit (in normal year) after depreciation
and taxes;
F Y =Annual interest charges;
Re  I = Total investment comprising of equity and
Q ----(5.5) debt; and;
Q = Equity capital invested.
• Decision rule: • In the case of
• If R or Re is higher choosing among
than the rate of several alternative
interest (r) prevailing projects, other things
in the capital market, being equal, the one
the project can be with the highest rate
considered as good of return either on
and should be total or equity
accepted. investment should be
selected for
• If R or Re < r, Reject
implementation.
the project.
Example:
If investment projects with a life of ten years are considered to
reach full capacity in the fourth year of operation and the
integrated financial analysis table of the projects display the
data (in ‘000 Birr) represent as follows:
Variables Symbol Project A Project B

Total initial investment I 500 800
Equity capital Q 250 500
Net profit after depreciation F 85 120
and taxes
Net profit before interest F+Y 105 144
Question:
1. Calculate the simple rate of return for both projects.
2. Based on your answer in (1) are the projects good or not if
they were to be evaluated alone?
3. Which of the two projects should be selected for
implementation if they were alternative projects? Why?
Answer:
• 1. The simple rate • 2. If the projects are
submitted at different time
of return will be: and evaluated alone both
are good because their R
and Re are greater than
• RA 
105
500
x100  21% ReA 
85
250
x100  34%
the prevailing rate of
RB 
144
x100  18%
interest (Y=8%) in the
120
800 ReB 
500
x100  24% capital market and hence
should be accepted.
• The rate of interest is
obtained by the following
formula
(F  Y )  F 105  85 20 144  120 24
r x100  x100  x100  8% & x100  x100  8%
I Q 500  250 250 800  500 300
Answer
• 3. Though both are good projects, project A
should be selected for implementation than
project B because its rate of return (21% or
34%) is higher than 18% or 24%.
2. Payback Period (PBP)
• The payback period is the length of time (years)
required by a project to recover its initial cash outlay
(investment).
– E.g., if a project involves a cash outlay of Birr
600,000 and generates cash inflow of Birr 100,000,
Birr 150,000, Birr 150,000, and Birr 200,000, in the
first, second, third, and forth years, respectively, its
payback period is 4 b/c the sum of cash flows during
the 4 years is equal to the initial outlay.
• When the annual cash inflow is a constant sum then the
payback period of the project is simply the initial outlay
divided by the annual cash inflow.
– For example, a project with an initial cash outlay of Birr
900,000 and a constant annual cash inflow of Birr 300,000 has a
payback period of 3 years. Symbolically, the PBP is expressed
as:
• Symbolically, the PBP is expressed as:
• I …….(5.6)
PBP 
c
Where,
– Initial investment outlay and
– annual cash inflow.
• For instance, the PBP of the project mentioned above
to having uniform cash inflow is obtained using
equation (5.6) as:
Initiall Investment Outlay 900,000
PBP    3 years
Annual Cash Inflow 300,000
• According to PBP criterion, the shorter the
PBP, the more desirable the project.
• Firms using this criterion generally specify
the maximum acceptable PBP.
• If this is n years, projects with a PBP of n
years or less are deemed worthwhile and
projects with a PBP exceeding n years are
considered as unworthy.
• Decision Rule:
– Accept the project if the PBP is equal to or
less than the predetermined cut-off PBP set
by the investor.
– For competing projects, choose the one
with quicker PBP.
• Decision Rule:
– Accept the project if the PBP is equal to or
less than the predetermined cut-off PBP set
by the investor.
– For competing projects, choose the one
with quicker PBP.
Year Cash flow Cumulative Cash flow Cumulative
of A capital of B Capital
recovery recovery
0 Birr (100,000) Birr (100,000)
(100,000) (100,000)
1 50,000 (50,000) 20,000 (80,000)
2 30,000 (20,000) 20,000 (60,000)
3 20,000 0 =PBP 20,000 (40,000)
4 10,000 10,000 40,000 0 =PBP
5 10,000 20,000 50,000 50,000
6 - 60,000 110,000
5.4. Discounted cash flow approaches
• For a variety of social and economic reasons
a unit of benefits now is considered more
valuable than an equivalent unit of benefit in
future.
• Social reasons include
– uncertainty about the future and the expectation
