2.

8 FINANCIAL ANALYSIS
FINANCIAL ESTIMATES & PROJECTIONS (only
as a basis for additional readings )
• To judge a project from the financial angle, we
need information about the following
– Cost of project
– Means of financing
– Estimates of sales & production
– Cost of production
– Working capital requirement & its financing
– Estimates of working results profitability projections
– Break even point
– Projects cash flow statements
– Projected balance sheets
 2.8 FINANCIAL FEASIBILITY
• From the point of view of:-
The direct project beneficiaries
Project as a whole
Any financial intermediary
The government
• Values directly quantifiable Project inputs at market
prices
• Government policy measure effects can either be
cost or benefits
• Debt services are costs; &
• Presents an entity's point of view
 PURPOSE OF FINANCIAL ANALYSIS

• Provide an adequate financing plan for the proposed investment

• To determine the profitability of project from the point of view
of the financial agency (bankers), the owners or the projects
beneficiaries;
• To assist in planning the operation & control of the project by
providing management information to both internal & external
users;
• To illustrate the financial structure of a project entity, & its
existing & potential financial viability including the financial
efficiency & effectiveness of this operations;
• To advise on methods of improving the financial viability of a
project entity including the appropriateness of tariffs, prices &
cost recovery generally
 METHODS OF FINANCIAL ANALYSIS

• Resources flow statements

• Cash flow statements
• Discounted cash flow
• Cost benefit analysis
Net present value
Internal rate of return
Benefit cost ratio
• Cost effectiveness analysis
• Sensitivity analysis
 BASIC
TECHNIQUES :DISCOUNTING
 DISCOUNTING
One birr received now is more than one birr received a year
later- because
• Pure time preference
• Opportunity cost of capital
• Inflationary period
• Risk & uncertainty
The concept of compounding
F=P(1+r)n
F = Future Value
P = Principal
R = Rate
N = The year
 DISCOUNTING

Discounting – Reverse of compounding

P= F
(1+r)n The discount factor

Time preference & project appraisal

• To compare the true value of resources-absorbed & released
• Use a common denominator i.e. some way of treating on the same
basis costs & benefits that arise at different points in time
 TIME VALUE OF MONEY
• For example, assume that an intervention requires Birr 1,000 & the subsequent
inflows of Birr 250 in each of the next 4 years.

Table: Timeline of cash flows

Year 0 1 2 3 4
Cash flows -1000 250 250 250 250

• Compounding & discounting:

• Cash flows occur at different points of time
• So, for meaningful comparison, all these cash flows should be assessed at the same
point of time.
• Either
• the cash flow occurring today has to be converted into its equivalent at a
future date or
• the cash flow occurring later has to be converted back to today’s value.
 COMPOUNDING

• With simple interest, the future value is determined by:

FVt  PV (1  r ) t
Where FVt = is future value at time n
PVt = is the original sum invested or the principal value &
I =stands for annual rate of simple interest

• Suppose you have won a lottery worth of Birr 1,000,000. If you

deposit it in Commercial Bank of Ethiopia with an interest rate of Birr
5% for 5 years, how much will the FV be in the 5th year?
• What about 1,000 Birr saved in Bank for 8 years with an interest of
10%?
 TIME VALUE OF MONEY

• Simple Interest Rate:

• If no interest payment is reinvested to earn further interest in future
periods, we apply the following formula:

• For example, if Birr 1,000 is invested at 12% simple interest for 5

years, what will be the value at the end of the 5th year?
• Answer:
1,000(1  5 * 0.12)  1,600
 TIME VALUE OF MONEY
• Basis of Time Value
– The cash inflow & outflow usually occurs over a period of time.
– This leads us to consider time value of money.
– The value of money depends on when the cash flow occurs.
– Thus, Birr 100 at present is worth more than Birr 100 at a future date.
• Reasons:
– Interest or rent: money, like any other commodity, has a price. If you own it,
you can rent it or deposit it in a bank & earn interest.
• The interest or rent reflects the e time value of money.
• It comprises:
– Risk-free rate of return rewarding investors for foregoing immediate
consumption
– Compensation for risk & loss of purchasing power

