Financial analysis of consulting projects

dr Paweł Wnuczak
pawelw@kozminski.edu.pl

1.
The scope of financial analysis of consulting projects

Scope of Evaluation of financial Evaluation of project risks Financial feasibility of

Analysis rationality project
Answering the question Answering the question Answering the question
Essence whether a project will whether if the conditions of whether the investor has
contribute to the growth operation change when enough money to
of value for owner compared to those originally implement project
expected, the project will be
still financially viable and
feasible
NPV Sensitivity Analysis Forecast of cashflow
statement
Techniques
IRR Monte Carlo Analysis
(Simulation)

MIRR
Scenario Analysis
NPVR

ARR

PP

etc.

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 Types of project

Types of project Financial rationality Evaluation of Financial feasibility

project risks of project

1. Bussines plan NPV, IRR, PP Risk analysis of financial Analysis of financial

2. Strategy for an Increase of value of
existing company –
large project
3. Strategy for an
existing company –
small project
4. Process, structural
and social projects
rationality and feasibility
Risk analysis of financial
company rationality and feasibility
NPV, IRR, PP Risk analysis of financial
rationality
- No analysis If possible: Risk analysis of
- NPV, IRR, PP financial rationality and
- ENPV feasibility
feasibility
Analysis of financial
feasibility (company
perspective)
No analysis
If possible: Analysis of
financial feasibility

2.
Analysis of the financial rationality of investment projects

Review of Methods of Evaluation of Profitability (Viability) of Investment Projects

Methods of Evaluation of Investment Projects: Description

Name Description Formula

Payback Payback Period is the length of time during

Period (PP) which the value of initial outlay is expected
to equal financial surpluses which are
expected from taking on a given project.
This method allows for sorting alternative
investment projects in terms of the criterion
of time needed to recover investment
outlay. Limitations:
a) This method does not take account
of the entire lifetime of a project;
b) Values used in this method are
nominal (the concept of time value
of money is not addressed) which
means that the payback period
cannot answer whether a projected
investment will increase the value
for shareholders.

Net Present t
FCFn
Value (NPV) Net present value is the sum of all cash flows NPV = 
n = 0 (1 + y )
n
(both inflows and outflows), updated at the
beginning of an investment, and generated
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 by that investment. The yield required by
the investor is used to update subsequent FCF1 FCF2 FCF3 FCFn
NPV = FCF0 + + + +
flows. (1 + y ) (1 + y ) (1 + y ) ........................... (1 + y) n
2 3

From the investor’s point of view, an

investment is profitable if the net present
value generated by it is positive (NPV>0). FCF0 – Financial cash flow at the beginning of investment (most
Positive NPV means that the present value often outflow – investment outlay); FCFn – Cash flow generated
of cash flows generated by the project by investments in n period; y – yield expected by investor from
exceeds the present value of outlays made an investment; t – number of years representing lifetime of
on the investment and, thus, the project investment;
recovers the costs of capital employed to
finance the investment. When NPV is
expected to be below zero, related
investments do not give hope to recover
outlays made at a given yield expected from
the investment.
Internal Rate Internal Rate of Return is the rate where
of Return cash inflows discounted at the beginning of 0 = FCF + FCF1 + FCF2 + FCF3 +
FCFn
(1 + IRR) (1 + IRR) (1 + IRR) ........................... (1 + IRR)n
0 2 3
(IRR) investment equal discounted cash outflows
(NPV is equal to zero).
t
FCF n
Investments with IRR exceeding expected 0=
n = 0 (1 + IRR)
n
yield on a given investment (IRR>y) are
considered profitable. This means that the
actual return on investment is higher than
expected. The higher IRR, the more FCFn – Cash flow generated by investment during n period; IRR
profitable investment. – yield expected by investor; t – number of years representing
lifetime of investment;

Example 1

The enterprise considers the rationality of the implementation of the project, which is to generate the following
cash flows:

0 1 2 3
FCF -25 11 11 11

The expected rate of return by investors is 13%. Please calculate the NPV, IRR and PP values and interpret the
obtained results.