that both society and individuals will be better off
in the future than they are now (Perkins,
1994:53).
• From a financial perspective, income
received now can be invested so that it
accrues interest.
• A project’s net benefits have to be measured against
the benefits that could have been gained by
investing the equivalent sum for alternative uses.
– This is termed as the opportunity cost of capital.
• This is achieved by using Discounted Cash Flow
(DCF) measures of project worth.
• In investment project analysis discounting is
normally used to work out the Present Value (PV) of
a set of several Future Values (FVs).
• The relationship between the present and future
values can be expressed as:
 1 
PV  FV  t 
 (1  r ) 
• Where,
• r is the The value in the
discounted rate bracket is called
expressed as a discounted factor
fraction or (DF) for each year.
percentage and
• t is year
• The discount rate is a rate that
– reflects the opportunity cost of capital.
• It is the rate at which streams of expected costs and
benefits are discounted in estimating NPV and IRR.
• It is a national parameter that should be determined by
central authority of a government by considering
several conditions such as
– international borrowing,
– returns to past projects
– Commercial bank interest rates and
• The recently published National Economic Parameters
and Conversion Factors for Ethiopia indicate that the
discount rate is 10%.
Discounting measures of project worth or
investment assessment criteria
• The Net Present Value (NPV) and Internal
rate of Return (IRR)for a project can be
calculated from the net benefits of the
projects by applying the appropriate
discounted factors at the predetermined
discount rate (r).
• There are four distinct but inter-related
measures of project worth based on
discounted cost and benefit streams.
• These are:
A. Net Present Value (NPV)
B.Internal Rate of Return (IRR)
C.The Benefit Cost (B/C) Ratio
D. The net benefit to investment/cost ratio
(NBCR)
• The NPV is defined as the difference
between the present values of the future
benefits and costs.
• It is the simplest of all the four methods
• It is essentially a measure of the present
value of aggregate surplus generated by the
project over its expected operating life.
• It is calculated by subtracting the present values of
costs (PVC) from the present values of benefits
(PVB).
– Total cost is the sum of
• investment costs
• incremental working capital (incremental
stocks plus net incremental receivables,
account receivable less account payable), and
• operating cost.
– Note also that incremental stocks and net
incremental receivable figure are the difference in
values between the total stocks and net
receivables in certain year minus total stocks and
net receivables in the preceding year.
• This implies that NPV represents the net benefit over
and above the compensation for time and risk.
• This involves two steps of calculations as expressed
by the formula.
Where,
•n is the life of the project.
•PVC-present values of costs
n n •PVB -present values of
NPV   PVB   PVC benefits
t 1 t 1
•Ct-total cost
--… (5.8a) Or
n n
Bt Ct
NPV     •Bt –Total benefit
(1  r ) t t 1 (1  r ) t
•r- discount rate
t 1 ------- (5.8b)
• Let us use this formula to calculate the NPV for the
hypothetical XYZ project we considered earlier to
show how cash flows are determined.
• Table 5.1: Cost and benefit streams discounted at
10% separately (Method 1)(all figures in million)
Yea 1.Tota 2.Discoun 3.Present 4.Total 5.Discount 6.Present
r l cost t factor at value of Revenues/Be factor at value of
10% costs (1*2) nefits 10% Benefits (4*5)
1 140 0.9091 127.3 0.0 0.9091 0.0
2 65 0.8264 53.7 100 0.8264 82.6
3 95 0.7513 71.4 150 0.7513 112.7
4 95 0.6830 64.9 200 0.6830 136.6
5 75 0.6209 46.6 150 0.6209 93.1
6 55 0.5645 31.1 100 0.5645 56.5
PVC=395 PVB=481.5
10% separately (Method 1)(all figures in million)
Yea 1.Total 2.Discount 3.Present 4.Total 5.Discount 6.Present

r cost factor at value of Revenues/Ben factor at value of
10% costs (1*2) efits 10% Benefits (4*5)
1 140 0.9091 127.3 0.0 0.9091 0.0
2 65 0.8264 53.7 100 0.8264 82.6
3 95 0.7513 71.4 150 0.7513 112.7
4 95 0.6830 64.9 200 0.6830 136.6
5 75 0.6209 46.6 150 0.6209 93.1
6 55 0.5645 31.1 100 0.5645 56.5
PVC=395 PVB=481.5
• For this project the
NPV  481.5  395  86.5

