Unit 4 Project

OROMIA STATE UNIVERSITY
Advanced Project Management
for LCM (PG students)

UNIT FOUR
FINANCIAL AND ECONOMIC ANALYSIS

 Financial Analysis
FINANCIAL AND ECONOMIC Economic Analysis (Feasibility)
ANALYSIS
Financial Analysis ?
Financial Analysis Economic Analysis
• Cost of Project
• Production costs • Difference b/n FA & EA
• Estimation of Sales and • Social-Cost Benefit Analysis
Production • UNIDO Approach
• Estimation of Material s Costs
• Little-Miracles (L–M)
• Estimation of Labor Costs
• Estimation of Factory Overhead
Approach
costs
• Estimating Administrative, Selling
and Other Costs
• Estimating Project Cash Flows
• Project Evaluation Techniques
ANALYSIS
Financial Analysis (FAs) ?

Financial analysis requires;
 The determination of project costs
 The estimation of cost of production and other expenses
 The estimation of project net cash flows, and
 The evaluation of the desirability of the project using

various criteria.
ANALYSIS
Project Cost ?
The cost of project represents the total of all items of outlay associated
with a project which are supported by long-term funds.
It is the sum of the outlays on the following:
• Land and site development,
• Building and civil works,
• Plant and machinery,
• Technical know-how and engineering fees,
• Expenses on foreign technicians and training local technicians abroad,
• Miscellaneous fixed assets,
• Pre-operative expenses,
• Margin money for working capital and Initial cash losses.
ANALYSIS
Production Costs ?
There are three major categories of manufacturing costs. These are;
i. Direct materials cost:
 The acquisition costs of all materials that are identified as part of the cost object
and that may be traced to the cost object in an economically feasible way.
 Acquisition costs of direct materials include inward delivery charges, tax,

and custom duties.
 Direct material often does not include minor items such as glue or tacks.
Why? Such items are called supplies or indirect materials and are
classified as part of the indirect manufacturing costs.
ANALYSIS
Production Costs ?
ii. Direct labor
• The compensation of all labor that can be identified in an economically
feasible way with a cost object.
Examples are the labor of machine operators and assembler.
iii. Indirect manufacturing costs (manufacturing overhead).

• All manufacturing costs that cannot be identified specifically with or
traced to the cost object in an economically feasible way.
• Other terms used are factory overhead, factory burden, manufacturing
overhead, and manufacturing expenses. Examples of factory overhead (when
products are cost object) include power, supplies, indirect labor, factory rent,
insurance, property taxes, and depreciation.
ANALYSIS
Estimates of Sales and Production?

A) ESTIMATING SALES
The sales forecast is the starting point for the projections of
profitability.
In estimating sales revenues, the following should be taken into
account:
• Economic level (activities)
• The project’s probable market share in each distribution territory
• Competitor’s and their capacities
• Pricing strategies
• The effect of inflation on prices
• Advertising campaigns, promotional discounts, and credit terms.
ANALYSIS
Estimates of Sales and Production ?

B) ESTIMATING PRODUCTION
• Once sales projections are made, the next step is production estimates.
• Production may be estimated as :
• Production = Sales + Desired Ending Inventory – Beginning Finished Goods
Inventory
• For the first year of operation, there is no beginning inventory.
• To illustrate, assume that the sales are projected to be 100,000 units in the first
year although the capacity is 180,000 units.
• It is estimated that there should be finished goods inventory of 5000 units on
hand at the end of the first year.
• Estimated production would be:
• Production = 100,000 + 5000 – 0 = 105,000 units
• Similar approach can be followed for a period of more than one year.
ANALYSIS

• To illustrate, assume that Addis Company has set the policy of maintaining finished
goods inventory of 10,000 units at the end of each year installed plant capacity is
estimated to be 300,000 per year. It is estimated that the project will operate at 50% in
year 1 and 60% year 2 and full capacity from year 3 to year 5.
• Annual production is computed as follows:.
Year 1 2 3 4 5
Installed 300000 300000 300000 300000 300000
capacity
Capacity 50% 60% 100% 100% 100%
Utilization
Production 150000 180000 300000 300000 300000
ANALYSIS

• Based on production estimates and ending finished goods inventory policy, sales
revenue projections can be that a unit of output is expected to be gold at Br. 160.
Revenue budget is prepared as follows:
Years
1 2 3 4 5
Production 150000 180000 300000 300000 300000
Desire Ending 10000 10000 10000 10000 10000
Inventory
Sold 140000 170000 290000 290000 290000
Expected 160 160 160 160 160
Price/Unit
Total Sale 22,400,000 27,200,000 46,400,000 46,400,000 46,400,000
Revenue
ANALYSIS
Estimation of Material Costs ?