11
 TIME VALUE OF MONEY
• Uncertainty:
– Birr 100 now is more than Birr 100 at a future date
– This ‘bird-in-the-hand’ principle affects many aspects of financial management
– That is why individuals prefer current consumption to future consumption
• Inflation:
– Under inflationary conditions, the value of money, expressed in terms of its
purchasing power over goods & services, declines.
– Nominal or market interest rate = real interest or return + risk premiums +
expected rate of inflation.
• There are two methods of estimating time value of money:
• these are
– compounding &
– discounting.

12
 THE NATURE OF PROJECT SELECTION MODELS
• There are two types of project selection models.
 Non-numeric and models do not use numbers as inputs
 Numeric But numeric models do

• What models should do for us:

 Models do not make decisions;
people do-the manager,
not the model, bears responsibility for the decision.
 All models, however sophisticated, are only partial
representations of the reality they are meant to reflect
• The non-numeric models are older & simpler.
 TYPES OF PROJECT SELECTION MODELS NON-
NUMERIC MODELS

The subtypes of non-numeric models are the following:

a) The Sacred Cow: the project is suggested by a senior & powerful official.
The project is “sacred” in the sense that it will be maintained until
successfully concluded, or until the boss, personally, recognizes the idea
as a failure & terminates it.
b) The Operating Necessity: If a flood is threatening the plant, a project to
build a protective dike does not require much formal evaluation.
c) The Competitive Necessity: for example, companies may need to
modernize their work to remain competitive
d) The Product Line Extension: adding new products to the line making
sure that it strengths a weak link.
e) Comparative Benefit Model: selecting a project based on the benefits it
brings
TYPES OF PROJECT SELECTION MODELS- NUMERIC MODELS

Subtypes of Numeric Models

a) Ranking by Inspection
b) Return on investment (ROI)
c) Accounting Rate of Return (ARR)
d) Payback Period:
 A) RANKING BY INSPECTION (RI)
• Basic question:
– Given alternative investments which one should be implemented & which one
should be discarded in a mutually exclusive investments?
• There may be an alternative as to build a factory or a business mall on the same
site.
• The investor might choose to start one with limited resources he/she has.
• RI consists of choosing the best investment by comparing the net proceeds of
alternative investments.
• The project having more cash proceeds will be preferred though are some
peculiarities on inspections.
• Comparing the net proceeds of A & B projects, we can find out which project has
shorter life period
• Compare the net proceeds of the short lived project with long lived one
• If the two have the same initial investment & proceeds throughout the period of
the short lived investment; & if the long lived investment continues to earn
income after the end of the short lived one, then the long lived one is more
desirable as the second project continues to earn proceeds while the first one has
ended
 PROJECT SELECTION BASED ON RI

Project Investment Initial Cost Net Cash Proceeds in Years

1 2 Total
A 20,000 20,000 - 20,000
B 20,000 20,000 2,000 22,000
C 20,000 14,625 9,825 24,450
D 20,000 16,325 8,125 24,000
Then, which one is more desirable-taking into account the net proceeds?

Net Cash Flow of 4 Hypothetical Projects with Identical Initial Investment Outlays & Life Periods
Although the total net proceeds of C & D are identical, D earns more income earlier than C.
Thus D is more desirable than C
Project B is more desirable than A
Why????
RLDS 605
 B) RETURN ON INVESTMENT (ROI)

• Also called average income on cost

• Calculated by dividing the average income by the cost of investment
• Some planners prefer to take the ratio of the average income to the book value
(cost of investment after depreciation)
 C) ACCOUNTING RATE OF RETURN (ARR)
• The accounting rate of return
(ARR), expresses the profit
forecast as a percentage of the
capital expenditure involved
• ARR is also known as accrual
accounting rate of return,
unadjusted rate of return model
& the book value model
• ARR is a measure of profitability
in accounting terms.
• This method aims to quantify the
profits expected from investment
projects under consideration
• There are different methods of
calculating the ARR
• ARR=Average Income after tax
Initial Investment
• ARR=Average Income after tax
Average Investment
• ARR= AIAT, but before Interest
Initial Investment
• ARR= AIAT, but before Interest
Average Investment
• ARR= Average Inc. b/r Int. &tax
Initial Investment
• ARR= Average Inc. b/r Int. &tax
Average Investment
 ARR: Example

