Development Planning and Project Analysis II

Chapter Two
Financial Analysis & Appraisal of Projects

By: Mulugeta F.

1 AMU 2023
 Outline
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2. Financial Analysis & Appraisal of Projects

2.1. Scope And Rationale of financial Analysis
2.2. Identification of Costs And Benefits
2.3. Classification of Costs And Benefits
2.4. The Valuation of Financial Costs And Benefits
2.5. Investment Profitability Analysis
2.5.1. Non-discounted Measures of Project Worth
2.5.2. Discounted Measures of Project Worth
2.6. Sensitivity Analysis
 Chapter Two
Financial Analysis & Appraisal of Projects
3

 Introduction
 A financial analysis of a project is a process that evaluates the

potential financial impact of a project.

 It involves identifying and quantifying the costs and benefits of the
project, and then using this information to make a decision about
whether or not to proceed with the project.
 Financial analysis refers to an assessment of the financial viability,

stability, and profitability of a project from the project point of view.

 Financial analysis focuses on the financial aspects of a project, such as

revenue, costs, and profitability.

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 It is concerned with determining the financial viability of a project by

examining its cash flows, return on investment, and other financial
metrics in the project life time.
 The project lifetime is the period of time during which a project is
active.
 It begins with the initiation of the project and ends with its completion
(initiation, planning, execution, monitoring & control and closing .
 It is evident that the economic life of a project can never be longer
than its technical life or its legal life;
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 When determining the economic life span of the project various

factors have to be assessed, such as:
• Duration of demand (position in the product life cycle);
• Duration of raw material deposits and supply;
• Rate of technical change;

• Life cycle of the industry;

• Duration of building and equipment;

• Opportunities for alternative investment;

• Administrative constraints (urban planning horizon).
 2.1. Scope and Rationale
6

 The scope of financial analysis of a project can vary depending on the

size & complexity of the project, and the needs of the stakeholders.
 Some common elements that are included in a financial analysis:
 Costs: The first step in any financial analysis is to identify and

quantify the costs associated with the project.

 This includes both direct costs, such as labor and materials, and
indirect costs, such as overhead and administrative costs.
 Benefits: The next step is to identify and quantify the benefits that the
project is expected to generate.
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 This includes both tangible benefits, such as increased revenue or

reduced costs, and intangible benefits, such as improved customer

satisfaction or increased brand awareness.
 Risks: Finally, the financial analysis should also consider the risks
associated with the project. This includes both financial risks, such as
the possibility of cost overruns or revenue shortfalls, and operational
risks, such as the possibility of delays or technical problems.
 Once all of these factors have been considered, the financial analyst

can then use a variety of tools and techniques to assess the financial
viability of the project.
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 Objectives/Importance of Financial Analysis

• To assess the earning capacity and profitability of a project

• To assess the operational efficiency and marginal effectiveness

• To make inter-project comparisons

• To make forecasts about future prospects of a project

• To help in decision making and control of a project

• To identify the reason for change in profitability and financial position

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 Steps in Financial Analysis

• Establish objectives of the analysis

• Define extent of analysis

• Re-organization and re-arrangement of financial data

• Relationship among financial statements with tools & methods

• Interpretation of information
• Drawing a conclusion for decision making process
 2.2. Identification of Costs & Benefits
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 The identification of costs and benefits in financial analysis of a

project is a critical step in determining the project's feasibility.

 The costs and benefits of a project depend on the objectives the project

wants to achieve.
 A cost is anything that reduces an objective, and a benefit is anything

that contributes to an objective.

 Costs can be direct or indirect, and they can be tangible or intangible.

 Direct costs are those that can be easily traced to the project.

 For example, the cost of materials and labor used on the project would
be direct costs.
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 Indirect costs are those that cannot be easily traced to the project.

 For example, the cost of overhead, such as rent and utilities, would be

indirect costs.
 Benefits can also be direct or indirect, & can be tangible or intangible.

 Tangible benefits are those can be easily measured in monetary terms.

 For example, the increase in sales that results from a new product

launch would be a tangible benefit.

 Intangible benefits are cannot be easily measured in monetary terms.

 For example, the improvement in customer satisfaction that results

from a new customer service program would be an intangible benefit.

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 Once all of the costs and benefits have been identified, they need to be
quantified.
 This can be done by assigning a dollar value to each cost and benefit.
 Once the costs and benefits have been quantified, they can be

compared to determine the project's net present value (NPV).