• The costs of materials include the cost of raw materials, chemicals, components, and
consumable stores required for production. The following should be considered in
estimating the cost of materials
Years
Production 150,000 180,000 300,000 300,000 300,000
Material required per unit of 3 3 3 3 3
output
Total requirements 450,000 540,000 900,000 900,000 900,000
Unit cost 5 5 5 5 5
Total cost of material before 2,250,000 2,700,000 4,500,000 4,500,000 4,500,000
contingency
Contingency (2%) 45,000 54,000 90,000 90,000 90,000
Total cost of material 2,295,000 2,754,000 4,590,000 4,590,000 4,590,000
ANALYSIS
Estimating Labor Costs ?

• Labor cost is a function of the number of employees and the rate of payment.
• Example; assume that 3 hours of direct labor are required to produce one unit of output.
• It is estimated that direct labor cost/hour is Br. 20 and is expected to increase at the rate of
5% annually. Accordingly, direct labor cost is estimated as follows:
Years
1 2 3 4 5
Production 150,000 180,000 300,000 300,000 300,000

Labor hour/unit Q 3 3 3 3 3
TotalL.hrs required 450,000 540,000 900,000 900,000 900,000

Labor rate/hour 20 21 22.05 23.15 24.31
Total cost of labor 9,000,000 11,340,000 19,845,000 20,835,000 21,879,000
ANALYSIS
Computation of unit cost ?

Direct Material Direct Factory
Year Costs labor cost overhead Total Production Unit cost
costs
1 5,355,000 9,000,000 5,400,000 19,755,000 150,000 131.70
2 6,426,000 11,340,000 6,804,000 24,570,000 180,000 136.50
3 10,710,000 19,845,000 11,907,000 42,462,000 300,000 141.54
4 10,710,000 20,835,000 12,501,000 44,046,000 300,000 146.82
5 10,710,000 21,879,000 13,127,400 45,716,400 300,000 152.39

ANALYSIS
Estimated Cost of Ending Inventory ?

• Once unit cost is determined, the cost of ending inventory and cost of goods
sold can be computed
Year
1 2 3 4 5
Desired ending 10,000 10,000 10,000 10,000 10,000
inventory
Unit cost 131.70 136.50 141.54 146.82 152.39
Cost of ending 1,317,000 1,365,000 1,415,400 1,468,200 1,523,900

Inventory
ANALYSIS
Estimated Cost of Goods Sold ?

Year
1 2 3 4 5
Cost of production 19,755,000 24,570,000 42,462,000 44,046,000 45,716,400
Add: Beg. Finished - 1,317,000 1,365,000 1,415,400 1,468,200

Goods inventory
Available for sale 19,755,000 25,887,000 43,827,000 45,461,400 47,184,400
Ded: Ending Finished 1,317,000 1,365,000 1,415,400 1,468,200 1,523,900

Goods inventory
Cost of goods sold 18,438,000 24,522,000 42,411,600 43,993,200 45,660,500

ANALYSIS
?
Estimating Administrative, Selling, and Other Costs
• Administrative, general, selling and other costs should be estimated in
order to prepare projected income statements. To prepare the projected
income statement, based on the foregoing illustration,
• a) Administrative and general expenses, including depreciation of Br.
100,000 per year are estimated at Br. 500,000 in year 1 and expected to
increase by Br. 10,000 thereafter.
• b) Selling expenses, including depreciation of Br. 60,000 per year are
estimated at Br. 400,000 in year 1 and year 2 and are expected to be Br.
420,000 thereafter.
• c) The project will be financed fully by equity.
• d) Income tax rate is 30% after two years
• Accordingly, the projected income statement is prepared as follows:
ANALYSIS
?
• Net Income after tax= Sales Revenue – (Cost of Good sold + Administrative & general
cost + Selling cost + total expenses +Depreciation + tax )
Year
1 2 3 4 5
Sales 22,400,000 27,200,000 46,400,000 46,400,000 46,400,000
Cost of goods sold 18,438,000 24,522,000 42,411,600 43,993,200 45,660,500
Gross profit 3,962,000 2,678,000 3,988,400 2,406,800 739,500

ANALYSIS
?
• .
Expenses:
Administrative & General 500,000 510,000 520,000 530,000 540,000

costs
Selling 400,000 400,000 420,000 420,000 420,000
Total expenses 900,000 910,000 940,000 950,000 960,000
Earnings before taxes 3,062,000 1,768,000 3,048,400 1,456,800 (220,500)
Taxes (30%) - - 914,520 437,040 -
Net income 3062,000 1,768,000 2,133,880 1,019,760 (220,500)

ANALYSIS
Determination of Project Net Cash Flows ?

• .
After tax cash = Net income + Non-cash expenses + Interest (1-tax rate)
Year
1 2 3 4 5
Items
Net income 3,062,000 1,768,000 2,133,880 1,019,760 (220,500)

Add: Depreciation 160,000 160,000 160,000 160,000 160,000
Salvage proceeds - - - - 80,000
Recovery in Net - - - - 100,000
Working capital
After tax cash flows 3,220,000 1,928,000 2,293,880 1,179,760 119,500

ANALYSIS
Financial Evaluation criteria ?

