Project Analysis and Evaluation

Prepared by: Amare Mabrie

(Assistant Professor of Economics)

November, 2023
Bahir Dar
Chapter One: Introduction
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Project-Definitions & Descriptions

 It is an investment activity in which financial resources are expended to

create capital assets that produce benefits over an extended period of time.
 It is a complex set of activities where resources are used in expectation of
return and which lends itself to planning, financing and implementing as a
unit.
 Is a group of tasks performed in a definable time period in order to
meet a specific set of objectives?
According to the project management institute (PMI)
 a project is a temporary endeavor undertaken to create a unique product ,
service, or a result.
 UNIDO (1986) defined
 “a project as a proposal for investment to create, expand and/or develop
certain facilities in order to increase the production of goods and/ or
services in a community during a certain period of time”.
 project gives life to and is the visual and concrete representation of plan,
strategy and policy

Basic Characteristics of a project

1. A project is an exception
2. Unique Activities
3. Specific deadlines and goals
4. The desired result is identified
5. Connected Activities/Interdependencies
6. Complex Activities
7. Sequence activities
8. Progressive Elaboration
9. Within Budget
10. According to Specification
11. High Degree of Activity

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 12. Conflict
13. Life Cycle
14. High level of uncertainty & risk
15. Teamwork/multi-skill
16. Irreversible

1. A project is an exception.

 Unlike routines, projects involve investigation, completion, arrangement,

and reporting of findings in some way that provides value.
 The answers to the basic project questions cannot be found in the routines
of your department, which is what makes it exceptional.

2. Unique Activities

 A project has never happened before, and it will never happen again under
the same conditions (time and space, outputs or deliverables etc).
 Something is always different each time the activities of a project are
repeated.
3. Specific deadlines and goals

 Projects have identifiable starting and stopping points with well known
goals and activities.
 However, projects may often have intended and unintended social,
economic and environmental impacts that far outlast the projects
themselves.

4. The desired result is identified

 A project is well defined only when a specific result is known.

 By comparison, departmental routines involve functions that may be called
‘‘process maintenance.’’

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  That means that rather than producing a specific outcome, a series of
recurring routines are aimed at ensuring the flow of outcomes (e.g., reports)
from one period to another

5. Connected Activities/Interdependencies.

 Connectedness implies that there is a sequence, parasail, logical or

technical relationship b/n pairs of activities.
 They are considered connected because the output from one activity is
the input to another.

6. Complex Activities

 The activities that make up the project are not simple and repetitive acts
like painting the house, washing the car, or loading the delivery truck.
 They are complex, example, designing an intuitive user interface to an
application system.

7. Sequence of Activities

 A project comprises a number of activities that must be completed in

some specified order, or sequence.
 The sequence of the activities is based on technical requirements, not on
management prerogatives.
 To determine the sequence, it is helpful to think in terms of inputs and
outputs

8. Progressive elaboration

 Project scope will be broadly described early in the project and becomes
more explicit and detailed as the project team develops better and more
complete understanding of the objectives and deliverables.
 We learn more and more about the project as it goes on

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9. Within Budget

 Projects also have resource limits, such as amount of people, money,

or machines that are dedicated to the project.
 While these resources can be adjusted up or down by management,
they are considered fixed resources to the project manager.

10. According to Specification

 customer, or recipient of the project’s deliverables, expects a certain level

of functionality and quality from the project.
 These expectations can be
 self-imposed; specification of the project completion date, or
 customer-specified; producing sales report on a weekly basis.

11. High Degree of Activity

 Especially during the execution stage, a project involves several hectic

(excited) activities.

12. Conflict

 A project may be impacted by competing activities with respect to

resource needs or management focus.

13. Life Cycle

 A project has different phases and is completed in stages

14. High level of uncertainty & risk

 As a result of its uniqueness, dependency on other agencies and its

relatively long-term nature; a project is faced with a lot of uncertainty and
risk
15. Teamwork/multi-skill

 Projects require a team of people with different skills to get the job done

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16. Irreversibility

 Wrong capital investment decision often cannot be reversed without

incurring substantial loss.
Why Project Planning?

1. The quest for change: dissatisfaction with the present and/or pressure or
incentive for different tomorrow;
2. Change involves investment/commitment of resources to realize the
objectives.
3. The scarcity of resources and unlimited development/ business needs;
4. Investment is all about resource commitment into the future, which is less
predictable and high risk involved
5. The costs and benefits are temporally spread and particularly the large part
of the costs are incurred earlier and the benefits are generated later on
6. In such a situation decision-making is not simple and perfect

1.2 Types of projects

 Projects can be classified in different way based on

A. Owner
 Public
 Private
B. Scale
 Small,
 Medium
 Large
C. Sector
 Agricultural
 Industrial
 Service
D. Task (objective)

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 (1) Manufacturing Projects:

 Where the final result is a vehicle, ship, aircraft, a piece of machinery

etc.
(2) Construction Projects:

 Resulting in the erection of buildings, bridges, roads, tunnels etc.

Mining and petro-chemical projects can be included in this group.

(3) Management Projects:

 Which include the organization or reorganization of work without

necessarily producing a tangible result.
 Examples would be the design and testing of a new computer software
package, relocation of a company’s headquarters or the production of
a stage show.
(4) Research Projects:

 In which the objectives may be difficult to establish, and where the

results are unpredictable.
e. New resources commitment

1. new investment

 Designed to establish a new productive process independent of previous

lines of production.
2. expansion projects

 Involve repeating or extending an existing economic activity with the

same output, technology & organization.
3. updating projects

 Involve replacing or changing some elements in an existing activity

without major change of output.
1.3 Projects, programs, and Plans

National Plan
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  Set overall growth and development target for a country
Policy
 It is a concept (usually in a written document), whereby the
government or a political party will determine decisions, actions and
other matters that will prove advantages to society in general.
Sector policy
 Agriculture policy: technology-based intensification of smallholder
agriculture, .
 Health policy: assurance of accessibility of health care for all segments
of the population
Strategy
 Approaches undertaken to achieve the stated policies. eg. ADLI
Programs
 They are planned-continuous or ongoing development or investment
activities that are not generally time bound.
 aim at improving the public welfare
 assumes decision making at national/organizational level.
 may consist of a number of projects with distinctly specified time and
resource.
Project
 the means through which development targets (programs) are
converted into tangible benefits for the project beneficiaries.
Examples
Programs
 Rural development program,
 General Education quality Improvement program ,
 Health extension program,
 Public service reform program …
Projects
 Water Supply projects,
 Teacher Development projects,

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 Ethiopia Health Centre Renovation and Coordination project

Project Program

Differences  Has specific real/geographic unit • May not have specific area
 Is specific in objectives/ purpose • Has got general objectives
 Has specific targets groups • May not have specific target
 Has clearly determined and groups
allocated fund • May not have clear and
 Has specific life time detailed financial allocation
• May not have specific time of
ending (open ended)

Similarities  Has purpose/objectives

 Require input (financial, manpower, material)
 Generate output (goods and/or services)
 Operate over space and time

Project vs. program

 If there is no organic link between plans, policies, and projects, then the
effectiveness and efficiency of investment decisions could be compromised.
 Promoting projects without having development policies and plans will lead to
scattered/dispersed and unorganized development endeavors.
 Policies and plans without projects mean non-implementation, paper tiger
decision making
 The organic link between plan, program and project

National plan ⇒ Policy ⇒ Sectoral policy ⇒ Programs ⇒ Projects ⇒

Outcomes / impacts /changes

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Furthermore project needs to be SMART

S – Specific: in its objective and activities

M –Measurable: in investment and production activities and benefits expected should be
identified and valued in financial, economic and social terms (if possible) .
A –Area bounded: specific and identifiable group of beneficiaries, so also have to have
boundaries
R –Real: project must fit with real social, economic political, technical, etc situations.
T –Time bounded: it has clear starting and ending point

1.4 Aspects of project analysis

There are seven aspects of project analysis:

A. Technical Aspect
B. Commercial Aspect
C. Institutional Aspect
D. Financial Aspect
E. Economical Aspect
F. Social Aspects
G. Environmental Aspects

A. Technical Aspect
 This aspect may include the works of engineers, soil scientists and
agronomists in case of, say, agricultural projects.
 The technical analysis is concerned with the projects inputs (supplies) and
outputs of real goods and services and the technology of production and
processing.
 It is analysis of the technical and engineering aspects of a project to be
done continuously when a project is formulated.

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  It seeks to determine whether the prerequisites for the successful
commissioning of the project have been considered and reasonably good
choices have been made with respect to location, size, process, etc.
 Here all physical quantity of inputs and outputs will be determined for the
estimation of costs and benefits of the project
 Provides the technical basis for all other aspects of a project study, since a
technically unfeasible project cannot be promoted.
 The main and challenging task in this technical analysis is to identify the
appropriate technology for the objective the project is intended to meet.
 Poor technical analysis will result in under or over- estimation of quantities related
to inputs required by and outputs of the project.
 Further analysis based on these estimates would eventually lead to spurious cost
and benefit estimates.
 Care must also be taken in assessing alternative designs and techniques.
 The project’s expected life time must also be determined carefully for it has
greater implication on its overall analysis and preparation.
 All these require creative, committed and competent specialists from different
fields.
 It also requires coordination among these specialists, as every technical aspect is
interrelated and interacting.
B. Commercial/Market/ Aspects
 Here the primary task is to identify the need and estimate the nominal and
effective demand of the visualized product or service.
 This aspect analysis needs to ensure the existence of effective demand at
remunerative price.
 It also assesses possible means in which the market will absorb the output without
affecting the output price and if it price inevitably be affected, we would have to
assess its magnitude.
Market analysis is basically concerned with:
1. What is the product/service to be undertaken?
• What is the specific need which is the basis for the product/service?

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• Are there alternative ways of satisfying the need?
• Have there been noticeable changes in the nature & structure of needs?
2. What would be the aggregate demand of the proposed product/service in
future?
3. What would be the market share of the project under appraisal?
4. What is the ongoing and competitive selling price?
5. Will the realization of the project affect the selling price(s) of the
products/services?
6. What are the marketing strategies that enable the firm to enter into a market
and capture adequate market size?
 To answer the above two questions the kinds of information required
are:
1. Consumption trends in the past and the present level
2. Past and present supply positions
3. Production possibilities and constraints
4. Imports and exports
5. Structure and competition
6. Cost structure
7.Elasticity of demand
8. Consumer behavior, intentions, attitudes, preferences, and requirements
9. Distribution channels and marketing policies in use
10. Administrative, technical, and legal constraints.
All aspects related to demand and supply of inputs and outputs must be
examined
C. Institutional-Organizational-Managerial
 A project must be related properly to the institutional structure of the
country or region where the project is to be carried.
Examples include the land tenure system, use of local institutions such as Idir
or Debbo
 Similarly, managerial issues are critical for successful completion of
projects.

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 Thus, the project analyst must examine the ability of available staff to identify
whether they have the capacity to carry out the managerial needs of the
project.
It aims at answering the following questions:
 Is the organizational set-up of the project adequate? It is about organization
chart of the implementing agency.
 Will project be provided with competent personnel to manage it? It aims at
ensuring that adequate project staff can be recruited locally or overseas.
There are three organizational levels:
i. Top management
ii. Middle management, and
iii. Supervisory management
 Even if the right staff is available, their success will depend mostly on the
institutional set-up
 the relationship between the various organizations involved with the
implementing agency.
 Therefore Appraising a project therefore includes appraisal of the project
related institutions like subsidiary companies, ministries, headquarters,
banks, transport companies and others.
 Here we need to answer the following questions
 What are the regulations or procedures?
 What are the policies – that favor & disfavor the project?
 Once the right institutions to facilitate project implementation are available,
the project should be implemented by competent, responsible and
committed managers.
 This requires arrangement of adequate incentives to attract competent
managers.
 Managerial appointment should be a function of competence and
commitment, not a function of race, tribe, creed or political opinion.
D. Financial Aspects

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 It seeks to ascertain whether the proposed project will be financially viable
to meet the burden of servicing debt and satisfy the return expectations of
those who provide the equity capital.
 It concerned with the financial effects of the proposed project on each of its
participants (firms, farmers/workers, government etc.)
 The analysts need to identify the projects
 financial efficiency,
 incentive impact to the participants in the project,
 Creditworthiness and liquidity (say, could the firm have enough
working capital?).
 The financial analysis establishes the magnitude of costs of investment,
production and overheads and magnitude of benefits.
 This analysis will be the basis for evaluating the project profitability.
 Project profitability depends on a comparison of costs versus revenues
using realistic market prices of materials, labor and outputs.
 This aspects, deals about:
1. Investment outlay and costs of the project
2. Means & source of finance, credit terms, interest rates,
3. Cost of capital
4. Projected profitability
5. Break-even point
6. Cash flows of the project
7. Investment worthiness judged in terms of various criteria of merit
8. Projected financial position
9. Level of financial risk
 Financial analysis must generate future financial statements such as:
 income statement,
 balance sheet and
 Uses-and-source-of-fund statement.
 After these statements are produced, analysts can undertake different
financial ratio analysis so as to ascertain financial feasibility.

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  The financial analysis must clearly show fund flows in each period in the
project life.
E. Economic Aspects
 It is primarily concerned with the determination of the likelihood of the
proposed project, and hence the committing of scares resources, by
justifying the significance of the project from the whole economy point of
view (the society as a whole).
 In such evaluation the focus is on the social costs and benefits of a
project, which may often be different from its monetary or financial costs,
and benefits.
 The financial analysis views the project form the participants (or owners)
point of view, while the economic analysis form the society’s point of view.
 Here decision makers are concerned about the investment of scarce capital
and other resources that will best further national objectives.
 Financial analysis uses projected market prices to value inputs and
outputs
 Economic analysis uses ‘economic prices’ or ‘shadow prices’ or
‘efficiency prices’ to better approximate the opportunity costs of an input –
the amount the economy must give up if the resource is transferred from its
present use to the project.
 Similarly, to value project’s output, economic analysis uses the marginal
value of a given output to approximate the real value – the value that
consumers place on that commodity.
 Thus economic analysis requires adjustment of market prices, which may
not reflect the real value of resources and outputs, into economic prices.
 It also requires determination of economic prices of those goods that might
not have market prices but that involve commitment of real resources.

F. Social Aspects
 Although the economic analysis will determine the amount of income
stream generated over and above the costs of labor and other inputs, it does

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 not specify who actually receive it and hence it does not deal about issue
of income distribution.
 So the social aspect analysis should address the income distribution
implications of a project.
 Other closely related aspects as
 employment opportunities,
 gender aspects,
 stimulating or competing effects with other sectors, and
 other desired objectives must be considered.
The issues of social analysis
1. The attitude and the likely response of the beneficiary ;
2. The existence of potential implementation capacities or organization within
communities;
3. The cultural factors related to the implementation and outcomes of the
project;
4. The political factors;
5. Income distribution implications of the project,
6. Employment creation:
7. Issues of balanced regional development,
8. The displacement impact of the project
9. The gender implication of the adopted technology;
10. Environmental impacts etc.

G. Environmental aspects

 In recent years environmental concerns have assumed a great deal of

significance.
 an environmental impact assessment is a prerequisite for project financing
by foreign donors (DCs) in LDCs,.

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  Environmental impact of a project refers to the effect of a project on the
world of animals, plants, water, air, and humans existing in the project
area.
 Ecological analysis should be done particularly for major projects, which
have significant ecological implications like power plants and irrigation
schemes, and environmental polluting industries.

Environmental
 Environmental impact assessment is important because economic benefits
that may be generated from the project can be counter-balanced by
undesirable environmental effects.
 The key questions raised in ecological analysis are:
 What is the likely damage caused by the project to the environment?
 What is the cost of restoration measures required to ensure that the
damage to the environment is contained within acceptable limits?
1.5 Project life cycle-Models
 A project life cycle is a sequence of events or activities, in which a project
follows.
 These events, stages or phases can be divided into several equally valid
ways, depending on the executing agency or parties involved.
 For the time being we can have the following
 Baum Project Cycle (World Bank)
 UNIDO Cycle
 DEPSA Model
1.5.1 Baum Project Cycle (World Bank)
 The first basic model of a project cycle was that of Baum developed in 1970,
 It has been adopted by the World Bank and initially recognized four main
stages, namely
1. Identification
2. Preparation
3. Appraisal and selection

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 4. Implementation
 At a later stage in 1978 the author has added another stage called
“Evaluation “thus making the stages 5.
5. Evaluation
1.5.2 UNIDO cycle

 The United Nations Industrial Development organization (UNIDO)is the most

devoted institution towards the development and the standardization of the
concept, context and content(CCC)of industrial project management system.
 According to the UNIDO approach, the project development cycle comprises
three distinct phases:
1. Pre- investment phase
2. Investment phase and
3. Operational phase
 Each of these three phases is divided into several stages, some of which
constitute important consultancy, engineering and industrial activities.
1. Pre-investment phase;
a. Identification/opportunity study/
b. Pre-feasibility study/ pre-selection/
c. Feasibility study
d. Support study;
e. Appraisal study.
2. Investment phase;
 Negotiating and contracting;
 Engineering design;
 Construction and Procurement
 Production and fixing
 Pre production marketing;
 Manning and training
3. Operation phase.
a. Commissioning and hand over and starting of operation

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 b. Post project evaluation/appraisal/
c. Replacement/rehabilitation
d. Expansion/innovation
 Throughout project cycle, the primary concern of the analyst is
 consider alternatives,
 evaluate them, and
 make decision as to which of them should be advanced to the next
stage.
 If it is decided to proceed to the next stage, the results (outputs) of a given
stage serve as part of the input of the next sage.
1.5.3 The DEPSA Model
 In Ethiopia, Development Project Studies Authority (DEPSA) made certain
efforts and developed a model for Project life cycle which is known as DEPSA’s
Project life cycle.
 This life cycle comprises three major phases. They are:
1. Pre-investment phase
2. Investment and
3. Operation
4. Each of these phases may be divided into different stages.
1. Pre- investment Phase
a. Identification Stage
b. Formulation Stage
 Pre-feasibility study
 Feasibility study
c. Appraisal
 Appraisal
 Decision
2. Investment Phase
 Implementation
 Tendering negotiation and contractual
 Detailed engineering design
 Construction, erection and commissioning
3. Operation Phase
 Operation
 Ex-post evaluation

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2. Chapter Two: Generation and Screening of Project
Ideas