 The NPV is a measure of the project's profitability. A positive NPV
indicates that the project is profitable, while a negative NPV indicates
that the project is not profitable.
 The identification of costs and benefits is a critical step in financial

analysis of a project.
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 Here are some tips for identifying costs and benefits:

 Be as comprehensive as possible. Try to identify all of the costs and

benefits, both tangible and intangible.

 Be realistic. When assigning dollar values to costs and benefits, be as

realistic as possible.
 Consider the time value of money. When comparing costs and

benefits, it is important to consider the time value of money.

 This means that costs and benefits that occur in the future are worth

less than costs and benefits that occur today.

 2.3. Classification of Costs & Benefits
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 One is to categorize both costs and benefits into:

• Tangible costs/ benefits and

• Intangible costs/benefits
 Some of the project costs are tangible and quantifiable while many

more are intangible and non-quantifiable.

 Costs are easier to identify (and value) than benefits.
 The prices that the project actually pays for inputs are the appropriate

prices to use to estimate the project’s financial costs.

 2.3.1. Tangible Costs of a Project
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 Tangible costs of a project can include any direct, measurable

expenses that are incurred as a result of undertaking the project.
 Some common tangible costs of a project include:
1. Labor costs: The cost of the human resources involved in the project,
including salaries, benefits, and overhead costs.
2. Materials and supplies: The cost of any physical items used in the
project such as equipment, tools, and raw materials.
3. Equipment costs: The cost of any equipment used in the project, such
as computers, machinery, and vehicles.
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4. Contractor or consultant fees: The cost of any external contractors

or consultants hired to assist with the project.
5. Travel and transportation expenses: The cost of any travel and
transportation associated with the project, such as airfare, hotel
accommodations, and rental cars.
6. Communication and technology costs: The cost of any
communication and technology required to support the project, such as
telephones, internet, and software.
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 Overall, understanding the tangible costs of a project is important to

accurately estimate the project budget and ensure that the project is
completed within budget.
 In general tangible costs of a project can be classified in to total
investment cost and operational cost (cost of Production).
A. Total Investment Costs
1. Initial investment costs
a. Fixed Investment costs
 The initial fixed investments constitute the major resources required
for constructing and equipping an investment project which includes:
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I . The Cost of Land and Site Development:

 Basic cost of land - conveyance charges
 Payment for lease
 Cost of leveling and development
 Cost of laying approach roads and internal roads
 Cost of gates
 Cost of tubes wells
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II. The Cost of Buildings and Civil Works

 Buildings for the main plant and equipment's
 Buildings for auxiliary services (workshops, laboratory, water Sup.)
 Warehouses and show rooms
 Non factory buildings like guest house, restaurants, staff rooms, etc.
 Silos, tanks, wells, basins, sewers, drainages, etc.
 Garages and workshops
III. The cost of Plant and machinery
 Cost of imported machinery, which the sum of:
 FOB (Free on Board) value,
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 Shipping, freight and insurance costs,

 Import duty, and
 Clearing, loading, unloading, and transportation charges
 Cost of indigenous machinery: FOR cost, sales tax, and other taxes if
any, and railway freight and transport charges to the site.
 Cost of stores and spares
 Foundation and installation charges
 The cost of plant and machinery is based on the latest available
quotation adjusted for possible escalation.
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 Generally, the provision for escalation is equal to the following

product: (latest rate of annual inflation applicable to the plant and
machinery) x (length of the delivery period)
IV. Miscellaneous Fixed Assets
 Expenses related to fixed assets such as furniture, office machinery &

equipment, tools, vehicles, laboratory & workshop equipments.

b. Pre-production Expenditures
 Is another component of the initial investment cost .
 Includes both tangible and intangible costs
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 In every project, certain expenditures are incurred prior to commercial

production and commencement of service delivery.
 This includes the following investment cost items:
i. Intangible assets: these assets represent expenditures which yield
benefits extending over a long time period. These include:
 Patents, licenses, lump sum payments for technology, engineering
fees, copy rights, and goodwill.
 Preparatory studies, like feasibility studies, consultant fees,
supervision costs, project management services, etc.
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ii. Preliminary expenses:

 Cost of registration and formation, legal fees for preparation of
memorandum and articles of associations.
 In addition, it includes costs of advertisements, brokerage for
mobilizing resources, expense for loan application & its processing.
iii. Other Pre-operation expenses. These include:
 Rents, taxes, and rates
 Trial runs, start-ups and commissioning expenditures( raw materials
and other inputs consumed before commercial operation)
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 Salaries, fringe benefits and social security contributions of

personnel engaged during the pre-production period;
 Pre-production marketing costs, promotional expenses, creation of
sales network, etc;
 Training costs, including all fees, travel, living expenses etc;
 Traveling expenses interest and commitment charges on borrowings
 Insurance charges
 Mortgage expenses interest on differed payments,
 Miscellaneous expenses
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2. Plant and Equipment Replacement Investment Costs

 Every machinery and equipment does not have equal economic life.
 So project planning work should adequately provide for replacement
of components for smooth operation of the same technology.
 In fact the first thing to do would be to identify such items and then
estimate the costs for replacement and then the same should be
reflected in the financial and economic analysis.
 Terminal Values/End-of-Life Costs/Salvage Costs/
 Though firms may be institutionally organized to live and operate for
unlimited period of time and have unlimited age.
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 Technologies, machineries and equipment do have limited

operational/economic/life.
 During the end of the economic life of a good/machinery, equipment,
building, etc) there is some salvaged value and the salvation may
involve incurring of costs.
 The costs of associated with the decommissioning of fixed assets at
the end of the project life, minus any revenues from the sale of the
assets, are end-of-life costs.
 Major costs are the costs of dismantling, disposal and land
reclamation.
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3. Net Working Capital (NWC)

 Net working capital is part of the total investment outlays.
 It is defined to embrace current assets (the sum of inventories,
marketable securities, prepaid items, accounts receivable and cash)
minus current liabilities (accounts payable).
 Any increase in NWC corresponds to a cash outflow to be financed,
and any decrease would set free financial resources (cash inflow for
the project).
 Working capital is generally categorized into gross working capital
and net working capital (NWC).
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 The gross working capital consists of all the current assets,

including:
• Raw materials;
• Stores and spares;

• Work-in-process;

• Finished goods inventory;

• Debtors/accounts receivable/;

• Cash and bank balance.

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 Net working capital is defined as gross working capital less current

liabilities.
 Current liabilities consist of credits, provisions, accrued expenses, and

short-term borrowings.
 NWC is the center of decision makers for the purpose of financial

analysis and management.

 Commercial banks and trade creditors provide the principal support
for working capital.
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B .Operational Cost/Cost of Production

 Once the project idea has been accepted and the project is being
implemented the cost of production may be worked out.
 It includes material cost, utilities, labor, factory overhead, land,
contingency allowances, Taxes & Debt service (payment of interest).
i. Sunk Costs: Incurred in the past and upon which the proposed new
investment will be based.
ii. Technical know-how and Engineering fees
 Often it is necessary to engage technical consultants or collaborators
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iii. Expenses on Foreign Technicians & Training of local technicians

 Services of foreign technicians may be required for Setting up the

project and supervising the trial runs.

 Likewise, expenses on local technicians who require training abroad

must also be included here.

Means of Finance
To meet the cost of project the following means of finance are available:
a) Share Capital: there are two types of Share capital- equity capital and

preference capital.
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 Equity capital represents the contribution made by the owners of the

business, (equity shareholders), who enjoy the rewards & bear risks of
ownership being risky if 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.
b) Term loans: Provided by financial institutions and commercial banks,
 Term loans represent secured borrowings.

 Two types of term loans

 Domestic currency term loans

 Foreign currency term loans
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c) Debenture capital: Debenture are instruments for raising debt capital.

 It is a long-term security yielding a fixed rate of interest, issued by a

company & secured against assets. There are two types of debentures:
 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.
 Convertible debentures
• As the name implies, are debentures, which are convertible, wholly

or partly, in to equity shares.

• The conversion period and price are announced in advance.
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d) Deferred credit: 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 i.e. credit in item.
e) Incentive sources: The government and its agencies may provide
financial support as incentive to certain types of promoters or for
setting up investment in certain location.
• It bay be seed capital assistance, or capital subsidy or tax exemption.

f) Miscellaneous sources: A small portion of project finance may come

from miscellaneous sources like unsecured loans, public deposits,
and leasing & hire purchase finance.
 2.3.2. Tangible Benefits
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 Tangible benefits can arise either from increased production or from

reduced costs.
 Tangible benefits of projects can vary depending on the project, but

some common benefits include:

 Cost savings: Projects can help identify ways to reduce operating

costs, streamline processes, and optimize resources, resulting in

significant cost savings.
 Improved efficiency: Projects can help improve business processes,

automate tasks, and reduce manual work, resulting in improved

efficiency and productivity.
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 Increased revenue: Projects can help identify new revenue streams,

improve customer satisfaction, and expand market share, resulting in
increased revenue.
 Enhanced quality: Projects can help improve product or service

quality, reduce defects, and improve customer satisfaction, resulting in

enhanced brand reputation.
 Risk mitigation: Projects can help identify and alleviate risks,

ensuring that potential problems are addressed before they become

major issues.
 2.3.3. Intangible Costs & Benefits
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 Intangible Benefits:

 It may includes the creation of new employment opportunities, better

health, better nutrition, reduced incidence of waterborne diseases,

national integration, or even national defense.
 Such intangible benefits, however, do not readily lend them to

valuation (difficult to value).

 One may have to choice to the least cost approach instead of the
normal benefit cost analysis.
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 Intangible Costs:
 It may includes:

• Disruption of family life,

• Increased pollution as a result of the project,

• Ecological imbalances as the result of the project.

 Those costs are difficult to capture and quantify.

 But efforts should be made to identify & quantify wherever possible.

 2.4. The Valuation of Financial Costs & Benefits
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 This is an issue of pricing/valuing/ of the project’s inputs and outputs.

 The inputs and outputs of a project appear in physical form and prices
are used to express them in value terms.
 Ideally, for the purpose of the feasibility study prices should reflect the

real economic values of project inputs and outputs.

 The financial benefits of a project are just the revenues received and
the financial costs are the expenditures that are actually incurred.
 All these receipts and expenditures are valued as they appear in the
financial balance sheet of the project and measured in market prices.
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 Market prices are just the prices in the local economy, and include all
applicable taxes, tariffs, trade mark-ups and commissions.
 This is the price at which producers are just willing to supply that
good/service or market-clearing price .
 Prices may be defined in various ways, depending on they exist as:
A) Market Vs Shadow prices:
 Market prices are those present in the market, no matter whether they

are determined by supply and demand or by the government.

 They are the prices at which the firm will buy the inputs and sell the

outputs.
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 In financial analysis market prices are applied.

 In economic analysis we raise the question whether market prices

reflect real economic value of project inputs and outputs.
 In economic analysis, if the market prices are distorted, then shadow
or imputed prices will have to be used for economic analysis.
 Shadow prices are border prices determined by international trade.
B) Absolute Vs Relative prices:
 Absolute prices reflect the value of a single product in an absolute

amount of money.
 Relative prices express the value of one product in terms of another.
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 The level of absolute prices may vary over the lifetime of the project
because of inflation or productivity changes.
 Both absolute and relative prices can be used in financial analysis.

C) Constant Vs Current prices

 Current and constant prices differ over time due to inflation.

 If inflation can have a significant impact on project inputs and output

prices, such an impact must be dealt with in the financial analysis; use
constant price.
 If inflation impacts are negligible, the problem of choosing between

current and constant prices does not exist, the planner may use either.
 2.5. Investment Profitability Analysis
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 The three basic steps in determining whether a project is worthwhile

or not are:
• Estimate project cash flows

• Establish the cost of capital

• Apply a suitable decision or appraisal rule or criterion.
 Once costs and benefits have been identified, priced & valued, project

analyst should work out to determine on which project to invest.

 The tools are only used to improve the decision making process.
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 The project analyst should select more profitable projects using

different criteria. These criteria may be classified into two categories:

A) Non-discounting criteria, including:
• Ranking by inspection
• Urgency;

• Payback period;
• Proceeds per unit of outlay

• Out-put- capital ratio

• The average annual proceeds per unit of outlay

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B) Discounting criteria, including:

• Net present value/NPV/
• Internal rate of return/IRR/

• Net benefit investment ratio /NBIR/

• Domestic resource cost ratio/DRCR/
• Benefit-cost ratio/BCR/

 Projects, which are powerful means of development, have to be

appraised by multiple criteria.