• The objective of Financial Analysis is to ascertain whether the proposed
project is :
• Financially viable (able to meet the burden of servicing debt) &
• Satisfy the return expectations
• Therefore, a financial manager must be able to decide whether a project is

worth undertaking and be able to choose intelligently between two or
more alternatives
• To do this, a sound procedure to evaluate, compare, and select projects is

needed. This procedure is called capital budgeting.
ANALYSIS

• Capital budgeting is the process of evaluating and selecting long-
term investments that are consistent with the firm’s goal of
maximizing owner wealth.
The most common capital budgeting techniques:
1. Non-discounting (traditional) criteria
 Payback Period (PBP)
 Accounting Rate of Return (ARR)
2. Discounted Cash Flows (DCF) criteria
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Profitability Index (Benefit-cost ratio)
ANALYSIS

Non-discounting (traditional) criteria
• i) Payback Period (PBP)
• Payback period refers to the length of time it takes to recover initial
investment of the project.
• a) When cash flow is in annuity form

• Annuity refers to equal amount of cash flows that occur every period over
the life of the project.
• PBP =Initial Investment/Annual net Cash Flows

ANALYSIS

• 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?
• PBP =24,000/6000 = 4 years
• It is expected to take the company four years to recover the

project’s initial investment of Br. 24,000
ANALYSIS

b) When cash flows are not in annuity form
• 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.
• 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
ANALYSIS

The payback period is computed as follows:
 PBP = 3 years + 15,000/20,000 = 3.75 years
Or
PBP = 3 years + (15,000/20,000)(12 months)
= 3 years and 9 months
Decision Rule for Payback Period
 Accept the project if its PBP is less than or equal to the required
PBP(standard)
 Reject the project if its PBP exceeds the required PBP.
 The shorter the payback period, the more desirable the project.
ANALYSIS

ii. Accounting Rate of Return (ARR)
 Also called the average rate of return on investment, it
measures of profitability which relates net income to
investment.
 Although there are several methods of computing ARR, the
most common method is:
 ARR = Average Annual net income
Average investment
 Average Investment = Original cost + Salvage value

2
ANALYSIS

• To illustrate, assume that a project has original investment of
Br. 70,000, life of 4 years, and salvage value of Br. 6000.
Straight-line method of depreciation is used. Income before
depreciation and taxes for each of the four years are as
follows: year 1, Br. 40,000; year 2, Br. 42,000; year 3, Br. 36,000;
and year 4, Br. 50,000. Income tax rate is 40%.
• Solution
• Depreciation = 70,000 – 6000 = 16,000
• 4
• From Each year receipt 16,000 of depreciation and (40%) of the income
after depreciation will be also deducted
ANALYSIS

 Net income after depreciation and tax.
Year
1 2 3 4
Income 40,000 42,000 36,000 50,000
Less Dep. 16,000 16,000 16,000 16,000
Income before tax 24,000 26,800 20,000 34,000
Less tax (40% ) 9,600 10,400 8,000 13,600
Net Income 14,400 15,600 12,000 20.400

ANALYSIS

14,400+15,600+12,000+20,400
 Average Net Income = = 15,600
4

70,000+6000
 Average Investment = = 38,000
2
15,600
 ARR= = 41%
38,000
 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
ANALYSIS

II) Discounting techniques
A) Net Present Value Method (NPV)
• The net present value of project is the difference between the
present value of net cash inflows and present value of initial
investment.
• NPV = Present value of cash inflows – Initial investment
• Decision criteria:
• If the NPV is greater than $0, accept the project.
• If the NPV is less than $0, reject the project.
• If the NPV is greater than $0, the firm will earn a return
greater than its cost of capital.
ANALYSIS

In formula, if the cash flow is not in annuity form,
n CFt
NPV   I
t  0 (1  k) t
In case of annuity(ordinary annuity), the NPV,
NPV = PV of NCF – I0
PV of NCF =
ANALYSIS

• 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%.
Net present value is determined as follows:
• NPV = PV of NCF – I0
• = 12,000 (3.791) – 40,000
• = 45,492 – 40,000 = 5492
Accept the project
ANALYSIS

 To illustrate, assume that a project is expected to have initial
 Not annuity
 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. If the required rate of
return is 10%, NPV is determined as follows:
ANALYSIS

 Year NCF DF(10%) PV
 1 10,000 0.909 9090
 2 8000 0.826 6608
 3 15,000 0.751 11,265
 4 12,000 0.683 8196
 Present value of NCF 35,159
 Less: Initial investment 30,000
 NPV + 5159
10000 8000 15000 12000
 Or NPV= 1 + 2 + 3 + 4 − 30000 = +5159
1.1 1.1 1.1 1.1
 What does NPV represent? NPV represents the amount by which the value
ANALYSIS

B) 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.
 PI, method compares the present value of future cash inflows
with the initial project on a relative basis.
 PV of Cash Flows 
PI  
 Initial Investment 
ANALYSIS

