01.

Critical report to the Investment Committee

I am writing to present a critical report on the capital investment project currently under
review. The purpose of this report is to thoroughly analyze the project's feasibility and
provide a well-justified recommendation based on a comprehensive assessment of its
financial aspects.
To: Investment Committee
From: Lourdes Emella Fernando
Date: 01st October 2023

Subject: Capital Investment Project Evaluation – Ai Nosh Residencies

a) Nature of the project and estimated cash flows for the period of the project & the
basis of including/excluding the cash flows for the evaluation of the project

Project Nature: Building a Residential Complex

The project involves the construction of a residential complex, which is a real estate
development venture. This type of project typically entails the design and construction of a
multi-unit housing facility. In this case, the real estate developer intends to build a residential
complex comprising 50 individual apartments.

These apartments can vary in size and configuration, catering to different market segments.
The project's estimated lifespan is 5 years, from the planning and construction phase to the
sale of all apartments.
Project Phases:
1. Planning Phase:
This is the initial stage of the project, where we would conduct feasibility studies, market
research, and site selection.
2. Construction Phase:
Once the planning phase is complete and all approvals are obtained, construction begins. This
involves building the 50 apartments according to the approved design and specifications.
3. Operating Phase:
After the construction is complete, the apartments are ready to be rented out. The operating
phase typically lasts for the remainder of the project's lifespan. During this phase, the
apartments are marketed to potential tenants, and rental agreements are signed.
4. End of Project Phase:
At the end of the project's estimated lifespan (5 years in this case), we may decide to sell the
entire residential complex. The sale of the apartments represents a significant cash inflow,
and this phase marks the completion of the project.
 5. Investment Phase:

6. Operating Phase (Year 1 to Year 5):

7. End of Project Phase (Year 5):

Apartment Sale: Assuming all apartments are sold at an average price of $300,000 per
apartment.
Total Revenue: $15,000,000
Remaining Debt Payment: If any loans are still outstanding, they need to be paid off.
8. Cash Flows for Evaluation:
Cash flows for each year and the total project's net cash flow, considering the initial
investment and annual cash flows:

Basis for Including Cash Flows:

Initial Investment:
This is the first cash outflow required to start the project. It includes expenses such as land
acquisition, construction costs, permit fees, and financing costs.
Annual Rental Income and Expenses:
These are cash flows generated by the day-to-day operations of the project during its life.
Annual Rental Income:
This is the revenue earned from renting out the apartments. It is included as it represents the
cash generated by the project.
Operating Expenses:
These expenses include property management, maintenance, insurance, and property taxes.
They are included because they represent the costs associated with generating the rental
income.
Sale Revenue:
At the end of the project, when all apartments are sold, the revenue generated from these
sales is a significant cash inflow. It is included because it represents a substantial return on
the investment made in the project.
Financing Costs:
If the project was financed through loans or other forms of borrowing, the interest payments
on these loans are included. These costs are real cash outflows and represent the cost of using
borrowed funds to finance the project.

Basis for Exclusions Cash Flows:

Depreciation:
Depreciation is the allocation of the cost of an asset over its useful life for accounting
purposes. It is a non-cash expense, meaning it does not involve actual cash outflows. In
financial analysis, we focus on cash flows, so depreciation is typically excluded from cash
flow calculations.
Income Taxes:
Income taxes are not explicitly included in the cash flow calculations. However, in a real-
world scenario, income taxes should be considered.
In summary, including or excluding specific cash flows in project evaluation depends on
whether they represent actual cash transactions and whether they are relevant to the financial
performance of the project.
(Marker , 2020) ( CFI Team, 2023)
 b) Systematic Risks & Unsystematic Risks

Systematic Risks:
Systematic risks are those that affect the entire market or economy and cannot be diversified
away. Real estate projects are exposed to several systematic risks:
Market Risk:
This is a type of systematic risk that affects the overall real estate market. Factors like
economic downturns, recessions, or changes in interest rates can significantly impact the
demand for real estate properties, including residential apartments. For example:
 Economic recession can reduce consumer confidence, leading to a decrease in
demand for housing.
 Rising interest rates can make borrowing more expensive, affecting the affordability
of apartments.
Interest Rate Risk:
Changes in interest rates, driven by central bank policies or market forces, can impact the
cost of financing for the project. Rising interest rates can lead to higher borrowing costs,
potentially reducing the project's profitability.