3.
Principles of using discount methods in the evaluation of investment projects

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Incremental Cash Flow Principle
Calculation of cash flows should only consider incremental cash flows from taking on a project, without any allocation of
costs that would have been incurred anyway, without taking on the project.

Sunk Costs
Past costs are not charged against free cash flows provided that such costs are non-negotiable (they have no resale value at
present).

Costs incurred before taking on a project

E.g., Historical Historical purchase of

marketing research land to be contributed
to the project

Investment outlays are not Included as negative figure in market value

included because research results of that land as it can be potentially sold
cannot be sold in the market

Principle of Including FCF of Owners in Evaluation of Investment Projects

In accordance with the principles of making financial projections of investments, costs (including free cash flows) should
only include wages paid to owners for work. In practice, this means that costs of owners’ wages should reflect the actual
market rates. Compensation for capital employed, if any, should be reflected in the required rate of return, i.e., the
discount rate.

Principles of free cash flow calculation for the purpose of investment valuation - concept

NPV calculation based on FCFF – Free Cash Flow to Firm (owners + other financing parts (banks, bondholder,
leasing companies) perspective)

Revenue Discount rate -

- Operational costs (without depreciation) marginal WACC of
- Depreciation company
= Operating profit (EBIT)
- Income tax*
= Net Operating Profit After Taxes (NOPAT)
+ Depreciation
- Capital expenditure
- Working capital investment
+ Continuing or Residual Value

= FCFF

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NPV calculation based on FCFE - Free Cash Flow to Equity (owners’ perspective)

Revenue Discount rate –

- Operational costs (net of depreciation) expected rate of
- Depreciation return by equity
= Operating profit (EBIT) holders
- Financial Costs
= Profit Before Tax (PBT)
- Income tax
= Profit After Tax (PAT)
+ Depreciation
- Capital expenditure
+ New debt
- Repayment of debt
- Working capital investment
+ Continuing value or Residual Value

= FCFE

Capital
Calculation
expenditure FCF Discount rate
perspective
treatment

Debt financing
Total, regardless of
operations (incurred Weighted average
All financing parties the financing
FCFF loans, repayment cost of capital
view source
and interests) are (WACC)
(bank/owner)
excluded

Incurred loans
Rate of return
Exclusively increase, but
expected only by the
FCFE Equity capital view investor's equity repayment and
owner (cost of
funds interest decrease
equity- re)
FCF for the owner

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 4.

The concept of BEP guaranteeing the achievement of the NPV value at the level of 0
0.

FC - fixed costs
CI - invested capital
RV - residual value
WACC - Weighted Average Cost of Capital
n - the number of years of the project duration
A - depreciation
M% - gross margin on the implemented project ((revenues - variable costs) / revenues)
T -income tax rate

Example 2
“Hotel” - Break Even Revenue Application
An entrepreneur plans to build a hotel. Planned expenditures for the purchase of the land are 1 million Euro,
construction works will amount to 4 million Euro. The anticipated income from a rented room per day will be
100 Euro and variable costs (electricity, the average variable cost of cleaning, food waste) at 18 Euro per rented
room / day. Planned annual fixed costs of maintaining the hotel amount to 550 thousand Euro. The building will
be depreciated over 30 years. After the period of analysis the building will not present a significant value. The
weighted average cost of capital is 12%, tax rate 19%. Analyses show that, in order to successfully operate a
company must provide working capital for about 50 thousand Euro. It is estimated that the residual value of land
and working capital will amount to 1600 thousand Euro. Based on the presented information, please:
A. Calculate the annual turnover, which guarantees the NPV at level 0
B. An average hotel occupancy rate, which guarantees the NPV at 0, given that the pension will be rooms
for 110 rooms at the same time

5.
Financial feasibility analysis of large projects
The knowledge of the structure of financial statements may be used for carrying on analyses of perspective
type. From the point of view of strategic financial planning, the planning of the financial liquidity is of the
crucial importance. For this purpose, it is necessary to determine requirements for subsidies and the optimum
moment for obtaining them. In practical terms, the most precise manner of planning liquidity and the
requirement for subsidies is using a model for planning financial statements, drawn up in a spreadsheet. The
model for planning financial statements consists of an input module, where planned base variables are
introduced (revenue, costs, expenditure) and an output module, which produces planned statements
automatically. The preparation of an annual projection broken down into months, will allow for estimating a
liquidity gap, and thus, the requirement for capital.