• In the application of PI, a project is accepted if PI > 1, rejected if PI <
1 and we remain indifferent if PI = 1.
• It should be noted that when PI > 1, NPV is positive; PI < 1, NPV is
negative and PI=1 when NPV is zero.
• Example
After tax cash flows of a small scale tannery project is given below.
Find the profitability index if discount rate is assumed to be 12%?
•
ANALYSIS

Solution
ANALYSIS

C) 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.
 IRR is determined using trial and error: the complexity of
determining IRR is greater if net cash flows are not in
annuity form.
ANALYSIS

 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.
 Step1: Compute the leading discount factor (using payback
period)
 PBP = Initial Investment/Annual NCF = 3.333
ANALYSIS

 Step 2. From the PV of annuity table, find two discount
factors and their corresponding interest rates closest to the
computed leading discount factor.
 If we look in the PV of annuity table on n = 5 years row
(horizontally), the leading discount factor (3.333) is found
between 15% and 16%.
 Interest rate 15% 16%
 Discount factor 3.352 3.274
ANALYSIS

 Step 3: Compute the actual IRR using the following formula
 IRR = r – ( PBP – DFr )
( DFrL - DFrH )
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
ANALYSIS

 Let's take r = 15%, IRR is determined as follows:
 IRR = 15% - (3.333- 3.352)
 (3.352- 3.274)
 = 15% - (-0.24)
 = 15.24%
 If we take r = 16%, the computation of IRR looks like the
following:
 IRR = 16% - (3.333- 3.274)
(3.352- 3.274)
 = 15.24%
ANALYSIS

b) Determination of IRR when net cash flows are non-annuity
 At the beginning to determine the weighted average net cash flow, - used to determine
the leading discount factor.
 To illustrate, assume that a project has initial investment of Br. 40,000 and the following
net cash flows:Yr.1, Br. 15,000; Yr. 2, Br. 10,000; Yr. 3, Br. 10,000; Yr. 4, Br. 15000; and Yr.
5, Br. 15,000. The discount rate is 15%.
 Step 1. Compute the weighted average net cash flows.
 Year Net cash flows Weight NCF X weight
 1 15,000 5 75,000
 2 10,000 4 40,000
 3 10,000 3 30,000
 4 15,000 2 30,000
 5 15,000 1 15,000
 Total 15 190,000
ANALYSIS

b) Step 2: Compute the leading discount factor (PBP)
• PBP = initial Iv’t/Weighted Average
• = 40,000/12,667 = 3.158
• Step 3: From the present value of annuity table, find the

starting rate (a good 1st guess) by looking for the closest
interest rate and discount factor. In this case, the nearest rate is
18%.
ANALYSIS

 Step 4: Compute NPV at the 1st guess (18%) NPV (18%)
 Year NCF Discount factor (18%) PV
 1 15,000 0.847 12,705
 2 10,000 0.718 7180
 3 10,000 0.609 6090
 4 15,000 0.516 7740
 5 15,000 0.437 6555
 Present value of net cash flows 40,270
 Less: Initial Investment 40,000
 NPV + 270
Since, at IRR, NPV is equal to zero, 18% is not the exact IRR.
 Thus, another rate should be tried. Which rate should be tried next?
ANALYSIS

• Generally as we go down (in rate decreasing direction), discount factor increases. Now
we need to find a rate at which NPV = 0. Thus, we should try a higher rate. The next
(2nd) guess could be 19%. Then NPV should be computed at 19% using the above
procedure.
NPV at 19%:
 Year NCF Discount factor (19%) PV
 1 15,000 0.840 12,600
 2 10,000 0.706 7060
 3 10,000 0.593 5930
 4 15,000 0.499 7485
 5 15,000 0.419 6285
 Present value of net cash flows 39,360
 Less: Initial investment 40,000
 NPV -640
ANALYSIS

• At 19% NPV is negative, this implies that IRR lies between 18% and 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
 Step 5: Divided the NPV of the smaller rate by the absolute sum and add to the smaller
rate
 IRR = 18% + 270/910
 = 18.30%
 Decision Rule for IRR
 Accept: If the IRR is greater than the discount rate
 Reject: If the IRR is less than the discount rate
Financial Analysis
FINANCIAL AND ECONOMIC  Economic Analysis (Feasibility)
ANALYSIS
Economic Analysis ?
• Economic (social cost benefit) analysis is a methodology for
evaluating projects from the social point of view.
Economic Analysis (EA) Vs. Financial Analysis (FA)
 FA focuses on monetary costs and benefits of the project whereas
 EA focuses on the social costs and benefits of the project.
 The major sources of discrepancies B/n (FA & EA) are market
imperfections, externalities, taxes, concern for saving and income
redistribution, and merit and demerit goods.
Financial Analysis
ANALYSIS
Economic Analysis ?
i) Market imperfections
 In computing the monetary costs and benefits, market prices are the
base.
 When imperfections exist, market prices do not show social values.
The common market imperfections are:
 Rationing – The control of the prices and distribution of
commodities. The price paid by the consumer is less than the
market price that would prevail in a competitive market.
 Prescription of minimum wage rates
 Foreign exchange regulation – the official exchange rate is less than