2.1 Generation of Ideas

 Identifying suitable project ideas is the most important step in the whole
process of project preparation.
 The search for promising project ideas is the first step towards
establishing a successful venture.
 The key to success lies in getting into the right business in the right
time.
 The objective is to identify investment opportunities which are feasible
and promising.
 Generation of an idea of producing a new product, new business, requires
 imagination sensitivity to environmental changes and
 The realistic assessment of what the firm can do?
 A project is not a product or commodity to be purchased.
 It has a promise as well as a risk.
 An idea regarding a required intervention in a specific area to address
identified problem is formed and developed.
 It usually come up through discussions with specialists and local leaders in a
community need based issues.
 Generally project ideas are generated depending on:
 Consumer needs
 Market demand
 Resource availability
 Technology
 Natural calamity
 SWOT analysis
 Political considerations etc.
 A project idea should be SMART:

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  S – Specific objective
 M – Measurable
 A – Achievable
 R – Realistic
 T – Time bounded
 Project identification should be an integral part of the Macro-planning exercise
of the state with sectored information and strategies as the main source of the
ideas.
 Project ideas should be in general aim at overcoming constraints on the national
development effort.
 Good project ideas are the key to success.
 The sources of project ideas can be categorized into
o Micro level source
o Macro level source

A) Micro-level project ideas emanate from:-

1. Identification of unsatisfied demands or needs;
2. Existence of unused or underutilized resources;
3. Analysis of the performance of existing industries;
4. Examination of the input-outputs of various industries;
5. Analysis of economic and social changes;
6. Study of new technological developments
7. Initiative of private or public enterprise in response to incentives provided
by the government;
8. Necessity to complement or expand investments previously undertaken;
9. Desire of local groups or organizations to enhance their economic status and
improve their welfare
10. Stimulating creativity for generation’s new product lines
b) Macro-level project ideas emerge from:-
1. Different level development plans and strategies;

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2. Constraints in the development process due to shortages of essential
infrastructural facilities, etc.
3. Unusual events such as droughts, flood, earthquakes,
4. General surveys, resource potential surveys, regional studies, master plans;
5. Multilateral or bilateral development agencies;
6. Government decision to correct social and regional inequalities.
2.2 Monitoring the Environment
 Basically a promising investment idea enables a firm to exploit opportunities
in the environment by drawing on its competitive strengths.
 Hence the firm must systematically monitor the environment and asses its
competitive abilities.
 For the purposes of monitoring the business environment may be divided
into six broad sectors.
 Economic Sector
 Government sector
 Technological sector
 Socio-demographic sector
 Competition sector
 Supply sector
Economic Sector
 State of the economy
 Overall rate of growth
 Growth rate of primary, secondary, and territory sectors
 Cyclical fluctuations
 Linkage with the world economy
 Trade surplus/deficits balance of payment situation
Government Sector
 Industrial policy
 Government programs and projects
 Tax frame work
 Subsidies, incentives, and concessions

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  Import and export policies
 Financing norms
 Lending conditions of financial institutions and commercial banks
Technological Sector
 Emergence of new technologies
 Access to technical know-how, foreign as well as local
 Receptiveness on the part of industry
Socio-demographic Sector
 Population trends
 Age shifts in population
 Income distribution
 Educational profile Employment of women
Attitudes toward consumption and investment
Competition Sector
 Number of firms in the Industry
 Degree of homogeneity and differentiation among products
 Entry barriers
 Comparison with substitutes in terms of quality, price, appeal, and
functional performance
 Marketing policies and practices
Supplier Sector
 Availability and cost of raw materials
 Availability and cost of energy
2.3 Profit Potential of Industries: Porter Model
 According to this model
 Effective industry analyses are products of careful study and
interpretation of data & information from multiple sources.
 Because of globalization, international markets and rivalries must be
included in the firm’s analyses.
 In fact, research shows that

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  in some industries, international variables are more important than
domestic ones as determinants of strategic competitiveness.
 because of the development of global markets, a country’s borders no
longer restrict industry structures.
 Movement into international markets enhances the chances of
success for new ventures as well as established firms.
 Using Porter’s analysis firms are likely to generate
 higher profits if the industry:
 Is difficult to enter.
 There is limited rivalry.
 Buyers are relatively weak.
 Suppliers are relatively weak.
 There are few substitutes.
 Firms are likely to generate low profit if:
 The industry is easy to enter.
 There is a high degree of rivalry between firms within industry.
 Buyers are strong.
 Suppliers are strong.
 It is easy to switch to alternatives.
 Following study of the five forces of competition, the firm can develop the
insights required to determine an industry’s attractiveness in terms of its
potential to earn adequate or superior returns on its invested capital.
 In general, the stronger competitive forces are, the lower the profit potential
for an industry’s firms.
 An unattractive industry has
 low entry barriers,
 suppliers and buyers with strong bargaining positions,
 strong competitive threats from product substitutes, and
 intense rivalry among competitors.
2.4 Scouting for Project Ideas

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  Project ideas can be sketched to its desire (to solve an existing problem or to
satisfy an unmet societal need).
 To find out the unmet need, one should do environmental scan.
 The factors to be considered in scouting for PI are
 political-legal factors,
 economic factors,
 Socio-demographic factors,
 technological factors and
 competition factors.
 If these factors are favorable for the enterprise, this can be
good opportunities for the development of entrepreneur.
Scouting
Political Legal Factors
 Industry Policy of Government,
 its taxation regime,
 its programs and
 export-import policy
Economic Factors
 state of economy,
 growth rate of the country,
 market conditions,
 natural endowment,
 exchange rate fluctuations and
 inflation trends
Socio-demographic Factors
 Population trends,
 age distribution,
 income distribution,
 education profile of the population,
 the kind of family structure and
 the life cycle of the families.

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Technological Factors
 The rapid emergence of technology (technological innovation)
 The rate of diffusion of new technology in the customers.
Competition Factors
 competitive pressure from suppliers and buyers or from the
competitors itself
 If is low, then there are more chances for the growth of new products
and services.
2.5 Preliminary Screening
 Once a list of project ideas has been put forward, the first step is select one
or more of them as potentially promising.
 This calls for quick preliminary screening by experienced professionals who
could also modify some of the proposals.
 At this stage, the screening criteria are vague and rough, that becomes
specific and refined as project planning advances
 during the preliminary screening we have eliminate ideas which are not
promising
In this stage one is required to look into the following aspects
1. Compatibility with the promoter
2. Consistency with government priorities
3. Availability of inputs:
4. Adequacy of the market
5. Reasonableness of cost:
6. Acceptability of risk level:
1. Compatibility with the promoter:
 The idea must be compatible with the interest, personality, and resources of
the entrepreneur.
 it should fit to the personality of the entrepreneur;
 it should be accessible to him and
 it should offer him the prospect growth and high return on the invested
capital.

26
2. Consistency with government priorities:
 The project idea must be feasible given the national goals and governments
regularity framework.
 The questions to be raised in this context are:
 Is the project consistent with national goals and priorities?
 Are there any environmental effects contrary to government regulation?
 Can the foreign exchange requirements of the project be easily
accommodated?
 Will there be any difficulty in obtaining the license for the project?
3. Availability of inputs:
 The resources and inputs required for the project must be reasonably
assured.
 Here the following questions need to be answered.
 Are capital requirements of the project within manageable limits?
 Can the technical know- how required for the project be obtained?
 Are the new materials required for the project available domestically
at a reasonable cost?
 If the materials have to imported, will there be problems?
 Is the power supply for the project reasonably obtainable from
external sources and Captive power sources?
4. Adequacy of the market:
 The size of the present market must offer the prospect of adequate sales
volume.
 Further there should be a potential for growth and reasonable return on
investment.
 Here the following factors have to be examined;
 Total present domestic market
 Competitors and their market shares
 Exports markets
 Sales and distribution system
 Projected increase in consumption

27
  Barriers to the entry of new units
 Economic, Social and demographic trends favorable to increased
consumption
 Patent protection
5. Reasonableness of cost:
 The cost structure of the proposed project must enable it to realize an
acceptable profit with a price.
 The following should be examined in this regard:
 Cost of material inputs
 Labor costs
 Factory overheads
 General administration expenses
 Selling and distribution cost
 Service cost
 Economies of scale
6. Acceptability of risk level:
 The desirability of a project critically dependent on the risk characterizing
 in the assessment of risk the following factors should be considered:
 Business cycles
 Technological changes
 Competition from substitute
 Competition from imports
 Government control over price and distribution
 During the preliminary selection, the analyst should eliminate project
proposals that
 Technically unsound and risky
 Have no market for the output
 Have inadequate supply of inputs
 Are very costly in relation to benefits and
 Assume over ambitious sales and profitability.
2.6 Project Rating Index (PRI)

28
 The PRI is a simple and easy-to-use tool for measuring the degree of scope
development on building projects.
 Here critical elements within a scope definition package are described in
detail.
 This provides project team members a checklist or tool for determining the
definition of a project at the time of analysis.
 The tool could then be used in predicting future project success or failure in
terms of cost, schedule, and changes.
 It allows project teams to focus on problem areas or scopes. It is used at
multiple stages in the front end planning process.
 PRI provides a means for an individual or a team to estimate the position of
industrial development during pre-project preparation and to find out a
score that corresponds to its level of definition.
 Project Rating Index (PRI) can be develop from:
 Earlier Construction Industry Institute (CII) research,
 Research team expertise,
 Scope development packages from companies;
 Brainstorming, affinity determining,
 Workshop of project managers and estimate.

 Poor scope definition is recognized as one of the leading

 causes of project failure,
 resulting in cost and schedule overruns, and
 long term operational issues.
 As a result, PRI is one of the most important process in the construction
and operation of a capital asset.
 The PRI methodology is proven to reduce risk in capital project delivery by
 promoting rigorous scope definition and
 a collaborative review process during front end planning.
 Using the PRI methodology will help your project teams
 improve scope definition,

29
  become better aligned,
 provide transparency on identified gaps,
 equip all project stakeholders to better mitigate risks identified in PRI
reviews,
 predict potential issues, and
 Overcome costly problems.
 There are three industry-validated PRI models (templates)
a. Industrial Projects
 The Industrial template is targeted for projects that provide an output in
terms of assemblies, sub-assemblies, chemical compounds, electricity, food
or other marketable goods.
 Examples power plants, chemical plants, oil & gas production,
refineries, water and waste treatment, and manufacturing facilities.
b. Building Projects
 It is designed for commercial building projects.
 Examples offices, schools, medical facilities, institutional buildings,
warehouses, parking structures and research facilities.
c. Infrastructure Projects
 It is targeted for projects that involve construction with extensive public
interface and environmental impact considerations.
 Examples include railways, highways, pipelines, transmission and
distribution and canals.
2.7 Corporate Appraisal
 It is a secondary look at the project report by a team of professionals, who
were not participated in the preparation of the study but qualified and
experienced to evaluate such studies.
 It is an independent assessment of the project to identify the weaknesses
and strengths of the study that have a bearing on the decision to invest,
and/or to finance the project.
 Appraisal is the comprehensive and systematic assessment or
reexamination of all aspects of the project before implementation

30
  It addresses particularly issues like:
 Specificity of objectives;
 Clarity of problems;
 Methodology;
 Project specific factors.
 The prime objective of project appraisal is
 To identify the weaknesses that have bearing on decision-making and
 To identify means of strengthening it adequately to ensure final success of
the project.
 Generally it is to improve and restore the project.
 The techniques applied to appraise the project center on all project
aspects.
A widely used project appraisal criteria classified as
1. Non-discounting criteria
 the payback period and
 the accounting rate of return
2. Discounting criteria
 the net present value,
 the internal rate of return, and
 the benefit cost ratio.
 To apply the various appraisal criteria suitable cut off values (hurdle rate,
target rate, and cost of capital) have to be specified.
 These are influenced by the level of risk pursued and it remains the most
intractable part of the project evaluation exercise.
 When the appraisal is completed, the findings and final recommendations
are put together in the form of an appraisal report.
 The recommendation may be to
 approve,
 re-formulate,
 postpone, or
 Discard the project under review.

 The appraisal report concentrates on

31
  the health of the company to be financed,
 the returns obtained by equity holders
 the protection of its creditors
 industries in which it will be carried out and
 Its implications for the economy as a whole.
 The Appraiser will ask the following questions

1. Have the objectives of the project been clearly stated?

2. How does the project fit into the development priorities of the
donor/country?
3. Is the size of the project realistic with regard to the capacity of the
organization?
4. Are the proposed method and process appropriate?
5. Is the project site appropriate?
6. Is the source of financing clearly identified and the amount money
adequate to implement the project?
7. Is proper cost estimate done for the project?
8. Is the project in a sector that merits priority
9. What are the likely contributions of the project?
10. What are the likely risks, and where are the weak points in the project?
11. Does the organization have the capacity required to manage the project?
12. Is the organizational structure of the project clearly defined?
13. Are the project activities socially and culturally acceptable?
14. Is the project gender sensitive?
15. Which economic and social groups will benefit from the project women,
children, youth, elderly, disabled, etc.?)
16. Are there significant social barriers or customs to respect?
17. Does the project involve the sustainable use of natural resources (if
applicable)?
18. What effect does the project have on natural ecosystems such as soil,
water forests etc. (if applicable)

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Chapter Three: PFS: Market and Demand Analysis

3. PFS: Market and Demand Analysis

Market and demand analysis

 The market analysis concerned with arrangement for
 supply of inputs needed to build & operate project and
 marketing the output to be produced
 Here we have to identify the need and estimate the nominal and effective
demand of the envisaged product or service.
 This depends upon the nature of the particular product/service/ under
consideration.
 If the product is a public good, or publicly provided private good, the
task may be to undertake social and institutional need assessment.
 If the product is private good, the first task is to determine whether
there is sufficient market or not.
 The market study needs to ensure the existence of effective demand at
remunerative price.
 Saying on perspectives on effective demand and market promotion, “an
economist and marketer were sent to make market study for shoes in an
island.
 Immediately after their arrival, they observed that the people were all
barefoot.
 Both had to write independent reports.
 The economist reported that there is no market because there is no
revealed demand for shoes as the entire population is barefoot.
 The marketer reported that there is big, untapped market, no one has
entered into the market & hence he appreciated the possibility of taking

33
 the entire market. But he qualified the fact that there is a need for
promotional work.
 Given importance of market and demand analysis, it should be carried out in
orderly & systematic manner.
 The key steps in market and demand analysis are:
 Situational analysis and specification of objectives
 Collection of information
 Conduct of market survey
 Characterization of the market
 Demand forecasting
 Market planning
3.1 Situational Analysis and Specification of Objectives

 In order to get a feel for the relationship b/n the product and its market, the
project analyst may talk to consumers, competitors, middlemen, and other
in the industry.
 He/she may also look at
 the preferences & purchasing power of consumer’s,
 actions & strategies of competitors and
 Practices of middlemen/distributors, whole sellers & retailers.
 If such a situational analysis generates enough data to measure the market
and get a reliable projection of the demand and revenues a formal study
may not need to be undertaken.
 In order to carry out such a study it is necessary to spell out its objective
clearly and comprehensively.
 A helpful way of spelling out the objectives would be to structure the
objective in the form of questions.
 Example: suppose a given project aims producing wheat
 Here the market and demand analysis objective may be to answer some of
the following questions.
 Who are the buyers of this product? (Consumers)

34
  What is the total current demand for wheat?
 How is the demand distributed over the year and geographically?
 What price will the consumers be willing to pay for the product?
 How can consumers be convinced that wheat could be substituted for
other foodstuffs?
 What channels of distributions are most suited for the product?
 What trade margins will induce distributors to carry it out?
 What are the possible immediate sales?

3.2 Collection of (Data) Information

 The principal sources of assembling market information:

 Secondary data sources;
 Primary data sources.
 The secondary sources will include
 the analysis of regular statistics and
 the study of the published results of previous surveys.
 Demographic, economic, financial and commercial statistics can
collected from the following sources:
 Official sources: customs statistics, various kinds of fiscal and monetary
statistics, statistical abstracts, etc.
 Trade groups: trade union and associations, chambers;
 Enterprises and government organizations who possess statistics for
their own use

Collection of Data

 In general, sources of information including;

census data,
national sample survey reports,
plan reports,
statistical abstracts,

35
 Industry specific sources of data etc.
Special survey provides a very effective method of investigating a market.

 Their purpose will be either

 to obtain quantified data or
 To find out how people feel about a product.

3.3 Conduct of Market Survey

 A market survey is a rapid snapshot identification of

 what goods and services are available
 how satisfied consumers are with the goods and services offered in a
local market and
 Goods that are in demand from customers but not being provided by
existing businesses.
 The market survey identifies key areas where
 there is demand for specific goods or services
 As well as areas where there is limited or no demand.
Conduct of Market Survey

36
Conduct of Market Survey

 Reasons to conduct a market survey

 Starting a new product and want to estimate demand.
 Changing an existing product and the want to find out acceptance in the
market for this changed product
 Want to find out competitor’s market and what are the features which
make the competitor’s product a strike.
 Want to find out the most effective distribution channel out of the various
channels that you are using
The information sought in a market survey may relate to one or more of the
following:
1. Total demand and rate of growth of demand
2. Demand in different segments of market
3. Income and price elasticity’s of demand
4. Motives for buying
5. Purchasing plans and intentions
6. Socioeconomic characteristics of buyers

37
 7. Unsatisfied needs
8. Attitudes toward various products
9. Distributive trade practices and preferences
10. Satisfaction with existing products

3.4 Market Characterization

 A market can be analyzed for its attractiveness to a particular company or

organization on different characteristics.
 Significant market characteristics that should be considered.
 Current market size
 Projected market growth rate
 Number of competitors, level of fragmentation
 Intensity of competition
 Technological skills required
 Production/operations skills required
 Capital requirements
 Other barriers to entry
 Seasonal and cyclical factors
 Industry profitability and returns
 Social, political, regulatory and environmental factors
 Strategic fits with other businesses already owned
 Based on the information gathered through the market survey, the market for
the product or service to be offered may be described in terms:
 Effective demand on the past and present
 Breakdown of demand

 Price

 Methods of distribution and sales promotion

 Consumers

 Supply of competition

38
  Government Policy

3.5 Methods of Demand Forecasting

There are many possible methods for forecasting future demand for a product.
 Simple study of import statistics, possibly backed up by a survey among
local consumers will give a fairly clear idea of the size of the future market.
 May be necessary to pursue the investigation further, possibly using
advanced econometric techniques.
 Between these two extremes there exists a whole range of methods from
which to choose, depending on:
 The nature of the market studies;
 The quality and quantities of the data available;
 The degree of accuracy to be achieved.