Unsystematic Risks:
Unsystematic risks are specific to the project or company and can be mitigated to some extent
through diversification or risk management strategies:
Construction Risks:
These risks are unique to the construction phase of the project. They include:
Construction Delays:
Weather, labor strikes, or supply chain disruptions can delay construction, leading to
increased costs.
Cost Overruns:
Unforeseen construction costs can exceed the budget, impacting profitability.
Market Demand Risk:
This relates to the project's ability to attract tenants or buyers. Factors include:
Vacancy Risk:
The risk of apartments remaining vacant due to a lack of demand.
Rental Rate Risk:
The possibility of having to lower rental rates to attract tenants in a competitive market.

Regulatory and Permitting Risks:

Obtaining the necessary permits and approvals can be a time-consuming process. Delays or
denials can impact the project's timeline and cost structure.
Credit Risk:
If the project is financed through loans, there is credit risk associated with the lender. This
risk includes the possibility of default on loan repayments.
Market Competition:
The presence of other real estate developers in the same market can lead to competition for
tenants or buyers, affecting rental rates and sale prices.
Operational Risks:
During the operating phase, various operational risks can affect the project's cash flows,
including:
Maintenance and Repair Costs:
Unexpected maintenance or repair expenses can impact profitability.
Tenant Defaults:
Tenants failing to pay rent or violating lease agreements can result in financial losses.
Market Volatility:
Real estate markets can be subject to price volatility. Fluctuations in property values can
affect the resale value of apartments at the end of the project.
Risk Management:
To manage these risks, real estate developers typically employ several strategies:
 Diversification: Developers may diversify their projects across different locations or
property types to reduce exposure to market-specific risks.
 Insurance: Developers can purchase insurance policies to mitigate risks related to
construction delays, damage, or liability.
 Thorough Due Diligence: Careful research, market analysis, and feasibility studies
can help developers identify potential risks early in the planning phase.
 Contractual Protections: Contracts with contractors, suppliers, and tenants may
include provisions to mitigate risks, such as penalties for delays or lease terms that
protect against tenant defaults.
 Financial Hedging: Interest rate risk can be managed through financial instruments
like interest rate swaps to fix borrowing costs.
(CFI Team, 2023)
 c) Estimation on Cost of Capital (WACC)
WACC represents the average cost of the various sources of financing used to fund the
project. To estimate WACC for the residential complex project, we'll consider the relevant
combination of capital sources that are expected to be used. These sources typically include
equity and debt.
Determine the Capital Structure:
Equity:
This represents the funds contributed by the real estate developer and other equity investors.
Debt:
This includes loans or bonds issued to finance the project.
 Equity (E): $8,000,000
 Debt (D): $4,000,000
Calculate the Cost of Equity (Ke):
The cost of equity represents the return required by equity investors. One common method
for calculating the cost of equity is the Capital Asset Pricing Model (CAPM):

Ke=Rf+(β∗(Rm−Rf))
Rf (Risk-free Rate):
The yield on a risk-free investment, such as a U.S. Treasury bond. It represents the time value
of money without any risk.
β (Beta):
A measure of the project's systematic risk or volatility compared to the overall market.
Rm (Market Risk Premium):
The expected return on the overall market, typically measured as the difference between the
expected market return and the risk-free rate.

Calculate the Cost of Debt (Kd):

The cost of debt represents the interest rate the project pays on borrowed funds. This rate can
usually be found in the terms of the loan or bond agreement.
 Cost of Debt (Kd): 5%
Determine the Weights of Equity and Debt (Weights):
The weights represent the proportion of equity and debt in the project's capital structure.
These weights are determined based on the actual or expected capital contributions from each
source.

Calculate the WACC:

WACC is calculated as the weighted average of the cost of equity and the cost of debt, with
the weights representing the proportion of each source in the capital structure:

So, the estimated WACC for the project is 8.484%.

So, the estimated Weighted Average Cost of Capital (WACC) for the project is
approximately 8.484%. This means that the project needs to generate returns higher than
8.484% to cover its financing costs and provide a return to the investors. It's a crucial
benchmark for evaluating the project's financial feasibility.
(CFI Team, 2023)
d) Evaluation of the Capital Investment Project

Evaluation of the capital investment project of building a residential complex using various
financial metrics, including Net Present Value (NPV), Internal Rate of Return (IRR), and
Payback Period. We will use the previously estimated cash flows and the Weighted Average
Cost of Capital (WACC) of 8.484%.
Net Present Value (NPV):
NPV measures the project's profitability by comparing the present value of cash inflows to
the present value of cash outflows.
NPV is calculated by discounting the cash flows to their present values using the WACC and
then subtracting the initial investment.

