Chapter 5

Financial Cost-benefit Analysis

5.1. Fundamentals of Financial Estimates
 Analysis of financial costs & benefits is a key step in the project
preparation process.
 Seeks to ascertain financial viability of the project
 Meet the burden of servicing debt.
 Satisfy promoters’ return expectations.
 Commercial profitability is yardstick for selection.
1. Objectives & Dimensions of Financial Analysis
Main Objective:
 To ensure the financial viability of the industrial project
for the private investor.
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Dimensions of Analysis:
– Investment cost estimation
– Revenue estimation
– Estimation of production costs & expenses
– Projected profitability analysis (I/S)
– Projected financial position (B/sheet)
– Cash flow estimation & evaluation
– Financial ratio analysis
– Means of financing & cost of capital
– Cash flow appraisal/evaluation
– Uncertainty/risk analysis (break even point, sensitivity
analysis, scenario analysis)
– Debt repayment (loan amortization) schedule, depreciation
schedule, etc.
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2. Guidelines For Estimating Financial Costs &
Benefits
A. Project Inputs, Outputs, and Prices
 Starting point for financial cost-benefit analysis:
 determination of project inputs & outputs
 determination of what price to use in the analysis
 Alternative basis for pricing:
 Constant prices … base year prices
 Market (or explicit) prices … current prices
 Shadow (or imputed) prices … economic prices
 General principle: Use constant prices for financial analysis
(valuation of project’s inputs & outputs).
 Common to use current prices as well.

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B. Impacts of Inflation
 Inflation complicates the process of estimating financial costs &
benefits.
 Complicates the task of investment appraisal.
 Difficult to forecast the level of inflation expected over the
planning horizon.
 Smaller changes in the level of inflation affects individual
components of cash flows in a different way.
 Impact is not easily visible to account for.
 Simplifying Assumption regarding Inflation
 Inflation equally affects both future stream of cash inflows
& outflows.
 Impacts offset over the planning horizon.
 Price contingency would take care of unforeseen price
increases during the construction period.
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 If there is strong evidence regarding inflation, examine its
impacts on:
 cost of capital (opportunity cost of capital)
 opportunity cost of equipment's & machineries
 level of revenue & operating costs, etc.
 A higher level of expected inflation (unless considered) may:
 Distort the NPV of the project
 Result in incorrect ranking of investment proposals
C. Estimating Economic Life of a Project
 Economic life refers to the optimal period over which the
project would generate economic gains.
 Project’s economic life:
 May be set to equal the technical life of machineries &
equipment's (maximum period).
 May be less than the technical life.
 Should never exceed the technical life.
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 Economic life is only relevant for project appraisal.
 Factors to be considered in setting economic life:
 Physical life (technical life of plant & machinery)… useful for
depreciation charge
 Duration of market demand (product life cycle)
 Change of taste & preference of customers
 National/international competition
 Technology change (obsolescence)
 Extent/duration/ of resource deposits, etc.
 Time horizon for cash flow analysis (i.e. the economic life): the
minimum of the ff:
 Physical life (or technical life of plant & machinery)
 Technological life
 Product life
 Investment planning horizon of the firm
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 Benchmark for estimating projects’ economic life:
 Small & Medium Sized Projects ….. 5 – 10 years
 Normal Industrial Projects ………… 10 – 15
 Heavy Industry Projects …………….. 15 – 25
 Infrastructure Projects ……………….. 20 – 25
Projects economic life.pptx
D. Discount Rate
 Refers to the cost of capital to project implementation &
realization.
 Market price of capital may be used as the cost of capital.
 Determined in view of the following:
 Opportunity cost of various sources of funds for the project.
 Minimum return expected as a compensation for taking risk.

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Consider the following 3 scenarios as a guide line:
1. All Loan Financing (Net Borrower): A project fully financed
from debt sources.
 Net (after tax) market-borrowing rate can be used as the
financial discount rate. [interest rate *(1 - tax rate)]
 After tax market interest rate used as cost of capital
(considering tax shield due to interest expenses).
2. Equity and Debt Financing: A project financed by mix of debt
and equity funds.
 Weighted Average Cost of Capital (WACC) used as the
appropriate financial discount rate.
WACC = (Debt% x Net Cost of Debt)
+
(Equity% x Cost of Equity)
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3. All Equity Financing (Net Lender in the absence of the project):
Project fully financed by owner(s):
 Net market interest rate will be used as the cost of capital
since the investor(s) could have lent the fund at market
interest rate.
 Given taxes on return on investment, the after tax market
lending rate can be used as the financial discount rate.
 The level of future inflation is assumed to be zero when we use
market discount rate.
 The discount rate used should be the minimum rate of return
below which an entrepreneur considers investing does not
payback.

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E. Interest on Loans
 Interest paid or accrued during construction:
 Considered part of pre-production expenditures (an
investment cost).
 Interest paid on loans during operating period:
 Considered an expense in the projected income statement
for the purpose of financial appraisal.
F. Cash Flows
 Project cash flows are classified into three:
 Pre-investment phase
 Implementation phase
 Operating phase
 Over all investment expenditure for the project is the sum of the
pre-investment expenditures
and
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expenditures made during implementation.
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 Investment phase covers the construction and start up periods.
[Involves cash outflows]
 Start up costs:– incurred in getting the project operational (initial commencement).
 Fees for supervisors, salaries & fringe benefits, training costs, wasted materials &
supplies, utilities used in the pre-production period, etc.
 Initial investment in net working capital is also part of the investment cost.
 Benefits (inflows) and costs (outflows) arise in the operating
phase.
 Determine net cash flows of the project for each year of operation. (Net Operating
Cash Flows)
 Usually the net operating cash flow is positive (net inflows).
 At the end of the project‘s economic life, terminal cash flows
(mainly inflows) occur:
 Scrap value of the project's assets treated as a negative capital cost (i.e., as a benefit).
 Recovery of net working capital treated as a negative capital cost (i.e., as a benefit).
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5.2. Initial Investment Cost
Initial Investment C o st : Summary

 Detail breakdown need to be included.

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1. Fixed Investment
 Land and Site Development:
 Cost of land
 Premium payable on leasehold
 Cost of leveling and site preparation
 Cost of laying approach roads & internal roads
 Cost of gate ways, tube wells, etc.
 Buildings and Civil Works:
 Buildings for the main manufacturing plant
 Buildings for auxiliary services like steam supply,
workshops, etc.
 Laboratory, water supply, etc.
 Warehouses, open yard facilities, etc.
 Non-factory buildings (guest house, cafeteria, clinics, etc.)
 Garages, sewage, drainage, etc.
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 Cost of Equipment's & Machinery:
 Costs of Imported Machineries & Equipment's:
 CIF import value
 Clearing charges (customs, import tariffs, etc.)
 Loading & unloading charges, local transportation &
insurance charges, etc.
 Costs of Indigenous Machineries & Equipment's:
 Purchase price of machinery and equipment
 Sales taxes (if any)
 Railway freights & transportation charges
 Cost of Stores & Spare Parts (acquired with machineries &
equipment's)
 Foundation & Installation charges (depends on the specific
requirements of the project)
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 Expenses on Foreign Technicians and Training of Local
Technicians Abroad.
 Travel expenses of technicians to & from abroad
 Boarding & lodging, salaries & allowances, etc.
 Miscellaneous Fixed Assets & Expenditures:
 Furniture & office equipment's
 Tools, vehicles, railway siding, diesel generators
 Transformers, boilers, piping system
 Laboratory & workshop equipments
 Effluent treatment plants & fire fighting equipment
 Expenses for acquisition of patents, licenses, trademarks,
or copyrights
 Deposits made with the electricity board, etc

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2. Pre-production Expenditures
 Establishment and Capital Issue Expenses
 Establishment Expenses:
 Expenditures incurred during the registration and
formation of the company.
 Legal fees for preparation of memorandum & articles of
association, costs incurred for capital issues, etc.
 Expenses for incorporating the company.
 Capital Issue Expenses:
 Underwriting commission & brokerage fees
 Fees to managers & registrars
 Printing & postage expenses
 Advertising & public announcements
 Listing fees & stamp duty expenses for processing of share
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applications and allotment
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 Pre-Operative Expenses
 Expenditures for Preparatory Studies:
 Opportunity, pre-feasibility, feasibility, and support or
functional studies.
 Consultant fees while project preparation.
 Other Pre-Operative Expenditures:
 Salaries, fringe benefits, and social security contributions
for personnel.
 Travel expenses
 Preparatory installation (workers camps, temporary
houses, and stores)
 Engineering services & supervision of plant erections and
constructions
 Pre-production marketing costs and promotional activities
 Training costs (fees, travel, and living expenses)
 Interest and insurance during construction
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 Before Commencement Production Costs:
 Rent, taxes, and interest on borrowings
 Start-up expenses, costs of trial runs, and commissioning
expenditures
 Initial Cash Losses:
 Most projects incur losses in the initial years.
 Failure to make a provision for such losses generally affects
the liquidity position & impairs the project’s operations.
 Pre-operative expenses incurred up to the point of
initial plant set-up are considered assets and treated as
part of the investment cost.

