Chapter - 5: Financial Analysis and Appraisal of Projects

o The main content of the chapter are:

Scope and Rationale

Identification of Costs and Benefits

Classification of Costs and Benefits

The valuation of financial costs and benefits

Investment Profitability Analysis

Sensitivity analysis
 Scope and Rationale

What is financial analysis?

• Every project has to be first analyzed in terms of its timely

implementation and financing.

• It aims at confirming that under prevailing market conditions the

project will become and remain viable.

• It is concerned with assessing the feasibility of a new project from

the point of view of its financial results.

2
 Cont…,

 The project’s direct benefits and costs are, therefore, calculated

in monetary terms at the prevailing market prices.

 This analysis is applied to appraise the soundness and

acceptability of a single project.

• A comprehensive financial analysis provides the basic data

needed for the economic evaluation of the project and is the

starting point for such evaluation.

3
 Cont…,

 It has to be noted that the financial analyst should be able to

communicate and know what to ask from the d/t team

members to collect relevant information on:

1. Revenue, both forecasted sales and selling price; (from Demand

and Market Study)

4
 Cont…,

2. Initial investment costs distributed over the implementation of

the project; (Engineering, Site Development as well as Materials

and Inputs);

3. Operating costs / over its operating life.

5
  Identification of Costs & Benefits

• In project analysis, the identification of costs and benefits is the first

step. This involves:

 The specification of the costs and benefit of variables for which data

should be collected,

Identification of the sources of information, and

Assessment of the quality and reliability of the collected information.

6
 Cont…,

• 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.

 The objective of the project may be:

 To maximize family net income /profit.

 Increase national income

7
 Cont…,

Income distribution.

Increase job opportunities

Raising the level of education,

Improve rural health, & etc.

• The dominant objective of the firm’s project is maximization

of income/profit and increased national income is the most

important objective of national economic policy.

8
 Cont…,

• Thus, anything that directly reduces the total final goods and

services is obviously a cost, and anything that directly increases

them is a benefit.

• Again, anything that reduces national income is a cost and

anything that increases national income is a benefit.

9
  Classifications of Cost and Benefits

• There are alternative ways of classifying costs and benefits of a project.

One is to categorize both costs and benefits into:

Tangible and intangible: The prices that the project actually pays for

inputs are the appropriate prices to use to estimate the project’s

financial costs.

• These prices may include taxes, tariffs, rents, or be net of subsidies.

10
 Cont…,

• Some of the project costs are tangible and quantifiable while

many more are intangible and non quantifiable.

• The costs of a project depend on the exact project formulation,

location, resource availability, or objective of the project.

 Tangible benefits can arise either from increased production or

from reduced costs.

11
 Cont…,

• In general the following benefits can be expected:

 Increased production

 Quality improvement

 Changes in time of sale

 changes in location of sale

 Changes in product form (grading)

 Cost reduction through technological advancement & etc.

12
 Another classification:

1. Total investment costs; including:

a. Initial investment costs;

 Fixed investment costs;

The cost of land and site development

The cost of buildings and civil works

Plant and machinery

Miscellaneous fixed assets (furniture)

13
 Cont…,

 Pre-Production expenditures; This includes the

following investment cost items.

 Intangible assets; These include:

o Patents, licenses, engineering fees, and goodwill.

o Preparatory studies, like feasibility studies, consultant

fees for preparing studies, supervision costs, & etc.

14
 Cont…,

 Other Pre-operation expenses. These include:

o Rents, taxes, Salaries, and others

o Pre-production marketing costs, promotional expenses,

creation of sales network, etc.;

o Training costs, including all fees, travel, living expenses etc.;

o Insurance charges;

15
 Cont…,

o Interest on loan,

o Miscellaneous expenses

16
 b. Plant and Equipment Replacement Costs

• Every machinery and equipment does not have equal economic life.

• Even though there are machineries and equipment that

productively be operated for many years, there are also equipment,

machinery components and parts which need to be regularly

replaced for smooth operation of the same technology.

17
 Cont…,

• So sound project planning work should adequately provide for

replacement of components and parts.