• A project requiring an average investment of ETB

1,000,000 & generating an average annual profit of ETB
150,000 would have an ARR of 15%.
 D) PAYBACK PERIOD

• the initial fixed investment in the project divided by the estimated annual cash
inflows from the project.
• The ratio of these quantities is the number of years required for the project to
repay its initial fixed investment.
– For example, assume a project costs $100,000 to implement & has annual net cash inflows of
$25,000. Then Payback period = $100,000/$25,000= 4 years.
• This method ignores any cash inflows beyond the payback period
• The payback period is the length of time from the beginning of the project until
the sum of net incremental benefits of the project equal to total capital
investment.
• It is the amount of time it takes to recover the original/investment cost.
• The method is very simple.
• Moreover, it is a good measure when the project has problem of liquidity.
• The pay-back period is also a common, rough means of choosing among projects in
business enterprise, especially when the choice entails high degree of risk.
• Payback rule: If the calculated payback period is less than or equal to some pre-specified payback period,
then accept the project. Otherwise reject it.
 TYPES OF PROJECT SELECTION MODELS
This method has two important weaknesses:
 fails to consider the time & amount of net benefits after the payback period.
 does not adequately take into account the time value of money even in the
payable periods.
 Payback Period
Peak
cumulative
Payback period cash flow
+ve
Total
profit

Birr
Time
h
as
- ve
fc
w o
flo te
Ra

Calculate annual net cash flow

Accumulate year on year
Cash trough
Plot on graph of CNCI against time
Cumulative net
cash inflow)(CNCI)
 PAYBACK PERIOD
• If the expected cash inflow is a constant sum:

Pay Back period= Cash outlay (investment)

Net Annual cash inflows
 If the expected cash inflow varies from period to period:

Pay Back period=Year before full recovery +

Unrecovered cost at the start of year
Cash flow during the year
But if the net cash inflow is the same across years, we use a
simple formula to get the payback period.
Example:
1. If Birr 2 million is invested to earn Birr 500,000 per annum
for 7 years, the pay back period is computed as follows:
Pay back period = Br 2million/500,000= 4yrs
 EXERCISE 1

• Assume that a firm is considering two projects:

– Project A & project B,
– each requiring an investment of Br100 million.
– Below is the summary of expected net cash flows in millions.
• Then
– find the payback period for the two projects &
– indicate which project should be chosen. Initial Investment= 100 million
 EXERCISE 2
Alternative Year Investment cost Net incremental Cumulative net
projects benefits incremental benefits

I 0 20000 -
1 2000 31000
2 8000
3 12000
4 9000

II 0 20000 -
1 2000 34000
2 12000
3 8000
4 12000

III 0 20000 -
1 1000 37000
2 5000
3 6000
4 8000
5 10000
6 5000
7 2000
 EXERCISE 3

• Calculate the payback period for this project given the net cash
flows indicated in the table below
• Show the cash flow graphically

Time 0 1 2 3 4 5
(yrs)
Revenue 100 100 200 200 200
Costs (300) 20 20 20 20 20
Net Cash -300 80 80 180 180 180
flows
 ANSWER TO EXERCISE 4