 2.5.1. Non-Discounted Measures of
Project Worthiness
46

1) Ranking by Inspection
 It is possible to determine by mere/slight inspection which of two or
more investment projects is more desirable. There are two cases.
A. Two investments have identical cash flows each year up to the final
year of the short-lived investment,
 But one continues to earn cash proceed (financial results or profits) in
subsequent years.
 The investment with the longer life would be more desirable.
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 Example: Consider the following hypothetical projects

Investment Initial cost Net cash proceeds per Total

(Project) year Proceeds
Year I Year II
A 10,000 10,000 - 10,000
B 10,000 10,000 1,100 11,100
C 10,000 3,762 7,762 11,524
D 10,000 7,762 3,762 11,524
 Accordingly, project B is better than investment A, since all things are
equal except that B continues to earn proceeds after A has been retired.
More analysis is required to decide between C & D.
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B. Two investments have the same initial out lay, the same earning life
and earn the same total proceeds (profits) but one project has more of the
flow earlier in the time sequence.
 We choose the one for which the total proceeds is greater than the total
proceeds for the other investment earlier.
 Thus investment D is more profitable than investment C; Since D
earns 4000 more in year 1 than investment C, which does not make up
difference until year 2.
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2) Urgency:

 On this criterion projects which are considered to be more urgent get

priority over projects which are regarded as less urgent.

 The problem with this criterion is: how can the degree of urgency be
determined? In certain situations it may not be practically difficult.

 For instance the project could be bottleneck alleviation of an ongoing

operation/firm/ etc.

 Since it is not a systematic decision, this is not something that can be

encouraged. Rather it is a practice that should be discouraged.
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3) The Payback Period

 It is one of the simplest and apparently one of the most frequently
used methods of measuring the economic value of an investment.
 The payback period is the length of time required to recover the
initial/original cash out lay on the project.
 Example-1: if a project requires an original outlay of Birr 300 and is
expected to produce a stream of cash proceeds of Birr 100 per year for
5 years, the payback period would be 300/100 = 3 years.
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 If the expected proceeds are not constant from year to year, then the

payback period must be calculated by adding up the proceeds expected

in successive years until the total is equal to the original outlay.

 Example 2: consider the previous project C.

 Then Then the payback period is 1.80 years.

 Investment B which has the same rank as A will not only earn 10,000
Birr in the first year but also 1,100 Birr a year later.

 Thus investment B is superior to A & D is superior to C with 1.6 PP.

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 But the payback period has two important limitations:

i. It fails to give any considerations to cash proceeds earned after the
payback date. It simply emphasizes quick financial returns.
ii. It fails to take into account differences in the timing of receipts and
earned proceeds prior to the payback date.
 Yet we know by the inspection method the project with more earlier
benefits should be desirable and should be preferred since the earlier a
benefits is received the earlier it can be reinvested or consumed.
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4) Proceeds per Unit of Outlay
 Under this method, investments are ranked according to their total
proceeds divided by the amount of the corresponding investments.
 Or the total net value of incremental production divided by the total
amount of the investment gives us the proceeds per unit of outlay. Ex:

Investment Total Investment Proceeds per Ranking

proceeds Unit of outlay
A 10,000 10,000 1.00 4
B 11,100 10,000 1.11 3
C 11,524 10,000 1.15 1
D 11,524 10,000 1.15 1
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 Accordingly project C and D must be implemented.

 Even if C and D have the same rank, we know by inspection that

project D is superior since D generates 4000 Br proceeds in year 1.
 This method is again deficient because it still fails to consider the
timing of proceeds .
 In other words, the method considers that 1 Birr of proceeds received
in year 2 is equal to 1 Birr received in year 1.
 This is inconsistent with the generally accepted economic principle

that 1 Birr today is more valuable than 1 Birr at some future date.
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5) Output-Capital Ratio:
 It is defined as the average (undiscounted) value added produced per
unit of capital expenditure.
 Under this criterion we select the project with the highest output
capital ratio or the lowest capital output ratio (capital coefficient).
 The main problem is that it ignores other factors of production such as

labor and land and concentrates only on the productivity of capital.

 It favors those projects that use large quantities of labor and land in

place of capital & not consider timely spread of costs and proceeds.
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6) The average annual proceeds per unit of outlay

 The total proceeds are first divided by the number of years during
which they are received, and this figure is then expressed as a ratio of
the original outlay.

 It fails to take properly into considerations the timing of proceeds and

exhibits a built in bias for short-lived investment with high cash

proceeds.
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Investment Total Average Original Average Annual Ranking

(Project) Proceeds Annual Outlay Proceeds Per
Proceeds Unit of Outlay

A 10,000 10,000 10,000 1.00 1

B 11,100 5,550 10,000 0.555 4
C 11,524 5,762 10,000 0.576 2
D 11,524 5,762 10,000 0.576 2

 A project with higher average annual proceeds per unit of outlay

(project A) is superior than other projects with less AAPUO.
 2.5.2. Discounted Project Appraisal Criteria
58

 The undiscounted methods discussed earlier share common Weakness.

