3.

FINANCIAL ANALYSIS AND PLANNING

Financial Analysis

Objective/s: to identify the project’s

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• Financial efficiency
• Incentive or impact to the participants (investors, creditors,
sponsors, etc.)
• Creditworthiness and
• Liquidity
 FINANCIAL ANALYSIS …

Information requirement
• Cost of project
• Means of financing

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• Estimates of sales and production
• Working capital requirement and its financing
• Projected cash flow statements (based on
projected balance sheets & income statements)
• Break even points
• Projected profits
• Projected risks
 
 FINANCIAL ANALYSIS (PDC) …

• Emphasis will be given on issues related to:

• The ‘With’ and ‘without’ Project situations.
• Types of financial cost and benefits.

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• Methods of Estimating Financial worth.
• Financial viability.
• Liquidity Ratios.
• Capital Structure Analysis.
• Financial plan.
• Stakeholders’ incentives.
• Cost Effectiveness Analysis
• Financing of maintenance & recurrent costs.
 3. FINANCIAL ANALYSIS AND PLANNING
I. Analysis and planning of Cost of Project
A. Estimate Investment Costs
– Investment cost represents the total of all items of outlay associated with
a project, which are supported by long term funds.

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– It is the sum of the following outlays:
Land and Site Development
Building and Civil Works
Plant and Machinery
Miscellaneous Fixed Assets
Preliminary and Capital Issue Expense
Pre - Operative Expense
Provision of Contingencies
 3. FINANCIAL ANALYSIS AND PLANNING
B. Production Costs
i. Direct material costs
cover those materials directly involved in the production/operational
process of the project and includes costs of acquiring raw materials and
processed materials.

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ii. Direct labor costs
are costs incurred to mobilize labor to direct operational activities and
are determined as periodic salaries/wages.

iii. Indirect material and labor costs

address those materials and labor adopted in supportive functions.

Such costs are committed to acquire accessories, establish power and

IT systems, storage and warehousing, mobilize materials handling
personnel, etc.
 3. FINANCIAL ANALYSIS AND PLANNING
C. Overhead Costs
Administrative overhead costs
Marketing and sales overhead costs
Factory overhead costs

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Service overhead costs
 3. FINANCIAL ANALYSIS AND PLANNING
II. Analysis & Planning of Means of Financing a Project
A. Sources/means of financing project
i. Share capital
Equity capital
Preferred capital

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ii. Term loan
provided by financial institutions and commercial bank’s credit facilities.
iii. Debenture capital
similar to that of the promissory note, which is a promise to pay some day
in the future, debentures are instruments for raising debts capital.
Such as issuing bond, which is long term financing.
iv. Deferred credit
often suppliers of plant and machinery offer a deferred credit facility under
which payment for the purchase of plant and machinery can be made over a
long period.
v. Incentive source
vi. Miscellaneous sources
 3. FINANCIAL ANALYSIS AND PLANNING
B. Selecting the Project Financing Means

• Guidelines that should be born in mind are:

i. Norms of regulatory bodies and Financial Institutions
• In many countries including Ethiopia, the proposed means of

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financing for a project must be either approved by a regulatory body
or conform to a certain norms laid down by the government or
financial institutions in this regard.

ii. Key business considerations

– cost
– risk
– control, and
– flexibility.
 3. FINANCIAL ANALYSIS AND PLANNING
III. Develop Projection of Financial Statements
– The potential financial performance/feasibility of a project is ultimately
examined using the financial evaluation techniques.

– To examine the project’s financial feasibility, we need to develop and

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analyze forecasted financial statements including:

• Cash flow statement

• Balance sheet

• Income statement

 
 3. FINANCIAL ANALYSIS AND PLANNING
 Prepare Projected Cash Flow Statements (CFS)
• shows the movement of cash in the firm and its net impact on the
cash balance with in the firm/project

• Analyzes and presents the future cash movement of the project in

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relation to:
» Investment
» Operations
» Financing

• The following format provides us with a structure to prepare a

comprehensive cash flow statement.
 3. FINANCIAL ANALYSIS AND PLANNING
Illustration: cash flow statement
i. Sources of funds (A) Disposition of funds (B)
– share issue 1. capital expenditures
– profit before taxation and interest 2. increase in working capital
– depreciation 3. decrease in loans