The project has a positive NPV of approximately $332,119.82, indicating that it is

expected to generate value for the investors. The project is acceptable based on this
metric.

Internal Rate of Return (IRR):

IRR represents the project's expected rate of return. If the IRR is greater than the WACC, the
project is deemed acceptable.
The IRR is approximately 9.1%, which is greater than the WACC of 8.484%,
supporting the project's acceptability.
Payback Period:
The payback period is the time it takes for the initial investment to be recovered from the
project's cash inflows.
Period Cash Flow Net Invested Cash
0 -12,600,000.00 -12,600,000.00
1 900,000.00 -11,700,000
2 900,000.00 -10,800,00
3 900,000.00 -9,900,000
4 900,000.00 -9,000,000
5 15,000,000.00 6,000,000
Total 6,000,000.00

The Payback Period falls between Year 4 and Year 5, indicating that the initial
investment is recovered within the 4.6 Years.
In summary, the project is financially acceptable based on NPV, IRR, and the payback
period. These metrics suggest that the project is likely to provide a return that exceeds the
cost of capital, making it an attractive investment opportunity for the real estate developer
and investors.
(Hofstrand, 2023) (CFI Team, 2023) (Team & Vipond, 2023) (CFI Team, 2023)
e) Sensitivity Analysis & Scenario Analysis for the project

Performing sensitivity analysis and scenario analysis is essential to assess the project's
sensitivity to changes in key variables and to consider different potential scenarios. In this
case, we'll focus on two critical factors: Rental income and Construction costs.
Sensitivity Analysis:
Sensitivity analysis helps us understand how changes in a single variable impact project
outcome. In this analysis, we'll vary the rental income and construction costs individually
while keeping other variables constant.

Variable 1: Rental Income

Base Case: Annual rental income per apartment = $900,000
Sensitivity: Let's consider a 10% increase and decrease in rental income.

Variable 2: Construction Costs

Base Case: Initial Investment (Year 0) = -$12,600,000
Sensitivity: Let's consider a 10% increase and decrease in construction costs.

Scenario Analysis:
Scenario analysis involves considering multiple scenarios by simultaneously changing
multiple variables. In this analysis, we'll consider a scenario where both rental income and
construction costs change together.

Scenario 3: Combined Scenario

New Annual Rental Income per apartment = $900,000 (5% decrease)
New Initial Investment = -$12,600,000 (5% increase)

Interpretation of Results:
Sensitivity and scenario analyses provide insights into how the project's financial metrics
respond to changes in key variables.
Rental Income Sensitivity:
When rental income increases by 10%, both NPV and IRR will increase. Conversely, when
rental income decreases by 10%, NPV and IRR will decrease. The project is sensitive to
changes in rental income.
Construction Cost Sensitivity:
When construction costs increase by 10%, NPV and IRR will decrease. Conversely, when
construction costs decrease by 10%, NPV and IRR will increase. The project is sensitive to
changes in construction costs.
Combined Scenario:
In the combined scenario with a 5% decrease in rental income and a 5% increase in
construction costs, NPV and IRR are expected to be affected in a way that depends on the
magnitude and direction of the changes. Further analysis may be needed to assess the overall
impact on project feasibility.

These analyses demonstrate the importance of considering sensitivity to variables and various
scenarios in project evaluation. It helps project stakeholders understand the potential risks
and opportunities associated with changes in critical factors that can impact project
profitability.
Conclusion:
In conclusion, we recommend proceeding with this project, subject to regular performance
reviews and risk management strategies. It is important to keep in mind that the success of
the project will depend on effective execution and market dynamics.