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How such expenditures are accounted for?
 Deferred Revenue Expenditure (Capitalization):
 All pre-production expenditures are capitalized & amortized
over a period of time usually shorter than the period over which
equipment's are depreciated.
 Partial Allocation and Partial Capitalization:
 Part of pre-production expenditures are allocated to respective
fixed assets (Partial Allocation).
 Pre-production expenditures not attributable to specific fixed
assets are capitalized & respectively amortized (Partial
Capitalization).
Note: Size of pre-operative expenses directly related to
project implementation schedule.
 Delay in implementation push-up these expenses.
 Financial institutions allow for delay in the implementation
schedule (20 to 25%):- permit caution in estimating pre-operative expenses.
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3. Investment in Net Working Capital
 WC Requirement consists of the following:
 Raw materials & components (indigenous + imported)
 Stocks of goods in process (WIP)
 Stocks of finished goods
 Debtors (accounts receivables)
 Operating expenses (prepaid insurances, prepaid rents, etc.)
 Consumable stocks (supplies)
 Principal Sources of WC Finance:
 WC advances provided by commercial banks (short term or
medium term WC loans)
 Trade credits (account payables)
 Accruals & provisions (such as salaries & wages payables, taxes
payable, interest payables, etc.)
 Long-term sources of financing (long-term debts & equity)
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 At least 25% of current assets must be supported by long-term
sources of finance.
 It is called Margin Money for Working Capital, i.e., WC
requirement financed by long-term funds.
 NWC is part of the initial investment cost.
 The margin money for working capital is sometimes utilized to
meet overruns in capital cost.
 may lead to WC problem during operation.
 Financial institutions stipulate (restrict) a portion of the loan
amount equal to the margin money for working capital initially
blocked to mitigate this problem.
 Released/free/ when the project commences operation.
 Margin requirement varies with the type of CA - no fixed
formula available to determine this amount.
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4. Provision for Contingencies
 Contingency allowance:- an amount included in a project account
to allow for adverse conditions that will add to baseline costs.
 Includes allowance for physical contingency and price
contingency
 Physical Contingencies:
 Allow for physical events such as the effects of adverse weather condition during
construction.
 5 to 10% of fixed investment cost for unexpected losses during construction
(included both in financial & economic analysis)
 Price Contingencies:
 Allow for general inflation.
 Usually 5 to 10% of fixed investment cost for price escalation during construction
period.
 Price contingencies omitted both from financial & economic analysis when constant
prices used.
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5.3. Estimate of Sales and Production Costs
5.3.1. Estimate of Sales/Revenue/
 Starting point for profitability projection.
 Derived from the market analysis.
Considerations:
 Not advisable to assume higher level of capacity utilization in
the 1st year of operations: Reasons
 Raw materials shortages
 Production & technological difficulties
 Limited power
 Marketing problems, etc.
 Reasonable assumption with respect to capacity utilization is
needed.
 Note that the installed capacity is different from optimum
level.
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 General guideline:
 40-50% of installed capacity in the 1st year
 50-80% of installed capacity in the 2nd year
 80-90% of installed capacity from 3rd year on
 Production would be assumed to equal sales.
 Not necessary to make adjustments for stocks of finished goods.
 Selling price considered should be the price realizable by the
company net of excise duty (tax on the production or sale of a specific products).
 Use net sales value.
 Use the present price (current market price) as a selling price.
 A change in the selling price assumed to offset with a
proportionate change in the cost of production.
 If a portion of production is saleable at a controlled price,
take the controlled price for that portion.
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Example: Format of Sales Schedule for Product X

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5.3.2. Estimate Production Costs
 Production costs should be calculated as total annual costs as
well as cost per unit produced.
 The overall production costs should be broken down at least
into main cost items/categories:
 Factory costs (DMC, DLC, and other Manufacturing overheads)
 Overhead costs (administrative & marketing overheads)
 Depreciation costs
 Financing costs
 Production costs must be determined for the different levels of
capacity utilization and operating period.
 Operating costs: is the sum of factory costs and administrative
overhead costs.
 Total Production Cost: is the sum of operating costs,
depreciation charges, and financial costs.
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 Cost of Products Sold: is the sum of total production costs,
direct marketing costs, and marketing overhead costs.

1. Factory Costs
 Includes the costs of the following:
 Materials costs (mainly variable): costs of raw materials,
factory supplies, and spare parts.
 Labor (production personnel) costs: fixed or variable
 Factory overheads (indirect materials, indirect labor,
factory supplies & utilities, etc.)

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2. Overhead Costs
 Frequently computed as a % charge on total material & labor
inputs or other basis of allocation.
 Types of overhead costs:
 Factory overhead (part of factory costs)
 Administrative overhead
 Marketing overhead
A. Administrative Overheads:
 Calculated separately or included under factory overheads.
 Wages & salaries (including benefits & social security
contributions).
 Office supplies such as utilities, communication, rents,
insurances (property), and property taxes.
 Estimated for administrative cost centers.

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B. Marketing Overheads
 Direct selling & distribution costs (special packaging &
forwarding costs, commissions & discounts, etc.) should be
calculated separately for each product.
 Indirect marketing costs are usually treated as marketing
overhead costs.
 Often included under administrative overheads.
 Marketing costs should be shown in the study as a separate
cost group if the total represents a significant share of the total
costs of products sold.
 Wages, salaries, benefits, etc. of employees involving in
marketing activities.
 Office supplies, utilities, communications, indirect
marketing costs, advertising, training, etc.

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3. Depreciation Costs
 Charges made in the annual income statement for the productive
use of fixed assets.
 Calculated based on the original value of fixed investments
according to the methods applicable.
 Reflected in the projected B/S and I/S.
 Frequently included under overhead costs.
 Depreciation should be shown separately from overhead costs because this
cost is treated separately for the discounted cash flow method.
 Represents investment expenditure (cash outflows during the
investment phase) instead of production expenditure (cash
outflow during production).

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 Depreciation charges added back if net cash flows are calculated
from the net profit.
 Do have impacts on net cash flows.
 The higher the depreciation charges, the lower the taxable income and the lower
the cash outflow corresponding to the tax payable on income.
4. Financial Costs
 Financial costs such as interest on term loans should be shown
as a separate item for financial analysis & investment appraisal,
although sometimes considered as part of administrative
overheads.
 Included for financial planning, but should be excluded when
computing the discounted cash flows of the project.

