Chapter Four Project Evaluation and Analysis: 05/26/22 1 ASTU/ Project/ Lecture Slides

CHAPTER FOUR
PROJECT EVALUATION AND ANALYSIS
05/26/22 ASTU/ Project/ Lecture Slides 1

Feasibility study and its components
 Viable project idea during identification and pre –feasibility studies enters into
feasibility study stage.
 Feasibility study – provide all data necessary for an investment decision.
an analysis of the viability of an idea
involves detail analysis of:
1. Market and demand analysis
2.Technical analysis
3. Financial analysis
4. Socio - Economic analysis
5. Environmental analysis
05/26/22 Hope/ Project/ Lecture Slides 2

Feasibility Cont’d…
1. Market Analysis
estimate the potential size of (beneficiaries/customers) market
increases the project’s probability of success
concerned with two questions:

What would be the aggregate demand of the proposed product/service?
What would be the expected market share of the project under appraisal?

Market Feasibility Cont’d…
 Steps in market and demand Analysis
i. Situational analysis and specification of objectives
ii. Collection of necessary information (both primary and secondary)
iii. Characterization of the market
iv. Demand forecasting
v. Market Strategies

i. Situational analysis and specification of objectives
determine the relationship between the product and its market by talking to
customers, competitors, middlemen, and others.
 helps to generates data to measure the market and make a reliable projection of
the demand and revenue.
Objectives of Market Analysis

Answers the following questions:
Who are the buyers of the product?
 What is the total current demand for product?

 How the demand is currently distributed?
 What is the current price of the product and willingness of consumers

to pay?
 Do consumers need the new product as a substitute for the products
in the market?
 What is the nature of distribution and what market channels are most
suitable?
 What are the possible sales of the product?

ii. Collection of necessary Information
If the situational analysis fails to address the questions adequately, formal
study may be needed.
Secondary and primary sources of data can be used for further
investigations.
a. Sources of secondary information
National sample survey reports
Annual survey of Industries
Records of different organization and market agents
Newspapers
 Relevance, accuracy, reliability of the data has to be carefully examined.
b. Collection of Primary Information
If the secondary data are not comprehensive, it needs to be supplemented
with primary information.
It can be a census and sample survey
Information sought in a market survey may be:
 Total demand and rate of growth of demand
 Demand in different segments of the market
 Income and price elasticity’s of demand

Customer preference, motives for buying
Purchasing plans and intentions
Satisfaction with existing products
Unsatisfied needs
Attitude towards various products
Existing trade practice
Socio-economic characteristics of buyers.

Steps in a Sample Survey
1. Define the target population
2. Select the sampling scheme and sample size
3. Develop the questionnaire
4. Recruit and Train the Field Investigators
5. Obtain information from the sample respondent
6. Synthesize the information gathered
7. Analyze and Interpret the Information

iii. Characterization of the market
The information gathered about the product/service may be described in
terms of the following aspects:
1. Effective demand in the past and present
the starting point to determine effective demand is apparent
consumption.
effective demand and apparent consumption are equal in a competitive
market.
 Effective demand represents the total quantity of a specific product
purchased at a given price in a particular market over a given period.

Actual consumption can be computed as:
Consumption = P + I – E – CSL
Where,
P = production
I = Imports
E = Exports
CSL = Changes in stock level(ending stock)
2. Breakdown of demand: breaking down aggregate demand for the product

into demand for segments of the market.
Market segmentation: is dividing of the target market into subgroups of
consumer with homogeneous characteristics.
The nature of demand (consumption) vary from one segment to another.
Bases of segmentation:
Geographic segmentation
Demographic segmentation (age, sex, family size, marital status, religion).
Socio-economic segmentation (income, consumption levels, culture).

Psychographics segmentation (based on how consumers think, feel,
and behave).
Buyer behavior segmentation (based on customer’s knowledge,
attitudes or responses to a product).
3. Price: the value of product attributes expressed in monetary terms

which a consumer pays.
External factors that affect pricing decisions

Cost of inputs
Competition
Consumer’s quality perceptions
Middlemen (distributors)
Suppliers
Government
Economic conditions
Ethical considerations
 Demand

Internal factors that affect pricing decisions
Organizational factors
Marketing mix
 Cost of products and objective of the firm
Product differentiation (color, size, attractive package, attractive uses)
Pricing strategy
a. Market skimming: setting a relatively high initial price for a new product

b. Market penetration: setting a relatively low initial price for new product.
4. Distribution: concerned with how products or services are made available

to customers.
 means for bridging the gap between the producer and the customers.
Components of distribution system
a. Channels of distribution: - refer to intermediaries (wholesalers, retailers,

dealers and agents).
b. Physical distribution: - is concerned with the flow of goods to consumers.

