3.

3 PROJECT
FEASIBILITY
STUDY
 7. FINANCIAL AND ECONOMIC ANALYSIS
Financial Analysis
 Financial analysis should accompany the design
of the project from the very beginning.
 Important aspects of financial analysis covers
such as criteria for investment decisions, pricing of
project inputs and outputs, the planning horizon
and project life, as well as risks and uncertainty.
 Objectives of financial analysis:
 The financial analysis and appraisal involves
the assessment, analysis and evaluation of
the required project inputs, the outputs to be
produced and the future net benefits,
expressed in financial terms.
 The scope and objectives of financial
analysis are to analyze and interpret all the
financial consequences of an investment
that may be relevant to and significant for
the investment and financing decisions.
 The analysis should ensure that the
objectives determined by the decision
makers and within the scope of the
feasibility study and also fulfill the following
conditions:
 The most attractive choice in project selection
under the conditions of uncertainty.
 The critical variables and possible strategies for
managing or controlling risks are identified.
 The flow of financial resources require during
the project cycle is determined and the lowest
cost of financial resources are identified.
 Principal aspects of financial analysis:
• The analysis should also accompany the various
alternatives that basically determine the marketing
strategies, project scope, resources, location,
production capacities and technology.
 Interest of parties Involved:
• The parties participating in a project expects
benefits differently and values them accordingly.
Basically, the equity provided by the investors and
the loans of financial institutions.
 Public interest:
• To be successful, investments also have to serve the
needs & development objectives of the socio-
economic system.
 Basic criteria for investment decisions:
 Investment is also the transformation of liquidity into
productive assets.
 The decision should be based on the following
criteria :
 Possible conflicts between the basic project objective and
the development objectives
 Suitability of the proposed strategy
 The matching of project parts
 Efficiency in utilizing the economic resources
 Total costs are in line with acceptable confidence level.
 Sufficiency of the total investment
 The cash flows met the requirements of investors and
financiers
 The availability of local and foreign currency
 Identification of critical variables
 The financial consequences of the risks
 The minimum condition for the investment to be appraised
by investors, financing institutions etc.
 Methods of Financial analysis and
investment appraisal:
 Financial analysis relies on a systematic
presentation and processing of relevant
business data on assets and liabilities, costs and
income, and the related flow of goods, services
and financial resources.
o Accounting
o Cost accounting
o Budgeting
 Pricing of project inputs and outputs:
 Prices may be defined in various ways:
o Market [explicit] or shadow [imputed] prices
o Absolute or relative prices
o Current or constant prices
 Planning horizon and project life:
 When determining the economic life span of the
project various factors [following] have to be
discussed:
o Duration of demand
o Duration of the raw material deposits
o Rate of technical progress
o Life cycle of the industry
o Opportunities for alternative investment
o Administrative constraints [urban planning horizon]
 Risk and uncertainty:
 A project analyst cannot forecast with certainty
 Risk is present when the probabilities associated
with various outcomes may be estimated on the
basis of historical data.
 Analysis of cost estimates:
 It covers the corresponding costs of initial
investment, production, marketing and
distribution, plant and equipment replacement,
working capital requirements and
decommissioning at the end of the project life.
 Pre-production expenditures
 Preliminary capital-issue expenditures:
 Expenditures for preparatory studies:
 Other pre-production expenditures:
 Trial runs, start-up and commissioning of
expenditures:
 End- of- life costs:
 Fixed assets:
 It comprises fixed investment costs and pre-
production expenditures
 Net working capital:
 It is the difference between current assets and
current liabilities
 Calculation of net working capital requirements:
 Steps in calculating net working capital requirements,
1. The minimum coverage of days for current assets and
liabilities has to be determined first.
2. Annual factory costs, operating costs, and costs of
products should then be computed.
3. The next step is to determine the coefficient of turn
over for the components of current assets and
liabilities by dividing 360 days by the number of days
of minimum coverage.
4. Subsequently the cost data provided from each item
of the current assets and liabilities are divided by the
respective coefficients of turnover.
5. Finally, the net working capital requirements for the
different production stages are obtained by
deducting the current liabilities from the sum of
current assets.
Example: The days of coverage for the following
items in your project are given below
Items Minimum days of coverage The annual requirements are
2011 2012
Cash 60 days Br.40,000 Br.45,000
Raw materials 20 days 60,000 70,000
Accounts Receivable 35 days 100,000 120,000
Work in process 10 days 15,000 17,000
Finished Goods 40 days 80,000 100,000
Accounts Payable 50 days 200,000 90,000