The scheme presented below, illustrates rules that govern financial planning on the basis of the model.

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 Input module

Planned Planned Planned

Planned Planned Planned Planned
costs by type capital credits and loans and
revenue cycles general subsidies special subsidies
expenditure rrepayment

Output module
Opening balance

Planned profit and

loss accounts

Planned
cash flow statement

Planned cash

Planned
balance sheet

The Relationship between Reports

Balance Sheet (Polish Standard)
Fixed Liabilities
assets

Current Net Income

assets
Stockholder's
Statement of
equity
Cash Flows Cash and The Income
equivalents
Net income Statement
Assets = Total liabilities
Operating and stockholder's Revenues
Cash Flow
equity
Costs
Investment
Cash Flow
Taxes
Financia
Cash Flow

Cash and Net income

equivalents
2

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 6
Architecture of models used in KU consulting projects

Case study I (model 1) - founding project

A group of people is considering creating a new training company operating in the training sector dedicated
to cultural institutions and non-governmental organizations. During the work on the business plan, investors
analysed the market, developed operating strategies and created a marketing mix that, in their opinion,
allows for the effective sale of training services in a selected market segment.
The new company will offer two types of training: open and dedicated closed training. Marketing and sales of
open trainings will take place through telephone contact of key accounts with potential customers,
announcements on portals dedicated to culture, in social media and via mailing.
The company's employees responsible for sales will also take part in meetings, events and conferences of
people of culture, during which they will attract customers for closed training. The company's business model
also assumes visits of sellers to customers who may have needs in the field of dedicated training.

In line with market standards, the company will rely on a group of external trainers specializing in the
management of cultural institutions. Planned sales, revenues and direct costs of training are presented in the
tables below:

I 2014 II 2014 III 2014 IV 2014 I 2015 II 2015 III 2015 IV 2015 2016 2017 2018 2019
Number of days of open training courses 4 8 6 10 8 12 8 12 55 65 70 71
Average price for one training day (payable by the
500 500 500 500 510 510 510 510 520 536 552 568
participant)
Average number of training participants 11 11 11 11 12 12 12 12 13 13 13 13
Planned revenues from open trainings 22 000 44 000 33 000 55 000 48 960 73 440 48 960 73 440 371 800 452 582 502 018 524 465
The cost of the trainer per day 1 400 1 400 1 400 1 400 1 400 1 400 1 400 1 400 1 450 1 494 1 538 1 584
The cost of renting the class room (daily) 600 600 600 600 618 618 618 618 637 656 675 696
Other variable costs per participants / dayily 25 25 25 25 25 25 25 25 25 25 25 25
Total direct costs of open trainings courses 9 100 18 200 13 650 22 750 18 544 27 816 18 544 27 816 132 635 160 819 177 703 184 956

I 2014 II 2014 III 2014 IV 2014 I 2015 II 2015 III 2015 IV 2015 2016 2017 2018 2019
Number of training days for closed training courses 2 9 10 11 10 12 12 16 50 60 70 70
Average selling price of the training day 4 300 4 300 4 300 4 300 4 500 4 500 4 500 4 500 4 600 4 738 4 880 5 027
Planned revenues from closed training 8 600 38 700 43 000 47 300 45 000 54 000 54 000 72 000 230 000 284 280 341 610 351 858
The cost of the trainer per one day 1 470 1 470 1 470 1 470 1 470 1 470 1 470 1 470 1 523 1 568 1 615 1 664
Total direct costs of closed training courses 2 940 13 230 14 700 16 170 14 700 17 640 17 640 23 520 76 125 94 091 113 065 116 457