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– reserves 4. repayment of debts
– New /increased loans 5. decrease in accounts payable
– increase in deposits 6. increase in investments
– increase in accounts payables 7. interest
– sale of fixed assets 8. taxation
– sale of investments 9. dividends
– sale of equity /shares 10. buy back of equity
Total of A Total of B

ii. Computing the ending balance of cash for a period

Opening balance of cash on hand for the period
+ Net surplus /deficit (A-B)
= Closing (ending) balance of cash for the period
 3. FINANCIAL ANALYSIS AND PLANNING
Illustration: preparing projected cash flow statements
– The sources information for the cash flow statement are:
– balance sheet for the end of period n
– expected changes for the period n +1
– changes on the income statement for period n+1

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Project A
Balance sheet
Dec. 31, year n
Assets Liabilities + capital
Fixed assets 720 Secured loans 320
Investments - Unsecured loans 200
Current assets Acc. payable 360
Cash 80 Provisions 80
Receivables 320 Share capital 400
Inventories 320 Reserve and surpluses 80
Total br 1,440 Total br 1,440
 3. FINANCIAL ANALYSIS AND PLANNING
Project A
Income statement
For the year n
Sales 1600
- Cost of good sold 1200

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- Depreciation 80
Profit before interest and tax 320
- Interest 80
Profit before tax 240
- Tax 120
Profit after tax (Net Income) 120
- Dividends 40
retained earning /surplus 80
 
 
 
 3. FINANCIAL ANALYSIS AND PLANNING
• Expected commitments and changes for n+1
• Raising a secured term loan of birr 80
• Repaying a term loan of birr 20
• Increasing un secured loan of birr 40
• Acquisition of fixed assets worth birr 120

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• Increase in inventories birr 40 and
• Increase accounts receivables birr 60
 3. FINANCIAL ANALYSIS AND PLANNING
Project A
Projected cash flow statement
For period n+1
Sources of funds (A)
– Profit before interest and tax 320
– Depreciation 80

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– Increase in secured loans 60
– Increase in unsecured loans 40
Total of (A) birr 500
Disposition of funds (B)
– Capital expenditure 120
– Increase in working capital 100
– Interest 80
– Taxation 120
– Dividends 40
Total of (B) birr 460

Opening balance of cash on hand birr 80

+ Net surplus/ deficit in period n+1 (A-B) 40
Closing balance of cash on hand for n+1 birr 120
 3. FINANCIAL ANALYSIS AND PLANNING
Project A
Projected balance sheet
Dec. 31 period n+1

Assets opening balance Changes during n+1 closing balance

Fixed assets 720 +(120) - 80(depreciation) birr 760
Investments - - -

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Current assets
Cash 80 +40 (net surplus) 120
Inventories 320 +40 (Expected increase) 360
Receivable 320 +60 (Expected increase) 380
Total birr 1,620

Liabilities Opening Changes during closing

And capital balance the period (n+1) balance
Secured loans br 320 +80 (term Loan)-20 (Repayment) birr 380
Unsecured loans 200 +40 (proposed increase) 240
Accounts payable 360 - 360
Provisions 80 - 80
Share capital 400 - 400
Reserves and surplus 80 + 80 (retained earnings) 160
Total birr 1,620
 
 
 4. FINANCIAL evaluation

 Evaluation focus
• Profit
• Risk

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 Techniques
A. Non-discounted evaluation methods
• do not consider the time value of money.
• Include techniques such as:
» Payback period
»ROI
 1. Payback Period
• considers the time taken to gain a financial return equal to the initial
investment.

• The period is usually expressed in years and months.

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• Payback period = Initial Investment
Accumulated annual cash flows

• The initial investment outlay includes all capital investments made

before the plant starts operation as well as during the plant operation
 1. Payback Period
Illustration 1: uniform annual cash flows
– A project whose initial investment outlay is Birr 800,000 is expected
to remain active for the next 12 years earning a uniform annual net
cash flow of Birr 150, 000.

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Solution
– Since the project has a uniform cash flow over its lifetime, dividing
the initial investment by annual cash flow will give you the payback
period.

Payback period = 800,000 = 5.33 years

150,000

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 1. Payback Period
Illustration 2: different annual cash flows
– a company wishes to buy a new machine for a 5-year project. The
manager has to choose between machine A and machine B, so it is
mutually exclusive solution.

