CH 6

Chapter 6:
Financial Estimates & Forecasts

BY
ATAKELT HAILU ,
MBA,M.COM & Ph.D.
DEPT. OF MANAGEMEN
:Questions of financial feasibility
• What are the total start-up costs required in order to begin operations?
For instance,
– what are the capital costs of the land, plant and equipment, and
other start-up costs such as legal and accounting costs?
– What are the operating costs involved?
• These include the daily costs involved in running the business, such as:-
– wages,
– rent,
– utilities, and interest payments on outstanding debt. These will
determine the cash flow requirements of the decision maker .
– What are the possible sources of financing for project?
• who are potential lenders?
• What will be their required terms and limitations of borrowing?
– Based on the estimated revenues and costs, what is the projected
profit(loss) of the project? What is the break-even point?
3 Chapter content
• Financial analysis would cover the following aspects

Cost of project
 Means of finance
 Estimates of sales and production
 Cost of production
 Working capital requirements and its financing
 Profitability projections
 Projected cash flow statement
 Project analytical tools
Project analysis and evaluation-Financial estimates & Forecasts

4 4.1 Cost of project
Land and site development

 cost of land lease and other charges
 cost of levelling and development
 cost of laying approach roads and
internal roads
 cost of gates
 cost of tube wells

Building and civil works

 building for main plant and equipment
 buildings for auxiliary services
 residential buildings
 garages
 drainage etc

Technical know-how and engineering

fees
 Consultants fees for advise in choice of
technology,selection of plant and
machinery, structures and civil works,
detailed engineering etc
 Cost for obtaining technical know-how is
part of initial cost while annual royalities
are part of operating expenses

Expense on foreign technicians and

training of local technicians abroad
 fee for services of foreign technicians
including transportation, lodging, salaries and
allowances etc
 cost of training local technicians abroad
including transportation, lodging, tuition fees
and etc

Miscellaneous fixed assets

 are not part of direct manufacturing process
 include furnitures, office machinery and
equipments, tools, vehicles, transformers,
laboratory equipments etc

Preliminary and capital issue expense

 cost of project identification,market survey,
preparation of feasibility report etc
 cost of raising capital such as underwriting
expenses, brokerage fees,legal fees etc

Pre-operative expense
 expenses incurred before commencement
of commercial production
 includes rents, interest on debt,insurance
charges, mortgage expenses, start-up
expenses etc

Provision of contingencies:-
– Provision for Contingency is made to provide for certain
unforeseen expenses and price increase over and above the
normal inflation rate
– Set the Provision for contingency at 5-10% of estimated cost
Margin money for working capital
– Principal support for working capital is provided by banks
and trade creditors. However certain part of working capital
requirement comes from sources of long term finance. This
is referred to as ‘margin money for working capital’.
Initial cash losses
 provision for losses of a project during early years

12 4.2 Means of finance
Share captal
 common stock
 Preferred stock
 debt financing
 Term loans
 bonds
 Incentives by governments

13
1. Share capital : Two types of share which are

i) Common stock,
• Common stock represents an actual ownership position in the firm
• shares which do not enjoy any preferential right in the payment of
dividend or repayment of capital
• Share profit- dividend is not fixed
• The rate of dividend is depend on the profits of the company.
ii) Preferred stock, represents the contribution made by preference
shareholders.
• stockholders have preferential right on payment of dividend over
common stock
• Have fixed dividend
• No voting power

14
2. Debt financing
• Debt financing comes in the form of a term loan or by issuing debt
securities like bond
• Term loan:- is provided by financial intuitions-bank-
- it is granted on the basis of a formal agreement between the borrower and the lending institution
• The second type of debt financing is corporate bonds.