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Total Annual Cost of Products

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5.4. Projected Financial Statements
A. Profit or Loss Statement

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B. Statement of Cash Flows

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C. Projected Balance Sheet

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NOTE: Projected Financial Statements are prepared for each year of the project’s economic life.
 Financial institutions often refer & evaluate these statements before making decisions (extending short-term
or longterm loans).
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5.5. Investment Cash Flows
5.5.1. Appraisal of Long-term Investments
 The term investment refers to a long-term commitment of
scarce economic resources with the objective of producing
gains as a compensation over the investment-planning horizon.
 Appraisal of long-term investments made in terms of cash flows.
 Cash flows occur at different stages in the capital budgeting process.
 Determine relevant cash flows (incremental after tax cash
flows) associated with the project so as to make financial
appraisal.
 Cash flows from long-term investments are classified into 3
parts:
 Initial Investment Outlays
 Operating Cash Flows
 Terminal Cash Flows
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(i) Initial Investment Cash Flows:
 Expenditures that occur at the beginning of the project’s life.
 Purchase of land (or payment for leasehold)
 Machinery, equipment, tools, etc.
 Installation, testing, and start-up costs
 Initial investment in NWC, etc.
 Investment tax credit - is incentive provided by government to
encourage investments.
 It is a benefit (treated as an inflow) – hence deducted from
the initial investment outlays.
(ii) Operating Cash Flows:
 Constitutes the cash inflows from revenue sources and the cash
outflows for different expenditures over the operating period.
 The net operating cash flows could be positive or negative.
 If we assume conventional cash flow pattern, the net
operating cash flows should be positive.
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(iii) Terminal Cash Flows:
 Refers to the after tax cash flows resulting from the termination
of the project and disposal of its assets at the end of its
economic life.
 Terminal cash inflows (positive cash flows):
 Proceeds from disposal of old assets (salvage value or
selling price of old assets)
 Recovery of net working capital
 Tax saving/tax shield due to loss on disposal of old assets
 Terminal cash outflows (negative cash flows):
 Liquidation and disposal costs
 Tax paid on gain on disposal of old assets

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5.5.2. Who Estimates Project Cash Flows?
 Estimating project cash flows is the most important but also the
most difficult step in capital budgeting.
 Forecasting project cash flows involves numerous variables &
participation of different professionals.
 Capital outlays are estimated by engineering and product development
departments.
 Revenue projections are provided by the marketing group.
 Operating costs are estimated by production people, cost accountants, purchase
managers, personnel executives, tax experts, and others.
 What is the role of the finance manager?
 Coordinate the efforts of various departments & obtain information from them.
 Ensure the forecasts are based on a great deal of consistent economic
assumptions.
 Keep the exercise focused on relevant variables.
 Minimize the biases inherent in cash flow forecasting.
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5.6. Principles of Cash Flow Projection
1. Principle of Cash Flow
 Project evaluation should be based on cash flows instead of
accrual accounting income.
 Cash is used to meet various requirements.
 Cash can be reinvested in other projects.
 The concept of income in accounting is ambiguous (difficult to understand).
 Different accounting methods may result in different net income figures.
2. Financial Cost Exclusion Principle
 Two sides of a project: the investment/asset side and the
financing side.
 Cash flows associated with these sides should be separated.
 Cash flows on the investment side should not include financing costs & expenses (i.e.,
interest & dividend payments).
 Financing costs are included in the cash flows on the financing side & reflected in
the cost of capital.
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 Cost of capital is the hurdle rate (discount rate) used to
judge/evaluate the return on the investment side.
 Interest & dividend are used in the determination of the
cost of capital.
 Including financing costs in investment cash flows may
mean double counting of the same cost.
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3. Incremental Principle
 The cash flows of a project must be measured in incremental
terms.
 What happens to the cash flows of the firm with the project
and with out the project?
 Incremental cash flows of a project is determined as follows:

 What considerations should be made in determining

incremental cash flows of a project?

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a) Consider all Incidental Effects
 Consider all the incidental (related) effects of the project on
the rest (cash flows) of the firm.
 Enhance the profitability of some of the existing activities
of the firm – complementary relationship.
 Detract (reduce) from the profitability of some of the
existing activities of the firm – competitive relationship.
b) Ignore Sunk Costs
 A sunk cost is an outlay already incurred in the past or already
committed irreversibly.
 Cannot be recovered – not relevant.
 Not differential (do not vary among alternatives).
 Not affected by the acceptance or rejection of the project.
 Do not influence the project related decisions.

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c) Include Opportunity Costs
 When a project uses resources already available with the firm,
there is a potential for an opportunity cost.
 It is a cost created for the rest of the firm as a consequence of undertaking the project.
 The resources used by the project might have been rented out, sold, or required else
where in the firm.
 The opportunity cost is the best-forgone option that arises from using scarce resources.
d) Estimate Working Capital Properly
 Properly consider working capital requirement while forecasting
the project cash flows.
NWC = Current Assets – Current Liabilities
 WC requirements often change over time.
 WC is renewed periodically – do not depreciate.
 It is assumed to have a salvage (or recovery) value equal to its book value at the end of the
project life. NWC may not be fully recovered sometimes due to uncollectible balances.

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e) Question the Allocation of Overhead Costs
 Costs that are not directly related with the production of goods or
services are referred to as overhead costs.
 General & administrative expenses
 Managerial salaries
 Legal expenses
 Office rents, etc.
 Overhead costs are allocated to various products on some basis
like labor hours, machine hours, or prime costs that appears
reasonable.
 When a new project is proposed, a portion of the overhead costs
of the firm is usually allocated to it.
 For purposes of investment analysis, only the
incremental overhead cost is relevant/attributable to the
project.
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4. Post-tax Principle
 Cash flows should be measured on an after-tax basis.
 Always use after–tax cash flows along with after tax discount
rate.
 The tax implications of losses & non-cash charges (tax saving
or benefit) should be taken into account.
 During the period of loss the project will not pay tax and
consider tax saving.
 Non-cash loss (e.g depreciation) affects tax liability and its
tax benefit is computed as:
Amount of depreciation x tax rate

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5. Consistency Principle
(A) Investor Group: All Investors vs Equity Investors
The discount rate used must be consistent with the definition of
the cash flows.

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(B) Choices
 Choice 1: incorporate expected inflation in the estimates
of future cash flows and apply a nominal discount rate.
 Choice 2: estimate the future cash flows in real terms and
apply a real discount rate.

 Consistency required between the type of cash flow and the

discount rate used.

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Example of calculating real cash flows and nominal cash flow

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5.7. Determining Project Cash Flow
1. Net Initial Investment Cost (NINV)
 It is the sum of the project’s initial net cash outlays at time zero
(or before commencement of operations).
 (+) Costs of fixed assets, installation & shipping costs, import tariffs, etc
associated with acquiring the assets & putting them into service.
 (+) Any increase in Net working capital initially required as a result of the new
investment.
 (-) Investment tax credit provided by the government.
 (-) Gross proceeds from the sale of existing assets (i.e. selling price of old assets
for replacement investments).
 (+/-) Taxes associated with the sale of existing assets.
 Taxes associated with gain on disposal of the old asset (+), or tax
saving due to loss on disposal (-).
 New Project Case:
3/12/2022 Mekonnen K. 55
 Replacement (Cost Reduction) Projects:

 Replacement projects generally do not require additional

investment in net working capital.
 Expansion Projects:

 The Net Initial Investment cost for replacement and

expansion projects only differ with respect to NWC.
3/12/2022 Mekonnen K. 56
2. Net Operating Cash Flows (NOCFs)
 Estimation of the after tax (net) operating cash flows (NOCFs)
of the project is also an important task in capital budgeting.
• It is the difference between the change in operating cash
inflows and outflows.
 For any year during the life of a project, the NOCF may be
defined as the:
• (+) change in operating earnings after taxes (Δ OEAT)
• (+) change in depreciation (Δ Depreciation)
• (-) change in net working capital investment (Δ NWC)

NOCF (Year x) = ΔOEAT + Δ Depreciation – ΔNWC

3/12/2022 Mekonnen K. 57
 Operating earnings after tax (OEAT) differ from earnings after
tax (EAT).
 Interest expense is not deducted in the determination of
OEAT.
 Financing charges are excluded in the process of estimating
Net Operating Cash Flows (NOCFs).
 A firm may increase its investment in net working capital
(NWC) associated with a particular project in a given year.
 This increased investment in NWC reduces NOCF.
 The effect of such a ΔNWC is negative at the operating
stage.

3/12/2022 Mekonnen K. 58
Computation of NOCFs of a project:

3/12/2022 Mekonnen K. 59
 If a decline in the requirement of net working capital were
expected over the life of the project, the effect would be to
increase the NOCFs of the project.
 The effect of such a ΔNWC is positive at the operating stage.
 The final year cash flows of the project includes the NOCFs of
that year plus terminal cash flows.
 Recovery of NWC invested over the life of a project (cumulative).
 Cash flows associated with the disposal of old assets of the project.