Time (yrs) 0 1 2 3 4 5

Revenue 100 100 200 200 200

Costs (300) 20 20 20 20 20

Net Cash flows -300 80 80 180 180 180

Cum cash flows -300 -220 -140 40 220 400

PBP = 2.78 years


MERITS OF PAYBACK PERIOD AS AN
INVESTMENT APPRAISAL TECHNIQUE
• Simplicity
• Rapidly changing technology,
if new plant is likely to be
scrapped in a shorter period
because of obsolescence, a
quick payback is essential,
• Payback favors projects with a
quick return
• Rapid project payback leads to
rapid company growth
• Rapid payback minimizes risk
CRITICS OF PAYBACK PERIOD AS AN
INVESTMENT APPRAISAL TECHNIQUE
• Project return may be ignored-
in particular, cash flows arising
after the payback period are
ignored.
• Timing is ignored
• Lack of objectivity- what length
of time should be set as the
minimum payback period
• Project profitability is ignored
 NUMERIC MODELS : DISCOUNTED MEASURES

• Net Present value (NPV)

• Internal rate of return (IRR)
• Benefit Cost ratio
NPV: as Investment Criteria
NPV: it determines the net present value of all cash flows by
discounting them by the required rate of return.

n
Ct
NPV  A0   t
i 1 (1  r )

Where,
Ct = the net cash flow in period t

r = the required rate of return, &

A0 = initial cash investment (because this is an outflow, it will be

negative).

32
 THE NET PRESENT VALUE

• Simplest measure
• Measures aggregate surplus generated by the
project
• PV of Benefit – PV of Costs

Decision criteria
NPV > 0 Accept
NPV < 0 Reject
NPV = 0 Marginal case
 NPV
Suppose that the project has the following data
• Initial Investment (I) = 300,000 Birr
• Annual costs of operation = 20,000 Birr
• Expected annual revenue =
100,000 Birr/year in the first 2 years &

200,000 Birr/year in the next 3 years

• Time horizon = 5 years

34
 Gross cash flows
Time 0 1 2 3 4 5
(yrs)
Revenue 100 100 200 200 200
Costs (300) 20 20 20 20 20
Net cash -300 80 80 180 180 180
flows

DF= 10%

N.B: - All revenues & costs are in thousands of Birr

35
Discounted cash flows for interest 10%
Year 0 1 2 3 4 5
Cash flows -300 80 80 180 180 180

DF (10%) 1 0.909 0.826 0.751 0.683 0.621

Discounted -300 72.72 66.08 135.18 122.94 111.78
Cash flow
(DCF)
Cum DCF -300 -227.28 -161.2 -26.02 96.92 208.79

NPV = 208.7
DPBP= 3.2 years

36
Find the NPV of an environmental project from the following
table & suggest whether the project should be accepted

Year Gross Benefits Costs

1 200,000 50,000
2 200,000 50,000
3 300,000 100,000
4 300,000 100,000
5 350,000 100,000
Initial Investment: Birr 1,000,000
Discount Rate: 10%

Find NPV & PBP

37
 Exercise
• Assume that the initial investment of a project is Birr
450,000. In the first & second years, the net benefits are
50,000 & 75,000 respectively. In the third, fourth & fifth
years, the net benefits stand at 100,000; 125,000 &
150,000. respectively. The discount rate is 10%.
 Based on this information, find the NPV & show whether
the project should be accepted or rejected.
• Will your decision change if the discount factor is
increased to 15%?

38
 NPV
To include the impact of inflation where we have is the predicted
rate of inflation p during period t
t

n
Ct
NPV  A0   t
i 1 (1  r  pt )

•Initial investment Birr 100,000.

•Net cash inflow Birr 25,000
• discount factor: 7%
•Inflation rate: 5%
•The life span of the project is 8 years
•Find the NPV & make a decision whether the project should be
accepted or not.

39
 NPV (exercise)
 Early in the life of a project, net cash flow is likely to be negative
 The major outflow at this stage is the initial investment in the
project
 The project is acceptable if the sum of the NPVs of all estimated
cash flows over the life of the project is positive.
 Example, the investment is 100,000 with a net cash inflow of
25,000 per year for a period of eight years. The discount rate is
15%, an inflation rate is 3% per year. Calculate NPV.
 Use the above formula.
 The answer is = 1939.
 The NPV of the inflows is greater than the NPV of the outflow-
i.e., the NPV is positive-the project is deemed acceptable.