Demand Forecasting count…

 After gathering the relevant information about various aspects of the market
and demand an attempt may be made to estimate future demand.
 The most commonly used methods include:
1. Projection of the trend
2. Using technical coefficients
3. International comparisons
4. Possibilities for export or for import substitution
5. Econometric models
6. Utilization of the result of family budget surveys
7. Forecasting without statistical data
3.6 Uncertainties in Demand Forecasting & Market Planning

 Demand forecasts and market planning are subject to error and uncertainty
which from three principal source.
A. Data about past and present market
B. Method of forecasting
39
 C. Environmental Change

Uncertainties count…

1. Data about past and present market

The analysis of past and present markets, which serve as the spring board for the
projection exercise, may be vitiated by the following inadequacies of data:
 Lack of Standardization: Data pertaining to market features like product,
price, quantity, cost, income, etc. may not reflect uniform concepts and
measures.
 Few observations: observations available to conduct meaningful analysis
may not be enough.
 Influence of abnormal factors: Some of the observations may be
influenced by abnormal factors like war or natural calamity.
2. Method of forecasting:

 It is characterized by the following limitations:

 Inability to handle unquantifiable factors:
 Most of the forecasting methods, being quantitative in nature, cannot
handle unquantifiable factors which sometimes can be of immense
significance.
 Unrealistic assumptions:
 Each forecasting method is based on certain assumptions.
 Uncertainty arises when the assumptions underline the chosen method
tend to be realistic and erroneous.
 Exercise data requirement: The more advanced a method, the greater
the data requirement.
3. Environmental Change.

 The environment in which a business functions is characterized by

numerous uncertainties.
 The important sources of uncertainty which less predictable in demand
forecasting are mentioned below:
40
  Technological Change
 Shift in Government Policy
 Development on the International Scene (Prospect)
 Discovery of New Sources of Raw Material
 Vagaries of the Weather condition

Coping strategies with Uncertainties:

1. Conduct analysis with data based on uniform and standard definitions.

2. In identifying trends, coefficients, and relationships, ignore the abnormal and
out-of-the-ordinary observations.
3. Critically evaluate the assumptions of the forecasting methods and choose a
method which is appropriate to situation.
4. Adjust the projections derived from quantitative analysis in the light of
unquantifiable, but significant, influences.
5. Monitor the environment imaginatively to identify important changes.
6. Consider likely alternative scenarios and their impact on market and
competition.
7. Conduct sensitivity analysis to access the impact on the size of demand for
unfavorable and favorable variations of the determining factors from their
most likely levels
 Consider we have planned to open computer training PLC in Bahir Dar
town, market analysis has done as follow:

Major prospected clients of the business

Operate in
No Group
Bahir Dar
1 National organizations ,unions and Regional 1000
2 NGOS 200
4 Privet Companies 300
5 Professional and Development Associations 100

41
Computer training PLC
Marketing Plan
 Pricing: Our price strategies are intended to serve our potential customers
with reasonable price by giving quality products and services.
 The following table shows the price of each of our products.

Name of the Products: Expected price of

Birr per unit
Desk top 7,000
Laptop 12,650
Printer 2,000
Photo copy machine 45,550
Flash disk 400

Computer training PLC

 Distribution:
 We will distribute our products using different agents and shops.
 The agents facilitate the distribution processes by taking commission.
 Product Forecast:
 We hope that the future awareness of the society towards the products
and services might increase; as a result our estimate demand capacity of
distribution will also increase.
 Promotion:
 In order to raise awareness in the society the business will use television,
radio, memos, social media and newspaper
 Controls:
 Controlling the teaching and learning process by reviewing the curriculum.
 Adopting inventory system by suing perpetual and periodic inventory
controlling mechanism.
 Competitors Analysis:
 Many competitors might inter into the market.

42
  By taking this into account, our PLC will diversify its service and product
and use different means of distribution and promotion.
 Product and service plan

A. Products

 Computer professionals:
 It will have a capacity to train 1600 skilled and qualified professional
customers within in a year.
 Soft ware engineer:
 It will train 400 executives who are responsible for the managerial
decision making.
 Companies that send executives for short-term business meetings are
also voluntarily trained for promotional purpose and to show the
training center Excellencies.
 Import computer Devices:

 The project will also be engaged in importing of laptop computer, desk

top computer, computer software, and other computer devices with
affordable price.
B. Services

 Training and Education:

 will offer courses for one year in areas such as creating and managing
system development, computer incident response reams, responding to
and analyzing computer and system problems, and improving network
and maintaining the highest ethical standards seminars
 Professional staff will provide computer program awareness and
workshops to administrators, general service workers and activities of
organizations.
 Employment Service:

43
  It will constantly grow and expand its employment service by getting
job opportunities for its trained customer and we will search immediate
employment opportunities for them to be employed.

 Private training service:

 It will also provide a service of private trainees to help them to be

effective and competitive investigation.
 By hiring trained computer professionals with knowledge of high-level
competitive in computer maintenance work at a different level and
software development ability, that will help the organizations to gather
information and process the data that might be difficult for
organizations or individual to gather.
 In the business situation, computer ability that helps to gather and can
help them to change data into information to achieve its organizational
objective.

Chapter Four: PFS: Technical Analysis

4.1 Raw Materials and Supply Study

In raw materials study as part of the feasibility study, the experts assigned for the
task to identify
 The required types of inputs,
 their sources and brief assessment of alternative types of inputs,
 their relative merits in terms of quality of the product (and hence
competitiveness in the market); and
 alternative sources of supply;
 Describe general availability of
 Raw materials,
 Auxiliary materials,
 Factory Supplies, and
 Utilities
 List annual supply requirements of material inputs;
44
Raw materials
 Summarize availability of critical inputs and possible strategies of acquiring
these inputs;
 Determine the procurement period of each imported input, if any.
 Outline costs related to procurement and storage of inputs (stores, containers
of required type; transport costs required e.g. forklifts etc.), and
 Identify the number of personnel required for this function giving due
emphasis for quality of man power
4.2 Location and cite
 Feasibility study should determine the location and site suitable for the
proposed project.
 The choice of a location should be made from a fairly wide geographical
area, within which several alternative sites can be considered.
 The main criteria or requirements for selecting proper locations should
always be determined at an early stage of the study.
The qualitative analysis of these key requirements would then allow the
assessment of a number of potential locations and the rejection of those not
fulfilling the key requirements.
 This involves the identification and analysis of:
a. Access to raw material and the corresponding weight;
b. Access to market and the corresponding weight;
c. Access to basic infrastructure like power, communication, water, road,
etc. & corresponding weights;
d. The implication on labor supply and issue of residence;
e. Cultural considerations, etc.
f. However it should be noted that the choice of location is not always based
on a systematic step-by-step analysis and assessment
g. The promoter of the project may suggest a location at an earlier stage
without undertaking the above analysis.
 Once the location of the project is decided, alternative sites have to be analyzed
and the final selection made.

45
 Here the ff requirements & conditions are to be assessed:
a. Ecological conditions on site (soil, site hazards, climate etc)
b. Environmental impact (restrictions, standards, guidelines)
c. Socio-economic conditions (restrictions, incentives, requirements)
d. Local infrastructure at site locations
e. Strategic aspects (future expansion, supply & marketing policies)
f. Cost of land
g. Site preparation and development, requirements and costs
h. This task is followed by description of location and plant site selected, and
the statement of significant costs.

4.3 Production Program and Plant Capacity

Production Program
 The range and volume of products to be produced depends primarily on the
market requirements and the proposed marketing strategies.
 This preliminary production layout defined in accordance with the marketing
concept, and in the qualities and quantities required.
 After the required sales program has been determined, the detailed
production program should be designed in a feasibility study.
The production program should define the levels of output to be achieved during
specified periods and it should be directly related to the specific sales forecasts.

Production Program

 Once a production program defines the followings should be quantified for

each stage
 the levels of outputs in terms of end products,
 possibly of intermediate products
 interrelation b/n various production lines and processes,
 the specific requirements of materials and labor.
 For this purpose, a material-flow diagram should be prepared, showing the
material and utilities balance at various stages of production.
46
  The input requirements and costs have to be assessed for basic material
such as
 raw material and semi-processed and bought-out items;
 major factory supplies (auxiliary materials and utilities);
 other factory supplies; and

Plant Capacity

 Refers to the volume or number of units that can be produced during a

given period.
 Is expressed usually in terms of feasible capacity and nominal capacity.

Feasible capacity
 Refers to the attainable capacity under normal working conditions, taking
into account not only the installed equipment and technical conditions of
the plant, but also the management system applied.
 Nominal capacity

 Refers to the technically feasible capacity, which frequently corresponds to

the installed capacities as guaranteed by the supplier of the plant’s
machinery.

Plant Capacity

 Under feasible capacity, the installed equipment and technical conditions of

the plant includes:
 normal stoppages,
 down time,
 holidays,
 maintenance,
 tool changes,
 desired shift patterns and
 indivisibilities of major machines to be combined,

47
 In determining the capacity of a plant the following factors are taken into
account:
 The marketing concept and the volume of sales, and
 The minimum available economic size of production technology and
equipment

4.4 Engineering and Technology Selection

A. Engineering

 It includes the following activities:

1. Plant lay out
2. Selection of Machinery and equipment
3. Civil engineering
4. Maintenance and Replacement Requirements
5. Estimates of Overall cost
Engineering and Technology

1. Plant lay out

 After selection of technology, the next task is to prepare the plant layout,
drawings, basic design and engineering.
 These charts and drawings should adequately reflect the interrelationship
between
 environmental conditions and constraints,
 socioeconomic infrastructure,
 technology flow,
 constructions and
 Material flow and inputs.
 The plant layout and basic engineering are prepared in accordance with
the selected technology and know-how.

48
2. Selection of Machinery and equipment

 The selection of machinery and equipment at the feasibility study stage

should broadly define the optimum group of machinery and equipment
necessary for a specific production capacity by using a specific production
technique.
 This selection differs in emphasis with type of project.
Equipment can be variously categorized.
 plant machinery,
 mechanical equipment,
 electrical equipment,
 instrumentation and control,
 transport and conveying equipment,
 testing and research equipment and
 Other machinery items.

3. Civil engineering

The feasibility study should provide plans and estimates for the civil works related
to the project. This should cover
 site preparation and development,
 factory and other buildings,
 civil engineering works relating to utilities,
 transport,
 emissions and effluent discharge,
 internal roads,
 fencing and security, and
 other facilities and requirements of the plant.
 Civil engineering works are fairly project-specific and have to be related to a
particular plant site and facilities may be required.
 The plans and estimates for the civil engineering works should be detailed for
cost estimates and implementation scheduling.

49
 The nature of each construction should be defined, including modular
construction where appropriate, the quality of construction materials and the
quantities and cost of materials required.
 Detailed civil engineering drawings are usually not required before the start of
project implementation.
 The estimates for buildings and other constructions should be based on unit
costs such as building costs per square meter in the plant surroundings.

4. Maintenance and Replacement Requirements

 An important aspect of project engineering is the determination of critical

maintenance and replacement requirements for the project.
 Satisfactory maintenance of plant, buildings and various facilities is
essential for efficient plant operations.
 Maintenance requirements should be assessed in terms of both the
maintenance equipment that may be necessary for efficient maintenance
of the plant and facilities, and the maintenance skills and capability that
need to be developed.
5. Estimates of Overall cost

 On the basis of the estimates from technology, machinery and equipment

and civil engineering works, the feasibility study should provide an overall

estimate of the capital costs of the project.

 Such an estimate will undergo modifications in accordance with the

proposal and offers received from suppliers and the contractors but will

nevertheless provide a fairly realistic estimate of capital costs.

B. Technology Selection

 An integral part of engineering at the feasibility stage is

 the selection of an appropriate technology, as well as

50
  Planning of the acquisition and absorption of this technology and the

corresponding know-how.

 Technology is an important factor in determining the production program

and plant capacity.

 Major issues addressed in technological analysis include:

 Brief review of the technology development history, focusing on the

areas of change and the implications of these changes on the
competitiveness of a business organization in terms of quality of
product, cost leadership and other relevant areas of competitiveness;
 Identification of alternative technologies and alternative scales under
use and their relative merits and demerits in terms of the major areas
that determine competitiveness of the product and the business
organization;
 Identification and analysis of the technology selection criteria and
description of the selected one
4.5 Organizational and Human Resource

A. Plant organization and management

 Organization is the means by which the operational functions and activities

of the enterprise are structured and assigned to organizational units.
 It is represented by managerial staff, supervisors and workforce, with the
objective of coordinating and controlling the performance of the project and
the achievement of its business targets.
 The organizational structure of an enterprise indicates the assignment of
responsibilities and delegation of authorities to the various functional units
of the company
 The organizational functions are the building blocks of the proposed project.
 The following organizational units in line with the specific requirements of
the individual company:

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  General Management
 Finance, financial control and accounting
 Personnel administration
 Marketing, sales and distribution
 Supplies, transport, storage
 Production:
 Main plant
 Service plants
 Quality assurance
 Maintenance and repair
 The organizational structure of the company can also take a number of
shapes, the most common being the pyramid shape, which has the following
three organizational levels:
 Top management
 Middle management, and
 Supervisory management

B. Human Resources
 The successful implementation of any operation of an industrial project
needs different categories of human resources- management, staff and
workers-with sufficient skills and experiences.
 The feasibility study should identify and describe such requirements and
assess the availability of human resources as well as training needs.
 On the basis of the qualitative and quantitative human resources
requirement of the project, the availability of personnel and training
needs, the cost estimates of wages, salaries, other personnel-related
expenses and training are prepared for the financial analysis of the
project.
 In case an economic evaluation is intended, the costs of unskilled labor
should be shown separately.

52
  Human resources as required for the implementation and operation of
industrial projects need to be defined by categories, such as management
and supervision personnel and skilled and unskilled workers, and by
 Functions:
 general management,
 production management and supervision,
 administration,
 production control,
 machine operation and
 Transport.
 The numbers, skills, & experience required depend on:
 the type of industry,
 the technology used,
 plant size,
 the cultural
 socio-economic environment of the project and location and
 The proposed organization of the project.
 Since the lack of experienced and skilled personnel can constitute a significant
bottleneck for project implementation and operation, extensive training
programs should be designed and carried out as part of the implementation
process of investment projects.

Technical Analysis of ABC PLC

 Facilities and Equipments

 ABC computer training PLC will acquire a land and construct buildings
that enable training activities and offices to facilitate its work.
 Through time it will expand and open branches in different areas in
Amhara region.
 ABC computer training PLC will be equipped with necessary office and
communication facility.
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 Requirement for potential applicants’ qualification:

 Applicants must have diploma certificate

 Soft ware engineers Bachelor
 Computer professional
 Applicants must be able to speak, read and write at least English and
Amharic language
 Applicants must be at least 20 years of age
 Applicants must be drug free
 Applicants for computer must be willing to work weekends
 Applicants must have ability to attract and retain the customer.
 Management Structure

 ABC computer training PLC will have a management body to deal with
strategic issues.
 The managing director who handles all the routine managerial decision is
countable to the management body of computer training PLC.
There are two executives under the managing director to carry out major areas of
service.
 Marketing Head: will pursue all the marketing process. He /She is
responsible to make contacts with the target customers and maintain
good working relationship/partnership with them.
 Training office head: will handle all the activities related to computer
training quality and buying and selling of computer and other related
material.

Organization Structure:

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Location & Site

 The area for establishing computer training center is in Bahir Dar city.
 Selecting this area will have the following advantages.
The presence of Bahir Dar university
Availability of infrastructure,
Most of the target customers are found within and few kilometers radius
of this area,
Proximity to skilled manpower,
Proximity to market and distribution agents.

Chapter Five: Financial analysis

Introduction
 Financial analysis is 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)
 The project’s direct benefits and costs are calculated in financial terms at
prevailing (expected) market prices.

55
 This analysis is applied to appraise the soundness and acceptability of a
single project as well as to rank projects on the basis of their profitability.
 Financial analyst should be able to collect relevant information on:
1. Initial investment costs distributed over the implementation of the project;
2. Operating costs of the imagined operational unit/firm/ over its operating life;
3. Revenue, both forecasted sales and selling price

Issues (concerns) of financial analysis are:

1. Identification of required data;

2. Analysis of the reliability of data;
3. Analysis of the structure and significance of costs and benefits/incomes/;
4. Determination and evaluation of the annual and accumulated financial net
Benefits;
5. Consideration of the spread of flows of the costs and benefits over time,
6. The economic life of the imagined economic unit /firm/public entity/and
7. Costs of capital over time

5.1 Project Costs and Benefits

 Identification of project cost and benefit is the first step in project financial
analysis
 In identifying costs and benefits of a project, objectives play important role.

 Simply
 a cost is anything that reduces an objective, and
 a benefit is anything that contributes to an objective.
 Here the problem is each participant in the project may have many objectives.

A private business firm can have objectives such as:

 Maximizing net income (profit)
 Increasing market share
 Improving customer satisfaction
 Reducing risk, etc.
56
 A society or a nation objective as:
 Increasing national income
 Ensuring equitable distribution
 Improving balance of payments
 Improving regional integrity
 Reducing inflation or unemployment
 Maintaining environment etc
Fundamental objective of a given project:
 maximization of profit for a private firm and
 Maximization of national income for a nation.
 In financial analysis, the project that will maximize the above fundamental
objectives given priority to other.
 All other objectives, if very important, can be considered in a separate
decision or if possible will include in analysis
 Based on tangibility, project costs and benefits grouped as:
 Tangible cost & benefit
 Intangible cost & benefit.
1. Tangible costs of a project
It includes the following costs
A. Initial Fixed Investment costs
B. Pre-production Expenditures
C. Plant and Equipment Replacement Costs
D. Terminal Values/End-of-Life Costs/Salvage Costs/
E. Net Working Capital (NWC)
F. Costs of Goods Sold
G. Sunk costs
A. Initial Fixed Investment costs: it constitute the major resources required for
constructing and equipping an investment project. It involves:
1. The cost of land and site development
2. Plant and machinery

57
 3. The cost of buildings and civil works
4. Miscellaneous fixed assets
1. The cost of land and site development
 Land charges and payment for lease
 Cost of leveling and development
 Cost of laying approach roads and internal roads
 Cost of gates and tubes wells
2. Plant and machinery
 Cost of imported machinery
 Cost of local or indigenous machinery
 Cost of stores and spares
 Foundation and installation charges
3. The cost of buildings and civil works

 Buildings for the main plant and equipments

 Buildings for auxiliary services (steam supply, workshops, laboratory,
water supply, etc.)
 Warehouses and show rooms
 Non factory buildings like guest house, staff rooms etc
 Silos, tanks, wells, basins, etc.
 Garages and workshops
 Other civil engineering works
4. Miscellaneous fixed assets
 Expenses related to fixed assets such as furniture, office machines,
tools, equipment, vehicles, laboratory equipment, workshop
equipment
B. Pre-production Expenditures

1. Intangible assets
 Patents, licenses, copy rights, and goodwill.

58
  Preparatory studies, feasibility studies, specific functional studies and
investigations, consultant fees for preparing studies, supervision costs,
project management services, e
2. Preliminary expenses includes
 registration and formation expenses,
 legal fees for preparation of memorandum and articles of associations
and similar documents.
 Costs of advertisements, brokerage for mobilizing resources,
shareholders, expenses for loan application and its processing.
3. Other Pre-operation expenses. These include:
 Rents, taxes, and rates
 Trial runs, start-ups and commissioning expenditures;
 Salaries, fringe benefits and social security contributions of personnel
engaged during the pre-production period;
 Pre-production marketing costs, promotional expenses, creation of sales
network,
 Training costs, including all fees, travel, living expenses etc;
 Traveling expenses interest and commitment charges on borrowings
 Insurance charges and mortgage expenses interest on differed payments,
 Miscellaneous expenses
C. Plant and Equipment Replacement Costs

 identify the items to be replaced and then estimate the costs for
replacement

D. Terminal Values/End-of-Life Costs/Salvage Costs/

 During the end of the economic life of a good/machinery, equipment,

building, etc) there is some salvaged value and the salvation may involve
incurring of costs.