It includes transportation, warehousing, and inventory management.
5. Promotion: the act of communication that provides consumers with
information about a company’s products.
 Involves the transmission of message to present, past, and potential
customers.
Means of Promotion
a. Personal selling – involves face-to-face contact between seller’s

representative and the buyer.
b Advertising፡ - is paid form of non-personal mass media communication

(print media, direct mail, TV, radio, billboard, Internet)
c. Sales Promotion፡ serve as incentives to motivate a desired response on the
part of target customers.
d. Publicity፡ -involves the news carried in the mass media about a firm and
its products, policies, personnel or actions, such as news releases, press
conference etc.
e. Public relations፡ -is a planned effort by an organization to influence the

attitudes and opinions of a specific group.

6. Supply and Competition
Supply: are sources of raw materials

Competition: -firms which produce and supply similar or related products
or service.

iv. Demand Forecasting
 Prediction of what will happen to your project’s product sales.
 inputs from sales and marketing, finance, and production should be

considered.
Steps of demand forecasting
1. Determine the use of the forecast
2. Select the items to be forecasted
3. Determine the time horizon of the forecast
4. Select the forecasting model(s)

5. Gather the data
6. Make the forecast
7. Validate and implement results
Methods of Demand Forecasting
I. Qualitative methods: relies on the judgment of experts
1. Jury of executive opinion method - involves soliciting the opinions of a

group of managers on expected future sales.
2. Delphi method: used for eliciting the opinions of a group of experts with
the help of a mail survey.
Steps
I. Send a questionnaire to a group of experts by mail
II. The responses received from the experts are summarized and sent to the
experts along with a questionnaire to probe further the reasons for the
extreme views expressed.
III. The process may be continued for one or more rounds till a reasonable
agreement emerges.

2. Quantitative Methods
i. Trend projection method (Least Square Method): uses historical data to

predict future demand.
1st Obtain demand data for some past periods
2nd Establish linear relationship using the following formula:
Yt = a + bt
Yt = Demand for year t
a = Intercept of the relationship
b = Slope of the relationship
t = time variable
The values of a and b can be computed as follows:
n ty   t  y
n t 2   t 
2
b=
a=  y  b t
n

Demand Forecasting Cont’d ….
 Using the above data, the computations a and b is as follows:
Year (t) Actual demand (y) ty t2
1 200 200 1
2 250 500 4
3 175 525 9
4 186 744 16
5 225 1125 25
t = 15 y = 1036 ty = 3094  t2 = 55
n ty   t  y
b=
n t 2   t 
2
= )
5(3094)  (15 x1036 15470  15540 7
5(55)  (15) 2 275  =225 5
a=  y  b t
n
= 1036    7 15
 
 5 
= 211.40
5
Yt = 211.40 -
7
t is used to forecast demand from period five to any period into
The above regression equation
5
the future. For example, the demand forecast for period 7 (t = 7) is computed as follows:

7
Yt = 211.40 – T
5
7
= 211.40 – (7 )
5
49
= 211.40 –
5
1075  49
=
5
= 1008= 201.6
5
Similarly demand for year 10 (t = 10) is forecasted as follows:
7
Yt = 211.40 - (10)
5
= 211.40 – 14
= 197.4
ii. Exponential Smoothing
 The current forecast is the weighted average of the last forecast and the
current value of demand.
New forecast =  (current observation of demand) + (1-) (last forecast) or

symbolically,
Ft = Dt-1 + (1 - ) Ft-1
Where 0 <   1 is the smoothing constant.
 (Alpha) determines the relative weight placed on the current

observation of demand.

1 -  is interpreted as the weight placed on past observations of demand.
 D refers to the actual demand of current period (t-1).
The above formula can be rewritten as follows:
Ft = Ft-1 + (Dt-1 – Ft-1)
Where,
Ft-1 = previous forecast
 = smoothing constant
Ft = New forecast
Dt-1 = the demand for the current period

Exponential smoothing method requires three items of data:
 Last period’s forecast,
Actual demand for the previous period and
 Smoothing constant ()
 If  is large, more weight is placed on the current observation of demand

and less weight on past observations.

To illustrate demand forecasting using exponential smoothing, assume that
demand for product X in April was forecasted to be 120 units (Ft-1 = 120).
Actual demand for April was 140 units (Dt-1 = 140). If smoothing constant is
0.4 ( = 0.40), the forecast for May would be:
FMay = Ft-1 + (Dt-1 – Ft-1)
= 120 + 0.40 (140 – 120)
= 120 + 8
= 128

Feasibility Cont’d…
3. Moving Average Method - the forecast for the next period is equal to the
average of the sales for several preceding periods.
St 1  St 2  ...  St n
Ft 1 
n
Where:
Ft+1 = Forecast for the next period
St = Sales for period t
n = period over which averaging is done

To illustrate, consider the following data for the past 10 years.
Year Sales (Actual)
1 80
2 60
3 70
4 90
5 75
6 100
7 80
8 85
9 60
10 80
If the company uses a four-year moving average, sales forecast for year 5 is:
S1  S 2  S3  S 4
F5 = 4
80  60  70  90
4 = 75
If the company uses a nine-year moving average, sales forecast for the 10th
year is:
S1  S 2  S 3  S 4  S 5  S 6  S 7  S 8  S 9
9
80  60  70  90  75  100  80  85  60
F10 =
 77.78
9

4. End use method/Consumption coefficient method
 Suitable for estimating the demand for intermediate products.
 Steps involved:
Step 1: Identify the possible uses of the product

Step 2: Define the consumption coefficient (usage rate) of the product for
various uses.
Step 3: Project the output levels for the consuming industries

Step 4: Derive the demand for the product.