The total net working capital for the construction period is

Br.50,000
Required:
1) Compute the Net Working Capital requirements of
each period
2) Compute the increase in Net Working Capital for each
period
Answer
1
Minimum The annual requirements
Items days of DCR
coverage Construction 2011 2012
pd.
Cash 60.00 6.00 6,666.67 7,500.00
Raw materials 20.00 18.00 3,333.33 3,888.89
Accounts Receivable 35.00 10.29 9,722.22 11,666.67
Work in process 10.00 36.00 416.67 472.22
Finished Goods 40.00 9.00 8,888.89 11,111.11
Total requirement 29,027.78 34,638.89
Accounts Payable 50.00 7.20 27,777.78 12,500.00
Net Working capital 50,000.00 1,250.00 22,138.89
Increase in working
capital 50,000.00 (48,750.00) 20,888.89
 Production costs: It is essential to make realistic
forecasts of production or manufacturing costs
for a project proposal in order to determine
the future viability of the product.
 Production costs should be calculated as total
annual costs and preferably also as cost per unit
produced.
 Production costs must be determined for the
different levels of capacity utilization
 Marketing costs:
 It comprises the costs for all marketing activities
• may be divided into direct marketing costs for each
product such as packaging and storage, sales costs,
transport, interim storage, and distribution costs, indirect
marketing costs, such as overhead costs of the
marketing department
 Basic accounting statements:
 Income statement
 Balance sheet
 Cash flows statement
 Projection of Cash Flows: Once a potential capital
budgeting project has been identified, its evaluation
involves the following steps:
1. First, the cost of the project must be determined.
2. Next, estimate the expected cash flows from the
project, including the salvage value at the end of its
expected life.
3. Third, the riskiness of the projected cash flows must be
estimated. (uncertainty of the cash flows)
4. Given the project’s riskiness, determine the cost of
capital at which the cash flows should be discounted.
5. Next, the expected cash flows are put on a present
value basis.
6. Finally, the present value of the expected cash inflows is
compared with the required outlay, or cost.
 If the PV of the cash flows exceeds the cost, the project should be
accepted. Otherwise, it should be rejected.
 Estimation of Cash Flows
 Cash flows should be determined on an after-tax
basis.
 Operating cash flows is a project’s operating
income plus depreciation.
 Sunk costs are not incremental and therefore must
be ignored
 All relevant opportunity costs must be included in
the analysis.
 In estimating cash flows, anticipated inflation must
be taken into account.
 When a depreciable asset is sold, the actual sales
price minus the book value is multiplied by the tax
rate to determine the applicable taxes. The net
salvage value, salvage value minus the applicable
taxes, is then added to after-tax operating income.
 It is helpful to place project cash flows into
three categories based on timing:
1. The initial cash flow (initial Investment).
2. Interim incremental net cash flow (operating
cash flows).
3. The terminal cash flow.
1. The initial Cash flow
 Cost of equipment, facilities and land purchased.
 All other costs related to investment
 Additional net working capital.
 Opportunity costs, net of taxes (Ex- land used for
this project that could have been sold).
2. Interim Incremental Net cash Flows
(Operating cash flows):
 Basic format for determining interim
incremental net cash flow (per period)
 Net increase (decrease) in operating revenue less
(plus) any net increase (decrease) in operating
expenses, excluding depreciation.
 - + Net increase (decrease) in tax depreciation
charges
 = Net changes in income before taxes.
 - + Net increase (decrease) in taxes.
 = Net changes in income after taxes.
 + - Net increase (decrease) in tax depreciation
charges.
 = Incremental net cash flow for the period.
 3. Terminal Cash flow:
 Terminal Cash Flows
 Calculate the incremental net cash flow for the
terminal Period.
 + - Salvage value (disposal/reclamation costs) of
any Sold or disposed assets.
 - + Taxes (Tax savings) due to the asset sale or
disposal of new assets.
 + - Decreased (increased) level of networking
capital.
 = Terminal year incremental net cash flow