• In fact the first thing to do would be to identify such items and

then estimate the costs for replacement .

18
 2. Operating costs

 This may includes

 Material cost

 Utilities: consisting of power, water, and fuel are also important cost

components.

 Labor: this is the cost of all manpower employed in the enterprise.

 Factory Overhead: the expense on repairs and maintenance, rent,

taxes, insurance on factory assets, etc.

19
 Cont…,

Contingency allowances are usually included as a regular

part of the project cost.

 It would be unrealistic to base project cost estimates only on

these assumptions of perfect knowledge and complete price

stability.

20
 Cont…,

• Sound project planning requires that provision be made in advance for

possible adverse changes in physical conditions or prices that would

add to the baseline cost.

• Contingency allowances may be divided into those that provide for

physical contingencies and those for price contingencies.

• In turn price contingencies comprises two categories, those for

relative changes in price and those for general inflation.

21
 Cont…,

• To avoid the problem of inflation on the other hand it is advisable

to work with constant prices instead of current prices.

22
  The Valuation of Financial Cost and Benefits

• 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.

• The financial benefits of a project are just the revenues received and

the financial costs are the expenditures that are actually incurred

by the implementing agency as a result of the project.

23
 Cont…,

• If the project is producing some goods and services for sale, the

revenue that the project implementer expects to receive every year

from these sales will be the benefits of the project.

• The costs incurred are the expenditures made to establish and operate

the project.

• In financial analysis all receipts and expenditures are valued as they

appear in the financial balance sheet of the project, and are

therefore, measured in market prices.

24
 Cont…,

• Since the project implementers will have to pay market prices

for the inputs and will receive market prices for the outputs

they produce, the financial costs and benefits of the project are

measured in these market prices.

25
Investment Profitability Analysis

A. Non-discounting (traditional) measures of project worth

1. Payback Period (PBP)

2. Accounting Rate of Return (ARR)

1. Payback Period (PBP)

• Payback period refers to the length of time it takes to recover

initial investment of the project.

• Depending on the nature of net cash flows, payback period may

be computed in two ways. 26

 Cont…,

a) When cash flow is in annuity form (even cash flows)

 Annuity refers to equal amount of cash flows that occur

every period over the life of the project.

Initial Investment
PBP =
Annual Net Cash Flows

27
 Cont…,

• To illustrate the computation of payback period, assume that a

project requires an initial investment of Br. 24,000 and annual

after tax cash flows of Br. 6000 for five years.

• How long it takes the company to recover its initial investment?

24,000
PBP = = 4 years
6000

28
 Cont…,

• It is expected to take the company four years to recover the project’s

initial investment of Br. 24,000

b) When cash flows are not in annuity form (Uneven cash flows)

• When net cash flows are not annuity, payback period is obtained by

adding net cash flows for successful years until the total is equal to

initial investment.
 Cont…,
PBP= Years before full recovery + Un recovered cost
Cash flow during the next year

• To exemplify, assume that a project requires an initial investment of

Br. 60,000.

 The after taxes cash flows (or net cash flows) are as follows:

Year 1 = 8000 Year 3 = 22,000 Year 5 = 20,000

Year 2 = 15,000 Year 4 = 20,000

30
 Cont…,

• The payback period

15,000 is computed as follows;
PBP = 3 years + = 3.75 years
20,000

• In the above example, if the 1st three years’ net cash

flows are added, the sum is equal to Br. 45,000.

• But the initial investment is Br. 60,000.

31
 Cont…,

• If the fourth year net cash flows (Br. 20,000) is added to Br.

45,000, the sum is Br. 65,000 which is greater than the initial

investment.

• Thus, the payback period is between year 3 and year 4.

• To find the exact payback period, we take the three years and

divide the remaining cash flows by the fourth year net cash flows.

32
 Cont…,

• If the exact payback period is needed in months the fraction can

be computed as follows:
15,000
PBP = 3 years + (12 months )
20,000

= 3 years and 9 months

 The shorter the payback period, the more desirable the

project.

33
 Cont…,

Advantages of Payback Period

 It is simple both in concept and application

 It is a rough and ready made method for dealing with risk & etc.