Illustration: - Assume that four industries (Electronics, Computer, Electricity
and Telecommunication) use chips as input to their products. The chip
manufacturer prefers to use End Use Method to forecasting demand for
chips in the upcoming year. The company collected consumption coefficient
and projected output of each industry and summarized the data below:
Industry Consumption Coefficient Projected output
Electronics 5 10,000
Computer 4 30,000
Electricity 6 15,000
Telecommunication 7 20,000

Required: Determine the total forecasted demand for chips
The consumption coefficient indicates the rate of input (chips) per unit of
output. For instance, the consumption coefficient of 5 for electronics
industry implies that the industry uses 5 chips to produce one unit of its
output.
Accordingly, demand for chips in the coming year is computed as follows:

Industry Consumption Projected Projected demand
Coefficient output for chips
Electronics 5 10,000 50,000
Computer 4 30,000 120,000
Electricity 6 15,000 90,000
Telecommunication 7 20,000 140,000
Total forecasted chips 400,000

v. Market Strategy
is the means by which objectives are achieved.
 critical to the success of the plan
 alternative marketing strategies should be assessed

Marketing strategies
a. Competition strategy: aims at gaining market shares from competitors.
Aggressive price strategy-dumping prices
Imitation strategy-competitors marketing efforts
Profile strategy - focusing on quality performance and brand name
b. Market expansion strategy: geared to the creation of new markets or to

demand.
2. Technical Analysis
Tells how a project technically feasible in terms of:
Manufacturing process/technology
Materials inputs and utilities
Product mix
Plant capacity
Location and site
Machinery and equipment
Structure and civil work

Technical Analysis Cont’d……
The broad purpose of technical analysis are:
 To ensure that the project is technically feasible (inputs availability)
To facilitate optimal formulation of the project (technology, size, location).
1. Manufacturing Process/Technology
To manufacture a product/service often two or more alternative
technologies are available (e.g. Cement can be made either by the dry
process or the wet process).

a. Choice of Technology
The choice of technology is influenced by:
 Plant capacity
 Principal Inputs - quality of raw materials
 Investment outlay and production Cost
 Uses by other Units - proved successful by other units
 Product Mix
 Latest developments
 Ease of absorption
b. Appropriateness of Technology
 suitable to local economic, social, and cultural conditions.
c Acquiring Technology
 Technology licensing - the licensee get the right to use technology
Outright purchases
Joint ventures - the supplier of technology participate technically and

financially in the project.
d. Technical Arrangements
 arrangements to obtain the technical know-how needed.
 collaboration sought in designing the project, selection and
procurement of equipment, installation and erection of the plant,
operation, etc.
2. Material Inputs and Utilities

Material inputs and utilities classified in to four:
i. Raw materials
ii. Processed industrial materials and components
iii. Auxiliary materials and factory supplies
iv. Utilities
i. Raw Materials
Agricultural products
Mineral products
Livestock and forest products, and
Marine products
ii. Processed Industrial Materials and Components

 represent inputs for a number of industries

 it includes:
semi-processed materials
Manufactured parts
Components
Sub-assemblies
iii. Auxiliary Materials and Factory Supplies

 chemicals, additives, packaging materials, paint, varnishes, oils, grease,
cleaning materials.

v. Utilities
 Power, water, steam, fuel, etc.
3. Production Program and Plant capacity
a. Plant capacity: the volume of units that can be produced.

Factors to be considered in capacity decision
Technological requirements - minimum economic size (a cement plant

should have a capacity of at least 300 tons per day).
Input constraints (e.g. Power, basic raw materials)

 Investment cost (investment cost/unit of capacity decreases as the
plant capacity increases).
Market conditions
Resources of the firm (e.g. finance)
Government policy
i. Feasible Nominal Capacity: achievable under normal working
conditions taking into account:
Normal stoppages
Downtime
Maintenance
Shift patterns
ii. Feasible Normal Capacity (FNC): technically feasible capacity and
corresponds to the installed capacity.
4. Product Mix
 variations in size and quality of the product to satisfy of customers’ need.

 guided by market requirements.
5. Location and Site
a. Location: fairly broad area like a city, and industrial zone.
b. Site: a specific piece of land where the project would be set up.

 Choice of location is influenced by:
 Proximity to raw materials and markets - cement plant or a steel mill
 Availability of infrastructure- Power, water, road, etc.
Labor situation - labor rates, skill, productivity, etc
 Governmental policies - governmental restrictions
 Other Factors:
Climatic conditions
General living conditions
Proximity to ancillary units
Ease in coping with pollution

Requirements and conditions in selecting sites:
Ecological conditions on site (soil, site, hazards, climate)
Environmental impact (restrictions, standards, guidelines)
Socio-economic conditions (restrictions, incentives requirements)
Local infrastructure at site
Strategic aspects
Cost of land
Site preparation and development, requirements and costs.

