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FinancialAnalysisoftheInvestmentProjects PDF
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Erkan REHBER1
1. Introduction
Because of the limitation of resources, choices must be made among the alternative competing
uses, and investments. In terms of how countries allocate their scarce resources, two chief types of
society can be distinguished;
i. The society with a planned economic system
ii. The society with a free market economic system
However, no country in the real world is either completely centrally planned or operates a
completely pure free market system. It can be said that no economic system can operate without any
state intervention or / and some production activities being undertaken by the state. Yet even in the
US, the command principle has some sway. That is why, like the almost all developing countries, the
national governments of the economies in transition must take a role formulating and evaluating
investment project. Of course, the mix of private and public sector investment varies from country to
country. Either direct investment in the public sector, or imposing controls on private investment or
the use of domestic taxes, tariffs, subsidies and the rationing of scarce resources, the government is
generally in a position to guide the development and restructuring of economy in the country
(Dasgupta and Amartya 1972). Project analysis is a method to evaluate an investment proposal itself
and making convenient and reasonable choices among alternatives in a convenient and
comprehensive fashion (Squire and V. D. Tak 1975).
A sound investment project must include, mainly costs and benefits of the investment and the
some other features of proposal such as, analysis related both input and output markets,
location of production unit, capacity and technology etc.
On the other hand, projects must be analyzed and evaluated to obtain some common
yardstick, to make decisions about realization and financing of them and to use in choosing
among alternative project proposals and in ranking of them.
We can put into four categories, the way of analysis and evaluation of a certain investment
project from the different viewpoints as follows (Rehber 1998).
i. Technical evaluation
ii. Financial analysis
iii. Economic analysis
iv. Risk, uncertainty and sensitivity analysis
In this article, the special importance has been given on the financial analysis while giving a brief
explanation about others, at least what their means are.
1
Prof. Dr., Uludag University, Faculty of Agriculture, Department of Agricultural Economics, Bursa, Turkey
(Presently a self employed economist and author, rehber@erekonomi.com; www.erekonomi.com)
amount of inputs. The other criteria are rather important from the economic and social point of
views in choosing technology such as, employment creation.
An appropriate technical evaluation has to focus on especially the mentioned tasks above.
However, technical evaluation also concerns with the other technical aspects of the project
framework such as, location of processing unit, marketing condition (transportation facilities,
availability of required raw material etc.), choosing of capacity and so on. In practice, some of the
well-prepared investment projects have been unsuccessful, because of the misleading or wrong
evaluation of location and market conditions.
3. Financial Analysis:
The financial analysis deals primarily with earning considerations of a project (Gittinger
1972). It is concerned with whether the project will able to secure the funds it will need and be able
to repay and whether the project can be financially viable or profitable. Financial analysis is
concerning with commercial or private profitability from the firm’s economic viewpoint. Therefore,
financial analysis is useful to investor who is interested in financing and for entrepreneur who owns
the project.
In financial analysis, we are going to calculate some measures to determine profitability and
repayment capability of the projects. These measures are based on the estimated costs and benefits
of the projects and so-called financial cost-benefit analysis.
On the other hand, testing of the reliability of the basic figures, the quantities and prices of
inputs and outputs are very important in financial analysis.
The project worth can be estimated by two groups of criteria:
i. Non-discounted measures of the project worth (Those do not take in to consideration the
time value of money and economic life of the project)
ii. Discounted cash flow measures (Those take in to consideration time value of money
and economic life of the project).
In this chapter we do not illustrate the non-discounted measures of the project worth, (pay
back method, simple rate of return), but only explain the widely used discounted measures of the
project worth taking a hypothetical example of an investment project.
Before illustrating mentioned measures (criteria), it will be necessary to explain some basic
concepts such as, time value of money, inflation and project evaluation, cost of capital, economic life
of the project, cash flow and cash flow table.
We can formulate this explanation, assuming the beginning worth as C0 and interest rate as r,
The worth, at the end of the first year C1 = C0 + C0. r = C0 (1+r) (i)
The worth end of the second year C2 = C1 + C1. r = C1 (1+r) (ii)
The worth end of the third year C3 = C2 + C2. r = C2 (1+r) (iii)
2
If we rewrite (iii) based on C0, and take q = 1+f we obtain,
C3 = C2. q3
Putting it in general form (for n years), we have;
Cn = C0 . qn (iv),
This is the compounding formula. The reverse of (iv);
C0 = Cn. 1 / qn (v)
(v) is called as the discounting formula. Then we call 1 / qn as the discounting factor. When the
cost and benefit streams would be equal, another discounting factors (qn-1) / (r. qn) could be used to
discount (n) number of equal values. These discounting factors for different periods and interest
rates were calculated and published (Neebe and Hyslop 1971).