 They fail to take into account adequately the timing of benefits.
 Thus inter-temporal variations of costs and benefits influence their

values and a time adjustment is necessary before aggregation.

 Therefore a time dimension should be included in our evaluation.

 That means we need to express costs and benefits in terms of value by

discounting all items in the cash flows back to year 0.
 Discounting is a technique or a process by which one can reduce
future benefits and costs to their present worth or present value.
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 The factor used to discount future costs and benefits is called the
discount rate and is usually expressed as a percentage.
 It will be rational prefer to receive birr 100 today than in a year time .
 It may preferable to take the money today and invest it at some rate of

interest (r) and receiving total of birr 100 (1+r) at the end of the year.
 One might reason that birr 100 today would be preferable on the

grounds there is a finite risk & inflation to collect the money next year.
 Any costs and benefits of a project that are received in future periods
are discounted, by some factor r, to reflect their lower value to the
individual (society) than currently available income.
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 Compounding is the technique of calculating the future worth (F) of a

present amount (P) at the end of some period T at given interest rate.

 Hence, if there is an initial amount p at present, then if this investment

was borrowed from the bank at an interest rate of "r" birr then after

one period it becomes:

 Since the borrower must also repay the principal After two periods the
amount becomes: = =

= =
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 The amount accumulated after t periods would be:

 Given that future value accumulated after t periods as above, to know

the present value of this amount we would be taking about
discounting.
A
 Hence the present value would be:
P 
(1  r ) t

 The term (1+r)t is referred to as discounting factor, a factor used to

estimate the present value of a stream of future values.

 So the discount factor tells us how much Br 1 at a future date is worth

today at a certain discount rate.

 A. Net Present Value (NPV)
62

 It is the most widely used method; obtained when a stream of cost and
benefits accruing over a period of time are discounted to the present.

 The NPV is the difference between the present value of benefits and
the present value of costs at a fixed, pre-determined interstate rate.

Where:

• Bt are the project benefits in period t.

• Ct Is the project cost in period t.

• r is the financial discount rate (interest rate paid by borrower)

• n is the number of years for which the project will operate

 Cont’d…
63

 The discounting period should normally be equal to the economic life

of the project and varies from project to project.

 Having set discount rate an investment project is deemed acceptable if

the discounted net benefits are positive and reject all projects that
show Negative NPV.

 Thus, the decision is to accept if NPV > 0. We can also discount

benefits and costs separately, and if B>C then NPV >0.

 Example: Table 1: Consider Discounted Cash Flows for a Fertilizer Project in M Birr
 Cont’d…
64

 Note: the values for discount factors for r = 10% and r = 20% can be

obtained from any standard set of discount tables.

 Since discounting the cash flow at 10 percent produces a positive NPV

of 4.57 million Birr and the project should be undertaken.

 If the cost of capital were to be raised to 20 percent, the project
produces a negative NPV of 3.21 million Birr and would be rejected.
 The NPV is critically dependent upon the level of discounting rate, r.
 The decision rule: discounted benefits should exceed discounted cost.
 Prioritization from a Number of Projects
65

 The NPV does not indicate the rate of return, in the sense it does not
directly indicate the magnitude of investment that generates the NPV.

 If one of several project alternatives has to be chosen, the project with

the largest NPV should be selected.

 The ratio of the NPV and the present value of investment (PVI) should
be considered and we get the net present value ratio (NPVR) when
comparing alternative projects.

 Given alternative projects, with the highest NPVR should be chosen.

 B. Internal Rate of Return of a Project (IRR)
66

 It is the yield of an investment method or simply the yield method.

 Unlike NPV, it does not rely on the selection of a predetermined

discount rate.
 The method utilizes present value concept but seek to avoid the

arbitrary choice of a discount rate.

 Hence an attempt is made to find that discount rate, which just makes
the net present value of the cash flow equal to zero.
 This rate of interest is termed as the Internal Rate of Return (IRR).
 Cont’d…
67

 The IRR (R) is the rate of discount, which makes the present value of

the benefits exactly equal to the present value of the costs.