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– Although both machines have the same initial cost (Birr 700,000), their
cash flows perform differently over the 5-year period.
 1. Payback Period
Cash-Flow (Birr)
Initial investment cost 700,000, - for each
Year machine

Machine A Machine B

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0 (700,000) (700,000)

1 200,000 100,000

2 380,000 300,000

3 240,000 150,000

4 100,000 300,000

5 150,000 400,000

Payback period 2 and half years 3 and half years

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 2. Return on Investment (ROI)
• Is a measure of profitability that relates income to investment.
• This method first calculates the average profit, which is simply the project
initial outlay deducted from the total gains or cash flows, divided by the
number of years the investment will run.
• The profit is then converted into percentages of the total outlay using the

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following equations:

Average Annual Profit = (Total NCF) – (Total investment outlay)

Number of years
Return on Investment = Average Annual Profit x 100%
Original investment
Illustration :
• Consider the machine selection example introduced earlier. Using this
example compute the Return on Investment.

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 2. Return on Investment (ROI)
Solution

Machine A
Total Profits = $1,070,000 – 700,000 = 370,000
Average Profit = $370,000/5 years = $74,000 per year

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Return on Investment = (74,000 x 100)/ 700,000 = 10.58%

Machine B
Total Profits = $1,250,000 – 700,000 = 550,000
Average Profit = $550,000/5 years = $110,000 per year

Return on Investment = (110,000 x 100)/ 700,000 = 15.71%

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 2. Return on Investment (ROI)
Selection criteria for ROI

– All independent projects having a ROI equal to or greater than a pre-specified

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ROI are accepted.

– For mutually exclusive projects, we will accept a project with higher ROI.

Selection decisions

– Machine A realizes its payback period earlier than machine B, meaning it has

a better chance getting selected than B.

– Machine B has larger rate of ROI than machine A, meaning it has a better

chance getting selected than A.

 Discounting Techniques
• Concept of discounting
– Money has time value

– One birr received today is more than one birr received in 2 years. Why?

1
1. Psychological explanation
2. If invested, can generate positive return
3. During inflation the future purchasing power decreases
 Discounting Techniques
1. Net Present Value (NPV)
– can be defined as the present worth of cash flow streams generated by an
investment.
– is calculated by adding the values obtained by discounting the annual
cash flows occurring throughout the life of a project as follows:

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NPV= ∑ NCF
(1 + r)n
Where: NCF = is net cash flow
n = is the period for which the PV is calculated
r = is the interest rate
Illustration
– Consider a 5 year agricultural investment project. Assume the discount
rate to be 18%.

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 Discounting Techniques
The steps to calculate NPV are:
– Setting up the NPV format/table
– Writing the corresponding years in the project life in column 1

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– Writing the net cash flows in column 2
– Writing the corresponding discount factors of each year at the specified
discount rate in column 3
– Writing the present value of the net cash flow of each year in column 4
by multiplying net cash flow by the corresponding discount factor.
– Aggregating the present values to give the NPV
 Discounting Techniques
Column 1 Column 2 Column 3 Column 4= (2) x (3)

Years Net Cash Discount Factor of Present Value

Flow br. 1 at 18%

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0 (700,000) 1.0000 (700,000)

1 200,000 0.8475 169,500

2 380,000 0.7182 272,916

3 240,000 0.6086 146,064

4 100,000 0.5158 51,580

5 150,000 0.4371 65,565

T.NPV Birr 5,625

 Discounting Techniques
• Selection criterion for NPV:

– We accept all independent projects with NPV greater than zero.

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– For mutually exclusive projects, project with higher NPV will be

accepted.
 2. Internal Rate of Return (IRR)
• The IRR is the return to the capital invested or allocated or investment in the
project.
• The IRR is the discount rate that makes the present value of cash inflows is

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equal to the present value of cash outflows, i.e., NPV is zero.
• Allows the firm to assess whether an investment in the projects would yield
a better return based on internal standards of return
• Allows comparison of projects with different initial outlays
 Steps in approximating the IRR
 Choose two different discount rates, one leading to a positive NPV, the other
to a negative NPV.

 Interpolation between these two NPV’s using the formula.