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N.B.
 The disposal price of old assets (and the associated gain or loss
on disposal) are determinants of the net (after tax) proceeds in
the final year.
Case 1: Old Assets sold at a price greater than the original cost.
 There is a gain on disposal.
 The amount in excess of the original cost is considered a capital gain, thus,
taxed at capital gain tax rate.
 The ordinary gain (i.e., the difference between the original cost and book value
of the old asset) is taxed at ordinary gain tax rate.
 Net disposal proceed is equal to the selling price of the old assets minus tax
paid on gain on disposal.
Case 2: Old Assets sold at a price less than the book value.
 There is a loss on disposal.
 The amount of loss is equal to the difference between the selling price of the
old asset and its book value.
3/12/2022 Mekonnen K. 61
  The loss on disposal reduces the firm’s/project’s taxable income and hence,
brings tax saving.
 The tax saving is an implicit (indirect) benefit treated as cash inflow.
 Net disposal proceed is equal to the sum of the selling price (salvage value) of
old assets and the tax saving due to loss on disposal of the old assets.
Case 3: Old Assets sold at a price equal to the book value.
 There is no gain or loss on disposal.
 Salvage proceeds of OA is equal to book value.
 Net proceeds on disposal is equal to the selling price of the old assets.
 Question: How can we determine net operating cash flows for new projects or
expansion projects under the indirect approach when interest expense is deducted in
the income statement? What if interest expense was not deducted?
• Case 1: interest expense deducted in the I/S.
• Case 2: interest expense not deducted in the I/S.
 See table: Assume T is the tax rate, and the after tax balance of interest is obtained by
multiplying it by (1 – T).
After Tax amount of Interest = Interest Expense x (1 – T)
3/12/2022 Mekonnen K. 62
Adjustments Needed under Case 1 and Case 2

_____________________//__________________
3/12/2022 Mekonnen K. 63
5.8. Financial Appraisal: Meaning And Criteria
 Defining the stream of costs & benefits of a project in the form
of cash flows is the basis for financial analysis/appraisal.
 Financial appraisal involves:
 Examining estimated costs & benefits (cash flows) of the project.
 Deciding whether the project is worthwhile or not.
 Financial Appraisal Criteria
 Non-Discounting Criteria/ Traditional Approach/:
1. Payback Period (PBP)
2. Accounting/Average Rate of Return (ARR)
 Discounting Criteria:
1. Net Present Value (NPV)
2. Profitability Index (PI) [Benefit-Cost Ratio (BCR), Net Benefit-Cost
Ratio (NBCR)]
3. Internal Rate of Return (IRR)
4. Modified Payback Period (MPBP) [Discounted Payback Period
3/12/2022
(DPBP)] Mekonnen K. 64
 Each of these criteria have advantages & limitations.
 Decisions should be made in light of risk & uncertainty of
future conditions.
5.8.1 Non-Discounting Criteria/ Traditional Approach/:
1. Payback Period (PBP)
A. Nature of the Criterion
 This is one of the widely used methods for evaluating the
investment proposals.
 The payback period is the length of time required to recover the
initial cash outlay on a project.
 Under this method the focus is on the recovery of original
investment at the earliest possible period.
 The number of years expected to pass-by for the sum of the
project’s net earnings (i.e., receipts minus operating costs) equals
the initial investment cost.
3/12/2022 Mekonnen K. 65
 It determines the number of years to get back the original cash
out flow, disregarding the salvage value and interest.
 This method does not take into account the cash inflows that are
received after the payback period.
 Decision rule: accept the project if it’s payback period is shorter
than the target (planed period) set by the management.

There are two methods in use to calculate the payback period

1) Where annual cash flows are not consistent (vary from year to
year)
2) Where the annual cash flows are uniform

3/12/2022 Mekonnen K. 66
1) Unequal cash flows
PBp = E + B Or
C

Where, PBp = payback period.

E = number of years immediately preceding the year of final recovery.
B = the balance amount still to be recovered.
C = cash flow during the year of final recovery.
Example: The following is the information related to a company
Project A Project B
Year Cash flow $ Cash flow $
0 -700 -700
1 100 400
2 200 300
3 300 200
4 400 100
5 500 0
Calculate payback period of two projects?
3/12/2022 Mekonnen K. 67
Project A Cumulative Project B Cumulative
Year Cash flow cash flow Year Cash flow Cash flow
0 -700 -700 0 -700 -700
1 100 -600 1 400 -300
2 200 -400 2 300 0
3 300 -100 3 200 200
4 400 300 4 100 300
5 500 800 5 0 -

Solutions;
P=E+ B B
C P=E+ C
100 = 2 + 0/200
=3+
400
= 2 years
= 3.25 year or
= 3 years and 3 months
2. Uniform cash flows:
 Where the annual cash flows are uniform
Original Investment
PBp =
Annual cash flows

Example: A project requires an investment of $ 100, 000, it will

generate annual cash flow of $25,000 per year.
 Calculate the payback period?

Original Investment 100 , 000

PBp = Annual cash flows =
25 , 000
= 4 years
B. Merits & Limitations of the Criterion
Merits of the PBP Criterion
 Ease for calculation/use - simple both in concept & application.
 Useful for risk analysis – crudely considers risk by accepting
projects having shorter payback periods.
 Often relevant in politically unstable countries, contexts
experiencing significant variability, and in some sectors or
industrial branches facing rapid technological obsolescence.
 Favors projects that generate substantial cash inflows in the earlier
years.
 If risk tends to increase with futurity, it may be true that the
payback criterion is helpful in weeding out risky projects.
 Since it emphasizes over earlier cash inflows, it may be a sensible
criterion when the firm is pressed with problems of liquidity.

3/12/2022 Mekonnen K. 70
Limitations of the PBP Criterion
 Does not consider the project’s fate after it has paid for itself (i.e.
ignores cash flows beyond the PBP).
 It over emphasizes quick financial returns.
 May reject projects that generate substantial cash inflows in
later years & more value adding to a firm.
 Ignores the time value of money.
 Cash inflows in the payback calculation are simply added
without suitable discounting.
 Does not measure the profitability of the project and much
concerned with its liquidity.
 Although it is a measure of the project’s liquidity, it does not
indicate the liquidity position of the firm as a whole, which is
more important.

3/12/2022 Mekonnen K. 71
B. Accounting Rate of Return
 This method is based on the financial accounting practices of the
company working out the annual profits.
 Here, instead of taking the annual cash flows, we take the annual
profits into account.
 The net annual profits are calculated after deducting depreciation
and taxes.
 The average of annual profits thus derived is worked out on the
basis of the period
ARR = average annual profit after tax / average investment
 As total investment cost (fixed assets + preproduction capital costs
+ net working capital).
How to Calculate Accounting Rate of Return
1.Calculate the average annual profit of the investment.
2.Subtract the depreciation expense.
3.Divide the annual net profit by the initial cost of the asset.
4.Multiply by 100 to arrive at the percentage rate.
3/12/2022 Mekonnen K. 72
Guideline:
 The higher the ARR, the better is the project.
 Projects having ARR equal to or greater than a pre-specified rate
of return can be accepted.
 Advantages and Limitations
 Advantages of the ARR Criterion:
 Simple to calculate as it is based on accounting information (Net
Income or Profit) that is readily available & familiar to business
persons.
 Considerers benefits over the entire life of the project.
 It may be calculated based on income for some typical years or
income for the first three to five years, in cases where complete
income data is not available for the entire life of the project.