Disadvantages of Payback Period

 It fails to consider time value of money

 It ignores cash flows beyond the payback period

 It is a measure of the project’s capital recovery, not profitability & etc.

2. Accounting/Average Rate of Return (ARR)

• The accounting rate of return is a measure of profitability which

relates/compare net income to investment. Compare

• The most common method of computing ARR, is shown below;

35
 Cont…,

 To illustrate, assume that a project has original investment of Br.

70,000, life of 4 years, and salvage value of Br. 6000.

• Income before depreciation and taxes for each of the four years

are as follows: year1, Br. 40,000; year 2, Br. 42,000; year 3, Br.

36,000; and year 4, Br. 50,000.

• Income tax rate is 40%.

36
 Cont…,
• Depreciation = 70,000 – 6000 = 16,000
4

• Before ARR is determined, it is necessary to compute net income

for each of the four years as follows:

37
 Cont…,

Year 1 Year 2 Year 3 Year 4

Income before depreciation & tax 40,000 42,000 36,000 50,000

Less: Depreciation 16,000 16,000 16,000 16,000

Income before taxes 24,000 26,000 20,000 34,000

Less: Taxes (40%) 9,600 10,400 8,000 13,600

Net income 14,400 15,600 12,000 20,400

38
Cont…,

39
 Cont…,

 The ARR for a project proposal shall be compared with a required

rate of return (normal saving interest rate).

 Therefore, if we compare the ARR of the project proposals in our

example, say with an interest rate of 36%, the proposal is good for

implementation.
Decision Rule for Accounting Rate of Return

 Accept the project if ARR exceeds the required rate of return.

 Reject the project if ARR is less than the required rate of return.
 Advantages of ARR

1. It is simple to calculate

2. It is based on accounting information, which is readily available

and familiar to businessmen.

3. It considers benefits over the entire life of the project & etc.

Limitations of ARR

1. It is based upon accounting profit.

2. It does not take into account the time value of money & etc.
 Discounted Cash Flows (DCF) measures of project worth

1. Net Present Value Method

• The net present value of project is the d/ce b/n the present value

of net cash inflows and present value of initial investment. Or;

NPV = PV of NCF – I0

Where: PV = Present value and NCF = Net cash flows

42
 Cont…,

• To illustrate, assume that a project is expected to have initial

investment and life of Br. 40,000 and five years respectively.

• The annual after tax net cash flow is estimated at Br. 12,000 for

each of the five years & the required rate of return is 10%.
 Cont…,

• Net present value is determined as follows:

NPV = PV of NCF – I0

= 12,000 (3.791) – 40,000

= 45,492 – 40,000 = 5492

44
 Cont…,

• In the above formula, represents the discount

factor and its value is equal to 3.791.

• This discount factor can be taken from the present value of

annuity table from the intersection of i = 10% and n = 5.

• It can also be determined using your calculator.

45
 Cont…,

• In the above example, net cash flows are annuity.

• The same procedure can be followed if net cash flows are not in

annuity form.

• To illustrate the computation of NPV when net cash flows are not

annuity, suppose the project has initial investment and useful

life of Br. 30,000 and four years respectively.

• Its annual cash flows are as follows: Year 1, Br. 10000; Year 2,

Br. 8000; year 3, Br. 15000; and year 4, Br. 12,000.

46
 Cont…,

• If the required rate of return is 10%, NPV is determined as follows:

47
 Cont…,

• NPV represents the amount by which the value of (wealth of)

the firm will increase if the project is accepted.

Decision Rule for NPV

• If NPV is greater than zero (NPV > 0), the project is

considered desirable.

• If NPV is less than 0, the project is considered undesirable.

48
2. Internal Rate of Return (IRR)

• Internal Rate of Return is the discount rate which equates the project

NPV equal to zero.

• It is the discount rate at which the present value of Net cash flows is

equal to the present value of initial investment.

• In other words, IRR is the rate of return on investments in the project.

• The determination of IRR is purely based on project cash flows.

49
 Cont…,

• IRR is determined using trial and error: the complexity of

determining IRR is greater if net cash flows are not in annuity

form.