– It is a contractual obligation between the issuer and the
holder.
• The issuer promises to make interest payments to the holder at
specific dates and to return the principal at a certain date (maturity).
3. Incentive source:- seed capital assistance
Considerations:
 Norms of regulatory bodies
and financial institutions
 Business considerations
including
- Cost of capital - Risk
- Control - Flexibility
is the mix of equity and debt used in financing a

project
 equityDebt
andcapital Equity
debt differ in many capital
respects
• Creditors have fixed claim • Shareholders have residual
claim
• Interest is tax deductible • dividend is not tax deductible
• has a fixed maturity • has indefinite life
• creditors do not exercise • shareholder’s exercise control
control over the firm over affairs of the firm
Project Analysis and evaluation- project financing Wednesday, December 20, 2023
17 4.3 Estimates of sales &
production
Considerations
• The starting point of profitability projections is the forecast for sales revenues.
• In estimating sales it is reasonable to assume that capacity utilization would be somewhat low
in the first year and rise there after gradually to reach the maximum level in the third or fourth
year of operation.
do not assume high capacity utilization level in the first year
a reasonable assumption would be
- 1st yr ............................40-50%
- 2nd yr........................... 50-80%
-3rd yr & onwards......... 80-90%
selling price should be net of exise tax
selling price may be present selling price, and increase in price will
be matched by increased production cost
18 4.4 cost of production
 Material cost
 Labor cost
 Factory overhead cost
Material cost
- include cost of raw materials,
chemicals,components, and etc

19 4.4 Cost of production...
Determining material cost

(1)Determine material consumption rate per unit
of output
(2) Total requirment= per unit rqt x annual output
(3)Determine price in CIF terms(cost,insurance
and freight). Present cost considered
(4)Seasonal fluctuation should be considered

Utilities cost
 detemine amount of usage by the help of
consultants and use present rates

Labor cost
 classify labor into groups
 differentiate between piecerate earners
 determine allowances and other benefits

Factory overhead cost

 repairs and maintenance
 rents
 taxes
 insurance on factory assets

23 4.5 Working capital requirement
Considerations
1. WC requirement includes:
 RM and components
 Inventory of goods-in-process
 inventory of finished goods
 accounts recievable
 inventory of materials and supplies

Considerations
2. Sources of WC financing:
 WC advances by commercial banks
 Trade credit
 accruals
 long-term financing
3. Net WC = CA-CL

Schedule of working capital requirement

1st Yr 2nd Yr 3rd Yr 4th Yr
1. Total current assets 80,000 86,000 91,000 100,000
2. Total current liabilities 65,000 79,000 95,000 103,000
3. Net working capital 15,000 7,000 (4,000) (3,000)
requirement

26 4.6 Profitability projections
• Given the estimates of sales revenue and cost of production, the next step is to prepare the
profitability projections
The profitability projections are prepared along the following lines:
1. Total cost production ( A+B+C+D)
A. Cost of production (Represent the cost of materials, labor, utilities and factory overheads)
B. Total administrative expenses(Consist of Administrative salaries, telegrams and telephones and office supplies
(-stationary , printing, packaging charge etc)
C. Total sales expenses(salary of sales staff, sales promotion and advertising expense
D. Royalty and know-how payable
2. Expected sales
3. Gross profit before interest (2-1)
E. Total financial expenses(interest rate on term loan,)
F. Depreciation
4. Operating profit ( 3-E-F)
H. Other income(sale of old machinery, sales of by product)
I. Preliminary expenses written off
5. Profit before tax ( 4+H-I)
J. Provision for taxes
6. Profit after tax ( 5-J)
K. Dividend of preference and equity capital
27 4.6 Profitability projections
attention should be paid to the following I/S

figures:
1. Gross profit
2. administrative expenses
3. Profit before tax
4.Profit after tax
5. Dividend and Retained Profit

F. 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.
• The cash flow statement provides information about:
• Cash Receipts (cash inflows) :-Share issue, long term
borrowing, sale of fixed asset, sales of investment , Sales of
Main product and By-product
• Uses of Cash (cash outflows):-Capital expenditure for the
project, payment of loan and interest rate, tax and dividend
payment
 The deference is Cash balance on hand
12/20/2023 prepared by: Temesgen Belayneh (PhD) 28

• Inflows(sources of funds) and outflows (uses of funds) are
reported for
1. Operating activities
2. Financing activities
3. Investing Activities
• Cash inflows and outflows from operations.
Operating Activities
Cash Inflow Cash Outflow

1) Cash Purchases
1) Cash Sales 2) Payment to Creditors
2) Received from Debtor 3) Payment of Wages
4) Income Tax
Net operating cash flow