3/12/2022 Mekonnen K. 73
 Limitations of the ARR Criterion:
 It is based on accounting profit, and not cash flows.
 Does not take into account the time value of money.
 It is true that income obtained in early years is greater than
and/or preferable to income obtained in later years.
 There are numerous measures of accounting rate of return
(EBIT, EBT, EAT, etc).
 Either the Initial Investment or Average Investment cost could
be used – may create controversy, confusion, or problem for
interpretation.
 The accounting income is ambiguous – influenced by the
methods of depreciation, inventory valuation, and allocation
of certain costs.
 Since the simple rate of return uses annual data, it is difficult
and often impossible to choose the most representative year of
the project.
3/12/2022 Mekonnen K. 74
Illustration
 An individual investor is considering an industrial project, that is,
opening of a Fertilizer Plant in Haramaya City. This plant will
manufacture and distribute fertilizers to farmers in the different
regions in Ethiopia. The following information is available:
 At the beginning, the project requires the following
expenditures: Birr 150 million on plant & machinery, Birr 7
million on pre‐operative expenditures, and Birr 50 million
on net working capital. These are the only expenditures
incurred at the beginning.
 Once the implementation is over, the project is expected to
generate revenues of Birr 250 million per year, while costs to
be incurred on account of the project is expected to be Birr
100 million per year (this includes all items of cost other than
depreciation, amortization, interest, and tax).
3/12/2022 Mekonnen K. 75
  The economic life of the project expected to be 7 years.
 The annual level of depreciation on plant and machinery will
be Birr 18.6 million, which is determined as per the straight
line method.
 The pre‐operative expenditures are initially capitalized and
then will be written‐off (amortized) straight over the economic
life of the project (i.e. Birr 1 million per annum).
 The firm pays interests of Birr 1 million annually on its Birr 7
million long‐term loan, which is payable at the end of year 7.
 The net salvage value (net proceed) from disposal of fixed
assets at the end of 7 years will be Birr 48 million whereas net
working capital will be liquidated at its book value.
 The applicable tax rate to the Plant is 30%; and the firm’s Cost
of Capital is 12%.

3/12/2022 Mekonnen K. 76
 Required:
 Estimate the net initial investment outlay as well as the annual
after‐tax cash flows of the project.
 Determine the Accounting Rate of Return
 Determine the Net Present Value (NPV) of the Project.
Should it be accepted?
 Determine the IRR of the Project. Should it be accepted?

3/12/2022 Mekonnen K. 77
3/12/2022 Mekonnen K. 78
Solution
 Accounting Rate of Return
ARR = average annual profit after tax / average investment
= 91,280,000 / 207,000,000
= 0.44097
= 0.44097 * 100
= 44.09%
 So, in this example, for every Birr that your company invests, it
will receive a return of 44.09 Birr.
 That’s relatively good, and if it’s better than the company’s other
options, it may convince them to go ahead with the investment.
Discount Rate = 12%
Present Value of Benefits = Birr 550,360,000
 NPV = 343,360,000 Check out the result
 IRR = 52% following the steps
3/12/2022 Mekonnen K. 79
5.8.2 Discounted Cash Flow Method
 This concept is based on the time value of money.
 The real value of Birr in your hand today is better than value of
birr you earn after a year.
 The future income, therefore, has to be discounted in order to be
associated with the current out flow of funds in the investment.
(A) Net Present Value (NPV)
a) Nature of the Criterion
 It is an investment project proposals evaluating and ranking
method using the net present value, which is the difference
between the present values of future cash inflows and the present
value of cash outflows, discounted at the given cost of capital, or
opportunity cost of capital.

3/12/2022 Mekonnen K. 80
In order to use this method properly, the following procedures are
followed.
1. Find the present value of each cash flow (both inflows and out
flows) using the cost of capital of the project for discounting.
2. Sum the discounted cash inflows and the discounted cash
outflows separately.
3. Obtain the difference between the sum of the cash inflows
and the sum of the cash outflows.
 If all the cash outflows for the project occur at time zero, i.e. at
the beginning of year 1, the present value of the cash outflows is
the same as to the net investment amount.
Decision Rule; The decision rule here is; accept a project if the NPV
is positive and reject if it is negative
 NPV > Zero Accept
 NPV = Zero Indifference
 NPV < Zero Reject
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 If the projects are independent, the projects with positive net
present values are the ones whose implementation maximizes the
wealth of shareholders.
 Hence, such projects should be accepted for implementation.
 If the projects, on the other hand, are mutually exclusive, the one
with the higher positive NPV should be accepted leading to the
rejection of the projects with lower positive NPV.
 NPV of zero imply that the cash flows of the project are just
sufficient to repay the invested capital and to provide the required
rate of return, no more, no less.
 Projects with negative NPV should not be considered for
acceptance in the first place.

3/12/2022 Mekonnen K. 82
 NPV = + + - Io
n
CFt
NPV =   Io
(1  K ) t

Where; NPV = Net present value

CFt = Cash inflows at different periods
Io = Cash outflow in the beginning (initial investment)
K = Cost of capital
t = time period
 Example; Assume that a given project is expected to have an initial investment and project
life of 40,000Birr and 5 years respectively. The annual after-tax cash flow is estimated at
12,000Birr for each of the five years.
1. Using the required rate of return of 10 percent, what is the net present
value (NPV) of the project?
2. How do you judge the acceptability of this project?
 To answer these question, it is wise to identify the cash inflows and
outflows. In this project, there are annuity cash inflows of 12,000 every
year for five years and single cash out flow of 40,000 at time zero.
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 The present value of the annuity cash inflows is:
Present value of annuity = (12,000*Annuity factor)
 The annuity factor given the period of 5 years and discount rate of
10 percent is 3.791 substituting the factor I the equation above
PVA = (12,000) (3.791) = 45,492 Birr or
= [12000/ (1.1)] + [12000/ (1.1)2] + ---+ [12000/ (1.1)5] = 45,492Birr
Present Value of Cash out flow = 40,000Birr
Net Present value (NPV) = 5,492Birr
Hence,
The Net Present value (NPV) = Present Value of inflows less present value of
outflows
NPV = 45,492 - 40,000 = 5,492 Birr
 Since the project makes the net present value (NPV) of positive
5,492 Birr, the project should be accepted.
 Consequently, the wealth of the shareholders would increase by
5,492 Birr in total as the result of accepting and running this project.
3/12/2022 Mekonnen K. 84
To further illustrate the NPV method, consider the following mutually
exclusive project alternatives, together with their cash flows.

Alternative Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

A (80,000) 20,000 25,000 25,000 30,000 20,000
B (100,000) 25,000 20,000 30,000 35,000 40,000

 The required rate of return on both projects is 12 percent.

 Then, Evaluate these projects using Net Present Value method?
 The evaluation of these two projects requires the computation of
the net preset values for both projects.
 Thus, we need to discount each of the cash flows individually.
 Then, the individual discounted cash flows are added.
 The cash out flows at time zero will be deducted from the sum of
the discounted cash inflows in order to get the net present value
3/12/2022
of the project. Mekonnen K. 85
 𝟏
Discount Factor = 𝟏∗(𝟏 𝒊)𝒏
The net present value (NPV) for project A is:
Year Cash flows Discount Factor (12%) Present Values
1 20,000 0.893 17,860
2 25,000 0.797 19,925
3 25,000 0.712 17,800
4 30,000 0.636 19,080
5 20,000 0.567 11,340
Present values of cash inflows (sum) 86,005
Present values of cash outflows 80,000
Net Present Value (NPV) 6,005 Birr
The net present value (NPV) for project B is:
Year Cash flows Discount Factor (12%) Present Values
1 25,000 0.893 22,325
2 20,000 0.797 15,940
3 30,000 0.712 21,360
4 35,000 0.636 22,260
5 40,000 0.567 22,680
Present values of cash inflows (sum) 104,565
Present values of cash outflows 100,000
Net Present Value (NPV)
3/12/2022 Mekonnen K. 4,565 Birr 86
 Since the two projects are mutually exclusive, the one with the
higher NPV has to be accepted.
 Thus, project A is selected as its NPV is higher than that of project
B.
 Had the two project been independent of one another, both of
them would be accepted because both projects have positive NPVs
What is a Discount Rate?
 Cut-off rate used in discounting future cash flows.
 Minimum rate of return required from an investment below
which a project is considered unacceptable (or an entrepreneur
considers investing does not pay/benefit).
 Opportunity cost of capital that corresponds to the return an
investor (financier) possibly obtains on the same amount of capital
if invested elsewhere (assuming the financial risks are similar for
both investment alternatives).