• This section illustrates the determination of net cash flows when

cash flows are annuity as well as non-annuity.

50
 Cont…,

a) Determination IRR when NCFs are annuity.

• Assume that the project has initial investment of Br. 40,000, and

useful life of five years.

• The annual net cash flows is estimated at Br. 12000 for five years.

• The required rate of return is 10%.

• The following steps can be followed to determine IRR.

51
 Cont…,

Step1: Compute the leading discount factor (payback period)

Step 2. From the present value of annuity table, find two discount

factors and their corresponding interest rates closest to the

computed leading discount factor.

52
 Cont…,

 If we look in the PV of annuity table on n = 5 years row

(horizontally), (3.333) is found between 15% and 16%.

Interest rate 15% 16%

Discount factor 3.352 3.274

53
 Cont…,

Step 3: Compute the actual IRR using the following formula:

Where:

r = either of the two interest rates (15% or 16%)

DFr = Discount factor for the taken interest rate

DFrL = Discount factor for the lower interest rate

DFrH = Discount factor for the higher interest rate

54
 Cont…,

• Let's take r = 15%, IRR is determined as follows:

= 15% - (-0.24)

= 15.24%

 If we take r = 16%, the computation of IRR looks like the following:

= 15.24%
55
 Cont…,

• At 19% NPV is negative, this implies that IRR lies between 18% & 19%.

• Thus, such iteration process ends when two neighboring rates, at lower rate NPV is

positive and at higher rate is negative.

• To find the exact IRR, steps 4 and 5 will be followed:

Step 4: Obtain the absolute sum of the two present values

Sum = |+270| + |-640|

= 270 + 640

= 910 56
 Cont…,

• Step 5: Divided the NPV of the smaller rate by the absolute sum and

add to the smaller rate

Decision Rule for IRR

o Accept: If the IRR is greater than the discount rate

o Reject: If the IRR is less than the discount rate

57
 Cont…,

3. Profitability Index (PI)

• The profitability index, also called benefit - cost ratio, is the ratio

of the present value of net cash flows and initial investment.

• To illustrate, assume that a project is expected to have initial

investment and useful life of Br. 90,000 and four years

respectively.
58
 Cont…,

• Annual net cash flows amounted to Br. 40,000 and the discount

rate is 10%.

• Profitability index can be computed as follow:

59
 Cont…,

Decision rule for profitability Index

Accept if the project's profitability index is greater than 1

Reject if the project's profitability index is less than 1

60
 Sensitivity Analysis

• Sensitivity analysis is a techniques applied to uncertainties.

• These uncertainties are factors affecting project outcomes, which

cannot be quantified.

• The purpose of sensitivity analysis is to tell us the factors,

which are liable to have the greatest influence over project

success and failure.

61
 Cont…,

• Once these factors have been identified it is then possible to

deign appropriate mitigation measures.

• Sensitivity analysis (sometimes called ‘what if’ analysis) shows

how the NPV or other criterion of merit changes with variations in

the value of any variable (sales volume, selling price per

unit, cost per unit etc.).

62
 Cont…,

• It consists of testing the sensitivity of the NPV or IRR to changes

of basic variables and parameters that enter the project’s input

and output streams.

• It generally involves considering the effect on the NPV of

plausible variations in some of the inputs.

• The purpose of the sensitivity analysis is:

To enhance our understanding of the structure and working of

the project;
63
 Cont…,

To guide us in the design of the project so that high NPV or IRR are

obtained;

To suggest areas and means by which risk can be reduced.

• The key variables whose variations should be studied will be different

from project to project.

• The variable that is most commonly varied in sensitivity analysis are:

 Discount rate/ interest rate;

64
 Cont…,

Total investment costs;

Implementation times;

Output levels and prices;

The volume of demand;

The level of capacity; and

Operating cost & etc.

65
 Cont…,

• This is done to determine the sensitivity of the estimated NPV to

changes in these variables.

• This should provide those planning and managing projects with

ideas about the areas that need to be studied in more depth or

where actions may be required to protect the project.

66