6. Machineries and Equipments
 Dependent on production technology and plant capacity.
 The equipment required for the project may be classified into:
Plant (process) equipment,
Mechanical equipment,
Electrical equipment,
Instruments,
Controls,
Internal transportation system

 Constraints in Selecting Machineries and Equipment
 Limited availability of power
Difficulty in transporting heavy equipment
Worker’s inability to operate
Import policy of the government
7. Structure and Civil Works
i. Site preparation and development
ii. Buildings and structures, and
iii. Outdoor works

i. Site preparation and development
Grading and leveling of the site;
 Demolition and removal of existing structures;
 Relocation of existing pipelines, cables, roads, power lines, etc.;
 Reclamation of swamps and draining and removal of standing water;
 Connecting electric power, water, communications, roads and railway

sidings.
ii. Buildings and Structures

 Factory or process buildings
 Ancillary buildings (warehouses, laboratories, utility supply centers,
maintenance services)
 Administrative buildings
Staff welfare buildings, cafeteria, and medical service building
 Residential buildings
iii. Outdoor Works

 Supply and distribution utilities (water, electric power,
communication, steam, and gas).
Handling and treatment of emission, wastages, and effluents
 Transportation and traffic signals
Outdoor lighting
Landscaping
Enclosure and supervision (boundary wall, fencing, barriers, gates, doors,

security posts).

3. Financial Analysis
 tells a project's worthiness
 analysis of the profitability of the project based on monetary costs and

benefits.
 involves the assessment of:
project inputs
the outputs
future net benefits, expressed in financial terms
 The objective is to analyze and interpret the financial consequences of an

investment.
Financial Analysis Cont’d……
Financial analysis requires the determination of:
i. Costs of the Project /Investment cost
ii. Estimation of sales and cost of production
iii. Estimation of project net cash flows, and
iv. Evaluation of the desirability of the project using various criteria
i. Cost of the Project

outlays associated with a project

Project cost includes:
a. Land and site development
b. Building and civil works
c. Plant and machinery
d.Technical know-how and engineering fees
e. Expenses on foreign technicians and training local technicians abroad
f. Miscellaneous fixed assets
g. Pre-operative expenses
h. Margin money for working capital and Initial cash losses.

a. Land and site development
 cost of land
Premium payable on leasehold
Cost of gates
Cost of laying approach roads and internal roads
Cost of leveling and development
b. Buildings and Civil Works

Buildings for the main plant and equipment
Buildings for auxiliary

Good owns, warehouses, and open yard facilities
Non-factory buildings like canteen, guesthouses, etc.
Garages
Sewers, drainage
Silos, tanks, wells, chests, basins
 Quarters for essential staff
c. Plant and Machinery

Cost of imported machinery
Cost of indigenous machinery

Cost of stores and spares
Foundation and installation charges
d. Technical Know-how and Engineering Fees

technical consultants preparation of the project report, choice of
technology, selection of the plant and machinery, detailed engineering.
e. Expenses on foreign technicians and training of local technicians abroad
f. Miscellaneous Fixed Assets

 furniture, office machinery and equipment, tools, vehicles, diesel
generating sets, transformers, etc.
g. Preliminary and Capital Issue Expenses
Expenses to identify the project, market survey, preparing the feasibility
report, raising of capital from the public, etc.
h. Pre-operative Expenses
Establishment expenses, rent, and taxes, traveling expenses, insurance
charges, etc.
 related to the project implementation schedule (delays in project
implementation will push up expenses).

i. Provision for Contingencies
to provide for certain unforeseen expenses and price increase
j. Margin money for working capital

 Provided by commercial banks and trade creditors.
sometimes utilized for meeting over-runs in capital cost.
k. Initial Cash Losses

 cash losses in the initial years

ii. Estimation of sales and cost of production

a. Production/Manufacturing cost
Manufacturing costs are categorized in to 3:
i. Direct materials cost
ii. Direct labor
iii. Indirect manufacturing costs (manufacturing overhead)

i. Direct materials cost
 identified as part of the cost of the object
 includes acquisition costs (delivery charges, tax, and custom duties)
ii. Direct labor

can be identified with a cost of the object (e.g. machine operators and
assembler).
iii. Indirect manufacturing costs (Manufacturing overhead)

cannot be identified specifically with or traced to the cost of object (e.g. power,
supplies, indirect labor, factory rent, insurance, property taxes, and depreciation).