Classification of Business Activities :
Inflow and Outflow of Cash
Investing Activities

1) Sale of Fixed Assets
2) Sale of investments 1) Purchase of Fixed Assets
3) Interest Received 2) Purchase of Investments
4) Dividend Received
Classification of Business Activities :
Inflow and Outflow of Cash
Financing Activities
1) Issue of Shares in Cash 1) Payment of Loans

2) Issue of Debentures in 2) Redemption of Preference
Cash Shares
3) Proceeds from long-term 3) Payment of Dividends
borrowings 4) Interest Paid
5) Repayment of Finance/
Lease Liability
32 4.7 Projected cash flow statement
Formulating the CFS

I. Adjust net income to determine Cash
flow from Operation
=NI+Depreciation+Amortization
II. Identifiy Cash flow from Financing
and Investing Activities

33 4.8 Project analytical tools
Investment criterias
1. Pay Back Period
2. Net Present Value (NPV)
3. Internal Rate of Return (IRR)

34 Methods of Project’s Financial
Appraisal
 Non-Discounting Methods
1. Urgency (Priority)
2. Pay Back Period (PBP)
3. Accounting Rate of Return (ARR)
 Discounting Methods
1. Net Present Value (NPV)
2. Benefit Cost Ratio (BCR)
3. Internal Rate of Return (IRR)

35 Non-Discounting Methods
Urgency (Priority): According to this criterion projects

that are deemed to be more urgent get priority over
projects that are regarded as less urgent
Pay Back Period (PBP): The payback period is the
number of years needed to recover the initial
investment of the project. It is the number of years
required for investments cumulative cash flows to
equal its net investment.
Decision rule: An investment is acceptable if it
calculated payback period is less than some pre-specified
number of years (maximum desired payback period).

Example 1: a) Uniform (annuity) cash flow

Investment $20,000
Cash flows per year $4,000
Pay Back Period = Investment
Uniform Cash Flows
= 5years

• For example, if a project involves a cash outlay of Birr 60,000 and
generates cash inflows of Birr 10,000, 15,000, 15,000, 20,000 and 22000 in
the first, second, third, fourth and fifth years, respectively, its payback
period is 4 years because the sum of cash inflows during 4 years is equal
to the initial years.
Year Non- uniform Cash inflows Cumulative

1 10,000 10,000
2 15,000 25,000
3 15,000 40,000
4 20,000 60,000
5 22,000 82,000
• While When the annual cash inflow is a constant sum, the PBP is simply the
initial outlay divided by the annual cash inflow.
• For example, a project which has an initial cash outlay of Birr 12,000 and a constant
annual cash inflow of Birr 3000 has a PBP of 12,000/3000 = 4 years.
• According to the PBP criterion, the shorter the PBP, the more desirable the project.
Example 2
Non-Uniform Cash Flows: Suppose the annual
cash flows are not equal for the same initial
investment of $20,000. The cash inflows from the
project for the first five consecutive years are $8,
000, $9, 000, $15, 000, $20,000 and $ 25,000
respectively. What is the payback period?
To determine the payback period of the above
project, we have to use the cumulative cash flow
method.

Exercise
 Suppose the annual cash flows are not equal for the initial
investment of $40. The cash inflows from the project for the first
five consecutive years are $10, $12, $15 , $ 10 and $7 respectively.
What is the payback period?
0 1 2 3 4 5
-40 10 12 15 10 7
-40 -30 -18 -3 7 14
PBP = 3 and ( 3 ) / 10 x12

Cumulative = 3.4 Years
Cash Flows Note: Take absolute value of last
negative cumulative cash flow value.
Accounting (Average) Rate of Return (ARR

The accounting rate of return (ARR), also referred to as
the average rate of return on investment, is a measure
of profitability which relates income to investment, both
measured in accounting terms.
The measures that are employed commonly in practice
are:
ARR = Average Income after Tax (AIAT)
Initial Investment
ARR = Average Income after Tax (AIAT)
Average Investment
41 Example 1: ARR with 50% tax
rate.