the rate that would prevail in the absence of foreign regulations.
Financial Analysis
ANALYSIS
Economic Analysis ?
iii) Externalities
 Externalities refer to the external benefits or costs that the project
creates and for which the users do not pay or get compensation.
 For example, a project may create infrastructure facilities like roads.
These roads benefit the neighboring areas.
 A project may have harmful external effects like pollution, the cost of
which is relevant in economic whereas it is irrelevant in commercial profitability.
 FA ignores such benefits/costs in assessing the project because the owners of
the project do not receive any monetary compensation from those who enjoy
this external benefits created by the project and vise versa.
 However, in economic analysis, all costs and benefits of the project are
relevant irrespective of whom they accrue and whether they are paid for
or not.
Financial Analysis
ANALYSIS
Economic Analysis ?
iii) Taxes and Subsidies
 From FA point of view, taxes are definite monetary costs and subsidies are
definite monetary gains.
 From the social point of view, they are generally regarded as transfer
payments. They are irrelevant for economic analysis.
iv) Concern for savings
 Private investments do not put differential valuation on savings and consumption.
 From social point of view, it is generally believed that a Birr benefit saved is
deemed to have more value than a Birr benefit consumed. This means a
higher valuation is placed on savings and a lower valuation is put on
consumption.
 Thus, economic analysis of the project reflects the concern of the society for
savings as well as investments.
Financial Analysis
ANALYSIS
Economic Analysis ?
V) Concern for Redistribution
 A private firm does not bother how its benefits of the project are distributed across
various groups.
 However, the society is concerned. This is based on the assumption that “a Birr of
benefit going to an economically poor section is considered more valuable than it goes
to an affluent (rich) section of the society”.
 Thus, EA is concerned with the redistribution.
VI) Merit wants
 Merit wants refer to goals and preferences that are not expressed in the market place.
 These goals and preferences are believed by policymakers to be in the larger interest.
 E.g, the government may prefer to promote girls/adult education, nutrition program.
 Merit wants are not relevant from the private point of view. But they are important
from the social point of view.
Financial Analysis
ANALYSIS
Approaches to Economic Analysis?

 There are two approaches to economic analysis. These are:
 UNIDO Approach
 The Diamond Little-Mirrlees (L–M) Approach
Financial Analysis
ANALYSIS
UNIDO Approach ?
1. UNIDO Approach
 The (UNIDO) method of the project appraisal involves five stages. These
are:
i. Calculation of the financial feasibility of the project measured at market
prices (Financial Analysis of the Project).
ii. Obtaining the net benefits of the project in terms of economic
(efficiency) prices.
iii. Adjustment for the impact of the project on savings and investments.
iv. Adjustment for the impact of the project on income redistribution.
v. Adjustment for the impact of the project on merit goods and demerit
goods whose social values differ from their economic values.
Financial Analysis
ANALYSIS
UNIDO Approach ?
 Stage 2. Net Benefit in terms of Economic (Efficiency) Prices
• Stage two of the UNIDO approach is concerned with the determination of
the net benefit of the project in terms of Economic Efficiency Prices, also
referred to as Shadow Prices.
• Shadow prices are defined as the value of the contribution to the country’s
basic socio economic objectives made by any marginal change in the
availability of commodities or factors of production.
• In perfect markets, market prices represent shadow prices.
• But when there is market imperfection, market prices do not represent
shadow prices and hence there is a need to develop shadow prices.
Financial Analysis
ANALYSIS
UNIDO Approach ?
a) Choice of Numeraire
Numeraire refers to the unit of account in which the value of inputs or outputs is
expressed.
To define Numeraire, the following questions have to be answered.
1. What unit of currency (domestic or foreign) should be used to express benefits and
costs?
2. Should costs and benefits be measured in current values or constant values?
3. With references to which point (present or future) should costs and benefits be
evaluated?
4. What use (consumption or investment) will be made of the income from the
project?
5. Should income of the project be measured in terms of consumption or investment?
6. With reference to which group should the income of the project be measured?
Financial Analysis
ANALYSIS
UNIDO Approach ?
b) Concepts of Tradability
 Whether a good is tradable or not is the key issue in shadow pricing.
 The international price is a measure of its opportunity cost to the

country for tradable goods.
 For tradable goods, it is possible to substitute import for domestic
production and vice versa.
 Likewise, it is possible to substitute export for domestic consumption and

vice versa.
 Thus, the international price (also called the border price) represents the
real value of the goods in terms of economic efficiency.
Financial Analysis
ANALYSIS
UNIDO Approach ?
C) Sources of shadow prices
 According to UNIDO, there are three sources of shadowing pricing;
namely,
i. Consumer willingness to pay – used if the impact of the project is on

consumption in the economy
ii. Cost of production – used if the impact of the project is on production in
the economy.
iii. Foreign exchange value – used if the impact of the project is on

international trade. (The project may increase/decrease imports or exports).
Financial Analysis
ANALYSIS
UNIDO Approach ?
D) Taxes
When shadow prices are being calculated, taxes usually pose difficulties.
With respect to taxes, UNIDO’s guidelines are as follows:
 Include taxes in shadow pricing – when a project results in diversion of
non-traded inputs, which are in fixed, supply from other producers or addition
to non-traded consumer goods.
 Exclude taxes from shadow pricing – when a project augments domestic

production by other producers. Taxes should also be excluded from
shadow pricing for fully traded goods.
Financial Analysis
ANALYSIS
UNIDO Approach ?
Shadow Pricing of Specific Resources
1. Shadow pricing for tradable inputs and outputs
A good is fully traded

