Chapter Five

Financial Analysis of Projects

5.1. Financial analysis basic

Financial analysis of a project amounts to reviewing it from the angle of the entity (private or public)
that will be responsible for its execution. The necessity to determine the financial profitability of a
project to the project implementer calls for undertaking financial analysis. It aims at verifying that
under prevailing market conditions the project will become and remain viable. It is concerned with
assessing the feasibility of a new project from the point of its financial results.

The project’s direct benefits and costs are, therefore, calculated in monetary terms at the prevailing
(expected) market prices. In other words, the financial analysis is all about the assessment, analysis and
evaluation of the required project inputs, the outputs to be produced/generated/ and the future net
benefits, (expressed in financial terms) with the aim of determining the viability of a project to the
private investor or the executing entity public body. The financial analysis is one of the analyses
conducted in a feasibility study and is normally undertaken after the market technical and
environmental analyses. The objective of the analysis is to determine the financial viability of the
project.

5.2. Cost of Project

The cost of the project represents the total of all items of outlay associated with a project that can be
financed by long - term funds. Generally, the total outlays will include the following:
 Land and site development
 Buildings and civil works
 Plant and machinery
 Technical know – how and engineering fees
 Expenses on foreign technicians and training
 Miscellaneous fixed Assets
 Preliminary and capital issue expenses
 Pre – operative expenses
 Provision for contingencies
 Margin money for working capital
 Initial cash losses

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 A. Land and Site Development
Major costs for land and site development include the following items:
 Basic cost of land including conveyance and other related charges.
 Premium payable on lease hold and conveyance charges.
 Cost of leveling and development.
 Cost of leveling approach reads and internal roads.
 Cost of gates.
 Cost of tube wells.
Practically, cost of land tend to vary from one location to another. In rural location the cost of land is
relatively lower. Whereas, in urban and semi – urban locations the cost becomes higher. Site
development expenditure also vary considerably depending on the location and topography of the land.

B. Buildings and Civil Works

The cost of the buildings and civil works depends on the types of structures required. Mainly, buildings and civil
works cover the following:
 Buildings for the main plant and equipment.
 Buildings for auxiliary services such as steam supply, workshops, laboratory, water supply, power house,
etc.
 Non – factory buildings like lounge, guest houses, time office, etc.
 Silos, tanks, wells, chests, basins, cisterns hopers, bins and other structures which are necessary for
installation of the plant and equipment
 Garages
 Sewers, drainage, etc.
 Other related engineering works.

C. Plant and Machinery

In a project undertakings, the cost of plant and machinery constitute the major component of the project
cost, consists of the following:
 Cost of imported machinery: It is the total of (i) FOB (free on board) value, (ii) shipping,
freight, and insurance cost, (iii) import duty, and (iv) clearing, loading, unloading, and
transportation charges.
 Cost of indigenous machinery: it consists of (i) for (free on board), (ii) sales tax, and other
taxes, if any, and (iii) transportation charges to the site.
 Cost of stores and spares.
 Foundation and installation charges.

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The cost of the plant and machinery is based on the recent available quotation adjusted for possible
escalation.
D. Cost of Production
Generally, it is essential to make realistic forecasts of production or manufacturing costs for a project in
order to determine it’s the future viability.
Given the estimated production, the cost of production may be worked out. The principal components
of cost of production are:
 Material cost
 Utilities cost
 Labor cost
 Factory overhead cost