 This is the interest rate that a project could pay for the resources used

if the project is to recover its investment and operating cost and still
can be at the break-even point.

 It would be the maximum interest rate the project could afford to pay
on its funds and still recover all its investment and operating costs.

 This is achieved in trial and error using the standard discounting table.
 Cont’d…
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 Calculation of IRR
 The procedure begins with the preparation of a cash flow table.
 Estimated discount rate is then used to discount the net cash flow to
the present value.
 If the NPV is positive a higher rate is applied. If it is negative at this
higher rate the IRR must be between those two rates.
 By iterations it is possible to determine the discount rate that makes
the project’s NPV equal to zero. This rate is the IRR of the project.
 Cont’d…
69

 Example: To illustrate the calculation of internal rate of return,

consider the cash flows of a road project (million Birr):

Year 0 1 2 3 4
Cash flow -100, 000 30,000 30,000 40,000 45,000

 100,000 30,000 30,000 40, 000 45,000

0    
(1  r ) 0
(1  r ) 1
(1  r ) 2
(1  r ) (1  r ) 4
3

30,000 30,000 40, 000 45,000

100,000    
(1  r ) 1
(1  r ) 2
(1  r ) 3
(1  r ) 4
 We try different values of r till we find that the right-hand side of the
above equation is equal to 100,000.
 Cont’d…
70

 Let r=12% NPV= 107,773 and r=14% NPV=103,046

 Since this value is higher than the target value of 100,000, we have to
30,000 30,000 40, 000 45,000
try a still higher value of r. Let r = 15%     100,802
(1.15)1 (1.15) 2 (1.15)3 (1.15) 4

 This value is a shade higher than our target value, 100,000. So we

increase the value of r from 15% to 16%.
30,000 30,000 40, 000 45,000
 The right-hand side becomes: 1
 2
 3
 4
 98,641
(1.16) (1.16) (1.16) (1.16)

 Since this value is now less than 100,000, we conclude the at the value

of r lies between 15 percent and 16 percent

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71

 1 percent difference (between 15 percent and 16 percent) corresponds

to difference of 2,161= (100802 - 98641).

 The difference between 100,802 (present value at 15 percent) and

100,000 (target present value) is 802= (100,802 - 100,000).

 This variation will correspond to a % difference of:

802
x 100  0.37 %
2161
 Adding this number to 15 percent, we get the interpolated value as
15.37 percent.
 Cont’d…
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 Decision rule for independent projects in IRR

 Accept all independent projects having an IRR greater than the
predetermined discount rate by the central bank.
 Once the IRR is identified, the decision rule is accept the project if the
IRR is greater than the cost of capital, say r. Note also that:
 When NPV > 0 then IRR > r, NPV = 0 then IRR=r and NPV < 0 then
IRR < r
 All projects with an internal rate of return greater than some target rate
of return r, should be accepted.
 Cont’d…
73
 Example: cash flows for a hypothetical project.
Cash flows
Year Project A Project B Project C
0 -20 -40 -20
1 4 8 14
2 4 8 14
3 4 8 -
4 4 8 -
5 4 8 -
6 4 8 -
7 4 8 -
8 4 8 -
9 4 8 -
10 4 8 -
NPV at 10% 4.57 6.08 4.36
IRR 15.1% 13.7% 25.8%
 Cont’d…
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 The IRR and NPV might suggest different projects for similar level of

discount rate.
 As it can be observed from the table above the three projects by their

NPVs (at 10% discount rate) results in project B heading the list,
while ranking them by their IRRs would lead the planners to prefer C.
 25.8% is better because a project with 25.8% economic rate of return
is likely to a better investment than with a project with 15% economic
rate of return.
 That is, it contributes more to the national income relative to the
resources used.
 Comparison of the NPV and IRR
75

 There are two possible reasons for not to undertake all the above

projects.
 The first is there may not be enough capital funds the second problem

is related to the fact that two projects could be mutually exclusive.

 If there are enough budget resources, both NPV and IRR give the

same accept-reject decision.

 However, ranking the projects using the two methods will lead to the
choice of different projects: project B on NPV basis and project C on
the IRR basis.
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 In general if funds are unlimited and the projects are not mutually

exclusive, the NPV is the relevant criteria. All projects with positive
NPV should go ahead.
 Both the NPV and the IRR methods can rank investment projects in
more rational manner than the other methods previously considered.
 The NPV method is simpler, easier, and more direct and more reliable.
 In some situations both the NPV and the IRR criteria give the same

accept- reject decision.