- when an increase in its consumption results in a corresponding increase
in import or decrease in export or
- when an increase production results in a corresponding increase in export

or decrease in import.
 For such goods, shadow pricing is the border (international)
price translated into domestic currency at the market
exchange rate.
Financial Analysis
ANALYSIS
UNIDO Approach ?
2. Shadow pricing for non-tradable inputs and outputs
A good is said to be non tradable when:

 Its import price (cost-Insurance-Freight ) is greater than its domestic cost
of production.
 Its export price (Free-on-board price) is less than its domestic cost of
production.
What then is the value of non-tradable goods?

Financial Analysis
ANALYSIS
UNIDO Approach ?
i) On the output side:
 If the impact of the project is to increase the consumption of the product
in the economy, the measure of value is the marginal consumers’
willingness to pay.
 If the impact of the project is to substitute other production of the same
non-tradable in the economy, the measure of value is the saving in cost
of production.
ii) On the input side :
 If the impact of the project is to reduce the availability of inputs to other
users, their willingness to pay for that input represents social value.
 If the projects input requirement is met by additional production of it,
the production cost of it is the measure of social value.
Financial Analysis
ANALYSIS
UNIDO Approach ?
3. Shadow pricing for externalities
 Externalities are special classes of goods.
The values of externalities are estimated by indirect means.
Generally, it is not easier to measure external effects (or externalities).

Due to this, some argue that these external effects should be ignored.
Other suggested should be taken into consideration whenever it is possible
to do so.
Although these effects cannot be measured in monetary terms, some
qualitative evaluation must be attempted
Financial Analysis
ANALYSIS
UNIDO Approach ?
4. Shadow pricing for labor inputs
Labor is considered to be a service. When a project uses a labor, it could
have three possible impacts on the rest of the economy:
 It may take labor away from other employment
 It may induce the production of new workers
 It may involve import of workers
When a project takes labor away from other, the shadow price of labor is equal
to what other users of labor are willing to pay for this labor.
The social cost associated with the import of foreign workers is the wage
they command.
Financial Analysis
ANALYSIS
UNIDO Approach ?
5. Shadow pricing for capital inputs (physical asset)
a) Financial resources are converted into physical assets
 The value (shadow price) of physical assets.
 If it is a fully traded good, - international price.
 For non-traded goods- The cost of production or consumer willingness to pay.
b) Financial resources are withdrawn from the national pool of savings and hence
alternative investments are foregone
 These financial resources involve opportunity cost.
 To the extent that it comes from additional savings, its opportunity cost is
measured by the consumption rate of interest.
 Or / comes from the denial of capital to alternative projects, - the rate of return
that would be earned from those alternative projects (the investment rate of
interest).
Financial Analysis
ANALYSIS
UNIDO Approach ?
6. Shadow pricing for foreign exchange
 According to UNIDO, the Numeraire is the domestic currency (Birr).
 Thus, the foreign exchange input of the project must be identified and
adjusted by an appropriate premium.
 The shadow price (value of unit of foreign exchange is equal to:
 ∑ Fi * Qi* Pi
 Fi = Fraction of foreign exchange, at the margin, spent on importing
commodity i.
 Qi = Quantity of commodity i that can be bought with one unit of
foreign exchange
 Qi=1/CIF C-cost, I-insurance F-fright
 Pi = Domestic market clearing price of commodity i.
Financial Analysis
ANALYSIS
UNIDO Approach ?
 To illustrate, the computation of the value of a unit of foreign exchange, assume
that commodity 1, commodity 2 and commodity 3 are imported at margin. The
proportion of foreign exchange spent on them, the quantities that can be bought
per unit of foreign exchange, and the domestic market clearing prices are as
follows:
 F1 = 0.4 F2 = 0.3 F3 = 0.3
 Q1 = 0.8 Q2 = 1.2 Q3 = 4
 P1 = 20 P2 = 10 P3 = 15
 The value of a unit of foreign exchange is computed :
 Value = (0.40 x 0.8 x 20) + (0.3 x 1.2 x 10) + (0.3 x 4 x 15) =Br. 28
 The above computation of shadow price is in terms of consumer willingness to
pay and is based on the assumption that the foreign exchange requirements of
the project are met from the sacrifice of others.
Financial Analysis
ANALYSIS
UNIDO Approach ?
 However, the use of foreign exchange by a project may also induce the
production of foreign exchange through additional exports or import
substitution.
 In such a case, the shadow price of foreign exchange would be based on