3/12/2022 Mekonnen K. 87
 Advantages of NPV
 It considers the concept of the time value of money i.e., a
dollar today is worth more than a dollar tomorrow owing to
its earning capacity.
 Shortcomings of the NPV criterion:
 Difficulty in selecting the appropriate discount rate.
 NPV only takes into account the cash inflows and outflows
of a particular project. It does not consider any hidden
costs, sunk costs, or other preliminary costs incurred about
the specific project. Therefore, the profitability of the
project may not be highly accurate.
 It cannot be used to compare projects of different sizes.
Therefore, the NPV of larger projects would inevitably be
higher than a project of a smaller size.
 Less understood by business people who used to think in
terms of a rate of return on capital.
3/12/2022 Mekonnen K. 88
(B) Modified NPV
 The standard NPV method is based on the assumption that
the intermediate cash flows are reinvested at a rate of return
equal to the cost of capital.
 This assumption may not be valid (may not hold) always.
 The reinvestment rates applicable to the intermediate cash
flows need to be defined for calculating the modified NPV.
 How is the modified NPV computed?
Steps Involved:
 Calculate the terminal value of the project’s cash inflows using
the explicitly defined reinvestment rate (s), which is supposed
to reflect the profitability of the investment opportunities
ahead of the firm:

3/12/2022 Mekonnen K. 89
 Then, determine the modified NPV as follows:

Illustration

Year 0 1 2 3
Cash flows -$10,000.00 -$7,000.00 $6,000.00 $26,000.00

 Re-investment Rate (usually set at the Weighted Average Cost of

Capital, WACC): 10.00%
 Project Discount Rate: 15.00%
Required
 Compute the Modified Net Present Value (MNPV)

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Year 0 1 2 3
Cash flows -$10,000.00 -$7,000.00 $6,000.00 $26,000.00
STEP 1: Present Value all = -$10,000.00 / -$7,000.00 /
cash outflows using ( 1 + 10%) ^ 0 (1 + 10%) ^ 1
re-investment rate

= -$10,000.00 -$6,363.64
PV(Outflows): -$16,363.64
STEP 2: Future Value all + $6,000.00 * + $26,000.00 *
cash inflows using (1 + 10%) ^1 (1 + 10%) ^ 0
reinvestment rate

+ $6,600.00 + $26,000.00
FV(Inflows): $32,600.00
STEP 3: Display modified -$16,363.64 $32,600.00
cash flows

Compute Modified Net $5,071.39 = $ 32,600.00 / (1 + 15% ) ^ 3 – $ 16,363.64 / (1 +

Present Value (MNPV) 15%) ^ 0
based on the project
discount rate and the STEP
3 modified
3/12/2022
cash flows: Mekonnen K. 91
C) Benefit-cost Ratio (BCR)]
 Also called Profitability Index (PI) Criterion.
 There are two ways of defining the benefit-cost ratio.
 The first profitability index measure is the ratio of the present
value of the expected cash flow (benefit) of the project and its
initial investment outlay.
Where; PV = Present value of cash flows
PI = = I0 = Initial investment outlay
PI = Profitability Index

 The second one is a net measure that relates net present value
to initial investment.
Where; NPI = Profitability Index
NPV = Net present value
NPI = = - 1 = PI - 1
I0 = Initial investment outlay

3/12/2022 Mekonnen K. 92
Decision rule
Profitability Index (PI) >1 Accept NPV is positive
<1 Reject NPV is negative
=1 Indifferent NPV is positive
Net Profitability Index (NPI) >0 Accept NPV is positive
<0 Reject NPV is negative
=0 Indifferent NPV is positive

Example 1: Consider the following two mutually exclusive projects.

Present Value Initial Profitability
of cash Flow Investment Index (PI)
Project A 200 100 2.0
Project B 3000 2000 1.50
 From the above example project A is accepted using profitability
index because its PI is greater than that of project B.
 If the projects are not mutually exclusive, both of them are feasible
3/12/2022 Mekonnen K. 93
 Present Value Initial Profitability Net Profitability
of cash Flow Investment Index (PI) Index (NPI)
Project A 200 100 2.0 2-1=1
Project B 3000 2000 1.50 1.5 – 1 = 0.5
 From the above example project A is accepted using Net
profitability index because its NPI is greater than that of project B.
 If the projects are not mutually exclusive, both of them are feasible

 Example 2: A project with Birr 100,000 initial investment and the

following estimated cash flows over its economic life is being
evaluated by a firm that has a cost of capital of 12%:
Year 1 2 3 4
Benefit 25,000 40,000 40,000 50,000
 Determine the gross and net benefit-cost ratios for the project. Is
this project acceptable?
3/12/2022 Mekonnen K. 94
 Benefit-cost ratio (BCR):

 Net Benefit-Cost Ratio (NBCR):

 The project is acceptable in both cases.

 BCR and NBCR give the same decision signal as the difference between the two
ratios is simply unity.
 The advocates of BCR argue that this criterion can better
discriminate b/n large & small investments as it measures net
present value per Birr of investment outlay.
– they argue that it is preferable to the NPV criterion
 Unsuitable as a selection criterion when cash outflows occur
beyond the current period.
3/12/2022 Mekonnen K. 95
D) Internal Rate of Return (IRR)
 The internal rate of return is the discount rate which equates
the present value of the expected cash flows with the initial
investment outlays.
 In other words, IRR is a method of ranking investment project
proposals using the rate of return on an asset (investment).
 At IRR, the sum of the present values of all cash inflows is
equal to the sum of the present values of all cash outflows.
 That is: PV (cash inflows) = PV (cash outflows).
 Hence, the net present value of any project at a discount rate
that is equal to the IRR is zero.
Io =
 IRR represents the exact profitability of the project.

3/12/2022 Mekonnen K. 96
 The calculation of IRR involves trial & error.
 The same kind of table can be used for the calculation of NPV
and IRR.
 An iterative process (using either table of present values or a
suitable computer program) finds the solution.
 “Interpolation’’ as a technique can be used to approximate the
IRR for a project.
 IRR lies between two estimated discount rates: at one the
NPV is positive and at the other the NPV is negative .
 The linear interpolation technique is given under the following
formula:

3/12/2022 Mekonnen K. 97
Where:
 NPVi1 & NPVi2 are the net present values obtained at the
estimated discount rates i1 & i2 respectively.
 Note that the lower discount rate (i1) and the higher discount
rate (i2) should differ by not more than one or two percentage
points (in absolute terms).
 The formula will not yield realistic results if the difference is too
large, since the discount rates and the NPV are not related
linearly.

3/12/2022 Mekonnen K. 98
Decision rule for the IRR technique is;
If the IRR ≥ r (the cost of capital) = Accept project
IRR < r (the cost of capital) = Reject the project
Example;
Year 0 1 2 3 4 5
After tax cash flow - $10,000 2,000 4,000 3,000 3,000 1,000
Required; Calculate IRR and decide whether to accept or reject the
project, since the firm has a cost of capital of 8%?
Solution; in order to solve for IRR, we need to solve the following
equation;
10,000 = + + + +