 Materials
Materials, predominantly variable costs, such as raw materials, factory supplies and spare parts. Materials are
the most important component of cost and generally the material cost comprises the cost of materials, chemicals,
components, and consumable stores required for production. It is a function of quantities in which these
materials are required and the prices that can be paid for them
The following points should be considered, while estimating the material cost:
i) The requirements of various material inputs per unit of output may be established on the basis of one
or more of the following : (a) theoretical consumption norms, (b) experience of the industry, (c)
performance guarantees, and (d) specification of machinery suppliers.
ii) The total requirement of various materials inputs can be obtained by multiplying the requirements
per unit of output with the anticipated output during the year.
iii) The prices of materials inputs are defined in CIF (cost, insurance, and freight) terms.
iv) The present costs of various material inputs is considered. In other words, the factor of inflation is
ignored. It may be recalled that the factor of inflation is ignored in estimating the sales revenues too.
v) If seasonal fluctuation in prices are regular, the same must be considered in estimating the cost of
material inputs.
 Utilities
Utilities consist of power, water, and fuel. The requirements of power, water, and fuel may be determined on the
basis of the norms specified by the collaborators, consultants, etc. or the consumption standards in the industry,
whichever is higher.

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  Labour
Cost of labour is the cost of all the manpower employed in the factory. Normally, the labour cost is the function
of the number of employees and the rate of remuneration. The requirement of workers depends on the number of
operators/helpers required for operating various machines and manning various services. Based on the existing
general norms in the given industry, the number of supervisory personnel and administrative staff may be
calculated.
While estimating remuneration rates, he prevailing rates in the industry- area should considered. The
remuneration should include, besides basic salary, dearness allowance, house rent allowance, conveyance
allowance, medical reimbursement, leave travel concession, provident fund contribution, gratuity contribution,
and bonus payment. Moreover, account should be maintained for vacations, overtime work, night work, work on
holidays, etc.
 Factory Over Heads
In general, factory over heads are fixed costs. Collectively, factory overheads referred to as the expenses on
repairs and maintenance, rent, taxes, insurance on factory assets, and so on. Repairs and maintenance expenses
depends on the state of the machinery – this expense bound to be lower in the initial year and higher in the later
years. Rent, taxes, insurance, etc. may be calculated at the prevailing rates.
5.3. Measuring Project cash flows
All the financial information obtained will be used to plan the project’s cash flow. Evaluating the
project requires identifying all benefits and costs of project. Thus, a cash flow schedule is an important
tool that shows the overall cash inflows (receipts) and outflows (payments) of a project throughout its
life.

5.3.1. Non-discounted cash flow approaches

The non-discounted criteria will not in general take into account the time value of money. That is, inter-
temporal variations of costs and benefits, and its influence on cash flow are largely ignored. As a result,
a time dimension is not included in the evaluation. There are different methods under this category:
1. Ranking by Inspection;
2. Payback Period;
3. Proceeds per Unit of Outlay;
1) Ranking by Inspection
It is possible, in certain cases, to determine by mere inspection that which of the two or more investment
projects is more desirable. There are two cases under consideration:

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 i. When two projects have identical cash flows but different project life, one has shorter life while the
other has longer project life, the project with the longer life would be more desirable.
ii. When two projects have the same initial outlay, the same total proceeds (profits), but one project has
more of the flow earlier in the time sequence, then we choose the project having higher proceeds in
the earlier period than later.

Accordingly, project B is better than project A, since all things are equal except that B continues to
earn after A has been retired. More analysis is required to decide between C and D. Project D is more
profitable than C, since D earns 2000 more in year 1 than project C, even if the total earning from the
two projects does not differ.
2) Payback Period;
The payback period is one of the simplest and apparently one of the most frequently used methods of
measuring the economic value of an investment. The recovered money can be reinvested in something
else. If the investor recovers its initial outlay, then in a way it is minimizing the risk it faces in the
subsequent operation of the project.
The payback period is defined as the length of time required for the stream of cash proceeds produced
by the investment (project) to be equal to the original cash outlay required by the investment (capital
investment). It is defined as the number of years it is expected to take from the beginning of the project
until the sum of its net earnings (receipts minus operating costs) equals the cost of the projects initial
capital investment. It is the period of time that the investor recovers its initial total outlay. This criterion
is most often used in the business enterprises. However, its use in agricultural projects is limited.
- Example: if a project requires an original outlay of Birr 300 and is expected to produce a
stream of cash proceeds of Birr 100 per year for 5 years, the payback period would be 300/100
= 3 years.