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 2. Internal Rate of Return (IRR)

IRR = rL + (rH - rL) x NPV (rL)

/NPV (rL)/ + /NPV (rH)/

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Where:

rL = is a lower interest rate

rH = is a higher interest rate
NPV (rL) = is NPV calculated at lower interest rate
NPV (rH) = is NPV calculated at higher interest rate
/ / = is a symbol representing absolute value
 2. Internal Rate of Return (IRR)
2. The next step is to calculate the NPV at the required rate of return. At 20% of required

rate of return the NPV of this project is computed as follows .

Column 1 Column 2 Column 3 Column 4= (2) x (3)

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Years Net Cash Flow Discount Factor of Present Value

br. 1 at 20%
0 (700,000) 1.0000 (700,000)

1 200,000 0.8333 166,660

2 380,000 0.6994 265,772

3 240,000 0.5787 138,888

4 100,000 0.4623 46,230

5 150,000 0.4019 60285

Total NPV Birr (22,165)

 2. Internal Rate of Return (IRR)

3. Now, using the IRR formula and these already generated figures, let us compute the
precise rate of return where NPV is equal to zero.

IRR = rl + (rh – rl) x NPV (rl)

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/NPV (rl)/ + /NPV (rh)/

– In our illustration: rl=18% (0.18) rh = 20% (0.20)

NPV (rl) =5,625 NPV (rh) = (22,165)

– Hence, given the formula and the required inputs,

IRR= 0.18 + (0.20 – 0.18) x 5,625
/5,625/ + /-22,165/
= 0.18 + 112.50
27,790
= 0.18 + 0.00404
= 0.18404
= 18.40%
2. Internal Rate of Return (IRR)

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Example 2
 2. INTERNAL RATE OF RETURN (IRR)
NPV of Machine A
Column 1 Column 2 Column 3 = (2) x (3)

Years Cash Flow Discounting Factor Present Value

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@20%

0 (35,000) 1 (35,000)

1 20,000 0.8333 16,666

2 15,000 0.6944 10,416

3 10,000 0.5787 5,787

4 10,000 0.4823 4,823

Total NPV 2,692

 2. Internal Rate of Return (IRR)
Table : Machine A : Discount Fact or 22 %

Column 1 Column 2 Column 3 =(2) x (3)

Years Cash F low Discount F act or 22% P resent Value

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0 (35,000) 1 (35,000)
1 20,000 0.8197 16,394
2 15,000 0.6719 10,079
3 10,000 0.5507 5,507
4 10,000 0.4514 4,514
Tot al 1,494
NP V
 2. Internal Rate of Return (IRR)

Column 1 Column 2 Column 3 = (2) x (3)

Years Cash Flow Discount Factor Present Value

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24%
0 (35,000) 1 (35,000)

1 20,000 0.8065 16,130

2 15,000 0.6504 9,756

3 10,000 0.5245 5,245

4 10,000 0.423 4,230

NPV @ 24% 361
 2. Internal Rate of Return (IRR)

Column 1 Column 2 Column 3 = (2) x (3)

Years Cash Flow Discount Factor Present Value

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25%
0 (35,000) 1 (35,000)

1 20,000 0.80 16,000

2 15,000 0.64 9,600

3 10,000 0.512 5,120

4 10,000 0.4096 4,096

Total NPV (184)

 2. Internal Rate of Return (IRR)

The exact IRR can be computed using the following formula.

IRR =rl + (rh - rl) x NPV (rl)

/NPV (rl)/ + /NPV (rh)/

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= 0.24 + (0.25 – 0.24) x 361
/361/ + /-184/

= 0.24 + 3.61 = 0.2466 = 24.7%

545

Thus, the IRR is 24.7 %.

 2. INTERNAL RATE OF RETURN (IRR)
Simplified Approach .
• When the cash flow is in the form of annuity
• When the cash flow is not in annuity form

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 The Dominance Technique – if the cash flows at least approximate an
annuity
 Weighted Approach – if the cash flows display no general annuity
pattern
 2. INTERNAL RATE OF RETURN (IRR)
1. If the cash flow is annuity .
• Consider the above example , if the cash in flows are similar for the life of
the project i.e 15,000

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• first calculate the quotient to approximate and locate the interest rate from
the annuity table 35000 = 2.333333
15000
• From the table we get 26%
• Then calculate the NPV at 26%=15,000x2.320= 34800-35000=(200)
• Then calculate the NPV at 25%=15000x2.362= 35430-35000=430
Then the IRR = 25.68
 2. INTERNAL RATE OF RETURN (IRR)
2. If the cash flow is not in annuity form.
a. dominance technique
• Consider the above example , if the cash in flows as follows