Assume IRR = 10%; first trial and error

10,000 = + + + +

3/12/2022 Mekonnen K. 99
 10,000 = + + + +

= 1,818.18 + 3,305.79 + 2,253.94 + 2,049.04 + 620.92

= 10,047.87
IRR = 11%; second trial and error
10,000 = + + + +

= 1,801.80 + 3,246.49 + 2,193.57 + 1,976.19 + 593.45

= 9,811.5
To find out the exact IRR, we can use interpolation system

IRR = I1+ (I2-I1) │ │

= 10 %+( 11%-10%) │ │

= 10 % + ( 1%*0.2025)
= 10% + 0.002025
= 0.10205
3/12/2022 = 10.205% Mekonnen K. 100
If the cash flow in Annuity form;
The following steps can be followed to calculate IRR for constant cash inflows.
Step 1: Find the critical value of discount factor
Discount factor = Initial investment
Annual Cash inflow
Step 2: Find the IRR by looking along the appropriate line (year) of the present
value of annuity table until the column which contains the critical discount
factor (i.e. the discount factor computed under step 1) is located.
 Illustrate:- Assume that a project has a net investment of 26,030 Birr and
annual net cash inflows of 5000 Birr for seven years. What is the IRR of
this project?
Step 1 Compute the critical discount factor. That is
Discount factor = 26,030 = 5.206
5,000
Step 2 look for the value that is equal to this discounting factor in the present
value of annuity table across the line corresponding to 7 years (i.e. n=7). The
discount factor of 5.206 appears in the 8 percent column on the line/row of 7
years. Therefore, the IRR = 8 %.
3/12/2022 Mekonnen K. 101
Interpretation of the IRR
 IRR is the maximum interest that a project could pay for the
resources used if it has to recover the initial investment, the
subsequent operating costs, and still break-even.
 It is the rate of return on capital outstanding per period while it is
invested in the project.
 The rationale for this method is that the IRR on a project is its
expected rate of return.
 Higher IRR on a project may mean the expected rate of return is higher
 If the IRR of a given investment project exceeds the cost of the funds used for
financing the project (cost of capital), there is a surplus remaining after paying for
the capital, and this surplus adds up on the wealth of the shareholders of the firm.
 Selecting a project whose IRR exceeds its cost of capital increases the shareholders'
wealth.
 A project with IRR less than the cost of capital imposes an
unnecessary cost on current shareholders.
 The return from the project will not cover even the cost of capital.
3/12/2022 Mekonnen K. 102
 If several projects or alternatives are being compared, it is not
necessarily the project with the highest IRR that should be
selected, provided the IRR is greater than the cut-off rate for at
least two of the projects under consideration.
 This occurs when ranking of investment proposals is
required as well as when the investment projects are
mutually exclusive.
 In ranking projects, the IRR criterion poses a problem as
different cash flow arrays can produce an identical IRR.
 A project with lower IRR may be accepted as for the IRR
merely being above the cut-off rate.
 The NPV criterion is preferable for choosing between
mutually exclusive projects – accept the project that has
relatively higher NPV.

3/12/2022 Mekonnen K. 103

E) Discounted Payback Period (DPBP)
 Also called the Modified Payback Period (MPBP).
 Suggested as an alternative financial appraisal criterion – as a
means to overcome the limitations of the simple payback period.
 Requires that cash flows are first converted into their present
value equivalent (by applying suitable discounting factors) before
being added to determine the payback period.
 Refers to the number of years required to recover the initial
investment of a project considering discounted cash flows.
 Uses discounted (and not nominal) cash flows.
 The expected future cash flows are discounted using the project‘s
cost of capital.
 The DPBP is longer than the simple payback period.

3/12/2022 Mekonnen K. 104

Illustration
Consider a project that requires an initial investment of Birr 30,000
and generates annual after-tax cash flows of Birr 15,000, Birr 18,000,
Birr 12,000, Birr 20,000, and Birr 22,000 respectively over its five
year economic life. The firm’s cost of capital is 10%. What is the
discounted payback period for this project?
Solution:

3/12/2022 Mekonnen K. 105

Note: the cumulative discounted cash flow at the end of year 2 is less
than the initial investment of Birr 30,000; and the cumulative
discounted cash flow at the end of year 3 is greater than the net initial
investment.
 The above project’s DPBP is b/n 2 to 3 years.
 The exact discounted payback period can be obtained as follows:

 A period of 2 years and 2 months is required to recover the

project’s initial net investment taking the time value of money
into account.

3/12/2022 Mekonnen K. 106

5.9. Financial Analysis Under Uncertainty
 Forecast of demand, production, and sales may not be exact as
the future is full of uncertainties.
 Assumptions concerning the estimates of production and
investment costs, prices, or the lifetime of the project may not
always be correct.
 Particularly 3 variables should be examined when dealing with
investments under conditions of uncertainty:
 Sales revenue
 Production cost
 Investment cost
 A host of individual items enters into these variables, all of
which are composed of a price and a quantity variable.

3/12/2022 Mekonnen K. 107

 Most common reasons for uncertainty:
 Inflation
 Changes in technology
 False estimation of the rated capacity level
 Length of the construction & operating period
 Uncertainty analysis includes:
 Sensitivity Analysis
 Scenario Analysis
 Break-Even Analysis

Reading………………………..
5.10. Project Evaluation Under Conditions of Risk
 Risk, Return and NPV [Risk Adjusted Net Present Value (RANPV)]
 The required rate of return can be set to equal the sum of the risk-free
rate plus some additional return to compensate for risk.
3/12/2022 Mekonnen K. 108
5.11. Project Financing
5.11.1. Overview
 The decision to accept or reject a project based on the
discounting criteria (like NPV, IRR, etc) cannot be made
without knowing the cost of capital.
 The capital outlay of a project can be appropriately
determined only after:
 Plant capacity & location have been decided.
 The costs of land, site development, buildings & civil
works, technology, equipment, etc estimated.
 Requirement of working capital determined.
 Determining the financial requirements of a project at the
operational stage in terms of working capital is also
necessary.

3/12/2022 Mekonnen K. 109

  Working capital requirement can be determined only
when production costs and the level of sales & income are
estimated and reflected in a cash flow analysis.
 It is prudent to proceed to the financing decision & project
implementation only when:
 Estimate of the fund requirements provided.
 Available resources sufficient to meet the fund
requirements.
 In academic literatures, the aspect of project financing is raised
after project selection.
 In practice, project financing is considered right from the time
of project conception.
 Project financing is intertwined with project planning,
analysis, and selection.
 The contours of project financing become clearer as the
project proposal progresses through these stages.
3/12/2022 Mekonnen K. 110
 Investment and Financing Si d es
(A Hypothetical P roje ct )

3/12/2022 Mekonnen K. 111

5.11.2. Capital Structure
 The major sources of finance available to a firm are
shareholders and lenders.
 Capital structure means the proportion of debt and equity
financing in a given firm.
 Explain the characteristics of debt and equity financing.
Comparisons Between Equity & Debt Financing:

3/12/2022 Mekonnen K. 112

 What considerations should be made in determining the
capital structure (debt equity ratio) of a firm?
 Key Business Considerations in Planning the Capital Structure
of a Firm:
 Nature of Assets (Tangible fixed assets serve as collateral to debt)
 Earnings Per Share (EPS)
 Risk (business risk & financial risk)
 Control
 Flexibility
 Capacity of Raising Funds
 Issue or flotation costs
 Loan Covenants
 Debt and Non-Debt Tax Shields

3/12/2022 Mekonnen K. 113

5.11.3. Sources of Finance
1. Equity
 General financing pattern for an industrial project:
 Cover the initial capital investment by equity and long-term loans to varying extent.
 Finance the minimum net working capital requirement using long-term capital.
 Meet subsequent WC requirements by additional short-term & medium-term loans
from banks.
 In situations where institutional capital is scarce & available
only at high cost, equity capital covers the initial capital
investment and net working capital.
 Maintain appropriate balance between long-term debt and
equity.
 The higher the proportion of equity, the lesser will be the debt service obligations
and hence, the higher the gross profit before tax (EBT).
 The higher the proportion of loan finance, the higher the interest payable on
liabilities will be and hence, the lesser the gross profit before tax (EBT).
3/12/2022 Mekonnen K. 114
 Carefully assess the implications of alternative patterns & forms
of financing in every project.
 Determine a financing pattern that is consistent with both
availability of resources & overall economic returns.

2. Loan Financing
 Financial institutions and commercial banks provide loans that
represent recurrent borrowings.
 Loans are very important sources for financing:
 New projects
 Expansion & modernization projects
 Replacement investments
 It is relatively easy for a sound project to obtain loans.
 Process of project financing may start by identifying:
 The extent to which loan capital can be secured.
 The interest rate applicable to the loan.
3/12/2022 Mekonnen K. 115
Sources of Loan Funds
A. Short-term & medium-term borrowings from commercial
banks for WC financing or suppliers’ credit for purchases of
materials and inputs.
B. Long-term borrowings from national or international
development finance institutions for making investment in
fixed assets.
 Loan financing is usually subject to certain restrictions vis-à-vis raising additional
debt funds, convertibility into shares, declaration of dividends, etc.
 Certain ratios in the capital structure of the company need to be maintained.
 Investments may also be financed partly by issues of bonds & debentures.
 An important source of finance is also available at government-to-government
level in developing countries.
• This can be a bilateral credit or tied credit, which may be related to the
purchase of machinery & equipment from particular country or source.
 Identify the pattern of advancing the funds obtained from loan sources.
3/12/2022 Mekonnen K. 116
 Enter into loan contract with lenders.
 The loan contract will be the basis for loan repayment
schedule … input for the financial plan.
 Contract terms on the Loan:
 Amount of loan & currency involved (local/foreign)
 Interest rate (amount, frequency of compounding, etc)
 Grace period
 Loan amortization/repayment arrangements (amount of
installment payments, maturity date, etc)
 Collateral requirements
 The contract should explicitly state the arrangements for
periodically drawing the loan funds based on some condition
(e.g., % of project completion, etc).