• The alternative method (method 2) of calculating
NPV is that the difference between benefits
(revenues of cash inflows) and costs (cash outflows)
may be taken separately and then the single stream
of net cash flows could be discounted to arrive at the
NPV.
• For it reduces the number of discounting
calculations, the second method is usually adopted.
The formula is expressed as:
n
NPV   PV ( B  C )
t 1 ----- (5.9a) Or
 ( Bt  Ct ) 
n
NPV     ----- (5.9b)
t 1  (1  r ) t

10% (Method 2)(all figures in million)
Yea 1.Total 2.Total 3.Net 4. Discount 5.Present

r cost Revenues/Ben benefit/cash factor at 10% value of
efits flow (2 – 1) Benefits
(3*4)
1 140 0.0 -140 0.9091 -127.3
2 65 100 35 0.8264 28.9
3 95 150 55 0.7513 41.3
4 95 200 105 0.6830 71.7
5 75 150 75 0.6209 46.6
6 55 100 45 0.5645 25.4
NPV=86.6
n
NPV   PV ( B  C )
t 1 ----- (5.9a) Or
n
 ( Bt  Ct ) 
NPV   
 (1  r ) 
t
t 1 ----- (5.9b)
• If the information given is only cash flow like under
PBP instead of costs and benefits then the formula
for the NPV will be
n
CFt
NPV    initial investment
t 1 (1  r ) t
• Where, CFt- is cash flow at the end of year t,

For example the NPV for project X and Y with four years lifetime
Table 5.3: Cost and benefit streams discounted at 10%
Project X Project Y
Year Cash flow Discoun NPV Cash Discount NPV
t factor flow factor
0 (1,000,000) 0 (1,000,000 (1,000,00 0
) 0)
1 65,000 0.9091 59,091.5 35,000 0.9091 31,818.5
2 55,000 0.8264 45,452.0 45,000 0.8264 37,188.0
3 45,000 0.7513 33,808.5 55,000 0.7513 41,321.5
4 35,000 0.6830 23,905.0 65,000 0.6830 44395.0
-837,743.0 -845,277.0
n
CFt
NPV    initial investment
t 1 (1  r ) t
• Other things being equal,
– the project’s NPV increases with
• larger benefits and number of years
– but project’s NPV decreases with
• a higher discount rate and higher costs.
Decision Rule:
a. Accept the project if the NPV is positive.
b.If the NPV is zero, is a marginal case and hence
the decision may need to be informed by
other criteria particularly for public sector
projects. NPV equal to zero means the project
will return the capital utilized, but it will not
generate any surplus.
c.Reject the project if the NPV is less than
zero or negative because the project will not
recover its cost at the specified rate of discount.
B.Internal Rate of Return (IRR)
• IRR is defined as the rate o discount that reduces the
net present value of a project to zero.
• In calculating the IRR, the discount rate is adjusted
until the NPV becomes zero or at least as close to zero
as possible.
• Thus the rate is derived by trial and error or
interpolation.
– The interpolation is could be done arithmetically
using two discount rates,
• one which gives a positive NPV and
• the other which gives a negative NPV.
• IRR is expressed by the following formula.
  NPV1 
IRR  r1  (r2  r1 ) *    ------ (5.11)
  NPV1  NPV2 
C.The Benefit Cost (B/C) Ratio
• The benefit-cost ratio is defined as the ratio of the
discounted values of benefits to the discounted
value of costs.
• A ratio of least one is required for acceptability and
a B/c ratio of one indicates that the NPV of zero at a
particular discount rate.
• The formula for B/C ratio is expressed as
PVB
B/C
Ratio 
PVC
• To meet the cost of project the

following means of finance are
available:
– Share capital
– Term loans
– Deferred credit

available:
– Share capital
– Term loans
– Deferred credit
Share capital
• There are two types of share capital
– equity capital and
– preference capital
• Equity capital represents the contribution made by
the owners of the business, the equity
shareholders, who enjoy the rewards and bear the
risks of ownership.
– Equity capital being risk capital carries no fixed
rate of dividend.
• Preference capital represents the contribution made
by preference shareholders and the dividend paid
on it is generally fixed.