40
 NPV
Calculation & Answer:
NPVA = -5,000 + 500 + 1,000 + 1,000 + 1,500 + 2,500 + 1,000 = $469
(1.084)1 (1.084)2 (1.084)3 (1.084)4 (1.084)5 (1.084)6
NPVB = -2,000 + 500 + 1,500 + 1,500 + 1,500 + 1,500 + 1,500 = $3,929
(1.084)1 (1.084)2 (1.084)3 (1.084)4 (1.084)5 (1.084)6
Given that both machines have NPV > 0, both projects are acceptable. However, for
mutually exclusive projects, the decision rule is to choose the project with the
greatest NPV. Since the NPVB > NPVA, the company should choose the project for
Machine B.

41
 2. IRR
• Internal rate of return (IRR)
• The internal rate of return is defined as the rate of discount, which brings
about equality between the present value of future net benefits & initial
investment. It is the value of r in the following equation.
n
Ct
I   1  r 
t 1
t

• I – investment cost
• Ct – Net benefit for year t
• r - IRR
• n - Life of the project
• Illustration: For project A in the above table can be formulated as follows:

IRR is PV(Benefits) = PV(Costs). Use algebra or a spreadsheet

42
 IRR
 Internal Rate of Return (IRR);- emerges from the cost-benefit data of the
project
 It is the discount rate that reduces the NPV of a project to zero

IRR = Discount Rate, which makes the NPV zero

NPV
NPV

IRR

Discount Rate

43
 IRR
• Calculation of IRR
• Year Cash flow
• 0 -100000
• 1 30000
• 2 30000
• 3 40000
• 4 45000
• The IRR is the value of r which satisfies the following equation:

 1000,000 30,000 30,000 40,000 45,000

0 0
 1
 2
 3

(1  r ) (1  r ) (1  r ) (1  r ) (1  r ) 4
30,000 30,000 40,000 45,000
100,000    
(1  r ) 1 (1  r ) 2 (1  r ) 3 (1  r ) 4
The calculation of r consists of a process of trial & error by assuming various values
of r say eg.14, 15, 16 & so on. The IRR % may fall anywhere between these % values.

44
 IRR

Year 0 1 2 3 4
Cash flow (100,000) 30,000 30,000 40,000 45,000

IRR is the value of r which satisfies the following equation:

30,000 30,000 40,000 45,000
100,000    
1  r 1 1  r 2 1  r 3 1  r 4
• The calculation of r involves a process of trial & error. We try different values of “r”
till we find that the right-hand side of the above equation is equal to 100,000. Let us
try to use 15%. This makes the right-hand side to be:

30,000 30,000 40,000 45,000

100,000      100,802
1.15 1.15 1.15
2 3
1 .154

Since the value is slightly higher than our target value, which is 100,000, we
increase the value to 16%.

30,000 30,000 40,000 45,000

100,000      98,641
1.16  1.16 1.16
2 3
1 .164

45
 IRR
• Since this value is now less than 100,000, we conclude that the value of r
lies between 15 & 16%. For most of the purposes, this indication suffices.
• If a more refined estimate of r is needed, we use the following procedure:
1. Determine the NPV of the two closest rates of return
(NPV/15%) = 802
(NPV/16%) = 1,359
2. Find the sum of the absolute values of the NPVs obtained in Step 1
802+1,359 = 2,161
3. Calculate the ratio of the NPV of the smaller discount rate, identified in
Step 1, to the sum obtained in Step 2
802/2,161 = 0.37
4. Add the number obtained in Step 3 to the smallest discount rate
15+0.37 = 15.37

46
 INTERNAL RATE OF RETURN

• Equates the PV of the costs and benefit streams

• NPV becomes zero
• Measure the efficiency of the use of capital

Decision criteria

• IRR > Test Discount Rate – Accept

• IRR < Test Discount Rate - Reject
• IRR = Test Discount Rate – Marginal
 IRR

NPV
IRR Project-A

IRR Project-B

Discount rate

48
 IRR

Two Value Method

Interpolation

NPV

Extrapolation Project IRR

Too low Too

high
Discount rate

49
 Self-check Exercise
Table 1. Cash flow for project A & B
Initial investment is Birr 20,000 each.
Discount factor: 10%
  Project A Project B