(CFI Team , 2023) (COLLIN, 2021)

02. Debt Instruments and Stock Market

a) Debt Instruments

Debt instruments, particularly bonds, play a crucial role in the financial markets of Sri Lanka
and are important to various parties, including the government, corporations, investors, and
the overall economy. In this analysis, we will delve into the importance of debt instruments,
specifically bonds, with reference to the bond market in Sri Lanka, considering bond
fundamentals and recent issues.
Government of Sri Lanka:
One of the primary issuers of bonds in Sri Lanka is the government itself. Bonds serve as a
critical tool for the government to raise funds for various purposes, such as infrastructure
development, budgetary requirements, and debt refinancing. Bonds allow the government to
manage its fiscal policy effectively, ensuring economic stability. For example, the Sri Lankan
government issued sovereign bonds in the past to fund infrastructure projects like highways
and ports, which had a positive impact on the country's development.
Recent Issue: In 2020, the Sri Lankan government issued international sovereign bonds to
raise funds for budgetary support. This issue was critical in addressing immediate financial
needs, although it also raised concerns about the country's debt sustainability due to the
associated high interest costs.
Corporations and Businesses:
Sri Lankan corporations use bonds as a means of raising capital for expansion, debt
restructuring, or working capital. Bond issuances allow them to diversify their sources of
funding beyond traditional bank loans. This is especially important for businesses in sectors
such as manufacturing and infrastructure development.
Recent Issue: In 2021, Ceylon Electricity Board (CEB), the state-owned electricity utility,
issued bonds to fund various projects, including upgrading the power infrastructure. This
issuance helped CEB secure long-term financing for essential projects.
Investors:
Bonds offer a safe and relatively predictable investment avenue for investors, including
institutions and individuals. Investors in Sri Lanka can earn interest income and benefit from
potential capital appreciation when bond prices rise. Bonds also provide portfolio
diversification and can serve as a hedge against inflation.
Recent Issue: In 2019, the Central Bank of Sri Lanka issued 'Sri Lanka Development Bonds'
targeted at non-resident Sri Lankans and foreign investors. These bonds provided an
opportunity for investors to earn higher returns compared to similar instruments in developed
economies.

Economic Stability:
The bond market in Sri Lanka contributes to overall economic stability by providing a
benchmark for interest rates. The Central Bank uses government bond yields as reference
rates for monetary policy decisions. Stable interest rates are essential for controlling inflation
and promoting economic growth.
Recent Issue: Amid the COVID-19 pandemic, the Central Bank of Sri Lanka took measures
such as reducing policy interest rates and providing liquidity support through open market
operations involving government bonds to stabilize the economy.
Risk Management:
Bonds can be used for risk management. For instance, firms can hedge against interest rate
risk by issuing fixed-rate bonds or floating-rate bonds, depending on their interest rate
outlook.
Recent Issue: Some Sri Lankan corporations have issued floating-rate bonds, protecting
themselves from interest rate fluctuations and ensuring more predictable interest expenses.
In conclusion, debt instruments, especially bonds, play a vital role in Sri Lanka's financial
ecosystem. They serve the financing needs of the government and corporations, provide
investment opportunities for various investors, contribute to economic stability, and allow for
effective risk management. However, it is essential to carefully manage debt levels to avoid
adverse consequences, such as high interest costs and debt sustainability issues, as witnessed
in some recent bond issuances in Sri Lanka. The bond market continues to evolve, and its
proper functioning is integral to the country's economic development and stability.
(Central Bank of Sri Lanka Annual Report 2019, 2019) (Frequently Asked Questions
(FAQs), 2023)
b) Stock Market

The stock market is a vital component of any economy, and its importance cannot be
overstated. It serves as a barometer of economic health, a source of capital for businesses, a
means of wealth creation for individuals, and a mechanism for efficient resource allocation.
In this analysis, we will explore the importance of the stock market, focusing on the Sri
Lankan Stock Market (Colombo Stock Exchange or CSE), considering its history, recent
trends, and special factors.
Capital Formation and Business Growth:
History: The CSE was founded in 1985, providing Sri Lankan businesses with a platform to
raise capital through the issuance of equities. This has been instrumental in fostering
entrepreneurship and business expansion.
Recent Trends: The CSE has witnessed periods of significant growth, with numerous
companies going public. For instance, in recent years, Sri Lankan companies from various
sectors, including telecommunications and finance, have conducted Initial Public Offerings
(IPOs) to raise funds for expansion.