Cost of production = Material cost + labor cost + factory overhead
Cost of production per unit = Total Cost of Production
Total Number of units produced
b. Estimates of Sales and Production
1. Estimating Sales
starting point for the projections of profitability
Estimating sales revenues requires analyzing:
Economic level (activities)
Probable market share

 Competitor’s and their capacities
Pricing strategies
Inflation
Advertising campaigns
2. Estimating Production
Production = Sales + Desired ending Inventory – Beginning finished goods

inventory
 no beginning inventory in the first year

Illustration: Addis Company has set the policy of maintaining finished goods
inventory of 10,000 units at the end of each year. The installed plant capacity
is estimated to be 300,000 per year. It is estimated that the project will
operate at 50% and 60% in year 1 and year 2 and full capacity from year 3 to
year 5. Hence, annual production is computed as follows:
Year 1 Year 2 Year 3 Year 4 Year 5
Installed capacity 300,000 300,000 300,000 300,000 300,000
Capacity utilization 50% 60% 100% 100% 100%
Production 150,000 180,000 300,000 300,000 300,000

Financial Analysis Cont’d ….
Estimation of total Revenue
Year
1 2 3 4 5
Production 150,000 180,000 300,000 300,00 300,000
Desiredending nventory 10,000 10,000 10,000 10,000 10,000
Sold 140,000 170,000 290,000 290,00 290,000
Selling price/unit 160 160 160 160 160
Total sales Revenue 22,400,000 27,200,000 46,400,000 46,400,000 46,400,000
3. Estimation of Material Costs

Costs of materials include:
Cost of raw materials

Chemicals
Components
Consumable stores for production
Factors to be considered in estimating the cost of materials
 requirements of various material inputs per unit of output
 total requirements of various inputs
Total requirements = (Requirements per unit) x (Expected Production)

 The prices of material inputs
 The present costs of various material inputs
 The seasonal fluctuations in prices
Estimated cost of material X
Year
1 2 3 4 5
Production 150,000 180,000 300,000 300,000 300,000
Material x /unit of 3 3 3 3 3
output
Total requirements 450,000 540,000 900,000 900,000 900,000
Unit cost 5 5 5 5 5
Total cost of material x 2,250,000 2,700,000 4,500,000 4,500,000 4,500,000
before contingency
Contingency (2%) 45,000 54,000 90,000 90,000 90,000

Total cost of material X 2,295,000 2,754,000 4,590,000 4,590,000 4,590,000
Estimated cost of material Y
Year
1 2 3 4 5
Production 150,000 180,000 300,000 300,000 300,000
Material y/unit of 2 2 2 2 2
output
Total requirements 300,000 360,000 600,000 600,000 600,000
Unit cost 10 10 10 10 10
Cost before 3,000,000 3,600,000 6,000,000 6,000,000 6,600,000
contingency
Contingency (2%) 60,000 72,000 120,000 120,000 120,000

Total cost of material y 3,060,000 3,672,000 6,120,000 6,120,000 6,120,000
Total material costs are summarized below:
Year Material X Material Y Total
1 2,295,000 3,060,000 5,355,000
2 2,754,000 3,672,000 6,426,000
3 4,590,000 6,120,000 10,710,000
4 4,590,000 6,120,000 10,710,000
5 4,590,000 6,120,000 10,710,000
4. Estimating Labor Costs

 includes the cost of all the manpower employed in the factory.
Labor Cost = (number of employees) x (rate of payment)

Assume that 3 hours of direct labor are required to produce one unit of
output. It is estimated that direct labor cost per hour is Br. 20 and is
expected to increase at the rate of 5% every year. Accordingly, direct labor
cost is estimated as follows:
Estimated direct labor cost
Year
1 2 3 4 5
Production 150,000 180,000 300,000 300,000 300,000
Labor hour/unit of 3 3 3 3 3
output
Total labor hours 450,000 540,000 900,000 900,000 900,000
required
Labor rate/hour 20 21 22.05 23.15 24.31
Total cost of labor 9,000,000 11,340,000 19,845,000 20,835,000 21,879,000
5. Estimating Overhead Costs
 costs other than direct material costs and direct labor costs
 estimated based on direct labor hours, direct labor costs & material costs.
Suppose that the factory overhead costs of Addis Company are estimated
to be 60% of direct labor costs. Then factory overhead costs are estimated as
follows:

Estimates of Factory overhead
Year
1 2 3 4 5
Estimated labor costs 9,000,000 11,340,000 19,845,000 20,835,000 21,879,000
Overhead rate 60% 60% 60% 60% 60%

Estimated Factory 5,400,000 6,804,000 11,907,000 12,501,000 13,127,400
Overhead
6. Computation of Unit Costs
Unit Cost = Manufacturing costs
Units produced
Computation of unit cost
Direct Direct labor Factory

Year
Total Production Unit
Material cost overhead
cost
Costs costs
1
5,355,000 9,000,000 5,400,000 19,755,000 150,000 131.70
2
6,426,000 11,340,000 6,804,000 24,570,000 180,000 136.50
3
10,710,000 19,845,000Hope/11,907,000
05/26/22
42,462,000 300,000
Project/ Lecture Slides
141.54
79
**Estimated cost of ending inventory
Cost of ending inventory = Desired ending inventory X Unit cost
Year
1 2 3 4 5
Desired ending 10,000 10,000 10,000 10,000 10,000
inventory
Unit cost 131.70 136.50 141.54 146.82 152.39