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Note: if the expected proceeds are not constant from year to year, then the payback period must be
calculated by adding up the proceeds expected in successive years until the total is equal to the original
outlay.
- Example: consider project C. 10,000 - 3762 = 6238. Then 6238/7762 = 0.8 so the payback
period is 1.80 years.

Investment A and B are both ranked as 1, since they both have shorter payback periods than any of
the other investments, i.e., 1 year. Investment B, which has the same rank as A, will not only earn
10,000 Birr, but also 1,100 Birr a year later. Thus, investment B is superior to A. But a ranking
procedure such as the payback period fails to disclose this fact.
 Two important limitations of payback period:
 It fails to give any considerations to cash proceeds earned after the payback date. It simply
emphasizes on quick financial returns, ignoring the performance of the project over its
economic life.
 It fails to take into account differences in the timing of receipts and earned proceeds prior to the
payback date. For instance, if we have two projects with the same capital cost and if they have
the same payback period then they are equally ranked. Yet, we know by the inspection method
that the project with earlier benefits should be desirable and preferred, since it can be reinvested
or consumed.
3) Proceeds per Unit of Outlay
Under this method, investments are ranked according to their total proceeds divided by the amount of the
corresponding investments. In other words, the total net value of incremental production divided by the total
amount of the investment gives us the proceeds per unit of outlay.

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Accordingly, project C and D given the same rank must be implemented. Although, we know by
inspection that project D is superior because D generates Birr 2000 of proceeds in year 1.
This method is again deficient because it still fails to consider the timing of proceeds. In other word, the
method considers that 1 Birr of proceeds received in year 2 is equal to 1 Birr received in year 1. This is
inconsistent with the generally accepted economic principle that 1 Birr today is more valuable than 1
Birr at some future date.

5.3.2. Discounted cash flow approaches

This concept is based on the time value of money. The flow of income is spread over a few years. 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. Two methods of appraisal of investment project are based on this concept. These are
net present value and internal rate of return method.

The undiscounted measures discussed so far share a common weakness. They fail to take into account
adequately the timing of benefits and costs. It is an accepted principle in economics that inter-temporal
variations of costs and benefits influence their values and a time adjustment is necessary before
aggregation.
For a whole range of reasons, people, enterprises and governments are said to have time preference in
that they prefer to receive income sooner rather than later, and to pay for expenditures later rather than
sooner.
Example: if a person is offered the choice between receiving Birr 100 now, or year later, he will
invariably opt to receive Birr 100 now.
Some of the main reasons why people prefer to have income now rather than in the future include the
following:

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1. There is an expectation that society and individuals will be better off in the future than they are
now:
2. One may expect inflation to reduce the real value of Birr 100 in the coming year.
3. If there is no inflationary effect (say where the offer is made in real terms) it would still be
preferable to take the money today and invest it at some rate of interest, r, hence receiving a total
of Birr 100 (1+r) at the end of the year.
4. Uncertainty about the future: Even if no investment opportunities are available, one might reason
that Birr 100 today would still be preferable on the ground that there is a finite risk of not being
around to collect the money next year.
5. Even where inflation, investment opportunities, and risk are ignored, there is pure time
preference, which would lead one to prefer the immediate offer.
For all these reasons, tomorrow’s income available from a project cannot be treated as if it were equally
valuable to today’s income. The most important discounted cash flow measures are:
1) The Net Present Value (NPV)
2) Profitability Index (PI)
3) The Internal Rate of Return (IRR)
a) Net Present Value
Net present value may be defined as the total of present value of the cash proceeds in each year minus the
total of present values of cash outflows in the beginning
n
CFt Sn+Wn
∑ (1+ +
K ) (1+ K )n
t
−Co
NPV =

Where; NPV = Net present value

CFt = Cash inflows at different periods
Wn = Working capital adjustments
Co = Cash outflow in the beginning
K = Cost of capital
Sn = Salvage value at the en
The decision rule here is to accept a project if the NPV is positive and reject if it is negative
I. NPV > Zero accept
II. NPV = Zero accept
III. NPV < Zero reject