3
determining the economic life is the technical life of the major investment item. Especially in an
industrial project, the economic life of a major investment item is shorter than its technical life
because of the obsolescence.
On the other hand, economic life can be called as the term that the project no longer pays to
operate it, making such repair and replacements are necessary (Little and Mirrles 1976). In
practice, generally 20-30 years are accepted as economic life, because in application of
discounted cash flow measures, any returns beyond about 20-30 years, probably will make no
difference in evaluating and ranking of alternative projects concerning with the given discount
rate.
3.5. Cash flows and derivation of the cash flow table
Discounted measures of the project worth are based upon the cash flow table which consists of
investment and operating costs as outflows, gross benefits as inflows, covering the whole
economic life of the project. As an illustrative example, table 1 is given, for the applications of the
criteria.
Table 1. Cash Flows of The Hypothetical Investment Project (Thousand US dollars)
Item Years
0 1 2 3 4 5-20
1. Investments 1 000.0 2 550.0 - - - -
2. Operating Costs - - 2 200.0 2 200.0 2 200.0 2 300.0
3. Gross Benefits - - 2 950.0 3 000.0 3 200.0 3 400.0
(i.e. Gross Sales)
4. Net Benefits (Net cash -1 000.0 -2 550.0 750.0 800.0 1 000.0 1 100.0
Flows) 3-(1+2)
Specifically, to compute the cash flow we do not add to operating costs any allowance for
depreciation nor any allowance for interest on the investment capital employed.
On the other hand, income and other taxes (sale tax, etc.) must be deducted from the net cash
flows or gross benefits for the financial analysis. Hence, taxes are costs just like any other
expenditure. Let’s illustrate now, three common criteria ; net present value, cost-benefit ratio,
and internal rate of return with application to the our hypothetical project.
4
Table 2. Illustrating Computation of Net Present Value (Thousand US dollars)
Year Net Cash Flow (1) Discount factor (2) Discounted Value (1x2)
0 -1 000.0 1.000 -1 000.0
1 -2 550.0 .800 -2 040.0
2 750.0 .640 480.0
3 800.0 .512 409.6
4 1 000.0 .410 410.0
5-20 1 100.0 (.410) 3.887 * 1 753.0
Total 12.6
th th
* Because of the amounts from 5 to 20 year are equal, a single discount factor (1+0.25)16-
1/0.25(1+0.25)16 was used discounting these amounts to the end of forth year. And, then this amount was
discounted again to present.
n
Bt / q t
t 0
B/C n
where Ct is the costs, and Bt ,the benefits.
Ct / qt
t 0
To illustrate calculation of the B/C ratio of our project the costs and benefits in table.1 were
transferred in table.3. For calculation, we must first discount each stream in order to find its present
value. This discounting procedure was presented in table 3. Dividing the present value of the gross
benefits by present value of the total costs we found the Benefit-Cost Ratio as 1.0001 ((10 154.4) /
(10 141.8) =1.001)
5
Table 4. Illustrating Computation of IRR (Thousand US Dollars)
Year Net Cash Flows Discount Factor Present Value
(1) (%26) (2) (1x2)
Net present value of our project was 12 600 dollars with a discount rate of 25 percent. Using a
discount rate of 26 percent, present value became negative (- 117 100). The IRR is thus between 25
and 26. To determine the precise rate of return, we interpolate between 25 and 26 percent, as
follows.
NPV at 25 percent = + 12 600 dollars
NPV at 26 percent = - 117 100 “
26 % IRR 25 %
6
If we take in to consideration only B-C ratio, it must be equal or more than one for acceptance.
When a single project is being evaluated, internal rate of return of it should exceed the cost of
capital. If a project has an equal or higher internal rate of return than the capital cost, project can be
acceptable for all tree criteria, because the IRR is a rate, which just makes the net present value of
the project equal to zero and B-C ratio equal to one.
In the case of alternative project are available, projects having an internal rate of return above
the opportunity cost of capital can be acceptable. In addition, they could be ranked in order of the
value of internal rate of return (The lowest one is termed the "cutoff rate"). But in the case of
mutually exclusive projects, direct comparison of IRR can lead to wrong investment choice. This
misleading evaluation can be avoided either by discounting the differences in the net cash flows of
alternative projects or by using NPV criterion.
4. Economic Analysis
In economic analysis of any project, we are interested in the merits of the project to the whole
society or national economy regardless of who is in the society realizing it. Therefore, economic
analysis called as social cost-benefit analysis. While the main criterion is commercial profitability in
financial analysis, economic analysis is rather concerned social profitability and the economic merits
of the project such as, the removal of poverty, the promotion of growth and the reduction of
inequalities in income distribution etc.