Cost of ending 1,317,000 1,365,000 1,415,400 1,468,200 1,523,900
Inventory

**Estimated cost of goods sold
Year
1 2 3 4 5
Cost of production 19,755,000 24,570,000 42,462,000 44,046,000 45,716,400
Add: Beg. Finished - 1,317,000 1,365,000 1,415,400 1,468,200

Goods inventory
Available for sale 19,755,000 25,887,000 43,827,000 45,461,400 47,184,400
Ded: Ending Finished 1,317,000 1,365,000 1,415,400 1,468,200 1,523,900

Goods inventory
7. Estimating Administrative, Selling, and Other expenses
 needed prepare projected income statements.
Illustration: Assume that:

Administrative and general expenses: Br. 500,000 including depreciation of
Br. 100,000 in year 1 and expected to increase by Br. 10,000/year.
Selling expenses: Br. 400,000 including depreciation of Br. 60,000 per year
in year 1 and year 2 and are expected to be Br. 420,000 thereafter.
The project will be financed fully by equity.
Income tax rate is 30% after two years.

Addis Company
Projected Income Statement
For the year ended Dec. 31, years 1 – 5
Year
1 2 3 4 5
Sales 22,400,000 27,200,000 46,400,000 46,400,0 46,400,0
00 00
Cost of goods sold 18,438,000 24,522,000 42,411,600 43,993,20 45,660,5
0 00
Gross profit 3,962,000 2,678,000 3,988,400 2,406,800 739,500
Expenses:
Administrative & 500,000 510,000 520,000 530,000 540,000
General
Selling 400,000 400,000 420,000 420,000 420,000
Total expenses 900,000 910,000 940,000 950,000 960,000
Earnings before taxes 3,062,000 1,768,000 3,048,400 1,456,800 (220,500)
Taxes (30%)
05/26/22
- Hope/ Project/ Lecture
- Slides 914,520 437,040 - 83
Net income 3062,000 1,768,000 2,133,880 1,019,760 (220,500)
iv. Estimation of Project net cash flows
Project cash flows comprises of three basic components: -
1. Initial investment (Initial cash flow )- the cash outlay on capital

expenditures (Purchase price, installation costs, taxes, transportation costs
and increase in networking capital).
2. Operating cash flows: - include the after-tax cash flows resulting from the
operations of the project during its economic life.
 is a project’s operating income plus depreciation.
After tax cash = Net income + Non-cash expenses + Interest (1-tax rate)
3. The terminal cash flow: cash flows that occur at the end of the life of the
project.
it involve mainly salvage value (net of tax) and recovery in networking
capital.
Assume the project required increase in networking capital of Br. 100,000 at

the beginning of year 1 and is expected to be recovered at the end of year 5.
Besides, the project has salvage value of Br. 80,000 at the end of year 5.

Determination of project net cash flows
Year
Items
1 2 3 4 5
Net income 3,062,000 1,768,000 2,133,880 1,019,760 (220,500)
Add: Depreciation 160,000 160,000 160,000 160,000 160,000
Salvage proceeds - - - - 80,000
Recovery in NWC - - - - 100,000
After05/26/22
tax cash flows 3,220,000Hope/
1,928,000
Project/ Lecture 2,293,880
Slides 1,179,760 119,500 86
v. Project Evaluation using various Techniques

Steps involved in determining whether a project is worthwhile or not are:
Estimate the cost and benefits (revenues) of the project
Calculate the cost of capital (Required Rate of Return)
Compute the criterion of merit and judge whether the project is

good or bad.

Project’s evaluation techniques are classified into two categories.
1. Non-discounting (traditional) criteria
i. Payback Period (PBP)
ii. Accounting Rate of Return (ARR)
2. Discounted Cash Flows (DCF) criteria
i. Net Present Value (NPV)
ii. Internal Rate of Return (IRR)
iii. Profitability Index (Benefit-cost ratio)

i. Payback Period (PBP): the length of time it takes to recover initial
investment of the project.
a. When cash flow is in annuity form (equal amount of cash flows)
PBP = Initial Investment

Annual
E.g. Assume that aNet Cashrequires
project Flowsan initial investment of Br. 24,000 and
annual after tax cash flows of Br. 6000 for 5 years. How long it takes the
company to recover its initial investment?
PBP = = 4 years
24,000
6000
b. When cash flows are not in annuity form
 obtained by adding net cash flows until the total is equal to initial
investment.
Assume that a project requires an initial investment of Br. 60,000. The after
tax cash flows (or net cash flows) are as follows:
Year 1 = 8,000 Year 4 = 20,000
Year 2 = 15,000 Year 5 = 20,000
Year 3 = 22,000

The payback period is computed as follows:
15,000
PBP = 3 years + =,000
20 3.75 years
= 3 years + (0.75)( 12)
= 3 years and 9 months

Decision Rule for Payback Period
Accept: if the payback period is less than or equal to the required
payback period (standard).
Reject: if the payback period exceeds the required payback period.

ii. Accounting Rate of Return (ARR)
 relates net income to investment
Average Annual Net Income
ARR =
Average Investment
Original cos ts  Salvage value