Planned margin I 18 560 51 270 47 650 63 380 60 716 81 984 66 776 94 104 393 040 481 953 552 860 574 910
Planned bonus for employees [in %] 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5%
Planned bonuses for employees 928 2 564 2 383 3 169 3 036 4 099 3 339 4 705 19 652 24 098 27 643 28 745

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 The company intends to employ 5 people: two key account managers, a sales assistant, a person responsible for
technical development of materials and logistics, as well as a managing manager. Planned fixed remuneration for
employees is presented in the table below:

I 2014 II 2014 III 2014 IV 2014 I 2015 II 2015 III 2015 IV 2015 2016 2017 2018 2019
Fixed salary of the managing director per month 6 000 6 000 6 000 6 000 6180 6180 6180 6180 6 365 6 556 6 753 6 956
Fixed salary of Key Acconts per month 4 800 4 800 4 800 4 800 4 944 4 944 4 944 4 944 5 092 5 245 5 402 5 565
Fixed salary of a sales assistant per month 3 200 3 200 3 200 3 200 3 296 3 296 3 296 3 296 3 395 3 497 3 602 3 710
Fixed salary of the person responsible for the
3 200 3 200 3 200 3 200 3 296 3 296 3 296 3 296 3 395 3 497 3 602 3 710
technical matters / monthly
Total fixed salary 51 600 51 600 51 600 51 600 53 148 53 148 53 148 53 148 218 970 225 539 232 305 239 274

In addition, the team will receive bonuses of about 5% of the first margin obtained from the sale of training. A
detailed breakdown of the margin will be regulated in a separate document. The average salary mark-ups (part
of the employer) will be around 20% of the total salaries.
Fixed costs also include office rental and maintenance cost (including telephone costs), travel costs and
advertising costs. It is estimated that advertising costs should not be less than PLN 4,000. PLN per month. Travels
of about 2,000 PLN per month, while the cost of renting an office is about PLN 2.5 thousand per month. Detailed
calculations are presented in the table below:

I 2014 II 2014 III 2014 IV 2014 I 2015 II 2015 III 2015 IV 2015 2016 2017 2018 2019
Advertising costs 12 000 12 000 12 000 12 000 12 360 12 360 12 360 12 360 50 923 52 451 54 024 55 645
Business travel expenses 6 000 6 000 6 000 6 000 6 180 6 180 6 180 6 180 25 462 26 225 27 012 27 823
Office rental costs 7 500 7 500 7 500 7 500 7 725 7 725 7 725 7 725 31 827 32 782 33 765 34 778
Total fixed cost 25 500 25 500 25 500 25 500 26 265 26 265 26 265 26 265 108 212 111 458 114 802 118 246

Computer and photocopying equipment will be purchased once every two years. The unit purchase costs of the
equipment will not exceed PLN 3,500 net, therefore the equipment will be depreciated once. The planned one-
off expenditures will amount to approximately PLN 12,000 net.
The planned receivable turnover rate in days is to be 21 days, and the account payables turnover ratio (payments
to trainers) - 30 days. Income tax will be on the level of 19%. Based on the data provided, please:
a) check how much capital must be raised for the planned project
b) from which moment it will be possible to obtain bank loans to finance the company's development
c) assess whether the proposed business model is reasonable and will increase the wealth of the owners
d) define what conditions must be met in order to resell the company as a functioning business in 2019.

Case study II (model 2) - a large project for an existing company

Financial analysis of the feasibility and profitability of the investment project of Delta Press Sp. z o.o.