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  Costs associated with the decommissioning of fixed assets at the end of the
project life, minus any revenues from the sale of the assets is termed as end
of life time cost

E. Net Working Capital (NWC)

 It is gross working capital less current liabilities

 The gross working capital consists of all the current assets, including:
a. raw materials;
b. stores and spares;
c. work-in-process;
d. finished goods inventory;
e. Debtors/accounts receivable/;
f. Cash and bank balance.
 Current liabilities consist of creditors, provisions, accrued expenses, and
short-term borrowings.
F. Costs of Goods Sold: Once the project idea has been accepted and the project
is being implemented the cost of production may be worked out
 It includes Material cost, utilities of power, water and electricity, land,
labor, tax, debt contingency allowances, factory overhead, etc….
G. Sunk costs: are those incurred in the past and upon which the proposed new
investment will be based.
 Not included in this analysis

2. Tangible Benefits

 For any project tangible benefits appear, however valuing them might be
difficult.
 In general the following benefits can be expected from a given project :
 Increased production
 Quality improvement
 Changes in time and location of sale
 Changes in product form (grading and processing)

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  Cost reduction through technological advancement
 Reduced transport costs
 Loses avoided
 Other kinds of tangible benefits
3. Intangible benefits
 creation of job opportunities,
 better health and reduced infant mortality,
 better nutrition,
 reduced incidence of disease,
 National integration,
 National security, etc.
4. Intangible costs
 Displace of workers,
 Increase disease incidences,
 increase regional income inequality,
 Destroy or reduce the lovely (beauty) of an area, etc.
 All those intangible benefits and costs must be carefully identified and
where possible, be quantified although valuation is impossible (not reflected
in market prices).
 These costs and benefits will not usually appear in financial accounts but
should be in economic accounts

5.2 Means of Financing

 Project finance is the funding (financing) of long-term infrastructure,

industrial projects, and public services using a non-recourse or limited
recourse financial structure.
 The debt and equity used to finance the project are paid back from the cash
flow generated by the project.
 Project financing is a loan structure that relies primarily on the project's
cash flow for repayment, with the project's assets, rights, and interests held
as secondary collateral.
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  Project finance is especially attractive to the private sector because
companies can fund major projects off-balance sheet of its sponsors

Means of Financing

 Usually, a project financing structure involves a number of equity investors,

known as 'sponsors', and a 'syndicate' of banks or other lending institutions
that provide loans to the operation.
 It is a decision in part supported by financial modeling.
 A project finance model is used throughout the project term and will need to
get updated depending on the phase of the project.
 Look the following chart of project financing model

Means of Financing

Key Components of a Project Finance Model

 Inputs
 Derived from technical studies, financial market expectations, and
understanding of the project using different inputs and assumptions
 Calculations
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  Revenue
 Construction, operating and maintenance costs
 Accounting and Tax
 Debt financing
 Distributions to equity
 Project IRR
 Outputs
 Contain a summary of project metrics important to management for
informed decision making
 It include Income statement, balance sheet, cash flow statement

5.3 Sales and Production Estimates

 Accurate estimating sales and production for a proposed project as a new

business is difficult.
 You have no history to review and it's easy to overlook expenses when
you've not been in business long.
 Here, entrepreneurs planning their new business often make estimates
based on statistics that don't take into consideration all the factors that will
actually come in to play once they open their doors.
 As a result, they often overestimate their future sales volume &
underestimate the amount of money they'll need to start the business
and keep it going until it becomes profitable.
 In estimating sales and production, the following considerations should be
borne in mind:

 It is not advisable to assume a high capacity utilization level in the first

year of operation.
 It is not necessary to make adjustment for stocks of finished goods.
 The selling price considered should be the price realizable by the
company net of excise duty.

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  The selling price used may be the present selling price: it is generally
assumed that changes in selling price will be matched by proportionate
changes in cost of production
 Sales and production are closely interrelated. Hence they may be estimated
together.
 In order to make estimates of sales & production, the following details must
be furnished for each product until the maximum capacity utilization of the
plant
 Installed capacity
 Number of working days
 Number of shifts
 Estimated production per days
 Estimated annual production
 Estimated out put as a percentage of plant capacity
 Sales after adjusting stocks
 Value of sales
 One typical approach is to predict sales by researching the size of the
market for the product or service and then estimate what sales will be
assuming the business gets some small percentage of that market.
 The problem with this approach is that the market share assumptions are
often pulled out of thin air.
 They sound good on paper – "Hey, we only need to get 1% of the market
and we'll make a wealth." -- but without any sales history to back them
up, they're often way off base.

 You can avoid the problem by researching sales results that have been
achieved by other companies with the size of yours.

Source for information about sales sizes

1. Industry trade magazines.

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  Look to see if they have published or sell reports about the industry,
information about changes in same-store sales, and other data that will
be useful to you.
 look for articles and editorial pieces about changing trends in the
industry that might affect sales in the future.
2. Online search average annual sales of the product
3. Review Census data for your industry (product).
4. Visit your local library and the nearest Small Business Development Center
 Ask if they can help you to make realistic sales projections.

5. Contact other business owners in your industry

 Ask them about their experience

 Business owners who are not in your geographic area may be willing
to share tips and information about the average number of sales,
busy and slow seasons, and other data that may help you more
accurately predict sales.

6. Contact industry vendors (sellers)

 ask their experience/ information which can help you predict sales

7. Attend an industry trade show

 Question vendors and other knowledgeable people about what the

typical annual sales are, how long it takes to get established, and other
information that may help you predict your sales.
 Doing this type of research will help you make more realistic sales
projections and get a better understanding of what it takes to be
successful in your industry.
5.4 Working Capital Requirements & Its Financing

Working capital requirement (WCR)

 It refers funds the company needs to finance its operations.

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  It represents operating liquidity available to a business, organization, or
other entity.
 Along with fixed assets such as plant and equipment, working capital is
considered as part of operating capital. Gross working capital is equal to
current assets.
 Working capital= current assets - current liabilities.
 If current assets < current liabilities, an entity has a WC deficiency
(deficit) or Negative WC.
 Knowing WCR concept is essential for any entrepreneur wishing to
ensure that his business is financially sound.

WCR and Its Financing

Current asset

Cash 50,000

Account receivable 20,000

Inventory 75,000

Total 145,000

Current liability

Account payable 25,000

Short term borrowings 12,000

Accrued liability 25,000

Total 62,000

Working capital 83,000

Components of WC with example

5.5 Projected Financial Statements

 Financial statements are important for

66
  the analysis of the structure of project financing and
 The computation of the capital costs of a company.
 In the case of rehabilitation, modernization and expansion projects, the
financial statements of the existing company are usually the best
source of information and the basis for starting the financial analysis.
 There are basically two categories of financial statements:
 Net income statement is linked to the balance sheet; and
 Cash flow table for financial planning.

Financial Statements
A. Net income statement

 It is used to compute the net income (net earnings) or deficit of the

project arising each year.
 The projections are required for the entire duration of the planning
period chosen for the project.
 The net income statement differs from the cash flow statement is it
shows costs and incomes (and not expenditures and revenues) by
period
 To keep computations simple, in feasibility studies it is usually
assumed that inventories of raw materials, work-in progress and final
products are the same at the beginning and end of each accounting
period (usually calendar year).
 For the purpose of a feasibility study the net income statement should
show at least:
 how the net earnings are divided between different classes of equity
shareholders,
 the different suppliers of loan capital and tax authorities.
 For the break-even analysis the variable costs, the variable margin,
fixed costs (including depreciation and financial charges) and the
operational margin.

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For further information refer UNIDO manual (1991) (page 272)

B. Balance sheet

 It is a statement showing
 the accumulated assets
 the wealth-of a company and
 how this wealth is financed.
 The sources of finance are treated as the aggregate liabilities of the
company, those providing it with funds, namely the investors (equity
shareholders) & the group of creditors, banks and debenture holders.
 By definition both sides of a balance sheet, representing assets and
liabilities, are equal.
 The projected balance sheet in the feasibility study should consist of
estimates of key items, such as
 cash and other current assets (raw materials, accounts receivable,
work-in-progress, and finished products),
 fixed assets,
 equity and loan capital and
 current liabilities that are required for the smooth performance of the
enterprise.
 The series of projected balance sheets shows the projected development of
accumulated assets & how these are financed.
Further information, refer UNIDO manual (1991) (page 273)
5.6 Project Selection Criteria
 Once costs and benefits have been identified, quantified and priced (valued),
the analyst is trying to determine which among various projects to accept,
which to reject.
There are two methods for measuring the worthiness of projects:
1. Undiscounted
2. discounted methods.

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The two critical points important to note:
 First, there is no one best technique for estimating project worth; each has
its own strength & weakness.
 Second, are only tools of decision-making, they are necessary conditions
but not sufficient condition for final decision.
There are many other non- quantitative & non-economic criteria for making final
decision of project selection.

1. Undiscounted Method

A. Ranking by inspection

 In this method we examined the following points for selection of projects:

 Total cost of investment and investment period;
 The structure, & amount of costs and benefits;
 The structure & total amount of the net incremental benefit;
 The lifetime of the project, etc.
 The problem with this method is that the selection lacks objectivity.
B. Payback Period
 The payback period is the length of time from the beginning of the project
until the sum of net incremental benefits of the project equal to total
capital investment.
 It is the length of time that the project requires to recover the investment
cost.
 This method is very simple and it is a good measure when the project has
problem of liquidity.
 The pay-back period is also a common, rough means of choosing among
projects in business enterprise, especially when the choice entails high
degree of risk.
 Since risk generally increases with futurity, the criterion seems to favor
projects that are prima facie less risky.
 This method has two weaknesses:

69
  First, it fails to consider the time & amount of net benefits after the
payback period.
 Second, it does not adequately take into account the time value of
money.

Alternative Net incremental Commutation

projects Year Investment cost benefits net incremental
benefits
I 1 20000 - 29000
2 2000
3 8000
4 12000
5 7000
II 1 20000 - 32000
2 2000
3 12000
4 8000
5 10000
III 1 20000 - 37000
2 1000
3 5000
4 6000
5 8000
6 10000
7 5000
8 2000

 Based on payback period criterion, project I & II have equal higher rank (4
years) than project III (5 years).
 This method fails

70
  to consider the time & amount of net incremental benefit after the
payback period- project III.
 it equally rank both project I and II, yet we know by inspection that we
would choose project II over project I because more of the returns to
project II are realized earlier.
 This method is a measure of cash recovery, not profitability.

C. Rate of return on investment

 This method includes

 Proceeds per unit of outlay
 Average annual proceeds per unit of outlay
 Average income on book value of the investment
Even if these methods are differ in computation they have two features in
common;
(i). use of accounting concepts in calculating benefits and
(ii). no adjustment for time value of money.

1. Proceeds per unit of outlay

 Here investments are ranked by the proceeds (cumulative of net

incremental benefits) per unit of outlay (investment cost).
 It is the total net value of incremental net benefits divided by the total
amount of investment.
 In the previous example the proceeds per unit outlays calculated as follows,

29000 32000 37000

=1. 45 =1. 6 =1. 85
I= 20000 II= 20000 III= 20000

 Hence, according to this criterion, project III will be ranked first.

2. Average annual proceeds per unit of outlay

 To calculate this measure,

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  first the total net incremental benefits will be divided by the time it will
be realized to arrive at average annual net incremental benefits, and
 Then this average value will be divided by total investment costs.
 Thus project I, II & III will have average annual proceeds per unit of outlay
of 0.36, 0.40 and 0.37, respectively.
 Hence, project II will be chosen.
 This criterion has automatically introduces a serious bias toward short-
lived investments with high cash proceeds.
3. Average income on book value of the investment

 This is the ratio of average income to the book value of the asset after
subtracting depreciation stated in percentage terms.
 This measure is useful and commonly used way of assessing the
performance of an individual firm
 This measure does not take into consideration the timing of the benefit
stream.
 In the above example, assuming strait-line deprecation for all project,
average income on book value can be calculated as follows:

Undiscounted Method Count…

Average net value of Annual Net Average Average

Project incremental benefit deprecation average book income on
income value book value
I 7250 5000 2250 10000 0.225
II 8000 5000 3000 10000 0.300
III 5285.7 2857.1 2428.6 10000 0.242

 As a result based on this method project II is selected

2 Discounted measure of project worth

Time value of money

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 Present values are better than the same values in the future and earlier
returns are better than later.

 This shows that money has time value. Thus, to include the time dimension
in our project evaluation, we have to use discounting methods.

 Discounting is essentially a technique that ‘reduces’ future benefits and

costs to their ‘present worth’.

 Suppose a bank lends 1567.05 Birr for a project at 5% interest rate. The
project owner is supposed to repay the principal & interest rate after 5
years. How much the owner will have to pay at the end of 5 years? A t -= P(1
t
+ r)

Where At = total amount after t years,

r = interest rate and t = time
A5 = 1567.05 (1 + 0.05)5 = 2000 Birr
 Suppose again a project is expected to obtain 2000 Birr after 5 years.
Value of this money today can be calculated as:

At 2000
P= = =1567 . 05
( 1+r ) ( 1+ 0 .05 )5
t

 The difference between the two is the interest rate used for compounding
assumes a viewpoint from here to the future, whereas discounting looks
back ward form the future to the present respectively.
 For financial analysis, the discount rate is usually the marginal cost of
money to the firm (project owner).
 This often will be the rate at which the enterprise is able to borrow money.
 If the incremental capital to be obtained is a mixture of equity and
borrowed capital the discount rate will have to be weighted to take account
of the return necessary to attract equity capital on the one hand and the
borrowing rate on the other

Equity borrowed cap

r= x return needed to attract cap+ x borrowry rate
total cap total cap
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  For economic analysis; the best discount rate to use is the opportunity
cost of capital (the return on the last marginal investment made).
 If set perfectly, the rate would reflect the choice made by the society as a
whole between present and future returns, & hence, the amount of total
income the society is willing to save.
 In the NPV method, the higher the NPV, the more desirable the project is.
 All projects that have a positive NPV are accepted and projects that have
a negative NPV are rejected.
 However, in ranking mutually exclusive project (if one is chosen, the other
cannot be undertaken), ranking based on NPV depends on the dissonant
rate used.

 That is if we have two mutually exclusive projects, project A and project B -

project A may be ranked first in some ranges of discount rates but may turn
out to be second in some other ranges.
 Discounted measure of project worth based on discounted NPV, though it
accounts the time value of money and all flows in the lifetime of the project,
it depends on the value of discount rate (r).
Discounted Measure Count…
Example: Assume two projects have the following net financial or economic
return.
Year Project A Project B
0 -1000 -1000
1 200 600
2 400 400
3 500 400
4 700 200
 Calculate the NPV of project A and B for various discount rates, say discount
rates of 0, 4, 8, 12, 15.44, 16, 20, 24.

NPV and Discount rates

Discount rate NPV of B NPV of A

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 0 600.00 800.00
4 473.30 604.99
8 363.03 439.56
12 266.41 298.20
15.44 192.53 192.56
16 181.23 176.61
20 105.71 71.37
24 38.41 -20.24

 When r<15.44 % the NPV of project A >project B, but if r>15.44% project B is

preferred to project A.
 The discounted present value of the two projects and their relationship with r
depicted by the following graph.

75
 NPV
600

800
Project A
15.44

Project A
Discount rate (%)

Discounted Measure Count…

B. Internal Rate of Return (IRR)

 It is defined as the rate of discount, which brings about equality between

the present value of future net benefits & initial investment.
n
At
I = ∑ t
Where r=IRR
t = 1 (1 + r )

 Illustration: For project A in the above table can be formulated as

200 400 500 700
1000 = + + +
( 1 + r )1 (1 + r )2 ( 1 +r )3 ( 1 +r )4
76
 r can be found through trial & error method.
At r = 23.068 percent the value in the above equation in the right hand side will
be equal to 1000.0087

 The problem with this method is that the value of r (IRR) can only be found by
trial and error.
 The procedure can be described as follows:
1. Select an arbitrary value of r;
2. Calculate the value of the right hand side equation with this value of r.
3. If the RHS value <I reduce the value of r.
4. If RHS >LHS, increase the value of r; continue until this the RHS is very
close to the LHS.
 When the RHS is more or less equal to LHS, it is that value of r, which is the
IRR.
What does IRR really mean?