42 Accounting (Average) Rate of
Return (ARR)
a) AIAT=150,000/6 =25,000
b)Initial Investment =100,000
c) Average Investment=360,000/6 =60,000
ARR = Average Income after Tax (AIAT) =
Initial Investment
25,000/100,000=25%
ARR Tax (AIAT) =
Average Investment
25,000/60,000=41%
43 Discounting Methods
Exercise 1. Net Present Value (NPV) Method: The net present value of the project is the
sum of the present value of all the cash flows-positive as well as negative-that are
expected to occur over the life of the project
CF1 CF2 CFn

NPV = + +...+ - In
(1+k)1 (1+k)2 (1+k)n
Decision rule: The net present value represents the net benefit over and above the
compensation for time and risk. Hence the decision rule associated with the net present
value criteria is:
If the net present value (NPV) is positive or greater than 0; accept the project
If the net present value (NPV) is negative or less than 0; reject the project.
If we are going to select one project from two or more projects with a NPV>0, mutually
Example
Cash flows for the project ‘A’ will be $10,000; $12,000; $15,000; $10,000; and
$7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will
be $40,000. appropriate discount rate (k) for this project is 13%.
NPV = $10,000 $12,000 $15,000

+ + +
(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
4 + - $40,000
(1.13) (1.13)5
NPV = 8,850 + 9,396 + 10,395 + 6,130 + 3,801 - 40,000=-1428
= means 38,572-40000=- $1,428
45 Example
Exercise 1: Consider a project which has the following

cash flows.
Year Cash Flows
1._____________________65,000
2.______________________(2,000)
3.______________________(4,000)
4.______________________25,000
5._______________________40,000
6._______________________42,000
If the cost of cash is 10%, what is the NPV?

46 Benefit Cost Ratio (BCR) or
Profitability Index (PI):
BCR gives the return for each dollar invested. There are two ways of defining the
BCR.
The first definition related the PV of benefits (PVB) to the initial
investment.
The second measure relates NPV to initial investment.
Benefit Cost Ratio: BCR=Present Value of Cash Inflows
Present Value of Cash Outflows
Net Benefit Cost Ratio: BCR= or BCR-1

Where PVB = Present Value of Benefit
I = Initial investment
47
Decision rule:
When BCR or NBCR Decision rule
>1 >0 Accept

=1 =0
Indifferent i.e., benefit=cost
<1 <0 Reject
Example 1: The project which has a cost of capital of
12%, initial investment and cash flows are given below

48 Example

49 Example
The benefit cost ratio measures for this

project are:
Benefit cost ratio: BCR = = = 1.145
Net Benefit Cost Ratio = BCR - 1 = 1.145 - 1 =
0.145
The project should be accepted, since the BCR
is greater than 1

50 3. Internal Rate of Return
Internal Rate of Return (IRR)

It is another DCF method, which represents the actual rate of return
when profit and time value of money are taken in to account
It is the rate that equates the present value of cash inflow with the
present value of cash outflow of an investment.
It is the discount rate which makes its NPV equal to Zero.

…Cont’d
 Hence, the question will be searching for the discounting rate that equates
the PV of the investment and cash inflows. That is why IRR is some times
called the internally generated rate of return. Mathematically, IRR will be
obtained when;
IO - PV (NCF) = O
o The primary decision rule with IRR is to accept only projects with an IRR
greater than the discount rate.
Project Analysis & Management (ASA)

… Cont’d
Example
To illustrate the calculation of IRR, consider the cash flows of a
project being considered by X Company.
Year 0 1 2 3 4
CFs $(100,000) 30,000 30,000 40,000 45,000

o The IRR is the value of r which satisfies the following equation:
30,000 + 30,000 + 40,000 + 45,000

(1+r)1 (1+r)2 (1+r)3 (1+r)4
 The calculation of r involves a process of trial and error. We try different

values or r till we find that the right-hand side of the above equation is
equal to $100,000. Let us, to begin with, try r=15%. This makes the right-
hand side equal to:
30,000 + 30,000 + 40,000 + 45,000 = 100,802