the cost of producing foreign exchange and not consumer willingness to
pay for foreign exchange.
Financial Analysis
ANALYSIS
UNIDO Approach ?
Stage3. Measurement of the Impact of Distribution
 This is concerned with measuring the value of the project in terms of its
contribution to income redistribution among various groups.
 Within the society, the project may results in a gain or loss to an

individual group.
 Gain or loss to an individual group on physical resources is the difference
between the shadow price and the market price of each input or output.
 For financial transactions, gain or loss is the difference between the price
paid and the value received.
Financial Analysis
ANALYSIS
UNIDO Approach ?
 To illustrate the computation of gain or loss, assume that Residents of
certain area use 600,000 cubic meter water provided by water project. The
benefit derived by the residents, measured in terms of the willingness to
pay, is equal to Br. 20 per cubic meter. The tariff paid by the residents to
the water authority is Br. 15 per cubic meter. What is the gain or loss by
the residents due to the project?
Gain = (20 – 15) x 600,000 = Br. 3,000,000

 The shadow price is Br. 20 and the market price is Br. 15. Since the
residents are required to pay less than the shadow price, thus gain from
the project.
Financial Analysis
ANALYSIS
UNIDO Approach ?
Stage 4. The saving impact of the project
 The scarcity of capital characterizes most of the developing countries which are
concerned with the impact of a project on savings and its value thereof. The
following questions should be answered:
 What is the impact of the project, given the income distribution impact?
 What is the value of such saving to the society?
The saving impact of the project is determined as follows:
 Saving = ∑ ∆y*MPSi
 where:
 ∆y = Chang in income of group i as a result of the project
 MPSi = Marginal propensity to save of group i.
Financial Analysis
ANALYSIS
UNIDO Approach ?
 To illustrate
 assume that the income gained or lost by three groups of the society as a
result of the project is shown below:
 Group 1 = Br. 600,000 Group 2 = Br. (200,000),
 Group 3 = Br. 400,000
MPS of the three groups is as follows =
 MPS1 = 0.20 MPS2 = 0.15 MPS = 0.30
What is the impact of the project on saving?
 The saving impact of the project is determined as follows:
 Saving = (600,000 x 0.20) + (-200,000 x 0.15) + (400,000 x 0.30)

= 120,000 – 30,000 + 120,000
Financial Analysis
ANALYSIS
UNIDO Approach ?
Stage 5. Adjustment for Merit and Demerit Goods
 A merit good is one for which the social value exceeds the
economic value.
 The best example of merit good could be oil, and creation of
employment.
 A higher social value may be placed over economic value on
production of oil by the country because it reduces dependence on
foreign suppliers.
 Demerit good is a good whose economic value exceeds social
value.
 Some of the best examples of demerit goods are tobacco products, and
Financial Analysis
ANALYSIS
UNIDO Approach ?
 In order to adjust, the following steps may be used:
Step1. Estimate the economic value of the project
Step2. Calculate the adjustment factor
Adjustment factor = (Social value/Economic Value) -1
 For merit goods, adjustment factor becomes positive.
 For demerit goods, the adjustment factor becomes negative.
 Multiply the economic value by the adjustment factor to obtain
adjustment
 Adjustment = Economic value x adjustment factor
 Compute the social value by adding adjustment to the economic value
 Social value = Economic value  Adjustment
Financial Analysis
ANALYSIS
UNIDO Approach ?
 To illustrate
 Assume that the present economic value of the project is Br. 5,000,000.
The output of the project is merit good and its social value exceeds its
economic value by 30%.
 Based on the above information, the adjustment factor is computed as
follows:
Adjustment factor = (130%/ 100%) - 1

= 1.30 - 1
= 30%
Financial Analysis
ANALYSIS
UNIDO Approach ?
 Adjustment for merit good is computed as follows:
 Adjustment = Economic value X adjustment factor
 = 5,000,000 X 0.30
 = 1,500,000
 Then social value is equal to the sum of economic value and adjustment
 Social value = 5,000,000 + 1,500,000 = 6,500,000
Financial Analysis
ANALYSIS
Little-Mirrlees (L – M) Approach ?
• I.M.D. Little and J.A Mirrlees have developed an approach to social cost benefit
analysis of the project. The UNIDO and L-M approaches have considerable
similarities between them. Some of the similarities are:
• The calculation of shadow (Accounting) prices

• The consideration the factor of equity
• the use of Discounted Cash Flow (DCF) analysis
• Although L-M approach and UNIDO approach are similar in some aspects, they
are not without differences.
Financial Analysis
ANALYSIS
The difference between UNIDO Approach and L-M approach
UNIDO Approach L-M approach