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EX: ABC PLC is considering to invest in a cement project. It has on hand $180, 000. It is expected that the
project may work for seven years and likely to generate the following annual cash flows. Calculate the Net
present value.
Year ACF
1 30,000
2 50,000
3 60,000
4 65,000
5 40,000
6 30,000
7 16,000

The cost of capital is 8%

Solution: Year ACF PV factor Present value
1 30, 000 .926 27, 780
2 50, 000 .857 42, 850
3 60, 000 .794 47, 640
4 65, 000 .735 47, 775
5 40, 000 .681 27, 240
6 30, 000 .630 18, 900
7 16, 000 .583 9, 328
221, 513
- Original investment 180, 000
Net present value 41, 513

The above problem the NPV is greater than zero hence, it may be accepted. You have already learned
in financial accounting to calculate the time value of money and the usage of present value tables.
Hence, you may directly use the present value factors from tables.
1 1
n
= 1
Present value of birr 1 = (1+r) (1+.10 )

The present value of 1 Birr @ 10 cost after one year .909

two year .826
three .751

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  Profitability Index Method / Benefit Cost Ratio B/C Ratio
Profitability index method is the relationship between the present values of net cash inflows and the
present value of cash outflows. It can be worked out either in unitary or in percentage terms. The
formula is
Present value of cash inflows
Profitability Index = Pr esent value of cash outflows

PI > 1 Accept
PI = 1 indifference
PI < 1 reject
Higher the profitability index more is the project preferred.

From the above example we can calculate the profitability index as below

Present value of cash out flows $ 180, 000

Present value of cash inflows $ 221, 513

221,513
: - PI = 180,000 = 1.23

 Internal Rate of Return (IRR)

The internal rate of return is also known as yield on investment, marginal efficiency of capital,
marginal productivity of capital, rate of return time adjusted rate of return and so on. Internal rate of
return is nothing but the rate of interest which equates the present value of future earnings with the
present value of present investment. Therefore, IR depends entirely on the initial outlay and the cash
proceeds of the project which is being evaluated for acceptance or rejection. The computation of IRR is
difficult one; you have to start equating the two values i.e., present value of future earnings and present
value of investment. It is possible through trial and error method.
IRR can be calculated basing on the pay back period where annual cash flows are uniform, in case the
annual cash inflows are different for the periods, the fake pay back period is calculate then adopt trial
and error procedure.
PB−DFr
r−
IRR = DFrL−DFrH

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 Where; PB = Pay back period

DFr = Discount Factor for interest

DFrL = Discount Factor for lower interest rate

DFrH = Discount Factor for higher interest rate

r = Either of the two interest rates used

or

NPVL
×R
IRR = LRD + PV

Where; IRR = Internal Rate of Return

LRD = Lower Rate of Discount

NPVL = Net present value at lower rate of discount

(i.e., difference between present values of cash)

PV = The difference in present values at lower and higher discount values at lower.
R = The difference between two rates of discount.

Ex: Nissan Plc. has $100, 000 on hand. This amount is invested in a project, where the annual benefits after
taxes are as below. It would like to know the rate of return earned by the company at the end of the life of the
project.

Year ACFS
1 $ 40, 000
2 35, 000
3 30, 000
4 25, 000
5 20, 000

Solution
At Discount Factor 20% At Discount Factor 10%

Year ACFS PV Factor PV in $ PV Factor PV in $

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1 40, 000 .833 33, 300 .909 36, 400

2 35, 000 .694 24, 300 .826 28, 900

3 30, 000 .579 17, 400 .751 22, 500

4 25, 000 .482 12, 100 .683 17, 100

5 20, 000 .402 8, 000 .621 12, 400

95, 100 117, 300

NPVL
×R
IRR = LRD + PV

17,300
×10
= 10 + 22,200
= 17.8

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