The easiest way to understand social cost-benefit analysis is to examine the differences between
economic and financial analysis. Main differences between them can be summarized as follows
(Rehber 1998).
i. In economic analysis, certain prices must be changed to reflect better true social and economic
values, while in financial analysis current market prices are used to estimate cost and benefits.
Especially in developing countries, market prices do not reflect the real value of the commodities in
national economy, because of some reasons such as, intervention to market,
underemployment of resources etc. Therefore in economic analysis `shadow` or `accounting` prices
must be used.
ii. Some cost and profit items could not be evaluated as real costs and profits from the economic
viewpoint. For instance, in financial analysis market prices including taxes and subsidies are always
used. In economic analysis, taxes and subsidies are treated as transfer payment. A subsidy as a cost
and taxes as a benefit to a society must be included to costs and profits of project in economic
analysis.
On the other hand, external effects should be taken in to consideration in economic analysis,
such as, environment pollution, education and demonstration effects etc. However, it is not easy
to put out some of these externalities in quantitative terms.
iii. In economic analysis, social rate of discount must be used instead of discount rate using in
financial analysis. Social rate of discount which reflects social time preferences and social
opportunity cost, is really different from the discount rate reflecting private time preference and
interest rates.
In economic analysis all discounted measures of project worth can be used after adjusting
project costs and benefits according to the differences mentioned above.
But especially in developing countries, it is not easy to find appropriate data for calculation of
shadow prices, social discount rate and externalities. Therefore some rather rough measures can
be used to indicate, the socio-economic merits of the projects, such as, value added , creation of
new employment facilities, substitution of import, promotion of export etc.
7
5. Risk, Uncertainty and Sensitivity Analysis
A project is based on some technical, financial and economic information. We are making some
predictions and estimations about yields, prices etc. These estimations and predictions may involve
some risk and uncertainty. In the cases possible outcomes can be characterized by numerical
probabilities is termed risk, and the cases probability distribution of the various outcomes is not
known is termed uncertainty (Dasgupta and Pearce 1981).
For a food processing project, for instance, variation in the production of main raw material
can be shown as a sample of risk, probability of the technological changes in the economic life of
the project is a sample of uncertain circumstances. The techniques for dealing with risk and
uncertainty in financial and economic analysis are relatively sophisticated.
On the other hand, in practice, some simple approaches are used which provide some figures
showing how a project responds to changing conditions. The way of taking expected probable
changes in to consideration is named as sensitivity analysis. For instance,
i. Adding a risk premium to the discount rate in calculating present value,
ii. Raising some cost items, reducing some items of benefits that appear to be uncertain by a
certain percentage,
iii. Using a project life less than the formal life, could be considered the ways of sensitivity
analysis.
References
Daggupta, A. K. and D. W. Pearce, 1981, Cost-Benefit Analysis: Theory and Practice, The Macmillan
Press Ltd. London 1981.p.163.
Frey, T. L., 1976, Time Value of Money and Investment Analysis; Explanation with Application to
Agriculture. Dept. of Agri. Econ. University of Illinois, AET. 15-76.p.l
Gittinger, P., 1972, Economic Analysis of Agricultural Project, the Johns Hopkins University Press,
Baltimore and London.
Gruebele, J. W., and T. L. Frey, 1976, Evaluating Investment Decisions of Agribusiness Firms,
University of Illinois, College of Agri.Circular 1127, Urbana Illinois, p.4.
Little, M. D., J. A. Mirrles, 1976, Project Appraisal and Planning For Developing Countries,
Heinemann Educational Books, London p.7.
Lumby, S., 1991, Investment Appraisal and Financing Decisions, A First Course in Financial
Management, Forth Edition, Chapman & Hall, 517 p.
Neebe, N. J. and J. D. Hyslop, 1971, Compound Interest and Discount Factor Tables for Use in Capital
Project Analysis, US.Dept.of Agri.Co-operating with Us.Agency for International Development,
71pp.
Rehber, E., 1998, Project Preparation and Appraisal (Proje Hazirlama Teknigi), IV. Edition,
Publications of Ankara University: 1496, Textbook: 451, Ankara, 93 p.
Solberg, B., 1978, Decision Criteria Regarding Choice of Technology in Development Projects. Eight
World Forestry Congress Jakarta, 1978.p.2-3
Squire, L., H. G. Van Der Tak, 1975, Economic Analysis of Projects, World Bank, the J. Hopkins
University Press, 153 p
Prefered Citation:
REHBER, E., Financal Analysis of the Investment Projects, UEA (In: Guidelines for the
Emerging Economies: Univesity for Economic Activities, Warsaw, Poland), 1999. pp.
137-150