available:
– Share capital
– Term loans
– Deferred credit
Term loans
• provided by financial institutions and
commercial banks
• represent secured borrowings which are a
very important source (and often the
major source) for financing new projects
as well as expansion, modification, and
renovation schemes of existing firms.

available:
– Share capital
– Term loans
– Deferred credit
Debenture capital
• Akin to promissory notes
• debentures are instruments for raising debt capital.
• There are two broad types of debentures:
– convertible debentures
• are convertible, wholly or partly, into equity
shares.
• The conversion period and price are announced
in advance.
– Non-convertible debentures
• are straight debt instruments.
• Typically they carry a fixed rate of interest and
have a maturity period of 5 to 9 years.

available:
– Share capital
– Term loans
– Deferred credit
Deferred credit
• Many a time the suppliers of plant and
machinery offer a deferred credit facility
under which payment for the purchase of
plant and machinery can be made over a
period of time.

available:
– Share capital
– Term loans
– Deferred credit
Incentive sources
• The government and its agencies may provide
financial support as incentive to certain types of
promoters or for setting up industrial units in certain
locations.
• These incentives may take the form of
– seed capital assistance
• provided at a nominal rate of interest to enable the
promoter to meet his contribution to the project
– capital subsidy
• to attract industries to certain locations
– tax deferment or exemption
• particularly from sales tax for a certain period.

available:
– Share capital
– Term loans
– Deferred credit
Miscellaneous sources
• A small portion of project finance may come from
miscellaneous sources like
– unsecured loans
• are typically provided by the promoters to bridge
the gap between the promoters' contribution (as
required by the financial institutions) and the
equity capital the promoters can subscribe to.
– public deposits
• represent unsecured borrowings from the public at
large.
– leasing and hire purchase finance
• represent a form of borrowing different from the
conventional term loans and debenture capital.
Miscellaneous sources
• A small portion of project finance may come from
miscellaneous sources like
– unsecured loans
• are typically provided by the promoters to bridge
the gap between the promoters' contribution (as
required by the financial institutions) and the
equity capital the promoters can subscribe to.
– public deposits
• represent unsecured borrowings from the public at
large.
– leasing and hire purchase finance
• represent a form of borrowing different from the
conventional term loans and debenture capital.
Planning the Means of Finance
• We described the various means of finance
that can be tapped for a project.
• How should you go about determining the
specific means of finance for a given project?
• The guidelines and considerations that should
be borne in mind for this purpose are as
follows:
– Norms of regulatory bodies and financial
institutions
– Key business considerations
follows:
institutions
Norms of regulatory bodies and
financial institutions
• In many countries the proposed means of financing
for a project must be either approved by a regulatory
agency or conform to certain norms laid down by the
government or financial institutions in this regard.
• The primary purpose of such regulation is
– to impart prudence to project financing decisions
and
– provide a measure of protection to investors.
• In addition, the norms of financial institutions, which
often provide substantial assistance to projects
significantly shape and circumscribe project financing
decisions.
follows:
institutions
Key business considerations
• The key business considerations which are
relevant for the project financing decision
are:
A. cost
B. Risk
C. Control and
D. flexibility.
A. cost
• the cost of debt funds is lower than

the cost of equity funds.
• Why?
– The primary reason is that the interest
payable on debt capital is a tax-
deductible expense whereas the
dividend 'payable on equity capital is
not.
B. Risk
• The two main sources of risk for a firm (or

project) are:
1. Business risk
– refers to the variability of earnings before interest
and taxes and arises mainly from fluctuations in
demand and variability of prices and costs.
2. Financial risk
– represents the risk arising from financial leverage.
– It must be emphasized that while debt capital is
cheap it is also risky because of the fixed financial
burden associated with it.
B. Risk
• Generally the affairs of the firm are, or