 It is the maximum interest that a project could pay for the resources used if
the project is to recover its investment and operating costs & still break even.
 It is the maximum rate of interest that a project could pay if all resource were
borrowed.
 The IRR is a very usefully measure of project worth.
 IRR represents the rate of return on uncovered balance; and
 IRR represents the command rate of return earned on initial investment
for the life of the project.
How do we use IRR for selection criterion?
 Basically a project will be accepted if its IRR is equal to or greater than the
opportunity cost of capital.
 In financial analysis the lending interest rate is usually taken for decision-
making.
 But in economic analysis the IRR must be compared against the social
rate of discount

77
  opportunity cost of capital at the margin if saving is taken as a
enumerative and
 the rate of decline in marginal utility of income if consumption
taken as a enumerative.
 If we take the previous two projects (project A & B), project A gives a greater
NPV than NPV of B as long as the discount rate is below 15.44% and hence
project A will be preferred to project B.
 Therefore, as long as the opportunity cost of capital the discount rate, is
less than 15.44%, we never know for sure that project B would contribute
more (to the owner in financial analysis & to the economy in economic
analysis).
 But if the discount rate or opportunity cost of capital, either in consumption
or saving, is greater than 15.44% project B would be ranked first in both
measures of project worth.
C. Net Benefit - investment Ratio

 This criterion is suitable and convenient for ranking projects especially

when sufficient budget is not available to implement all projects that
satisfy other criteria.
 That is, two or more projects may all have a positive NPV, IRR that exceeds
the discount rate, both financial and economic discount rates, and a
benefit-cost ratio of greater than one.
 In this case, ranking could be made using net Benefit - investment ratio.
n
This can be calculated as: ( Bt −Ct
∑ ( 1 +r ) t
Net benefit - investment ratio t =1
n
∑ I /( 1 + r )t
t =1

 The formal selection criterion for the net benefit - Investment ratio measure
of project worth is to accept all projects with a ratio of 1 or greater when
they are discounted with appropriate rate - in order, beginning with the
largest ratio value and preceding until available investment funds are
exhausted

78
  This ratio determines if project will have a net benefit greater than the
investment at some stated amount of return on capital.

5.7 Project Appraisal

 The measures of project worth may give different ranking if projects that are
being compare are different in their:
 Cash flow structure
 Magnitude of costs and benefits
 Life time
 If a firm or government has unlimited funds, projects with a positive NPV,
the IRR value > OC of capital (discount rates), and the B-C ratio >1 will all
be chosen.
 If there is limited funds, and if different criterion gives rise to different
results, a decision must be made as to which criterion to use for selection.
Project Appraisal

 Two projects could be mutually exclusive (implementing one project

necessarily prohibit implementing another) for two reasons:
 one, If there is no enough capital funds, and
 Second, if these two projects are technically contradicting (such as labor
intensive or capital intensive techniques).
 In this case, one can calculate the IRR on the marginal flows and
compare it against the cost of capital for the firm.

 If a firm has a number of proposals which have NPV>0 (IRR>K) but cannot
undertake all these projects because of the limited availability of funds at
present.
 Since the objective of investment decision making is to maximize the NPV of
the chosen package of investments the following procedure may be followed
for selection (appraisal).
 Consider all combinations which can be accommodated with in capital
budget constraint.

79
  choose feasible combination which has the highest NPV
Example: A firm has a capital budget constraint of Birr 100.000 and six proposals
with the following characteristics.

Proposal Outlay required NPV IRR (%)

1 60,000 25000 14
2 50000 20000 14.5
3 40000 18000 15.0
4 25000 10000 13.0
5 20000 10000 12.0
6 5000 6000 25.0

 The set of proposals which can be accommodated within the budget of Birr
100,000 and their NPV are
Set Outlay required NPV
1,3 100,000 43000
1,4,6 90,000 41000
1,5,6 85,000 41000
2,3,6 95,000 44000
2,4,5,6 100,000 46000
3,4,5,6 90,000 44000

Financial analysis ABC Computer PLC

 This part of the project proposal will clearly show the profitability of the ABC
computer training PLC.
 It covers cost to start up as well as ongoing operating cost and the cash flow
for the coming 5 years.
 These will be depicted on
 an income statement,
 a balance sheet,
80
  cash flow statement,
 break even analysis,
 Source and application of funds.
 Source of finance: All members are expected to contribute equal amount of
finance, resource materials and their skills.
Cost of the project
Description Cost in Birr
Acquisition of land 600,000.00
Cost of constructing the center 2,000,000.00
Cost of Equipment and office furniture 600,000.00
Vehicles 450,000.00
Pre-operating expense 60,000.00
Sub-total 3,710,000.00
Allowance for contingency (9%) 333,900.00
Margin for working capital (12%) 445,200.00
Sub-total 779,100.00
Total Cost 4,489,100.00

B. Financial Statement & Schedules

 Before preparing the projected financial statements, it is important to

consider the following assumptions.
 Construction of training center and the offices and developing the
training manual will be performed in the first year.
 Sales will start in the second year.
 The ABC computer training PLC would operate for 360 days per year.
 The sales realization for the ABC computer training PLC is taken from
revenue allocation schedule.
 Direct operation costs are expected to be 50% of sales.

Financial analysis

 Indirect costs are divided in to two, these are:

81
  Utilities like electricity, telephone and water are expected to cost 10% of
sales.
 Other indirect costs like transportation, maintenance, repairs and other
are also assumed to be 10% of sales.
 Wages and salaries are expected to be Birr 542,600.00 and would rise
at the rate of 5% per year.
 Administrative cost (fixed, will be Br. 200,000.00 per year.
 This will include salaries of management staff and other fixed costs, which
are related to the administration and finance department.
 The selling expense including all promotional and marketing related costs
will be assumed to be 10% of sales.
 The depreciation rates will be as follows
 Building 8%
 Equipment and office furniture 12%
 Vehicle 10%
 Pre-operating expense 10%
 The company plans to retain 40% of the net profit and 60 % of it will be
distributed to the partners equally, starting from the third year of
operation.
 Tax rate is taken as per the law, 35% of the net profit.
 After understanding the above assumptions then the projected financial
statements can be developed.
 To prepare a forecasted income statement, balance sheet and a cash flow
statement, first we have to prepare depreciation schedule and revenue
allocation schedule.
 In the following slides of the business plan we will see all prepared projected
financial statements.

Depreciation Schedules for income tax purposes

Item Total Cost Year

2014 2015 2016 2017 2018

82
Building (8%) 2,000,000.00 160,000.00 160,000.00 160,000.00 160,000.00 160,000.00

Equipment and office 600,000.00 72,000.00 72,000.00 72,000.00 72,000.00 72,000.00

furniture (12%)

Vehicle (10%) 450,000.00 45,000.00 45,000.00 45,000.00 45,000.00 45,000.00

Pre-operating exp 60,000.00 6,000.00 6,000.00 6,000.00 6,000.00 6,000.00

(10%)

Total Depreciation. 283,000.00 283,000.00 283,000.00 283,000.00 283,000.00

Exp.

Revenue Allocation Schedule

A. Desk top computer sell

Year
Particular
2014 2015 2015 2017 2018

Annual working day 360 360 360 360 360

Daily sell 10 10 10 10 10

Annual Sell (Unit) 3600 3600 3600 3600 3600

Estimated capacity 50% 65% 80% 95% 98%

Over all estimated capacity 1800 2340 2880 3420 3528

Price 7000 7000 7000 7000 7000

Revenue (sell in Birr) 12,600,000 16,380,000 20,160,00 23,940,00 24,696,00

B. laptop computer sell

Year
Particular
2014 2015 2016 2017 2018

Annual working day 360 360 360 360 360

Daily sell 5 5 5 10 20

Annual Sell (Unit) 1800 1800 1800 3600 7,200

Estimated capacity 50% 65% 80% 95% 98%

Over all estimated capacity 900 1170 1440 3420 7056

83
 Price 12,650 12650 12650 12650 12650

Revenue (sell in Birr) 11,385,000 14,800,500 18,216,000 43,263,000 89,258,400

C. Photo copy machine sell

Year
Particular
2014 2015 2016 2017 2018

Annual working day 360 360 360 360 360

Daily sell 1 1 2 3 3

Annual Sell (Unit) 360 360 720 1080 1080

Estimated capacity 50% 65% 80% 95% 98%

Over all estimated capacity 180 234 576 1026 1058

Price 45,550 45,550 45,550 45,550 45,550

Revenue (sell in Birr) 8,199,000 10,658,700 26,236,800 46,734,300 48,191,900

D.Customer training service

Year
Particular

2014 2015 2016 2017 2018

Number of Trainers /Year 1,600 1,600 1,600 1,600 1,600

Salary Per month(average) 2000 2000 2000 2000 2000

Salary per year 24000.00 24000.00 24000.00 24000.00 24000.00

Commission for the P.L.C 6000.00 6000.00 6000.00 6000.00 6000.00

(25% of salary)

Unit price for trainers 600 600 600 600 600

Total Revenue per year 9,600,000. 9,600,000 9,600,000 9,600,000 9,600,000

E. Revenue from sell of flash disk

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 Particular Year

2014 2015 2016 2017 2018

Annual working day 360 360 360 360 360

Daily sell (unit) 10 12 12 20 20

Annual sell (unit) 3600 4320 4320 7200 7200

Estimated capacity 50% 65% 80% 95% 98%

Over all estimated 1800 2808 3456 6840 7056

capacity

Price 400 400 400 400 400

Total revenue per year 720,000 1,123,200 1,382,400 2,736,000 2,822,400

F. Revenue from Operation

Description Year

2014 2015 2016 2017 2018

Desk top computer 12,600,000.00 16,380,000.00 20,160,000.00 23,940,000.00 24,696,000.00

Laptop computer 11,385,000.00 14,800,500.00 18,216,000.00 43,263,000.00 89,258,400

Photo copy machine 8,199,000.00 10,658,700.00 26,236,800.00 46,734,300.00 48,191,900.00

training service 9,600,000.00 9,600,000.00 9,600,000.00 9,600,000.00 9,600,000.00

Flash disk 720,000.00 1,123,200.00 1,382,400.00 2,736,000.00 2,822,400.00

Total 42,504,000.00 52,562,400.00 75,595,200.00 126,273,300.00 174,578,700.00

Projected Income Statement from 2014-2018

Description Year

2014 2015 2016 2017 2018

Desk top computer 12,600,000.00 16,380,000.00 20,160,000.00 23,940,000.00 24,696,000.00

Laptop computer 11,385,000.00 14,800,500.00 18,216,000.00 43,263,000.00 89,258,400

85
Photo copy machine 8,199,000.00 10,658,700.00 26,236,800.00 46,734,300.00 48,191,900.00

training service 9,600,000.00 9,600,000.00 9,600,000.00 9,600,000.00 9,600,000.00

Flash disk 720,000.00 1,123,200.00 1,382,400.00 2,736,000.00 2,822,400.00

Total 42,504,000.00 52,562,400.00 75,595,200.00 126,273,300.00 174,578,700.00

Projected Income Statement from 2014-2018

PARTICULARS Year

2014 2015 2016 2017 2018

Sales realization (in Birr) 42,504,000.00 52,562,400.00 75,595,200.00 126,273,300.00 174,578,700.00

Less direct (variable cost)

Direct operation cost 21,252,000.00 26,281,2 37,797,60 63,136,65 87,289,35

(50%) 00.00 0.00 0.00 0.00

Total Direct Cost 21,252,000.00 26,281,200.00 37,797,600.00 63,136,650.00 87,289,350.00

Gross Profit 21,252,000.00 26,281,200.00 37,797,600.00 63,136,650.00 87,289,350.00

Fixed cost (over head)

Wage & salaries 542,600.00 569,730.00 598,217.00 628,128.00 659,534.00

Utility (10% of sales ) 4,250,400.00 5,256,240.00 7,559,520.00 12,627,330.00 17,457,870.00

Other indirect ( 10% of 4,250,400.00 5,256,240.00 7,559,520.00 12,627,330.00 17,457,870.00

sales)

Administration 200,000.00 200,000.00 200,000.00 200,000.00 200,000.00

Selling expense (10% of 4,250,400.00 5,256,240.00 7,559,520.00 12,627,330.00 17,457,870.00

sales)

Depreciation 283,000.00 283,000.00 283,000.00 283,000.00 283,000.00

Other expense

Total fixed cost 9,526,400.00 11,565,210.00 23,759,777.00 38,993,118.00 53,516,144.00

Net profit before tax 11,725,600.00 14,715,990.00 14,037,823.00 24,143,532.00 33,773,206.00

Provision for tax (35%) 4,103,960.00 5,150,597.00 4,913,238.00 8,450,236.00 11820622.00

Net profit after tax 7,621,640.00 9,565,393.00 9,124,585.00 15,693,296.00 21,952,584.00

Less dividend (60%) 5,474,751.00 9,415,978.00 13,171,550.00

Profit retained (40%) 7,621,640.00 9,565,393.00 3,649,834.00 6,277,318.00 8,781,034.00

Add depreciation 283,000.00 283,000.00 283,000.00 283,000.00 283,000.00

86
 Net cash flow 7,904,640.00 9,848,393.00 3,932,834.00 6,560,318.00 9,064,034.00

Projected Statement of Cash Flows 2014-2018

Construction
Particular 2014 2015 2016 2017 2018
period (2013)

RECEIPTS:

SALES-CASH 42,504,000.00 52,562,400.00 75,595,200.00 126,273,300.00 174,578,700.00

Capital introduced 4,489,100.00

Total (1) 4,489,100.00 42,504,000.00 52,562,400.00 75,595,200.00 126,273,300.00 174,578,700.00

PAYMENTS:

Direct operation 21,252,000.00 26,281,200.00 37,797,600.00 63,136,650.00 87,289,350.00

Wage &salaries 542,600.00 569,730.00 598,217.00 628,128.00 659,534.00

Utility expense 4,250,400.00 5,256,240.00 7,559,520.00 12,627,330.00 17,457,870.00

Other indirect 4,250,400.00 5,256,240.00 7,559,520.00 12,627,330.00 17,457,870.00

Administration 200,000.00 200,000.00 200,000.00 200,000.00 200,000.00

Selling expense 4,250,400.00 5,256,240.00 7,559,520.00 12,627,330.00 17,457,870.00

Local tax 4,103,960.00 5,150,597.00 4,913,238.00 8,450,236.00 11,820,622.00

Dividend 5,474,751.00 9,415,978.00 13,171,550.00

Capital expenditure 3,710,000.00

Total payment (2) 3,710,000.00 38,849,760.00 47,970,247.00 71,662,366.00 119,712,982.00 165,514,666.00

Cash flow (1-2) 779,100.00 3,654,240.00 4,592,153.00 3,932,834.00 6,560,318.00 9,064,034.00

Opening Balance 779,100.00 80,344,688.00 24,404,700.00 28,308,024.00 28,918,668.00

Closing Balance 779,100.00 80,344,688.00 24,404,700.00 28,308,024.00 28,918,668.00 37,982,702.00

Projected Balance Sheet as of December 31, 2014 –2018

Particular Construction Year

87
 period (2013) 2014 2015 2016 2017 2018

Assets

Current

Cash & back 779,100.00 80,344,688.00 24,404,700.00 28,308,024.00 28,918,668.00 37,982,702.00

balance

Fixed Asset

Gross block 3,710,000.00 3,710,000.00 3,710,000.00 3,710,000.00 3,710,000.00 3,710,000.00

Less acc. 283,000.00 283,000.00 283,000.00 283,000.00 283,000.00

depreciation

Total Fixed Asset 3,710,000.00 3,427,000.00 3,427,000.00 3,427,000.00 3,427,000.00 3,427,000.00

Total Asset 4,489,100.00 12,110,740.00 14,955,193.00 9,028,834.00 11,616,618.00 13,520,578.00

Liability and

owners equity

Liability 900,700.00 889,900.00 850,200.00 250,444.00

Owners equity

Share capital 4,489,100.00 4,489,100.00 4,489,100.00 4,489,100.00 4,489,100.00 4,489,100.00

Retained earning 7,621,640.00 9,565,393.00 3,649,834.00 6,277,318.00 8,781,034.00

Total 4,489,100.00 12,110,740.00 14,955,193.00 9,028,834.00 11,616,618.00 13,520,578.00

Investment Appraisal

 In this part of the project proposal, we will try to analyze the return on investment of the

proposed ABC computer training center P.L.C.

 We the net present value and profitability index method in the analysis of project financial

profitability.

 The following tables show us the net present value (NPV) of the business by using 12%

discounting factor (discount rate).

Net present value & profitability index of the business

Year Net cash flow Present value factor Present value

88
 (12%)

2013 4,489,100.00 1.00 4,489,100.00

2014 7,940,640.00 0.89286 7,089,879.83

2015 9,484,393.00 0.79719 7,560,863.26

2016 3,932,834.00 0.71178 2,799,312.59

2017 6,560,318.00 0.63552 4,169,213.30

2018 9,064,034.00 0.56743 5,143,204.81

Total present value 31,251,573.79

NPV 26,762,473.79
Financial analysis

NPV = Total PV NCFS- Initial investment

= 31,251,573.79- 4,489,100.00

= 26,762,473.79

Generally

 The ABC computer training service PLC has a positive net present value

 This shows that investing in this venture is going to be profitable.

 Hence, the investment of computer training P.L.C is financially viable.

Chapter Six: PFS: Social Cost Benefit Analysis (SCBA)

Introduction

89
 SCBA is a methodology developed for evaluating investment projects from the
point of view of the society.
 SCBA aids in evaluating individual projects with in the planning framework
which spells out national economic objectives and broad allocation of
resources to various sector of the economy.
 In other words SCBA is concerned with tactical decision making with in the
framework of macro level.
 The main purpose of SCBA is to determine which project will increase
welfare once distributional impact is considered.
 In an economic analysis of a project it is implicitly assumed that a dollar
received by any individual will increase the community’s welfare by the
same amount as a dollar received by any other individual.
 But an extra dollar given to a very poor person will usually increase the
person’s welfare by much more than would a dollar given to a rich
person.
 Here the project analysts will not be only concerned to determine the level
of project’s benefits and costs but also who receives the benefit and pays
the costs.

6.1 Rationale for SCBA

1. Market imperfection

 Rationing
 Prescription of minimum wage rate
 Foreign exchange regulation
2. Externality
 Both positive and negative
3. Taxes and subsidy consideration
 Are transfer payments not considered here
4. Concern on saving
 Here it is given much value than consumption

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 5. Concern for redistribution
 The poor society give much value than the rich
6. Merit wants
 Women empowerment, regional equality, assisting the poor etc
7. Misleading of consumer’s surplus.
 We may select project with higher consumer surplus, but not benefit
the poor

6.2. UNIDO Approach

 It was first articulated in the guideline for project evaluation which
provide a comprehensive framework for SCBA in developing countries
 It values all traded and non-tradable goods and services in terms of
domestic price equivalent.
 It measures cost and benefit in terms of consumption
 Focus on efficiency, saving and redistribution aspects in different stages
UNIDO method for project appraisal involves five stages
1. Calculation of the financial profitability of the project measured at
market prices
2. Obtain the net benefit of the project measured in terms of its economic/
efficiency prices
3. Adjustment for the impact of the project saving and investment
4. Adjustment for the impact of the project income and distribution
5. Adjustment for the impact of the project merit goods and demerit goods
whose social values differ from their economic values

6.3. Net Benefit in Terms of Economic (Efficiency) Prices

 Important step in economic analysis:
• First Identifying costs and benefits of the project
• Second quantify them and
• Finally value them in monetary terms.