3/12/2022 Mekonnen K. 117

C. Denture Capital
 Debentures (such as bonds, mortgages, etc) issued to the
public to raise additional long-term funds.
 Debentures are important instruments for raising debt capital.
 Similar to promissory notes.
 Can be convertible (wholly or partly) into equity shares.
 There are non-convertible debentures as well.
 Straight debt instruments carrying fixed rate of interest and have a maturity period.
3. Supplier Credits (Deferred Credits)
 Suppliers of plant & machinery provides deferred credits.
 Payment made over a period of time (not immediately).
 Suppliers of machineries in developed countries are willing to
sell on deferred-payment terms to buyers in the developing
nations.
 Significant proportion of imported machineries & spares often
are financed on deferred credit terms (payments may spread
over 6 to 10 years).
3/12/2022 Mekonnen K. 118
4. Leasing
 Instead of borrowing, it is sometimes possible to lease plant
equipment or even complete production units.
 Productive assets could be borrowed on a long-term basis –
through a lease contract.
 Represents a contractual arrangement.
 The lessor grants the lessee the right to use an asset in return
for periodic lease rental payments.
 Usually requires an initial down payment and periodic
payments (often annual rents) – lease fee.
 Leasing of land & building has been known a long ago.
 The leasing of industrial equipments is a relatively recent
phenomenon (for instance, in Ethiopia).
 Types of Lease: Finance Lease and Operating Lease.

3/12/2022 Mekonnen K. 119

A. Finance Lease (or Capital Lease)
 It is essentially a form of borrowing.
Salient features of Finance Lease:
 It is an intermediate term to a long-term noncancelable
arrangement.
 The lease cannot be cancelled during the initial lease period.
 Referred to as the “primary lease period”.
 Usually 3 years, 5 years, or 8 years.
 The lease is more or less fully amortized during the primary
lease period.
 During this period, the lessor recovers (through the lease rentals) his/her
investment in the equipment along with an acceptable rate of return.
 A finance lease transfers substantially all the risks and rewards
incident to ownership to the lessee.
 The lessee is responsible for maintenance, insurance, and taxes.
 The lessee usually enjoys the option for renewing the lease for further periods at
reduced lease rentals.
3/12/2022 Mekonnen K. 120
B. Operating Lease
 Defined as any lease other than a finance lease.
Salient features of an Operating Lease:
 The lease term is significantly less than the economic life of
the equipment being leased.
 The lessee enjoys the right to terminate the lease at a short
notice without any significant penalty.
 The lessor usually provides the operating know-how & the
related services and undertakes the responsibility of insuring &
maintaining the equipment.
 Such an operating lease is called a “wet lease".
 An operating lease where the lessee bears the costs of insuring & maintaining
the leased equipment is called a “dry lease".
 An operating lease does not result in a substantial transfer of
the risks and rewards of ownership from the lessor to the
lessee.
3/12/2022 Mekonnen K. 121
 The lessor has to depend upon multiple leases or on the
realization of a substantial resale value (on expiry of the first
lease) to recover the investment cost plus a reasonable rate of
return.
 Specializing in operating lease calls for an in-depth knowledge
of the equipments and the secondary (resale) market for such
equipments.
 The prerequisite for popularly using operating leases is the
existence of a resale market.
 Assets acquired through lease contracts are contained in the
balance sheets of the lessors and not in the lessees.
 The lessee cannot claim depreciation on the leased assets.
(The lessee is not the owner of the asset)
 The lessee charges the periodic lease payments as a tax-
deductible expense.
 The lessee does not enjoy the asset’s salvage value.
3/12/2022 Mekonnen K. 122
 Leasing was considered as an off-balance sheet financing to the
lessee.
 Basic concern of financial managers: to choose the best option
(leasing or purchasing of capital assets).
 Discounted cash flow technique should be applied to evaluate such alternatives.
 Cash outflows (i.e., investment cost) of the project constitutes the initial down
payment, current leasing fees, and subsequent payments under the lease agreement.
 Duration of lease contracts often is shorter than the technical
(or economic) life of the leased assets.
 How should the residual value of the leased assets treated for
the sake of financial appraisal?
 When comparing leasing with other alternatives such as loan financing (equivalent
loan/buy the asset by borrowing), the residual/resale value of the asset should be
included as an inflow in the latter.
 The amount that is considered an inflow for the borrow & purchase option would
usually not be the book value.
 It should be the lower of either the BV or the MV (minus the lessors cost of selling
3/12/2022 the used items). Mekonnen K. 123
5. Incentives
 Government units or agencies may provide financial support in
various forms:
 Seed capital assistance provided at nominal rate of interest
in order to enable the promoters meet their contribution to
the project.
 Capital subsidy provided by regional or local governments
in order to attract industries to certain locations (less
developed, backward, or marginalized areas).
 Provisions for deferring payment of taxes, partial or full
exemption of taxes for a certain period (such as sales tax),
etc.

3/12/2022 Mekonnen K. 124

5.11.4. Cost of Capital
 Equity and long-term loans often are used to cover the initial
capital investment.
 Short-term & medium-term loans are used to meet additional
WC requirements in later years/periods.
 Loans are very important sources for financing various forms
of investments/projects.
 Lending:
 Long-term, medium-term, or short-term commitment for
transferring surplus funds to the deficit spending (or
borrowing) units.
 Reduces the liquidity of the lender.
 Increases risk due to uncertainties concerning the full
return of the funds lent.

3/12/2022 Mekonnen K. 125

 Lenders need a reward as a compensation for:
 Risk assumed
 Time value of money
 Opportunities foregone
 Equity investors (owners) also provide substantial amount of
funds for a firm with the expectation of a return that
compensates:
 Business & financial risks assumed
 Implied costs arising from the sacrifice of alternative
investment opportunities.
 We cannot finance projects using equity funds alone, nor is it
necessary.
 Many lenders provide long-term loans for sound projects
at optimum prices.

3/12/2022 Mekonnen K. 126

 A balance needs to be maintained between long-term debt &
equity financing.
 These are external sources of funds.
 A firm must pay reasonable prices to suppliers to raise (or
obtain) such funds.
 This price is referred to as the cost of capital or cost of
funds.
 Cost of capital comprises:
 Interest charges on borrowed funds (usually expressed as a
% per annum)
 Certain fixed charges (such as commitment fee, charge on
capital not drawn, commissions, etc)
 Periodic dividends to the shareholders (paid on the basis
of outstanding shares of the firm)

3/12/2022 Mekonnen K. 127

 Interest is usually computed on the outstanding balance of the
corresponding liabilities.
 Dividend payments depend on the level of income generated
from current operations (paid as per the decisions of the firm’s
board of directors).
 Carefully assess the implications of alternative patterns and
forms of financing.
 Determine the financing pattern that is consistent with both the
availability of resources and overall economic returns.
 The tax implications of debt financing should be considered in
the process of determining the optimum capital structure.
 Interest is a tax deductibility expense.
 The tax deductibility of interest reduces the effective cost of
debt.

3/12/2022 Mekonnen K. 128

 Determine the Weighted Average Cost of Capital (WACC) in
light of the proposed proportion of longterm financing and
specific costs of each source.
 The WACC is the discount rate used in discounting the future
cash flows of the project.
 Considering debt and equity sources of external finance, we
can use the following formula:
WACC = (D% x Kd) + (E% x Kre)

where:
D% = proportion of funds raised from a specific debt source
Kd = after tax (or net) cost of specific source of debt
E% = proportion of funds raised from equity source
Kre = specific cost of equity funds
_________________________//________________________

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 End of Chapter – Five
Thank You!!!

3/12/2022 Mekonnen K. 130