Year Net benefits Gross benefits Costs

1 7,500 7,000 2,000
2 7,000 5,500 2,000
3 5,500 7,500 2,500
4 6,250 8,500 2,500
5 6,500 9,500 2,000

50
 Exercise
Find the NPV & IRR of an environmental project from the following table

Year Gross Benefits Costs

1 200,000 50,000
2 200,000 50,000
3 300,000 100,000
4 300,000 100,000
5 350,000 100,000
Initial Investment: Birr 700,000

Consider different discount rates.

Hint: you may start from 10%
51
 Conditions of Financial Viability of a Project
• The acceptance criterion for an investment is:
 NPV positive,
 IRR greater than the discounted rate; &
 discounted benefits greater than discounted costs

52
 BENEFIT- COST (B/C) RATIO

• Ratio of the PV of benefits to the PV of costs

• Measure of efficiency
B/C Ratio = PVB
PVC
Decision criteria
B/C Ratio > 1 Then NPV +ve Accept
B/C Ratio < 1 Then NPV -ve Reject
B/C Ratio = 1 Then NPV 0 Marginal
3. Benefit-Cost Ratio (BCR) Computation

• BCR =

Or

Pr esent Value of Cash Inflows

BCR 
Pr esent Value of Cash Outflows

54
 BCR
t T
Benefit t 

t 1 1  r t
BCR  t T
Cost t 
t 1 1  r 
t

55
Find the BCR & decide whether to accept the project

Time Gross Cost

Benefit
0 100 150

1 100 100

2 100 50

DF: 10%
56
 Find the BCR

Time Benefit Cost Net Benefit

0 100 150 -50

1 100 100 0

2 100 50 50

What is your decision?

57
 BCR

PVB= 100/(1.1)0 + 100/(1.1)1 +100/(1.1)2 = 273.54

PVC = 150/(1.1)0 + 100/(1.1)1 +50/(1.1)2 = 282.22

BCR = 273.54/282.22 = 0.97 < 1

58
 Exercise
• The details of a project which costs Birr. 25,000 as initial investment
are given below:
• Year Cash flow
• 0 (25,000)
• 1 5,000
• 2 7,000
• 3 13,000
• 4 16,000
• Calculate:
• a)Net present Value(NPV) at 20%:
• b) Internal Rate of Return(IRR):
• c) Payback Period:
• Use graphs to display your answers

59
DF 10% 15% 17%

4545.4545 5000 4347.8261 1.74900625 4273.50427

5785.124 7000 5293.0057 5113.59486

9767.0924 13000 8547.711 8116.81723

10928.215 16000 9148.0519 8538.40077

31025.886 27336.595 26042.3171

NPV 6025.89 2336.59 1042.32

60
Summary of Decision-making Methods

Technique Accept Reject

Payback Period(PBP) PBP < target period PBP > target period

Accounting Rate
of Return(ARR) ARR > target rate ARR < target rate

Net Present Value(NPV) NPV > 0 NPV < 0

Internal Rate of
Return(IRR) IRR > cost of capital IRR < cost of capital

Profitability Index(PI) PI > 1 Profitable PI < 1 not profitable

or
BCR BCR > 1 BCR <1

61
COMPARISON OF DISCOUNTED MEASURES OF PROJECT
WORTH

RLDS 605
 Financial checklist

• Are the sources of financing clearly identified (equity, loan, grant)?

• Is the amount of money required to implement & operate the project
adequate & will it be timely available?
• What are the terms of financing the project?
• Is proper cost-benefit analysis being done for the project?
• Do the expected results bring about a reasonable return on the capital
invested?
• What is the financial rate of return (NPV, IRR, etc)?
• Is sensitivity analysis made for the project?
• What are the net effects on the government’s budget, allowing for any
loss of customs duty on imports, the cost of fiscal incentives & allowances,
& initial equity participation, & recurrent subsidy?