91
  The projected financial benefits and costs are often a good starting point for
identifying economic benefits and costs, but two types of adjustments are
necessary.
 First, include or exclude some costs and benefits.
 Second, revalue inputs and outputs at their economic opportunity
costs (efficiency prices).
The difference b/n financial and economic analysis
 FA looks at the project from the perspective of the implementing agency while
EA looks at a project from the perspective of the entire country, or society
 FA assesses items that require monetary outlays while EA assesses the
opportunity costs for the country.
 FA is based on the actual prices that the project entity pays for inputs and
receives for outputs while EA are based on the opportunity costs to the
country.
Items to be include or exclude in economic analysis
1. Sunk Costs
 Are costs incurred in the past
 For both FA and EA, the past is the past, are not considered.
 What matters are future costs and future benefits?
 Ignoring sunk costs sometimes leads to seemingly paradoxical, but
correct results.
2. Transfer payments
 Are payments made among different persons/economic agents / but
are not related to any particular resources cost.
 They do not reflect changes in national economy.
 Hence they have to be excluded from all estimates of economic costs
and benefits analysis of a project.
 They affect the distribution of income though they don’t affect the
overall level of resources available to the economy/society/.
 So they are important to assess gainers and losers

92
3. Externalities (±)

 A project may have a negative or positive impact on specific groups in

society without the project entity incurring a corresponding monetary cost
or enjoying monetary benefit.
 Analysts should consider these externalities, when adjusting financial
flows to reflect economic costs.

4. Consumer Surplus (+)

 New projects will lowers the price of its output and the old consumers pay
a lower price for same product (CS gain).
 when supply is rationed at a price below what consumers would be
willing to pay for public goods gain CS.
 Therefore it should have to be considered in economic cost benefit analysis
of a project.

Taxes versus User Charges (-T and + Charges)

 Not all charges levied by governments are transfer payments.

 Some are user charges levied in exchange for goods sold or services
rendered by the government.
 We have to consider these elements in EA

6. Subsidies (-)

 Subsidies shift control over resources from the giver to the recipient and do
not constitute a cost to society.
 Because the flows net out (benefit overset cost), they are not a cost to
society.
 Nevertheless, because subsidies often flow from government to the project
entity, they are part of the project's fiscal impact, and analysts must take
care to show them explicitly.

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7. Donations and Contributions in Kind (+)

 The project entity receives goods and services free of charge.

 For example, hospitals may receive costly medical equipment as gifts
from the private sector or NGOs
 When evaluating projects from society's viewpoint, it is important to
include these items by valuing them at their market price as a first
approximation to their economic cost .

8. Interest Payments and Repayment of Principal (-)

 Both entails cash out lays, but omitted from EA and FA.
 In both cases assessing the quality of the project independently of its
financing mode is what matters most.
 Another reason for excluding debt service from EA is that debt service
does not entail a use of resources, but only a transfer of resources from
the payer to the payee.

9. Interest during Construction (-)

 Sometimes lending institutions may add the value of interest during

construction to the principal of the loan and do not require any interest
payments until the project begins to generate income.
 Whether the bank capitalizes the interest or not, we treat the interest the
same for purposes of economic analysis.
 Interest during construction is still a transfer, and we omit it from the
economic accounts.
 Once we identified items to be considered we value them using shadow/
efficiency price for selected commodities

Shadow prices are the value of the contribution to the country’s basic
socioeconomic objectives made by any marginal change in the availability of

commodities or factors of production.

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Items should be Revalued in EA

1. Primary factors: labor, land, natural resources, domestic resources and

foreign exchange.
 Land & natural resources are valued indirectly through estimation of
their productivity in their alternative uses rather than as capital values.
 This is done through taking the ‘with-out project situation’ rather than
through adjustment of prices.
 For this reason there is no national parameter for land.
2. Tradable (traded) goods: whose use or production causes a change in the
country’s net import (M) or export (X) position?
 When there is a significant difference between the border price and the
local market price and/or
 Where the item concerned is likely to feature prominently as an input
or an output for a number of projects.
3. Non-tradable (non-traded) goods
 Where there is a significant difference between the local market
price and the economic value and/or
 where the item concerned is likely to feature prominently as an
input or an output for a number of projects.
4. Average Estimates relating to particular sectors:

 here cost data do not allow further breakdown or where the

sector concerned is not a high priority for further investigation.
 Important average is the standard conversion factors (SCF).
5. . The Discount rate

 The rate at which the future steams of costs and benefits are
brought into common denominator, the present values.
 A project will be profitable to society if NPV of the project to society is
greater than zero.

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 Here the question is,
 how should a projects economic/social benefits and costs be measured,
and
 what common unit of account should be used to expressed the benefits
& cots of the project
The two methods of measuring in economic costs & benefits analysis of a project
are:
 UNIDO approach and

 Little- Mirrlees approach.

1. UNIDO Approach
 It values all traded and non-tradable goods and services in terms of
domestic price equivalent.
 Domestic prices are used as a numeraire
 In this Approach
 First all traded goods & services will be adjusted for any distortions in
the domestic markets
 Then multiply the adjusted domestic price by shadow exchange rate
(SER ) to make domestic resources be comparable with foreign
resources.
 Suppose we have a project producing export item that uses both foreign &
domestic inputs, the net benefit (ignoring discounting) would be estimated
as:
Where Net benefit (NB)= SER ( X- M )−D
X - Border price of exports in foreign currency

M - Border price of imported goods in foreign currency

D - Adjusted (economic) values of domestic goods in domestic currency

SER - shadow exchange rate (assuming OER does not accurately reflect the

true value of foreign currencies to the economy).

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 Example: Valuation at Domestic Price

(a) Valuation of Imported Inputs

 In the Table below it has been estimated that the country has a foreign
exchange premium of 30% & shadow exchange rate is therefore (1+0.30) X
OER.
 All tariffs and taxes are deducted from the domestic retail price of textile
and their tradable component (FX) is inflated by the SER to obtain the
domestic price equivalent of the import price.
 The economic cost of domestic transport and handling is then added.

Valuation of imported textile inputs using the domestic price approach (in Million
Birr)
Item Financial cost Economic cost

Import price (@OER) 250 -

( @ SER =1.3 X OER),= 1.3*250 - 325

Import tariff (40%), 0.4*250 100 0

Internal transport; 50 50

Handling and distribution* (60% of these c osts 50 20

represent rents earned from privileged access to FX)

Total (Column Sum) 450 395

(b) Valuation of Exported output

 The Table below shows valuation of a project’s exported garment output,

using the domestic price approach.
 The country again has 30% of foreign exchange premium.
 The FX earnings are inflated by the SER and all export subsidies are
deducted form the fob export price to obtain the domestic price equivalent of
the border price.
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Valuation of exported garment using domestic price approach (in Million Birr)

Item Financial cost Economic cost

Output value (@OER) 1200 -

( @ SER =1.3 X OER) -120 1560

Export tax (10 %)

Transport to the port* -40 -30

(Including 25% fuel tax)

Total (Column sum) 1040 1530

* The market price of transport includes a 25% fuel tax. Since fuel equals has of
total transport costs it economic value = 40 - (40x0.25) = 30.

II. Little-Mirrlecs or Border Price Approach

 Here benefits & costs measured at world price to reflect the true
opportunity cost of outputs and inputs
 Official exchange rate taken as the numéraire
 It does not mean that project accounts are necessarily expressed in foreign
currency.
 The unit of account can remain the domestic currency, but the values
recorded are the foreign exchange equivalent, how much net foreign exchange
is earned
 This method originally came in the context of import substitution policies
pursued by many LDCs in the 1950s & 1960.
 It was thought that if a project was analyzed at world prices, this would an
indication of
 whether it could survive in the long term in the face of international
competition, and
 Whether its output could be obtained more cheaply from international
sources.

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  If world prices are used, the economic price at which to value a project’s
output is
 its export price if it adds to exports, or
 its import price if domestic production leads to a saving in imports.
 Similarly, on the cost side, the price at which to value a project input is
 its import price if it has to be imported, or
 Export price if greater use leads to a reduction in exports.
 This adjustment applies for traded goods).
 A project that produces export goods can be assessed as: Net Present Value
(NPV) = OER (X-M) - SCF.D
Where - OER- official exchange rate
X- Exported goods in foreign currency
M- Imported goods in foreign currency
SCF- standard conversation factor
D- Price of non-traded goods in domestic currency
 To summarize, as long as SCF is the ratio of OER to SER, the two
approaches UNIDO and Little-mirrless - differ only to the extent that
SER is different from the OER.

Valuation of imported textile inputs using the border price approach (in Million

Birr)

Item Financial value Economic value

Import price (@OER) 250 250

Import tariff (40%) 100 0

Internal transport* 50 40

Handling and distribution** 50 14

Total (Column sum) 450 304

Ratio of economic to financial value 304/450 = 0.68

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 * The conversion factor for transport, which puts the domestic price of transport
into its border price, =0.8, hence the transport’s economic value = 50X0.8=40.

** 60% of items represent rents earned form privileged access to foreign

exchange. In addition, the conversion factor for handling = 0.7. Hence economic
value = (financial value x 0.4) x Cfh = 20 x 0.7= 14.

Valuation of export garment outputs using the border price approach (in ‘000 Birr)

Item Financial value Economic value

FOB output price (@OER) 1200 1200

Export tax (10%) -120 0

Transport* -40 -24

Total 1040 1176

 Ratio of economic value: financial value = 1176/1040 = 1.13

 * The 25% fuel tax is deducted (fuel = half transport tax), and the CF=0.8, hence
the transport’s economic value = [40 - (40 x 0.25)] x 0.8 = 24

B. Valuation of non-traded goods

 Steps for valuation of non-tradable goods at world price

(a) Net out taxes from domestic market price of commodity;

(b) The net of taxes price is decomposed into its traded and non-tradable cost

elements.

 For non-traded goods by their very nature one or two decomposing is a pre
requisite to their valuation in terms of world prices.
 The non-tradable items are further decomposed into traded and non-tradable
and the procedure continues until in successive rounds the original inputs or
outputs are restated in terms of traded components and labor.

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  After one or two rounds of decomposition, then;
1. The non-tradable components will be valued at the domestic price &
multiplied by a conversion factor,
2. Traded components will be valued at border prices
3. Labor at the shadow wage rate.
 There always remain items that are non-tradable and for which there is only
domestic market.
 To estimate the accounting prices for all other non-tradable goods (inputs and
outputs) we use conversion factors.
 A typical list of conversion factors includes:
 Unskilled and skilled labor
 Some of the main non-tradable sectors
 Consumption conversion factor
 Standard average conversion factor,
 The discount rate,
 Shadow foreign exchange rate, etc.

6.4 Measurement of the Impact on Distribution

 It attached to changes in income, costs and benefits, received by different
income groups.

 It ensuring that a project’s impact on the income of the low income groups
receive a higher weight than the same dollar impact of the income of the
high-income groups.
 The introduction of these distributional weights enables projects to be
assessed on the basis of distributional as well as efficiency objectives.
 In economic analysis, project-generated-changes in consumption enjoyed by
all income groups are weighted at unit, d = 1.
 In social analysis income accruing to (or being taken from) lower income
groups would typically be given a distributional weight greater than one, d > 1.
 Income accruing to a high-income group would be given a weight less than
one, d < 1.
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  A project that benefit a low income group would therefore have a

higher social NPV than that benefits a high income group, if all other un-

weighted costs and benefits remain the same.

Project A Project B

Poor Rich Poor Rich

Costs paid by 0 100 80 0

Benefits received by 150 0 0 160

If distributional weights 1 1 1 1

Economic NPV +50 +80

We select project B., a pure economic analysis with no weight for income distribution

If distributional weights 2 1 2 1

Costs paid by 0 100 160 0

Benefits received by 300 0 0 160

Social NPV +200 0

We select project A: this is a SCBA, providing a weight for income distribution.

Arguments against use of distributional weights

1. Difficulty of tracing the net income changes accruing to different income

groups as a result of the project
2. How the government or project analyst can objectively determine the
appropriate set of weights to employ
3. Weak fiscal system, large segment of the population pay no tax; corruption
weak to distribute income
4. Conventional cost-benefit analysis does not capture the distributional
impact of a project,

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Chapter Seven: Environmental Impact Assessment

7. Environmental Impact Assessment

Introduction
 Environmental assessment is a field of growing importance in project
appraisal.
 Underestimation of the environment has resulted in negative outcomes such
as (Serageldin & Steer, 1994)
 poor human health,
 social disruption,
 reduced productivity and,
 undermining of development.
 Now this trend is being reversed & policy makers are becoming increasingly
concerned with making development ‘sustainable’.
 Careful analysis of a project’s potential environmental impact has
therefore come to play a central role in appraisal process.
 A clear understanding of the meaning of sustainability in terms of
development is essential if project appraisal is to consider which forms
of environmental impact are either acceptable or unacceptable.
 To assess the potential impact on sustainability it is necessary to
identify and analyze the areas of potential environmental impact
of the project.
 If a project is liable to have a significant environmental impact then it
may prove necessary to suggest ways in which that impact could be
reduced at a reasonable cost.
 Environmental assessment (EA) is the assessment of the environmental
consequences of a plan, policy, program, or actual projects prior to the
decision to move forward with the proposed action.
 The term "environmental impact assessment" (EIA) is usually used when
applied to actual projects by individuals or companies \

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  The term "strategic environmental assessment" (SEA) applies to policies,
plans and programs most often proposed by organs of state.
 It is a tool of environmental management forming a part of project
approval and decision-making.

7.1 Environmental Conflicts

 Environmental conflicts have emerged as key issues challenging local,

regional, national and global security.
 Environmental crises and problems throughout the world are widespread
and increasing rapidly.
 Several authors argue conflict emerges when stakeholders have
irreconcilable differences or incompatible interests, values, power,
perceptions & goals.
 Furthermore, if unresolved or not managed, conflicts are likely to escalate
and intensify.

Types of environmental conflicts:

1. Biodiversity conflicts: it includes conflicts

 Relating to conservation of protected areas, green technologies, fair
trade and patenting rights in relation to biodiversity and indigenous
knowledge linked to natural resources.
2. Coastal zone conflicts
 This has to do with high development demands, high population
density, environmental degradation, poor and disjointed
management to balance conservation and development.
3. Conflicts about air quality and noxious pollutants:
 issues pertaining to social justice and the right to live in a healthy
environment
7.2 Objectives of EIA

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 1. Identifying, predicting, and evaluating economic, environmental, &
social impacts of development activities.
2. Providing information on the environmental consequences for decision
making.
3. Promoting environmentally sound and suitable development by
identifying appropriate alternatives and mitigation measures.

Importance of EIA

1.EIA is a good tool for careful environment management.

2.It is government-policy that any industrial project has to secure EIA
clearance from concerned body before approval for the project itself.

7.3 Phases and Structure of EIA

The phases of EIA include:

1. Screening
2. Scoping
3. Baseline study
4. Impact prediction
5. Impact assessment
6. Decision Making
7. Mitigation
8. Producing the environmental impact statement
9. EIA review
10. EIA follow up

1. Screening:

 It is the process of answering the questions:

 What will be the effects of this project on the environment?
 Are those effects significant?'
 If answer to second question is 'yes', EIA may be required.

2. Scoping

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  It is defining the issues that need to be addressed, i.e., those impacts
that have a significant effect on the environment.
 It is essential for focusing the available resources on the relevant
issues.
3. Baseline study
 It is collecting all relevant information on the current status of the
environment against change attributed the project
4. Impact prediction
 It involves forecasting the likely changes in the environment that will
occur as a result of the project.
5. Impact assessment
 It requires interpretation of the importance or significance of the
impacts to provide a conclusion
 It can ultimately be used by decision-makers in determining the chance of
the project application.
6. Decision making
 It answer whether the project is to be given approval or not and
 if it is to be given, under what conditions
7. Mitigation
 Taking measures to reduce or remove environmental impacts.
8. Producing environmental impact statement (EIS)
 It is a formal document for outcome of an EIA in non-technical summary
 It sets out factual information relating to the development, and all the
information gathered relating to screening, scoping, baseline study,
impact prediction and assessment, mitigation, and monitoring measures.
 EISs are very important public documents intended to inform the public
of the nature and likely consequences of a development in time to
comment and/or participate in the final project design.
9. EIS review

 Once EIA is complete, EIS is submitted to the competent authority to

permit or refuse project applications.

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  Review can take a number of forms:
1. purely an ad hoc process whereby the document is read and
commented on by decision-makers;
2. more formalized and expert opinion is sought; or
3. Formal review methods designed specifically for the purpose.
 It should enable the decision-maker to decide whether
1. the EIS is adequate (eg whether it is legally compliant),
2. the information is correct, and
3. it is unbiased.

10. EIA Follow up

 It relate to post-approval phase of EIA and encompasses

1. monitoring of impacts,
2. the continued environmental management of a project, and
3. Impact auditing.
 It presents an opportunity both
1. to control environmental effects and
2. to learn from the process and cause-effect relationships.
 Follow up data should be compared with the original predictions &
mitigation measures in EIS to determine
1. the accuracy of the original predictions
2. the degree of the deviation from the predictions
3. the possible reasons for any deviation
4. whether mitigation measures have achieved their objective of reducing
or eliminating impacts

7.4 The Assessment Process

 Key stages in Environmental Assessment process include:

 screening,
 alternatives,

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  preliminary assessment,
 scoping,
 mitigation,
 main EIA study
 environmental impact statement,
 review and
 monitoring
1. Screening

 It is to decide whether an EIA is required and focus resources on projects

most likely to have significant impacts, those where impacts are
uncertain and those where environmental management input is likely to
be required.
 Official EIA guidelines usually contain lists or schedules specifying which
developments require an EIA

2. Consideration of possible alternatives

 It should be undertaken before a choice is made.