The company Delta Press Sp. z o.o. operates in the sheetfed offset printing market. The company is based in
one of the towns near Warsaw. Currently realized revenues are at the level of PLN 7 million net per year. So
far, printing has been performed on a four-color Polly machine and a two-color Heidelberg machine. The use
of the machines so far shows that there is no further possibility of increasing revenues without expanding the
machine park.
In 2011, the company intends to purchase a new five-color offset press with a module for applying UV varnish
in B1 format from Man-Roland, which is intended to increase production capacity, improve the quality of
prints, and increase production flexibility. Obtaining the expected results is very important for the company
due to the increasing competition in the industry and growing customer requirements as to timeliness and
print quality. The investment outlays are to amount to approximately PLN 3.8 million net. The purchase will be
financed in 80% with an investment loan repaid (loan granted for a net amount) in 3 equal principal
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installments at the end of subsequent years (first repayment at the end of 2011). Interest on the loan will be
paid quarterly. The loan interest rate will be 8% per annum. It is planned that the machine will be put into
operation at the end of the first quarter of 2011. Payment for the machine should coincide with the time of its
start-up. It is expected that the investment VAT will be recovered from the Tax Office by the end of the second
quarter.
As part of the loan application, the company presented the following projection assumptions (business plan):
• After conducting a market analysis, the Delta Press sales manager estimated that the implementation of
this investment will increase revenues by 20% in 2011 and by another 30% in the next two years. After
this period, revenues should stabilize at a constant level.
Material and energy costs:
• The experience so far shows that the costs of materials and energy are highly dependent on the
generated revenues and constitute approx. 37% of revenues.
External services and other prime costs:
• The results obtained historically indicate that external services and other costs also remain dependent on
revenues. So far, they accounted for 23% and 2% of revenues, respectively. This parameter will remain
unchanged in the case of orders carried out on the machines used so far.
• However, in the case of orders performed on Roland, it is expected that the share of external service costs
in revenues will drop to about 10% in the subsequent years of the analysis (lower subcontracting and
service costs).
Payroll costs:
• The salary costs currently amount to PLN 1.6 million per annum
• And they will increase by 10% at a time as a result of the investment (the need to hire new
employees).
• In subsequent years, salaries are expected to be indexed at the rate of inflation (2% per year).
Overheads on salaries (Social security and other benefits):
• The salary surcharges account for 21% of the salary costs on average. It is expected that this relationship
will also remain in the future.
Depreciation and future capital expenditure
• Annual depreciation of the fixed assets used so far is at the level of PLN 600 thousand PLN and will
decrease in the next 2 years at the rate of 10% annually. After this period, it is assumed that the
depreciation will remain at a constant level, because the company's management plans that from the
third year it will make investment purchases at the level of depreciation costs. In this way, it will protect
the company against decapitalization of assets.
• The annual depreciation rate of the new machine will be at the level of 20% per year.
Assumptions about the value of working capital:
• Taking into account the historical data, it is assumed that throughout the projection period,
inventories are to constitute 10% of planned revenues (on a quarterly basis), the period of collection of
receivables in days - 21 days, the period of payment of trade payables is at the level of 30 days.
• In the case of new sales, as well as increased costs as a result of project implementation, the
receivables and liabilities turnover periods should be at the same level as in the case of the current
activity.

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Other information
• The finance director claims that the safe cash balance in the first year of the projection should amount to
approx. PLN 250,000. PLN and should grow at the rate of the planned revenue growth.
• The company has an open credit line in the amount of 250 thousand. zloty. Currently, Delat Press uses
207 thousand of it. zloty.
Additional information:
• Tax rate: 19%
• Owners' required rate of return: 15%
• The attached file presents the financial statements of Delata Press sp.z o.o. for the last few quarters.

Period 0
ASSETS
(31.12.2010)
Fixed assets 5 200
Tangible and intangible fixed assets 5 200
Land and other non-depreciated assets (e.g.
investments)

Technical devices and machines 5 200

Current assets 900

Inventory 100
Finished products and work in progress 0
Other inventory 100
Receivables 300
Short-term investments (including cash) 500
Total assets 6 100
0
Period 0
LIABILITIES
(31.12.2010)
A. Equity 5 700
Share capital 5 700
Supplementary capital
Net profit (loss)
B. Provisions for liabilities 400
Long-term liabilities 0
Short-term liabilities 400
Credits and loans
Trade liabilities 400
Tax, customs, insurance and other liabilities
Payroll liabilities
TOTAL LIABILITIES 6 100