Average Investment =
2
Assume that a project has original investment of Br. 70,000, life of 4 years, and
salvage value of Br. 6000. Straight-line method of depreciation is used. Income
before depreciation and taxes for each of the four years are as follows: year1, Br.
40,000; year 2, Br. 42,000; year 3, Br. 36,000; and year 4, Br. 50,000. Income tax
rate is 40%.
Depreciation = 70,000 – 6000 = 16,000
4
 It is necessary to compute net income for each of the four years is:
Year 1 Year 2 Year 3 Year 4
Income before depreciation & tax 40,000 42,000 36,000 50,000
Less: Depreciation 16,000 16,000 16,000 16,000
Income before taxes 24,000 26,000 20,000 34,000
Less: Taxes (40%) 9,600 10,400 8000 13,600
Net income 14,400 15,600 12,000 20,400
Average Net income =

70,000  6000
 38,000
Average Investment = 2
14,400  15,600  12,000  20,400
 15,60015,600
ARR = = 4 4
38,000
Decision Rule for Accounting Rate of Return
Accept: if ARR exceeds the required rate of return.
Reject: if ARR is less than the required rate of return.
2. Discounted Cash Flows (DCF) criteria
i. Net Present Value Method

the difference between the PV of net cash inflows and present value of
initial investment.
n
Ct
NPV =   I0
t 1 1  i t

Where፡
NPV = Net present value
Ct = Net cash flows at the end of year t
n = Life of the project
r = Discount rate
I0 = Initial investment
Net present value can also be determined as follows:
NPV = PV of NCF – I0
Where: PV = Present value
NCF = Net cash flows

Assume that a project is expected to have initial investment and life of Br.
40,000 and five years respectively. The annual after tax net cash flow is
estimated at Br. 12,000 for each of the five years. The required rate of return
is 10%. Net present value is determined as follows:
 1 
1 
 1  0.105   40,000
= 12,000  0.10 
 
 
= 12,000 (3.791) – 40,000
= 45,492 – 40,000
= +5,492

Suppose the project has initial investment and useful life of Br. 30,000 and
four years respectively. Its annual cash flows are as follows: Year 1, Br. 10000;
Year 2, Br. 8000; year 3, Br. 15000; and year 4, Br. 12,000. If the required rate
of return is 10%, NPV is determined as follows:
Year Net cash flows Discount factor (10%) Present value
1 10,000 0.909 9090
2 8000 0.826 6608
3 15,000 0.751 11,265
4 12,000 0.683 8196
Present value of NCF 35,159
Less: Initial investment 30,000
NPV + 5,159
Decision Rule for NPV

If NPV is greater than zero (NPV > 0), the project is considered desirable.
If NPV is less than 0, the project is considered undesirable.
ii. Internal Rate of Return (IRR)

the discount rate which equates the project NPV equal to zero.
the discount rate at which the present value of Net cash flows is equal to
the present value of initial investment.

n
Ct
IRR = i 1 (1  r )
=t Initial investment
IRR is determined using trial and error.
a. Determination IRR when NCFs are annuity
Assume that the project has initial investment of Br. 40,000, and useful life
of five years. The annual net cash flows is estimated at Br. 12000 for five
years. The required rate of return is 10%.
Step1: Compute the leading discount factor (payback period).
PBP = Initial Investment = 3.333

40,000
 Hope/ Project/ Lecture Slides
05/26/22 Annual net cash flows 12,000 99
From the PV of annuity table on n = 5 years row (horizontally), the leading
discount factor (3.333) is found between 15% and 16%.
Interest rate 15% 16%
Discount factor 3.352 3.274

Compute the actual IRR using the following formula:
IRR = r –
Initial Investment 40,000

r = either of the two interest
Annual net cashrates (15% or12
flows 16%)
,000
Let's take r = 15%, IRR is determined as follows:

3.333  3.352 
IRR = 15% -  
 3.352  3.274 
= 15% - (-0.24)
= 15.24%
If we take r = 16%, the computation of IRR looks like the following:
IRR = 16% -
 3.333  3.274 
 
 3.352  3.274 
= 15.24%
b. Determination of IRR when net cash flows are non-annuity

 same with preceding except one step is added at the beginning to
determine the weighted average net cash flow, which will be used to
determine the leading discount factor.