 Some projects can be site specific (eg in mining, extraction can only
occur were a mineral is sited).
 In such cases the EIA might focus more on measures such as scale,
mitigating measures and traffic management.
3. Preliminary assessment
 It is done where screening suggests further assessment is needed or if
there is uncertainty about the nature of potential impacts.
 Uses rapid assessment techniques, but provides sufficient detail to
identify key impacts, their magnitude and significance, and evaluate
their importance for decision-making.
If a full EIA is needed - involving the following steps.
4. Scoping

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  It should involve all interested parties such as proponent & planning or
environmental agencies & members of public.
 The results determine the scope, depth & terms of reference to be
addressed within an Environmental Impact Statement
 Once the site has been selected, the number of issues usually decreases
and attention to detail increases.
5. Main EIA study
 Building on and deepening the preceding steps to predict the extent and
magnitude of impacts and determine their significance.
 A variety of methods can be used including:
1. checklists,
2. questionnaires,
3. matrices,
4. overlays,
5. networks,
6. models and
7. Simulations.
The study should incorporate consideration of mitigating

1. reviewing the action proposed/taken to prevent, avoid or minimize actual

or potential significant adverse effects of a project
 Example: abandoning or modifying a proposal, or substituting
techniques using BATNEEC (Best Available Technology Not Entailing
Excessive Costs) such as pollution abatement techniques to reduce
emissions to legal limits.
2. If the uncertainties are great, with the possibility of grave consequences
and no mitigating measures then the proposed development should be
rejected.
3. If there are uncertainties that might be reduced by further studies, then
an application can be deferred pending until further studies.
4. If mitigation is inappropriate, compensation may be an option.

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 6. Environmental Impact Statement (EIS)

 is a comprehensive document that report’s findings of EIA & now often

required by law before a new project can proceed.
 A typical EIS, usually prepared by the project on behalf of the proponent
(usually by consultants), focuses on the issues most relevant to
decision-making.

It can be broken down into three parts :

1. Volume 1 - a comprehensive & concise document drawing together all

relevant information regarding the development project;
2. Non-Technical Summary (NTS) - a brief report of volume 1 in non-
technical language that can easily be understood by public;
3. Volume 2 - a volume that contains a detailed assessment of the
significant environmental effects.(not necessary when there are no
significant effects either before or after mitigation).

7. Review

 to assess adequacy of EIA to decision-making and consider its

implications for project implementation (in some countries, such review
is a formal and independent process)

8. Monitoring of project implementation and operation

 Including decommissioning and eventually an audit of the project after

its completion.

Expected outputs

 An EIS provides clear, relevant, understandable information to influence

the final decision on the development project.
 A better development project (minimized negative impacts, maximized
positive impacts, optimal location, best alternative selected, etc)

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7.5 Methodologies and tools

We can have the following tools for EIA

1. Ad hoc methods
 Used when time constraints & lack of information require that the
EIA must rely exclusively on expert opinion.
2. Checklists and matrices
 Are good tools for organizing and presenting information?
3. Sectorial guidelines
 an appropriate technique for conducting initial environmental
analysis.
4. The systematic sequential approach (SSA)
 Provides a proven approach to “thinking through” the causal chain:
activity - changes - impacts - mitigation.
5. Networks

 are a formalized way of representing causal chains.

6. Simulation modeling workshops

 Are techniques for taking network representation of impacts and

building simple conceptual models?
 Here the conceptual models are translated into mathematical and
computer language.
 In dynamic simulation, impacts over time can be projected.
7. Spatial analysis methods
 Allow for the presentation of the spatial pattern of environmental
impacts through map overlays.
 GIS is used for analyzing and displaying spatial impacts.

8. Rapid assessment techniques

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  Have been designed to cope with need for quick assessments to deal
with rapid changes in many parts.
7.6 CBA of Environmental Impacts

 Environmental cost-benefit analysis (CBA) is the application of CBA to

projects or policies that have
 the deliberate aim of environmental improvement or
 actions that somehow affect the natural environment as an indirect
consequence
 This requires understanding what these options provide in:
 benefits (defined as increases in human well-being) and
 Costs (defined as reductions in human well-being).

7.7 Cost-benefit analysis models

 Several cost-benefit models have been constructed for use in developing

countries but are primarily oriented toward the use and management of
natural resources.
These would include the

1. Extended Cost Benefit Analysis

2. Cost-Benefit Analysis of Natural Systems Assessment and
3. Extended Cost-Benefit Analysis Graph
 CBA is generally applied at the project level to consider all the economic
benefits and costs resulting from
 employment of national resources of any character and
 Production of goods and services.

7.8. Assessment of environmental costs and benefits

 The basic principle underlying quantitative assessment of environmental

impacts is the value that may be placed by society or individuals on
environmental improvement or degradation.

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  These C&B can be expressed monetarily in terms of:
 willingness to pay for environmental improvement or
 willingness to accept as compensation for environmental degradation
 We can have the following methods
1. Direct monetary methods
2. Direct surveys-based methods
3. Indirect market based methods

1. Direct monetary methods

 It estimates the charges in household expenditures and in production

costs for other industrial activities affected by the environmental changes
attributable to the project under study.
 The method develops a dose-response function to assess physical changes
in receptor organisms or materials, which is then converted to monetary
units by assessing the value of the changes.
 Example: if a crop yield is altered by a change quality of the
environment, the change in the economic value of the crop is a
monetary measure of the environmental change.
 In the case of risks to human life and health, valuation models have
been developed using risk-compensation data for occupations with
varying levels of risk.
 An alternative is the human-capital approach, in which the financial
costs associated with the health impact, principally medical costs and
the present value of lost earnings, are determined

1. Direct surveys-based methods

 This valuation method uses surveys to determine the value that the
affected population places on environmental changes.
 Subjects have described to them proposed environmental changes and
are asked for the

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  maximum amount they are willing to pay for an improvement or
 the maximum amount they would accept as compensation or
 the maximum amount they would accept to prevent the change in the
case of environmental degradation.
 The data are then statistically analyzed and aggregated across
households to arrive at a valuation of the environmental change.

3. Indirect market based methods

 This method attempts to input values for environmental change by
identifying their effect on the market price and price movement of economic
resources.
 Prices at different locations are assumed to reflect the implicit market
value of the environmental variation.
 The travel cost method identifies the relationship between visits to
recreation sites with different levels of environmental quality and the
cost of travel to these sites.
 In the context of industrial development, this method would be
applicable in cases where the environmental effect of the project alters
transport patterns of the public to recreational or other sites

7.9. Environmental Parameters

Common systems classify environmental impacts as:

A. Affected environment
 atmosphere,
 land,
 water,
 flora,
 fauna,
 Social community etc.) and
B. Nature or types of impact

 physical and chemical,

 Ecological and
 Aesthetic.

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Environmental Parameters

 Generally environmental impact factors can be

1. Physical and chemical impacts including noise emissions and impacts

of energy resources passed on the affect the physical and chemical
characteristics of the whole ecological system consisting of the
atmosphere, water and flora.
2. Ecological factors include the flora and fauna separately and conjointly
in terms of ecosystems, in which the population growth rate interacts as
well as other species interaction.
3. Aesthetic factors are concerned primarily with sensory impacts;
primarily visuals of land use and installations of the proposed project.
4. Social factors deal with the cultural and economic impacts such as the
quality of human life in terms of health, welfare and social
infrastructure.

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 Chapter Eight: Forecasting cash flows

Introduction

Definition of forecasting cash flow

 It is estimating or anticipating the cash inflow and outflow for the future
period by the management of the business to make sure that the business
will have sufficient funds to carry out the activities on a regular basis

 If there is any shortfall of cash, the management has to plan for

alternate sources of funding for the business.

The main Goal of forecasting the cash flow is to understand the liquidity position
of the business.

Forecasting the cash flow will help to

 know possibly available cash balance in the future period

 keep track of the cash inflow and outflow
 estimate the cash needs for running the business and the sources
available to fund it
 identify probable shortfall in the cash balance much earlier and acts like
a cautioning system.
 plan the cash outflow like payment to suppliers, employees’ salaries, etc
 buy credit days from the suppliers if they anticipate the shortfall in the
cash balance
 Make the monitoring system better.
 We have quantitative and qualitative techniques cash flow

8.1 Quantitative Techniques

 Quantitative forecasts often use historical data, such as previous sales and
revenue figures, production and financial reports and website traffic
statistics.
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 Looking at seasonal sales data, for example, can help you plan next year’s
production and labor needs based on last year’s monthly or quarterly
figures.
 Also it use projections based on statistical modeling, trend analyses or other
information from expert sources such as government agencies, trade
associations and academic institutions.

The main advantage of utilizing quantitative techniques is based on

available hard data.
1. This ensures forecasting results are as objective as possible, as the
importance is placed on numerical information and quantifiable past
performance rather than the opinions of industry experts or customers.
 The more historical sales data a company has to work with, the more
reliable the forecasting results will be, as they'll have a better chance of
producing accurate seasonal averages throughout the years.
1. For example, a business could accurately predict how much a
particular product is likely to sell within a specific period of time,
purely based on past performance and previous sales information.
 This method of forecasting requires more than just a few quick looks at
charts and other past data
 Some approaches may require more complex calculations than others.
Here are five methods of quantitative techniques
1. Regression analysis method
2. Econometrics model
3. Index number (barometric) method
4. Input-output analysis
5. Trend or time series analysis

1. Regression analysis method

 By examining the relationship between two different variables (independent

and dependent)
 Businesses can determine how one factor may affect another

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 For example, they can compare the volume of sales to the changing
seasons
 If results show that sales tend to increase or decrease depending on the
time of year, the company's sales would be the dependent variable as it
relies on the season
 From here, they can examine how closely these two variables are related
to gain a more accurate picture of how different seasons will affect
future sales demand.

2. Econometrics model

 This method involves using mathematics to develop equations that help

to explain the relationship between different economic agents.
 Information from this forecast can show the connection between
variables such as inflation, exchange rates, GNP, and how changes in
these factors affect a business's performance.
3. Index number (barometric) method

 is more useful for short-term quantitative forecasting.

 Here businesses measure the state of the economy during several
different periods in time using index numbers.
 The resulting forecast will predict where the economy is headed in the
near future and businesses can prepare for falls or increases in demand
depending on the health of the local or global economic conditions.
4. Input-output analysis

 Also referred to as the end-use technique or I-O

 This is another form of quantitative economic research.
 Information from this forecast allows businesses to predict how a
specific input might create a certain output.
 For example, an I-O system will take into account the price of
materials, worker input to meet demand, and how much money they
may invest.

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5. Trend or time series analysis

 This method is based on extensive historical data as it assumes past

trends will continue and repeat in the future.
 This method is recommended for short-term projections, as the only
information utilized is previous sales data.
 The analysis examines trends, cyclical and seasonal changes, as well as
irregular variations in sales to identify a trend in the data.

Steps for Implementing Quantitative Methods

1. Choose a question or problem to ask of their data.

 "will this product continue to sell through a specific holiday or season?
"
2. look related past data that help to solve the current issue
 it would be helpful to pull previous sales information regarding that
particular item during the same holiday season from the years prior.
3. Choose a route that reflects business's needs the most
 Select favorable one from the above five methods
4. Take an analysis to observe any consistent patterns in the data before a
forecast is made.
 Users will analyze this forecast in comparison to actual events and
determine whether this methodology can be reliable in the future.
 Changes should be made accordingly to adjust to current situations
and increase the accuracy of the forecasts.

8.2 Qualitative or Judgmental Techniques

 Qualitative forecasting techniques come from the experience and

characters of seasoned business experts.
 These forecasting techniques aren’t just guesses;

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  It includes interpretation of data combined with professional expertise
you have developed over time on the job.
 You might forecast demand by holding focus groups of customers to
discuss and gauge their reactions to several new product features your
company is considering.
 Include asking your
 sales people to project their sales for the year by month or
 Distributors if they foresee any upcoming slowdowns or buying
increases during certain times of the year.
 They are primarily based upon judgment and intuition
 They are especially important when sufficient information and data is not
available so that complex quantitative techniques cannot be used.
 The widely used qualitative methods are:
 Jure of executive opinion
 Opinions of the sales person
 Consumers’ expectations
 Delphi method

Jury of executive opinion

 This is a method by which the relevant opinions of experts are taken,

combined and averaged.
 These opinions could be taken on an individual basis or there could
be a brain storming group session in which all members participate in
generating new ideas that can later be evaluated for their feasibility
and profitability.

b. Opinions of the sales person:

 The sales people being closer to consumers can estimate future sales
in their own territories, more accurately.

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  Based on these and the opinions of sales managers, reasonable trends
of the future sales can be calculated.
 These are good for short range planning since sales people are not
sufficiently sophisticated to predict long-term trends.

Consumers’ expectations

 Involves a survey of the customers as to their future needs.

 especially useful where the industry serves a limited market
 Based on the future needs of the customers a general overall forecast
for the demand can be made.
d. The Delphi method

 A panel of experts is given a situation and asked to make initial

predictions, on the basis of a prescribed questionnaire, these experts
develop written opinions.
 These responses are analyzed and summarized and submitted back to
the panel for further considerations.
 All these responses are anonymous so that no member is influenced
by others opinions.
 This process is repeated until a consensus is obtained.
8.3 Project Analysis under Certainty

 A condition of certainty exists when the decision-maker knows with

reasonable certainty
 what the alternatives are,
 what conditions are associated with each alternative, and
 the outcome of each alternative.
 Under conditions of certainty; accurate, measurable, and reliable
information on which to base decisions is available.
 The cause and effect relationships are known and the future is highly
predictable under conditions of certainty.

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  Such conditions exist in case of routine and repetitive decisions concerning
day-to-day operations of business.

Project Analysis under Certainty

 We experience certainty about a specific question when

 we have a feeling of complete belief or
 Complete confidence in a single answer to the question.
 There is always some degree of uncertainty about the eventual outcome of
such decisions there is enough clarity about the problem, the situation and
the alternatives to consider the conditions to be certain.
 The conditions of certainty are very rare particularly when significant
decisions are involved.
 Under conditions of certainty, the decision-maker knows which
particular state of nature will occur or he is aware of the
consequences of each course of action with certainty.

8.4 Project Analysis under Risk

 When a manager lacks perfect information or whenever an information

asymmetry exists, risk arises.
 Under a state of risk, the decision maker has incomplete information about
available alternatives but has a good idea of the probability of outcomes for
each alternative.
 While making decisions under a state of risk, managers must determine
the probability associated with each alternative on the basis of the
available information and his experience.

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Chapter Nine: Risk analysis of a single investment

9.1 Concept of Uncertainty and Risk

 Projects are implemented within a constantly changing and complex

environment.
 All projects are therefore subject to a degree of risk and uncertainly.
 In practice investment proposals differ in risk and all projections into the
future involve a margin of error.
 No appraisal would be complete without taking risk and uncertainty
elements into account.

Uncertainty and Risk

 The problem for the project analyst is how to handle uncertainty within
the rational framework provided by cost benefit analysis, so that it can be
taken into account when selecting projects.
 Uncertainty is inherently unpredictable and non-quantified.
 But, at certain times, the effects of specified uncertain events can be
quantified.
 Risk refers to the probability of an event occurring and can be quantified.

Uncertainty and Risk

Sources of uncertainty:

1. Internal to the project, related to doubts regarding the technical or

managerial capacity of the project to produce expected output levels using
projected input levels.
2. External to the project, including movements in local and international
price levels and the level of market demand for the project’s output.

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  It will be influenced by cyclical factors changes in tastes and
technological developments,
 such influences are likely to be particularly important sources of
uncertainty if the project’s output will be expected or sold in an
unprotected local market

Main Considerations in risk identification

1. It is a crucial stage in risk analysis.

 If a risk is overlooked at the identification stage then its potential

impact on project outcomes will not be quantified.
2. Iterative process:
 Risk identification is, by its very nature, an iterative process,
involving all stakeholders.
 The more people who are involved in risk identification the better will
enable one to have exhaustive risk identification.
3. Continuous effort:
 It should continue throughout the design, appraisal and
implementation phases because new risks can occur at any time.

Objectives of risk identification:

 The ultimate objective of identifying and dealing with risk is to develop

risk management strategies.

 Specifically the risk identification stage should:

1. Identify potential sources and causes of risk and uncertainty;

2. Characterize and classify these risks for the subsequent evaluation

stage;

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  It helps to design risk management strategies to avoid, eliminate

and/or mitigate risks.

Sources of Risks

 Timing- of project activities duration

 Workforce - not adequately trained (experienced) or not fully committed to
achieve project objectives.
 Political – this encompasses both national politics and internalized power
relationships within the project itself.
 Technological –untried technology,
 Financial – inappropriate funds at the given time.
In general anything that affects inputs and outputs of a project as well as
the need, demand & market of the product that the project produces
will have to be considered during risk identification.

Sources of information for possible risk:

 Specialist knowledge
 Past experience
 Checklists of previous problems
 Information gathered during technical, social, institutional and
environments appraisals
 Statistical analysis and simulations
 Interviewing
 Brainstorming
 Creation of cause/effect diagrams

9.2 Sensitivity Analysis

 Is the most popularly method used for analysis of risk which applied to
uncertainties.

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  Sensitivity analysis should be applied already during the project planning
stage, when decisions concerning major inputs are being taken
 The purpose of sensitivity analysis is to tell us the factors, which are
liable to have the greatest influence over project success and failure.
 Once these factors have been identified it is then possible to deign
appropriate mitigation measures.
 Sensitivity analysis shows how the NPV or other criterion of merit changes
with variations in value of any variable (sales volume, selling price per unit,
cost per unit etc.).
 It is the process of seeing what changes in value of the dependent variable is
consequent on a change in the value of one or more of the variables that
determine it.
 It generally involves considering the effect on NPV of plausible variations in
some of the assumptions made.
 The common practice is to vary them by fixed percentage
Purpose of sensitivity analysis (‘what if’ analysis):
 To enhance our understanding of the structure and working of the
project;
 To guide us in the design of the project so that high NPV or IRR are
obtained;
 To suggest areas and means by which risk can be reduced.

Variables for sensitivity test should be selected on the basis of:

 degree of uncertainty associated with the variable; and

 Importance of the variable in determination of NPV & IRR.

 To determine the critical variables, the structure of cash flows should be

analyzed.
 The variables having the greatest share of cash inflows and outflows are
then subject to variations of quantities or prices or both parameters at the
same time.

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 Variables most commonly varied in sensitivity analysis are:
Firstly
 discount rate
Secondly
 total investment costs,
 implementation times,
 output levels and prices,
 the volume of demand,
 the level of capacity, and
 operating cost
 This exercise can be performed by
 assigning values to the critical variables corresponding to reasonably
pessimistic, normal & optimistic scenarios, and
 Computation of the discounted cash flows (IRR or NPV) and any ratios
etc. chosen as a yardstick for investment appraisal.
 With the help of sensitivity analysis it is possible to
 identify the most important project inputs, such as raw materials,
labor and energy,
 determine any possibilities of input substitution, as well as
 Discover the critical elements of the marketing concept.
 We can apply switching values in Sensitivity analysis
 Switching value (SV) is the change in the value for the variable
concerned required to reduce the NPV of the project to zero.