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Year Cash inflow
1 15,000
2 15,000
3 10,000

4 10,000
first calculate the quotient to approximate and locate the interest rate from the
annuity table 35000 = 2.333333 and 35,000 =3.5
15000 10,00
• From the table we get 26% and 5%
• Then calculate the average percentage .25+.05 =15.5% . The calculate NPV using 15.5%
2
 2. Internal Rate of Return (IRR)
Column 1 Column 2 Column 3 = (2) x (3)

Years Cash Flow Discount Factor Present Value

15.5%

0 (35,000) 1 (35,000)

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1 15,000 0.8658 12987
2 15,000 0.7496 11244
3 10,000 0.6490 6490
4 10,000 0.5619 5619
Total NPV 1340

 Since the NPV is some how big find another rate that will give you

NPV = 0 . So use some larger value of 15.5 %. Now let’s try with 18%
 2. Internal Rate of Return (IRR)
Column 1 Column 2 Column 3 = (2) x (3)

Years Cash Flow Discount Factor 18% Present Value

0 (35,000) 1 (35,000)

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1 15,000 0.8475 12713
2 15,000 0.7182 10773
3 10,000 0.6086 6086
4 10,000 0.5158 5158
Total NPV (270)

 Since the NPV is negative , the rate that will give NPV = 0 is lower than 18

% so let’s use 17 %
 2. Internal Rate of Return (IRR)
Column 1 Column 2 Column 3 = (2) x (3)

Years Cash Flow Discount Factor 17% Present Value

0 (35,000) 1 (35,000)

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1 15,000 0.8547 12821
2 15,000 0.7305 10957
3 10,000 0.6244 6244
4 10,000 0.5337 5337
Total NPV 359

 Therefore the , the IRR will be between 17% and 18% . Using the formula

we can find the IRR= 17.58

 2. INTERNAL RATE OF RETURN (IRR)
2. If the cash flow is not in annuity form.
a. weighted approach
• Consider the above example , with different kinds of cash inflows, i.e
Year Cash inflow

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1 20,000
2 15,000
3 10,000
4 10,000
o First calculate the weighted cash flow using the following approach

Year Cash inflow Weight Weighted cash flow

1 20,000 4 80,000
2 15,000 3 45,000
3 10,000 2 20,000
4 10,000 1 10,000
Total 10 155,000
 2. Internal Rate of Return (IRR)
 The weighted cash flow is =15500 =15,500
10
 Then calculate the quetient to approximate the rate to from the annuity table . So 35,000 = 2.258
15,500
 So from the anity table we get 28%, so using this rate calculate the NPV

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Column 1 Column 2 Column 3 = (2) x (3)

Years Cash Flow Discount Factor 28% Present Value

0 (35,000) 1 (35,000)
1 15,000 0.7813 15626
2 15,000 0.6104 9156
3 10,000 0.4768 4768
4 10,000 0.3725 3725
Total NPV (359)
 2. Internal Rate of Return (IRR)
Since the NPV is very low , lets use another rate that will give you NPV = 0. now
let’s use 25%

Column 1 Column 2 Column 3 = (2) x (3)

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Years Cash Flow Discount Factor 25% Present Value

0 (35,000) 1 (35,000)

1 20,000 0.8 16000

2 15,000 0.64 9600

3 10,000 0.512 5120

4 10,000 0.4096 4096

Total NPV (184)

 2. Internal Rate of Return (IRR)
Since the NPV is nearer to zero to the negative side , lets use another rate that
will give us a positive NPV . Now let’s use 24%

Column 1 Column 2 Column 3 = (2) x (3)

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Years Cash Flow Discount Factor 24% Present Value
0 (35,000) 1 (35,000)
1 15,000 0.8065 16130
2 15,000 0.6504 9756
3 10,000 0.5245 5245
4 10,000 0.4230 4230
Total NPV 361

 Therefore the , the IRR will be between 24% and 25% . Using the formula
we can find the IRR= 24.67
 2. INTERNAL RATE OF RETURN (IRR)
• Selection criterion for IRR
– We accept all independent projects having an IRR equal or grater than
the opportunity cost of capital.

51
– For mutual exclusive projects, a project with higher IRR is accepted.