 However, there are two probable reasons why all acceptable projects
cannot be under taken. i.e. capital funds may be limited.
 C. Net Benefit Investment Ratio (NBIR)
77

 It is the ratio of the present value of the projects benefits, net of

operating costs, to the present value of its investment costs.

 This is given by:

 Where OCt is operating costs in period t; ICt is investment costs in

period t; r the appropriate discount rate, and Bt the benefits in period t.

 The NBIR shows the value of the projects discounted net benefits of
operating costs, per unit of investment.
 Cont’d…
78

 The decision rule using NBIR is to accept the project if its value is

greater than 1.
 This criterion is especially important for ranking investments that

shows the benefit per unit of investment.

 When we have a single period budget constraint projects with highest

NBIR should be selected up to the point where the budget exhausted.

 The main advantage of the NBIR is its capacity to determine the group

of priority projects if there is a single period budget constraint.

 D. Domestic Resource Cost Ratio (DRCR)
79

 It is a discounted measure of project worth calculated for a single

typical year of project operation.

 It is defined as the value of domestic resources in domestic currency

units required to earn or save a unit of foreign exchange that is the

cost per unit of foreign exchange saved for imported competing goods
and the cost per unit of foreign exchange earned for exports.
 The DRCR coefficient is a cost benefit ratio and it is a measure of the
efficiency of domestic production relative to the international market.
 Cont’d…
80

 If the DRCR for a commodity is greater than the appropriate

accounting price of foreign exchange a comparative cost advantage

exists in producing the commodity in question and vice versa.
 DRCR < 1 implies that the productivity is economically profitable
because its production yields more than enough international value
added to compensate for the cost of domestic factors used.
 DRCR = 1 implies a break-even situation, where it is only just

economically worthwhile to produce the commodity.

 DRCR > 1 indicates cost of domestic resources needed to generate one
unit of foreign exchange exceeds the value of the foreign exchange.
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 Undiscounted measures, as we noted, are excessively crude and most

invariably inaccurate.

 Thus, the discounted version is the most appropriate one.

• Where Btl are the benefits of the project obtained in local currency

• Ctl Are the costs of the project incurred in local currency

• Btf Are the benefits of the project obtained in foreign exchange

• Ctf Are the costs of the project incurred in foreign exchange

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 The decision rule for DRCR

 When undertaking a financial appraisal of a project should be accepted

if it’s DRCR is less than or equal to the official exchange rate, OER.
 This means a project should proceed if it uses less domestic resources,
measured in local prices, to earn 1 unit of foreign exchange than is the
norm for the whole economy.
 It produces own internal exchange rate, which is internal to the project
 E. Benefit Cost Ratio (BCR)
83

 The BCR is defined as the ratio of the sum of the project’s discounted

benefits to the sum of its discounted investment and operating costs.

 This is given as,

A project should be accepted if its BCR is greater than or equal to 1 (i.e.

if its discounted benefits exceed its discounted costs).

But if BCR is less than 1, the project should be rejected.

One possible advantage of the BCR, on top of being easy to show the
impact of percentage change in cost or benefits on the projects viability.
 2.6. Sensitivity Analysis
84

 It is a financial analysis that is used to evaluate the impact of changes

in key assumptions on the financial outcome of a project.

 It is a what-if analysis that allows you to see how different factors,

such as sales, costs, and discount rates, can affect the project's net
present value (NPV).
 Sensitivity analysis can be used to identify the key assumptions that
have the greatest impact on the project's NPV.
 This information can then be used to focus your efforts on managing

those assumptions.
 Cont’d…
85

 For example, if you find that the project's NPV is most sensitive to

changes in sales, you may want to focus on developing a more

accurate sales forecast.
 Sensitivity analysis can also be used to assess the risk of a project.
 By understanding how changes in key assumptions can affect the
project's NPV, you can make a more informed decision about whether
to proceed with the project.
 You can then vary the key assumptions in the model and see how the

NPV changes.
 Cont’d…
86

 Here are some of the key benefits of conducting sensitivity analysis:

 Identify the key assumptions that have the greatest impact on the
project's NPV.
 Assess the risk of the project.
 Make a more informed decision about whether to proceed with the

project.
 Overall, sensitivity analysis is a valuable tool that can help you make

better decisions about your projects.

 However, it is important to understand its limitations and to use it in
conjunction with other decision-making tools.