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Case study III (model 3) - a small project for an existing company

The owner of the hotel business considers the financial rationality of the development of the hotel. The project is
consisting of the construction of an additional modern hotel building in one of the mountain spa town. The new
infrastructure will include about 40 double rooms, a wellness center, sauna and several other amenities, which
should increase the attractiveness of the entire resort. The new building would be built on the site of another
building, which is currently used as a guesthouse (also run by a company planning an investment, 20 double
rooms). It is also assumed that the new building will be connected to the existing hotel building by connector,
which will allow for the creation of a more interesting offer also for guests using the existing infrastructure.
It is planned that the total investment expenditure, including the costs of demolition, will amount to
approximately PLN 6,500,000 net and will be incurred within the next year.
The implementation of investment works should not significantly affect the level of revenues. Although the
number of available rooms will drop periodically (20 double rooms), the works will be carried out in a season
with low tourist traffic. Hence, potential guests can, in most cases, be placed in a functioning building. Therefore,
it is expected that during the implementation of investment works the occupancy of the available infrastructure
will increase.

The conducted market research indicates, however, that as a result of the investment implementation, a
significant improvement in the financial result of the facility is expected. This is supported by the following
premises:
- having additional hotel beds,
- equalizing the standard of rooms,
- increasing the occupancy rate,
- better facilities for training groups (multifunctional room for 90 people and new rooms),
- increase in sales in the area of catering services resulting from the greater number of customers using hotel
services,
- sale of conference services resulting from the possession of a teaching room of a very good standard
(equipment and air conditioning).
The analyses also showed that failure to implement the project will lead to a further decline in the
competitiveness of the facility, which will translate into lower revenues. The performed analyses allowed for the
construction of two scenarios for the development of the market situation: in the non-investment variant and in
the investment variant (all necessary data are in the Excel file).

As a result of the project implementation, the operating costs of the entire facility will also change. Detailed
assumptions are presented below:

Costs
Media and energy:
• The costs of energy and other utilities will decrease by approx. PLN 40 thousand during the investment
implementation period in relation to the current state. The increase in energy costs related to the
construction works was included in the capital expenditure (in the amount of PLN 6,500,000). After the
new infrastructure operates, energy costs etc. will increase by approx. PLN 70 thousand. per year
(increased cubature of buildings). These costs are expected to grow at a rate of 4% annually.
External services and other prime costs
• The historical results show that apart from the costs of external services related to other sales, other
services do not show dependence on the revenues. Taking into account the experience to date, it was
estimated that these costs should increase by about PLN 100,000 a year after the infrastructure is
delivered and will grow at a rate of about 3%. At the same time, it is expected that due to the
decommissioning of the guesthouse building, the annual costs of renovation and repairs will decrease. It

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 is estimated that the savings compared to the current state will amount to approx. PLN 20 thousand. PLN
per year
Payroll costs
• The cost of salaries will increase by about 10 thousand. monthly as a result of the investment (the need to
hire new employees).
• In subsequent years, salaries are expected to be indexed at the rate of inflation (2% per annum).

Overheads on salaries (Social security and other benefits):

• Wage surcharges account for 24% of wage costs on average.
• This relationship is expected to continue in the future

Depreciation and no capital expenditure

• The old guesthouse building is fully depreciated. The new building will be depreciated on a straight-line
basis at the rate of 2% per annum.

Assumptions which refers to the value of working capital

• Taking into account the historical data, it is assumed that throughout the projection period:
o Receivables will constitute 8% of revenues
o Account payables 5% of revenues
o Do not expect an increase in inventories
Additional information:
• Tax rate: 19%

Required by the owners, rate of return: 15%; the target share of debt in the financing structure is 0.4, the cost of
debt is 10%. Income tax is 19%.Free cash flow growth rate after detailed analysis period: 0%

Task:
• Please estimate the NPV of your project using the FCFF method.
• Please calculate the IRR and PP of the project

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