Wealth Creation and Investment Opportunities:

History: The CSE has allowed Sri Lankan investors to participate in the wealth creation
process by providing opportunities for capital appreciation and dividend income.
Recent Trends: Investors have benefited from stock market rallies in Sri Lanka. For
example, the All Share Price Index (ASPI) reached record highs in the years leading up to
2019, providing significant returns to investors.
Economic Indicator:
History: The CSE has served as an important economic indicator, reflecting the overall
health and sentiment of the Sri Lankan economy.
Recent Trends: During periods of economic uncertainty, the CSE can experience declines,
as seen during the COVID-19 pandemic. However, it has also shown resilience, rebounding
as the economy recovered.
Liquidity and Resource Allocation:
History: The CSE has facilitated efficient allocation of capital by allowing investors to buy
and sell shares in listed companies, which helps in directing funds to the most productive
sectors.
Recent Trends: The CSE has attracted foreign investment, contributing to liquidity and
diversifying the investor base. Measures such as tax incentives for foreign investors have
been introduced to encourage this trend.
Special Factors in the Sri Lankan Stock Market:
Market Volatility: The CSE has experienced periods of volatility due to both domestic and
international factors. For example, political instability and global economic events have
influenced market sentiment.
Regulatory Framework: The regulatory environment in Sri Lanka, including the role of the
Securities and Exchange Commission (SEC), plays a crucial role in ensuring market integrity
and investor protection.
Foreign Investment: Sri Lanka has been actively promoting foreign investment in the CSE,
including the introduction of the "Dual Listing" framework, allowing foreign companies to
list on the CSE.
Technology and Access: Advances in technology have improved market access and trading
efficiency, making it easier for investors to participate.
Example - John Keells Holdings PLC:
John Keells Holdings is a prominent Sri Lankan conglomerate listed on the CSE.
History: The company's shares have been actively traded on the CSE, contributing to its
growth and diversification of business operations.
Recent Trends: Investors in John Keells Holdings have benefited from both capital
appreciation and dividend income, reflecting the wealth creation potential of the stock
market.
In conclusion, the Sri Lankan Stock Market, like stock markets worldwide, is of paramount
importance to the economy. It serves as a source of capital, a means of wealth creation, an
economic indicator, and a mechanism for efficient resource allocation. However, it also faces
challenges such as market volatility, which underscores the need for effective regulation and
investor education. The recent trends in the CSE demonstrate its potential to contribute
significantly to the economic development of Sri Lanka, attracting both domestic and foreign
investment.
(Colombo Stock Exchange, 2023) (L. Kengatharan & S. Vanajah, 2021)

03. An Investment Plan

Designing an investment plan to meet these objectives involves several steps. You'll need to
make assumptions about certain variables, such as expected returns on investments, inflation
rates, and life expectancy.
Define the Assumptions
  Retirement Age: 65 years.
 Estimated Cost of the Foreign Tour: $40,000
 Estimated Cost of Purchasing a House When You Retire: $500,000
 Desired Monthly Retirement Income: $4,000
 Desired Inheritance Amount: $600,000
 Expected Inflation Rate: 3% per year.
 Expected Rate of Return on Investments: 6% per year
 Estimated Life Expectancy After Retirement: 25 years.
Estimate Future Costs
a. Cost of the Foreign Tour (adjusted for inflation at retirement age):
Future Cost = $40,000 * (1 + 0.03) ^65 = $120,559
b. Cost of Purchasing a House When You Retire (adjusted for inflation at retirement
age):
Future Cost = $500,000 * (1 + 0.03) ^65 = $1,505,740
Calculate Retirement Income Needs
Desired Monthly Retirement Income: $4,000 per month
Calculate the Future Value of Retirement Costs
a. Future Cost of the Foreign Tour: $120,559
b. Future Cost of Purchasing a House: $1,505,740
Calculate the Future Value of the Inheritance
Desired Inheritance Amount (adjusted for inflation at the end of the withdrawal period):
Future Inheritance Amount = $600,000 * (1 + 0.03) ^20 = $885,136
Determine Investment Returns
Expected Rate of Return on Investments: 6% per year
Calculate the Required Retirement Savings
let's assume you need $2.5 million in retirement savings.
Calculate the Periodic Investment
Now, we'll use the formula mentioned to calculate the number of periodic investments
required to achieve the retirement savings goal:
PMT = [FV / ((1 + r) ^n - 1)] * ((1 + r) / r)
Where:
PMT is the periodic investment amount.
FV is the required retirement savings (calculated in step 9).
r is the expected rate of return on investments per period.
n is the number of investment periods until retirement.

PMT = [$2,500,000 / ((1 + 0.06) ^20 - 1)] * ((1 + 0.06) / 0.06)

PMT ≈ $21,372.90
You would need to make periodic investments of approximately $21,372.90 per year (or
adjusted to your preferred investment frequency) from now until your retirement at age 65 to
achieve your retirement goals based on the assumptions provided.
(Tamplin, 2023)