should be, managed in such a way
that the total risk borne by equity
shareholders, which consists of
business risk and financial risk, is not
unduly high.
C. Control
• From the point of view of the promoters of

the project, the issue of control is
important.
• They would ordinarily prefer a scheme of
financing which enables them to maximize
their control, current as well as potential,
over the affairs of the firm, given their
commitment of funds to the project.
D. flexibility
• This refers to the ability of a firm (or project) to

raise further capital from any source it wishes to
tap to meet the future financing needs.
• This provides maneuverability to the firm.
• In most practical situations, flexibility means that
the firm does not exhaust fully its' debt capacity.
• Put differently, it maintains reserve borrowing
powers to enable it to raise debt capital to meet
largely unforeseen future needs.
Key business considerations
• The key business considerations which are
relevant for the project financing decision
are:
– cost
– Risk
– Control and
– flexibility.
Reference:
• Prasanna Chandra, Projects – Planning Analysis, Financing,

Implementation, and Review
• UNIDO, A Manual for the Preparations of Industrial Feasibility
Studies
• UNIDO, A Guide to Practical Project Appraisal
• Harold Kerzner, Project Management
• Rory Burke, Project Management
• Trevor Tong, Planning Projects
The End
Thank you
Assignment
1. Select project topic and prepare

project proposal based on the
following particulars:
• Executive Summary
• Background of the project
• Objective of the project
• Scope of the project
• Project identification
• Project feasibility study (Feasibility study)
• Technical Feasibility
• Financial feasibility
• Environmental and Economic feasibility.
submission date 30/4/2012 E.c

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Chapter seven:

• To judge a project from the financial angle,

Initial Investment Costs

• At the pre-investment stage, in this regard, the

• the components of the total investment

• Travel expenses of technicians to- and -

• the components of the total investment cost.

• To meet the cost of project the following

• Typically, the starting point for profitability

• Given the estimated production, the cost

• The working capital requirement consists

• There are limits to obtaining working

• Given the estimates of sales revenues and cost of

• The estimates of working results may be prepared

• The estimates of working results may be prepared along the

• The estimates of working results may be prepared

• The estimates of working results may be prepared

• The estimates of working results may be prepared

• The estimates of working results may be prepared

• The estimates of working results may be prepared

• O.Profit After Taxation =(M - N)

• The estimates of working results may be prepared

• It is also helpful to know what the level of

• Steps of computing the break-even point,

• The cash flow statement shows the

• The balance sheet, showing the balances

• The liabilities side shows the sources of finance

• Secured loans represent the borrowings of the

• Current liabilities are obligations which

• The assets side of the balance sheet shows how

5.1. Financial analysis basic

• A cash flow statement contains information

• This enables the project appraiser to see whether

A. Basic principles of measuring project cash

A. Basic principles of measuring project cash

– The following principles should be

– The following principles should be

• There are two sides of a project;

Time Side Cash flow Time Cash flow

Time Side Cash flow Time Cash flow

• Note that the cash flows on the investment

Time Side Cash flow Time Cash flow

• The financing costs • The cost of capital is

• The cash flow of a project must be measured in

• Cash flow should be measured on an after-tax basis.

• In response to the above issues, the marginal tax rate

• For example, if the initial investment (BV0) is 100

Year Beginning book value Depreciation charge

A. Basic principles of measuring project cash

Operating Cash inflow 50,000

10,000 15,000 30,000 50,000 50,000 40,000 30,000 20,000

Initial Investment End of year

5.1. Financial analysis basic

Variables Symbol Project A Project B

Yea 1.Total 2.Discount 3.Present 4.Total 5.Discount 6.Present

• For this project the

NPV  481.5  395  86.5

Yea 1.Total 2.Total 3.Net 4. Discount 5.Present

• Where, CFt- is cash flow at the end of year t,

• To meet the cost of project the

• To meet the cost of project the

• To meet the cost of project the

• To meet the cost of project the