•
1. Measures costs and benefits in terms of 1. Measures costs and benefits in terms of
domestic Birr international (border) prices
2. Measures costs and benefits in terms of 2. Measures costs and benefits in terms of
consumption uncommitted social income.
3. The analysis focuses on, efficiency, savings, 3. Tends to view efficiency, savings, and
and redistribution considerations in redistribution considerations together.
different stages
Financial Analysis
ANALYSIS
• Shadow Pricing under L-M Approach
• L-M approach classified the inputs and outputs of the project into three categories.
a. Tradable goods and services
• The border price is considered the shadow price for a traded good or service.
Assume that foreign demand and supply are perfectly elastic, the shadow price of
exportable goods is Free-on-Board (FOB) price. On the other hand, the shadow
price of importable good is its Cost Insurance Freight (CIF) price.
Financial Analysis
ANALYSIS
• b. Non-tradable goods and services
• Certain goods are not amenable to foreign trade, such as land, building, electricity,
water, and transportation. Since there is no observable border price for such goods
and services, their shadow (accounting) prices are defined in terms of marginal
social cost and marginal social benefits.
 The marginal social cost of a good is the value in terms of accounting prices of the
resources required to produce an extra unit of the good. Similarly, the marginal social
benefit is the value of an extra unit of the good from the social point of view.
Financial Analysis
ANALYSIS
• c. Labor
• According to L-M, the shadow wage rate is the function of several
factors, some of which include:
• the marginal productivity of labor
• the cost associated with urbanization such as cost of transport, urban
overheads etc.
• the cost of having an additional amount committed to consumption
(when the consumption of the worker increases as a result of the
higher income he/she enjoys in urban employment).
.

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OROMIA STATE UNIVERSITY

Advanced Project Management

for LCM (PG students)

FINANCIAL AND ECONOMIC ANALYSIS

Financial Analysis (FAs) ?

 The determination of project costs

 The estimation of cost of production and other expenses

 The estimation of project net cash flows, and

 The evaluation of the desirability of the project using

 Acquisition costs of direct materials include inward delivery charges, tax,

iii. Indirect manufacturing costs (manufacturing overhead).

Estimates of Sales and Production?

Estimates of Sales and Production ?

Estimates of Sales and Production ?

Estimates of Sales and Production ?

Estimation of Material Costs ?

Estimating Labor Costs ?

Production 150,000 180,000 300,000 300,000 300,000

TotalL.hrs required 450,000 540,000 900,000 900,000 900,000

Computation of unit cost ?

1 5,355,000 9,000,000 5,400,000 19,755,000 150,000 131.70

2 6,426,000 11,340,000 6,804,000 24,570,000 180,000 136.50

3 10,710,000 19,845,000 11,907,000 42,462,000 300,000 141.54

4 10,710,000 20,835,000 12,501,000 44,046,000 300,000 146.82

5 10,710,000 21,879,000 13,127,400 45,716,400 300,000 152.39

Estimated Cost of Ending Inventory ?

Cost of ending 1,317,000 1,365,000 1,415,400 1,468,200 1,523,900

Estimated Cost of Goods Sold ?

Add: Beg. Finished - 1,317,000 1,365,000 1,415,400 1,468,200

Available for sale 19,755,000 25,887,000 43,827,000 45,461,400 47,184,400

Ded: Ending Finished 1,317,000 1,365,000 1,415,400 1,468,200 1,523,900

Cost of goods sold 18,438,000 24,522,000 42,411,600 43,993,200 45,660,500

Sales 22,400,000 27,200,000 46,400,000 46,400,000 46,400,000

Cost of goods sold 18,438,000 24,522,000 42,411,600 43,993,200 45,660,500

Gross profit 3,962,000 2,678,000 3,988,400 2,406,800 739,500

Administrative & General 500,000 510,000 520,000 530,000 540,000

Total expenses 900,000 910,000 940,000 950,000 960,000

Earnings before taxes 3,062,000 1,768,000 3,048,400 1,456,800 (220,500)

Taxes (30%) - - 914,520 437,040 -

Net income 3062,000 1,768,000 2,133,880 1,019,760 (220,500)

Determination of Project Net Cash Flows ?

Net income 3,062,000 1,768,000 2,133,880 1,019,760 (220,500)

After tax cash flows 3,220,000 1,928,000 2,293,880 1,179,760 119,500

Financial Evaluation criteria ?

• Financially viable (able to meet the burden of servicing debt) &

• Satisfy the return expectations

• Therefore, a financial manager must be able to decide whether a project is

• To do this, a sound procedure to evaluate, compare, and select projects is

Financial Evaluation criteria ?

Financial Evaluation criteria ?

• a) When cash flow is in annuity form

• PBP =Initial Investment/Annual net Cash Flows

Financial Evaluation criteria ?

• PBP =24,000/6000 = 4 years

• It is expected to take the company four years to recover the

Financial Evaluation criteria ?

• PBP= Years before full recovery + Un recovered cost

Financial Evaluation criteria ?

Financial Evaluation criteria ?

 Average Investment = Original cost + Salvage value

Financial Evaluation criteria ?

Financial Evaluation criteria ?

Income 40,000 42,000 36,000 50,000