E.g. Assume that a project has initial investment of Br. 40,000 and the
following net cash flows: year 1, Br. 15,000; year 2, Br. 10,000; year 3, Br.
10,000; year 4, Br. 15000; and year 5, Br. 15,000. The discount rate is 15%.
Solution:
Step 1፡ Compute the weighted average net cash flows
Year Net cash flow Weight NCF x Weight
1 15,000 5 75,000
2 10,000 4 40,000
3 10,000 3 30,000
4 15,000 2 30,000
5 15,000 1 15,000
Total 15 190,000
Note that the weight is assigned in the reverse order of the project's useful
life.
190,000
Weighted average NCF = = 12,667
15
Step 2: Compute the leading discount factor (PBP)

PBP = Initial Investment
Weighted Average NCF
40,000
=
12,667
= 3.158

Step 3: From the present value of annuity table, find the starting rate (a good
first guess) by looking for the closest interest rate and discount factor. In this
case, the nearest rate is 18% (i.e., first guess = 18%)
Step 4: Compute NPV at the 1st guess (18%) NPV (18%)
Year NCF Discount factor (18%) Present value
1 15,000 0.847 12,705
2 10,000 0.718 7180
3 10,000 0.609 6090
4 15,000 0.516 7740
5 15,000 0.437 6555
Present value of net cash flows 40,270
Less: Initial Investment 40,000
NPV05/26/22 Hope/ Project/ Lecture Slides + 270 104
Since, at IRR, NPV is equal to zero, 18% is not the exact IRR. Thus, another
rate should be tried. Which rate should be tried next? Generally as we go
down (in rate decreasing direction), discount factor increases. Now we need
to find a rate at which NPV = 0. Thus, we should try a higher rate. The next
(2nd) guess could be 19%. Then NPV should be computed at 19% using the
above procedure.
NPV at 19%:

Financial analysis Cont’d ….
Year NCF Discount factor (19%) Present value
1 15,000 0.840 12,600
2 10,000 0.706 7060
3 10,000 0.593 5930
4 15,000 0.499 7485
5 15,000 0.419 6285
Present value of net cash flows 39,360
Less: Initial investment 40,000
NPV -640
At 19% NPV is negative; this implies that IRR lies between 18% and 19%. Thus,
such iteration process ends when two neighboring rates, at lower rate NPV
is positive and at higher rate is negative.
To find the exact IRR, steps 4 and 5 will be followed:
Step 4: Obtain the absolute sum of the two present values
Sum = |+270| + |-640|
= 270 + 640
= 910
Step 5: Divided the NPV of the smaller rate by the absolute sum and add to
the smaller rate
270
IRR = 18% + 910
= 18.30%
Decision Rule for IRR
Accept: If the IRR is greater than the discount rate
Reject: If the IRR is less than the discount rate

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Chapter Four Project Evaluation and Analysis: 05/26/22 1 ASTU/ Project/ Lecture Slides

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CHAPTER FOUR

PROJECT EVALUATION AND ANALYSIS

05/26/22 ASTU/ Project/ Lecture Slides 1

05/26/22 Hope/ Project/ Lecture Slides 2

increases the project’s probability of success

concerned with two questions:

05/26/22 Hope/ Project/ Lecture Slides 3

i. Situational analysis and specification of objectives

ii. Collection of necessary information (both primary and secondary)

iii. Characterization of the market

iv. Demand forecasting

05/26/22 Hope/ Project/ Lecture Slides 4

Objectives of Market Analysis

Who are the buyers of the product?

 What is the total current demand for product?

05/26/22 Hope/ Project/ Lecture Slides 5

 What is the current price of the product and willingness of consumers

05/26/22 Hope/ Project/ Lecture Slides 6

05/26/22 Hope/ Project/ Lecture Slides 8

Purchasing plans and intentions

Satisfaction with existing products

Attitude towards various products

Existing trade practice

Socio-economic characteristics of buyers.

05/26/22 Hope/ Project/ Lecture Slides 9

1. Define the target population

2. Select the sampling scheme and sample size

3. Develop the questionnaire

4. Recruit and Train the Field Investigators

5. Obtain information from the sample respondent

6. Synthesize the information gathered

7. Analyze and Interpret the Information

05/26/22 Hope/ Project/ Lecture Slides 10

05/26/22 Hope/ Project/ Lecture Slides 11

CSL = Changes in stock level(ending stock)

2. Breakdown of demand: breaking down aggregate demand for the product

Demographic segmentation (age, sex, family size, marital status, religion).

Socio-economic segmentation (income, consumption levels, culture).

05/26/22 Hope/ Project/ Lecture Slides 13

3. Price: the value of product attributes expressed in monetary terms

External factors that affect pricing decisions

05/26/22 Hope/ Project/ Lecture Slides 15

 Cost of products and objective of the firm

Product differentiation (color, size, attractive package, attractive uses)

05/26/22 Hope/ Project/ Lecture Slides 16

4. Distribution: concerned with how products or services are made available

Components of distribution system

a. Channels of distribution: - refer to intermediaries (wholesalers, retailers,

b. Physical distribution: - is concerned with the flow of goods to consumers.

a. Personal selling – involves face-to-face contact between seller’s

b Advertising፡ - is paid form of non-personal mass media communication

e. Public relations፡ -is a planned effort by an organization to influence the

05/26/22 Hope/ Project/ Lecture Slides 19

Supply: are sources of raw materials

05/26/22 Hope/ Project/ Lecture Slides 20

 inputs from sales and marketing, finance, and production should be

Steps of demand forecasting

1. Determine the use of the forecast

2. Select the items to be forecasted

3. Determine the time horizon of the forecast

4. Select the forecasting model(s)

6. Make the forecast

7. Validate and implement results