(1.15)1 (1.15)2 (1.15)3 (1.15)4

Cont.
 This value is slightly higher than our target value

$100,000. So we must increase the value of r from 15% to 16%.
(In general a higher r lowers and a smaller r increases the right hand
side value).
 The right hand side becomes:
30,000 + 30,000 + 40,000 + 45,000 = 98,641

(1.16)1 (1.16)2 (1.16)3 (1.16)4

 Since this value is now less than $100,000 we conclude that the value
of r lies between 15% and 16%. For most of the purposes this
indication is sufficient, but if a more refined estimate of r is needed,
use the following procedures.
1. Determine the NPV of the two closest rates of return

(NPV/15%) = - 802
(NPV/16%) = + 1,359
2. Find the sum of the absolute values of the NPVs obtained in step 1
802 + 1,359 = 2,161
3. Calculate the ratio of the NPV of the smaller discount rate, identified in step
1, to the sum obtained in step 2.
802/2,161= 0.37

15+0.37 = 15.37 Percent
 The IRR, calculated in this manner, is a very close approximation to the

true internal rate of return.
 The decision rule for IRR is as follows:
ACCEPT: if the IRR is greater than the cost of capital

REJECT: if the IRR is less than the cost of capital

57
End of Chapter 6

CH 6

Uploaded by

Copyright:

Available Formats

CH 6

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CH 6

Uploaded by

Copyright:

Available Formats

Chapter 6:

Financial Estimates & Forecasts

• Financial analysis would cover the following aspects

Project analysis and evaluation-Financial estimates & Forecasts

Land and site development

Project analysis and evaluation-Financial estimates & Forecasts

Building and civil works

Project analysis and evaluation-Financial estimates & Forecasts

Technical know-how and engineering

Project analysis and evaluation-Financial estimates & Forecasts

Expense on foreign technicians and

Project analysis and evaluation-Financial estimates & Forecasts

Miscellaneous fixed assets

Project analysis and evaluation-Financial estimates & Forecasts

Preliminary and capital issue expense

Project analysis and evaluation-Financial estimates & Forecasts

Project analysis and evaluation-Financial estimates & Forecasts

Project analysis and evaluation-Financial estimates & Forecasts

Project analysis and evaluation-Financial estimates & Forecasts

1. Share capital : Two types of share which are

Project analysis and evaluation-Financial estimates & Forecasts

• The second type of debt financing is corporate bonds.

is the mix of equity and debt used in financing a

Project analysis and evaluation-Financial estimates & Forecasts

Determining material cost

Project analysis and evaluation-Financial estimates & Forecasts

Project analysis and evaluation-Financial estimates & Forecasts

Project analysis and evaluation-Financial estimates & Forecasts

Factory overhead cost

Project analysis and evaluation-Financial estimates & Forecasts

Project analysis and evaluation-Financial estimates & Forecasts

Project analysis and evaluation-Financial estimates & Forecasts

Schedule of working capital requirement

Project analysis and evaluation-Financial estimates & Forecasts

attention should be paid to the following I/S

Project analysis and evaluation-Financial estimates & Forecasts

12/20/2023 prepared by: Temesgen Belayneh (PhD) 28

Cash Inflow Cash Outflow

Net operating cash flow

Cash Inflow Cash Outflow

Cash Inflow Cash Outflow

1) Issue of Shares in Cash 1) Payment of Loans

Formulating the CFS

Project analysis and evaluation-Financial estimates & Forecasts

Project analysis and evaluation-Financial estimates & Forecasts

Project analysis and evaluation-Financial estimates & Forecasts

Urgency (Priority): According to this criterion projects

Project analysis and evaluation-Financial estimates & Forecasts

Example 1: a) Uniform (annuity) cash flow

Project analysis and evaluation-Financial estimates & Forecasts

Year Non- uniform Cash inflows Cumulative

Project analysis and evaluation-Financial estimates & Forecasts

PBP = 3 and ( 3 ) / 10 x12

Accounting (Average) Rate of Return (ARR

Project analysis and evaluation-Financial estimates & Forecasts

CF1 CF2 CFn

NPV = $10,000 $12,000 $15,000

Exercise 1: Consider a project which has the following

Project analysis and evaluation-Financial estimates & Forecasts