NPV 1
SV =( )P %
NPV 2 −NPV 1
Where:
 NPV1 is the base value for the project NPV and
 NPV2 is the new resulting from as assumed change in
price (or quantity) from P1 to P2,
 SV is the switching value

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Example: take the Hides & Skins Project as follows.

Situation I: Assume that the sales revenue of a Hides and Skins Project goes
down by 10% while the total cost of the project remains the same.
 The NPV of the project at a discount rate of 10% is reducing from 1,321,800
to – 3,654,000.
 To reduce NPV to zero would therefore require a change in sales revenue of:

SV= ( 1321800
−3616700−1321800 )
∗10 %=−2. 7 %

 a reduction in sales revenue of 2.7% would therefore be sufficient to reduce

the NPV at 10% discount rate to a marginal figure.
 This illustrates how sensitive projects with a single output are to changes in
the sales price.
Situation II: Assume that there is a 10% increase in the Raw Material Costs
(hides and skins).
 It reduces the NPV at a discount rate of 10% from 1,312,800 to – 1,459,800.
 To reduce the NPV to zero would therefore require an increase of:

SV=
( 1312800
−1459800−1312800 )
∗10 %=−4 . 8 %

 The project is very sensitive to an increase in the cost of hides and skins,
but it is not as a critical factor as fluctuation in sales revenue (2.7%
increase sufficient to reduce NPV to zero at a discount rate of 10%).

Situation III: Assume that the production level achieved by the project is 10%
below the level expected.
 A 10% reduction in the level of production reduces the NPV to –6,700 (i.e.,
to just below zero).
 To reduce the NPV to zero would therefore require a decrease of:

( 1312800
−6700−1312800 )
∗10 %=9. 95 %

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  The project is less sensitive to changes in production level than it is to
changes in the price of the main raw material.
 This is because the cost of unprocessed hides and skins is over 50% of the
sales value and so when the production goes down the costs go down
significantly as well as the benefits.
 It is quite common for agro – processing industries to be less sensitive to
production levels than to the price of the main raw material.
Situation IV: The discount rate used for calculating NPV is an uncertain
variable.
 For this reason a project’s NPV should be tested at rates which are
both above and below the best estimate for the discount rate.
 For the Hides and Skins Project, the NPV at various discount rates is
as follows:

Discount Rate Total NPV (Birr)

5% 5,480,800
10% 1,321,800
15% -5572,700

 These data show that the project’s NPV will be negative if the actual
discount rate is 15%.
 The project will have a positive NPV up to a discount rate of 13.1% (the
project’s IRR).
 It can be seen that the IRR is also a switching value.
 However the relationship between the NPV and the discount rate is not
linear.

9.3 Scenario analysis

 Scenario analysis is a process of analyzing future events by considering

alternative possible outcomes.
 It does not try to show one exact picture of the future rather it presents
several alternative future developments.

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  Consequently, a scope of possible future outcomes is observable and
develops the paths leading to the outcomes.
 It does not rely on historical data and does not expect past observations to
remain valid in the future.
 Instead, it tries to consider possible developments and turning points,
which may only be connected to the past.
 Scenario analysis is the process of estimating the expected value of a
portfolio after a given period of time, assuming specific changes in the
values of the portfolio's securities or key factors take place, such as a
change in the interest rate.
 Scenario analysis is commonly used to estimate changes to a portfolio's
value in response to an unfavorable event and may be used to examine a
theoretical worst-case scenario.

Steps involved in building a scenario analysis:

1. Define the risk or issue.

2. Recruit a team with appropriate skills to analyze the scenario
3. Identify the factors affecting the risk.
4. Obtain and review the data/information needed.
5. Develop a methodology technically to answer the questions.
6. Document the results of the analysis.
7. Set up a peer-review process for verifying the robustness of the
methodology, models, and procedures.
8. Use the results of the scenario analysis to make a business decision.

9.4 Break-even Analysis

 The purpose of break-even analysis is to determine the equilibrium point at

which sales revenues equal the costs of products sold.
 It serves to compare the planned capacity utilization with the production
volume below which a firm would make losses.

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  The break-even point can also be defined in terms of
 physical units produced, or
 The level of capacity utilization at which sales revenues and production
costs are equal.
 The sales revenues at the break-even point represent the break-even sales
value, and the unit price of a product in this situation is the break-even
sales price.

Break-even Analysis

 If the production program includes a variety of products, for any given

break-even sales volume there would exist a variety of combinations of
product prices, but no single break-even price.

Algebraic determination of the break-even point

 Break-even production is the number of units (U) necessary to produce

and sell to cover the annual fixed costs (Cf) for a given unit sales price
(p), and the variable unit costs (cv):

Cf= (p- cv)* U or U= Cf /(Ps- Cv)

Conditions and assumptions calculating break-even values:

 Production and marketing costs are a function of the production or sales
volume ;
 The volume of production equals the volume of sales;
 Fixed operating costs are same for every volume of production;
 Variable costs vary in proportion to the volume of production;
 The sales prices for a product or product mix are the same for all levels of
output (sales) over time.

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  The level of unit sales prices and variable and fixed operating costs
remain constant, that is, the price elasticity of demand for inputs and
outputs is zero;
 The break-even values are computed for one product; in case of a variety
of products, the product mix, that is, the ratio between the quantities
produced, should remain constant.

9.5 Hiller Model

 It is a technique of risk analysis which deals with the variation in the

expected cash inflow from an investment.
1. the risk associated with the project can be assessed through the
standard deviation of expected cash flows.
 It determining the viability of the project through calculating the deviations
in the cash flows from the mean of expected cash flows.
 Hillier model asserts that the computation of standard deviations of several
ranges of cash flows enables a firm to determine the uncertainty involved in
the future projects.
 This model was proposed by Frederick Hillier
 According to him, the expected NPV and the standard deviation of the NPV
of the project can be determined through analytical derivations.
 Under this model, there are two cases of analysis:
1. When there is no correlation among the cash flows
 the cash flow in the year “t” is independent of the cash flow in the
year “t-1”.
2. When there is a perfect correlation among cash flows.
 The cash flows in each period will be alike.

9.6 Simulation Analysis

 Simulation analysis uses a representation or model of a system to analyze

the expected behavior or performance of the system.

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  Simulates a model’s outcome many times to provide a statistical
distribution of the calculated results.
 To use a simulation analysis, you must have
 Estimates on (most likely, pessimistic, and optimistic) plus
 The likelihood of the estimate being between the most likely and
optimistic values.
Steps of a Simulation Analysis

 Assess the range for the variables being considered.

 Determine the probability distribution of each variable.
 For each variable, select a random value based on the probability
distribution.
 Run a deterministic analysis or one pass through the model.
 Repeat steps 3 and 4 many times to obtain the probability distribution
of the model’s results.
9.7 Decision Tree

 It is applicable to investments
 characterized by high uncertainty and
 Requiring a sequence of related decisions to be made over a period of
time.
 The decision tree method builds on concepts used in
 the risk analysis method and
 Analyzing investments.
 It permits the use of
 subjective probability estimates or
 Empirical frequency distributions for some or all factors affecting the
decision.
 It is applicable to investments
 characterized by high uncertainty and

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  Requiring a sequence of related decisions to be made over a period of
time.
 The decision tree method builds on concepts used in
 the risk analysis method and
 Analyzing investments.
 It permits the use of
 subjective probability estimates or
 Empirical frequency distributions for some or all factors affecting the
decision.
 It is a convenient method for representing and analyzing a series of
investment decisions to be made over .
 Each decision point is represented by a numbered square at a fork or node
in the decision tree.
 Each branch extending from a fork represents one of the alternatives that
can be chosen at this decision point
 At the first decision point there will be two alternatives.
 The forks in the tree where chance events influence the outcome are
indicated by circles
 A node representing a chance event generally has a probability associated
with each of the branches emanating from that node .
 This probability is the likelihood that the chance event will assume the
value assigned to the particular branch.
 The total of probabilities leading from a node must equal 1
 Each combination of decisions and chance events has some outcome (in
this case, NPV) associated with it

9.8 Risk Management

 Project risk management is the art and science of identifying, analyzing, and
responding to risk throughout the life of a project and in the best interests
of meeting project objectives.

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  Risk management is often overlooked in projects, but it can help improve
project success by helping
 select good projects,
 determining project scope, and
 Developing realistic estimates.
 A definition of risk is “the possibility of loss or injury.”
 Negative risk involves understanding potential problems that might
occur in the project and how they might obstruct project success.
 Positive risks are risks that result in good things happening;
sometimes called opportunities.
 The goal of project risk management is to
 minimize potential negative risks and
 Maximizing potential positive risks.
 It involves executing the risk management process to respond to risk events.
 Work arounds are unplanned responses to risk events that must be done
when there are no contingency plans.
 Main outputs of risk management are:
 Requested changes.
 Recommended corrective and preventive actions.
 Updates to the risk register, project management plan, and
organizational process assets.
9.9 Project Selection Under Risk

 Project selection is usually based on several decision-making points, such

as the project’s potential for profitability and its life-cycle cost.
 As the inflow of funds is usually limited, project selection is critical.
 Another key decision making point that is usually left out is the level of risk.
 During the project selection process, risk management needs to be
conducted.
 Let’s look at an example to understand the importance of risk management
during the process of project selection.

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  Suppose you are implementing a project that increases a manufacturing
plant’s capacity.
 The project involves installing new equipment and building workforce
capacity.
 After months of careful project execution and risk management, you close
the project successfully.
 This is when theoretically the project should provide value to the project
sponsor.
However, what if, during project selection, the stakeholders did not consider the
risk of low demand for the manufactured product?
 The extra plant capacity provided by the new project would be an
absolute waste.
 The money spent on the new project could have been used on another
project that would have given greater returns.
 Therefore, it is imperative to conduct Risk Management and Project
Selection simultaneously.
 For project selection techniques refer what you learn in financial analysis
part.

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 Chapter ten: Advanced risk analysis techniques: firm
and market risk

Introduction

 The term “portfolio” refers to any combination of financial assets such

as stocks, bonds and cash.
 Portfolios may be held by individual investors or managed by financial
professional, banks & other financial institutions.
 Portfolio is designed according to
 the investor's risk tolerance,
 time frame and
 Investment objectives.
 The monetary value of each asset may influence the risk/reward ratio of the
portfolio.
 When determining asset allocation, the aim is to
 maximize the expected return and
 Minimize the risk.
 The optimal portfolio must be selected by considering a tradeoff between
risk and return.
 In particular, a portfolio A is dominated by another portfolio A* if A*
has a greater expected gain and a lesser risk than A.
 If no portfolio dominates A, A is a Pareto-optimal portfolio.
 The set of Pareto-optimal returns and risks is called the
Pareto efficient frontier for the portfolio selection problem.

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  Recently, an alternative approach to portfolio diversification has been
suggested in the literatures that combines risk and return in the
optimization problem.

10.1 Portfolio Related Risk Measures

A. Definition of Portif0lio risk

 Portfolio risk reflects the overall risk for a portfolio of investments.

 Portfolio risk is the combined risk of each individual investment within a
portfolio.
 Different components of a portfolio and their weightings contribute to
the extent to which the portfolio is exposed to various risks.
 These risks need to be managed to ensure a portfolio meets its
objectives.
 You can only manage this risk if you can first quantify it.

Portfolio risk measures

 Before constructing a portfolio, you need to work out how much you can afford
to lose, both financially and psychologically.
 This is your risk tolerance.
 Losing too much money late in your career may mean your portfolio will
never recover.
 Losing more money than you are comfortable with can result in stress
and irrational decision making.
 You should never be in a situation where you can lose enough capital to
cause you to make irrational decisions.
 To determine your risk tolerance properly,
 you should speak to a financial advisor
 use one of the tools wealth managers often include on their websites
 considering your portfolio value, time horizon, monthly income, monthly
expenses and the reliability of your income.

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  consider your temperament and how much you are psychologically
prepared to lose.
 Risk tolerance can be rated as high, moderate or low.
 If you are at least 20 years off retirement age, have a reliable income
stream and some cash savings, your risk tolerance will be high.
 In the case of a market crash you will have time for the market to recover
and you won’t need to draw from your portfolio.
 If you are approaching retirement age or may lose your source of income,
your risk tolerance will be low.
 Losing money on your portfolio close to, or during retirement, will result
in drawing capital from an impaired portfolio.

 Risk tolerance is closely related to risk appetite (desire) and risk capacity.
 Your risk tolerance will change only gradually over time.
 At any given time, it will dictate your risk capacity.
 Risk capacity can also be thought of as the amount of risk that must
be taken to achieve investment goals.
 Risk appetite considers both tolerance and capacity, and the
investment landscape at any given time.

B. Types of portfolio risks

a. individual security level

 These risks can easily be managed through diversification:
 Liquidity risk
 Default risk
 Regulatory risk and political risk
 Duration risk
 Style risk
b. Main portfolio risks (can affect the entire portfolio)
 Market risk

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  Inflation risk
 Reinvestment risk
 Concentration risk
 Interest rate risk and
 currency risk

Portfolio risk measures

C. Measurement of portfolio risk

 There are numerous approaches to measuring portfolio risk.

 All have their advantages and drawbacks.
 There is no full proof method, so several methods are usually
combined.
 We have the ff measurement methods of portfolio risk
 Standard Deviation,
 The Sharpe ratio,
 The Sortino ratio
 Beta,
 Value at risk

Portfolio risk measures

1. Standard deviation

 Is the typical way to measure volatility?

 This applies to individual securities and to portfolios.
 The return of a portfolio can be calculated by simply averaging the
weighted returns.
 A portfolio’s historical standard deviation can be calculated as the
square root of the variance of returns.
 But when you want to calculate the expected volatility, you must
include the covariance or correlation of each asset.

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2. The Sharpe ratio

 Normalizes returns for a given level of risk.

 This allows one to compare investments and determine the return for
every dollar of risk taken.
3. The Sortino ratio

 is similar to Sharpe ratio, but only considers downside volatility.

 These ratios can be used for the performance of model portfolios, real
portfolios and individual securities.
 However, they are backward looking, and cannot predict future risk and
return.
4. Beta

 Indicate riskiness of individual security relative to market.

 The overall market has a beta of 1.
 A stock with a beta of 1 would be expected to move up and down the
same amount as the market.
 A stock with a beta of 0.5 would only be expected to rise or fall half as
much as the market.
 A stock with a beta of 2 would be expected to rise and fall twice as
much as the market.
 The beta of a portfolio is calculated as the weighted average of each
component’s beta.
 A portfolio with a high beta means you may be risking more than you
think you are.
5. Value at risk (VaR)
 Is used to calculate the maximum loss a portfolio can be expected to
lose in a given period.
 The result is calculated for a specific level of confidence, usually 95 or
99%.

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  There are two methods of calculating VaR – using either a normal
distribution, or simulations.
 VaR is widely used for quantifying risk by banks and regulators.
 However, it has also been widely criticized and is no longer used by
portfolio managers very often.

D. Manage risk of your investment portfolio

Diversification
 Diversifying investments across several asset classes is the first step
in managing a portfolio’s risk.
 A substantial percentage of most portfolios should be invested in
equities, but needs to be balanced with other types of assets.
 A basic diversified portfolio would include:
 Stocks: provide the greatest long-term returns,
 Bonds: provide predictable income, and
 Cash: offers immediate liquidity
 The objective of diversification is to find assets that have very low
correlations with equities and bonds.
 This brings us to alternative assets.
 Real assets like commodities and real estate are more resilient to
inflation than other assets.
 Their intrinsic value depends on physical supply and demand, rather
than on the complex dynamics that drive financial assets.
 Private equity and venture capital funds come with varying degrees of
risk.
 These types of investments are illiquid, and their values are only
calculated monthly or even quarterly.
 This would usually be viewed as a disadvantage.
 However, in the context of managing portfolio volatility, it can be an
advantage.

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  Value of these funds doesn’t fall during market corrections which
result in volatility across other asset classes.

10.2 Mean-variance Portfolio Construction

 Mean-variance model as a good optimizer can exploit the correlation, the

expected return, and the risk and user constraints to obtain an optimized
portfolio.
 Although it is the simplest model of investments, it is sufficiently rich to be
directly useful in applied problems and decision theory.
 The mathematical formulation of the mean-variance portfolio selection
problem is the trade-off between risk and return
 It combines probability theory and optimization theory to model the
behavior of the economic agent.

Mean-variance Portfolio

 As Britten-Jones (1999) notes: “Mean-Variance analysis is important for

both practitioners and researchers in finance.
 For practitioners, theory suggests that mean-variance efficient
portfolios can play an important role in portfolio management
application.
 For researchers in finance mean-variance analysis is central to many
asset pricing theories as well as to empirical tests of those theories
However practitioners have reported difficulties in implementing mean-variance
analysis.

10.3 Portfolio Theory and Capital Budgeting

 The development of the theoretical relationship between risk and expected

return is built partly on portfolio theory.

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  Portfolio theory deals with the selection of portfolios that maximize expected
returns consistent with individually acceptable levels of risk.
 Each security has its individual systematic – non diversified risk, measured
using coefficient beta
 It indicates how the price of security / return on security depends upon
the market forces.

Portfolio Theory and Capital Budgeting

The Security Market Line (SML)
 SML specifies the relationship between the expected return and beta of a
security.
 Each security can be described by its SML; they differ because their betas are
different and reflect different levels of market risk for these securities.
 In market equilibrium, an individual security’s expected rate of return and its
systematic risk will have a linear relationship.
 The beta of a portfolio is simply a weighted average of the betas of securities
comprising the portfolio.
 It is a measure of systematic risk in the portfolio

10.4 Capital Asset Pricing Model and Capital Budgeting

The Capital Asset Pricing Model (CAPM)
 The CAMP mostly used for estimation of the cost of capital for business
organization
 It is also useful in estimating the performance of managed portfolio
 It considers the market return, risk free rate of return and systematic risk
in order to estimate the cost of capital.
 The CAPM can be applied, like for individual securities, to portfolios to
determine their expected returns.
 The CAPM states that in equilibrium, only the systematic (market risk) is
priced, and not the total risk; investors do not required to be compensated
for unique risk.

Assessment Process
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Assumptions of CAPM
 There are many investors;
 Investors are price takers and they can’t influence the market individually
 All investors are looking ahead over the same(one-period) planning
horizon;
 Information is freely and instantly available to all investors;
 Each investor cares only about expected return and standard deviation;
 All investors have the same beliefs about the investment opportunities;
 Taxes and transaction costs are irrelevant;
 Investors can borrow and lend at the one risk-free rate.

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