Chapter Four :

Financial analysis and

projection

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Contents
 Cost of project

 Means of finance (project financing)

Project cash flows in financial analysis

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Financial Analysis & Economic analysis
Both the Economic analysis and the Financial Analysis
investigate whether or how the “benefit” ( or “revenues” in
the case of financial analysis) excesses the “cost” ( or
“expenditure” in the case of financial analysis) of the project
quantitatively.

The Difference between Economic and Financial Analyses

Financial Analysis Economic Analysis

 Will the project be  Will the project have an impact

Issues to be profitable for the project on society or the national
addressed owners? economy?
 Will the project worth investing
with a limited budget?

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 Cont...
The financing of a project is crucial for its sustainability.

Is adequate financing available for the project?

How will the financing arrangements affect the
distribution of costs and benefits of the project?

Specifically, if the project is planning to financially cover

its operation and maintenance by Revenue-generating,
it should be confirmed whether the total revenue
estimated could cover the total expenses for O/M

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 Forum for Financial analysis
Exercise_ Financial Analysis
Imagine that there is an irrigation facility constructed by an NGO.
This facility requires cost for its operation and maintenance.
• The cost is 3 million Birr a year. From the users, 5,000 Birr per ha
as the fee for irrigated water is planned to be collected in a year.
Supposedly the irrigated area is 200 ha.

Question: Based on these estimates, do you think that the

project is financially sustainable?

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 Financial analysis-Cont’d
Exercise_ Financial Analysis-Feedback
Answer: No, this is NOT financially sustainable
because the collected user fee is not enough
for covering the O/M cost of the facilities.
In a year, the facility needs 3 million Birr for its
operation and maintenance.
However, the total fee for collecting fee would be 1
million Birr only (5000Birr X 200 ha =1 million Birr).
Expenditure= 3 million Birr (O/M cost) > 1 million
Birr (collected fee) =Revenue
•Therefore, Without other support, this facility cannot
operate.

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 The Costs of a Project
• It is the total outlay of all items associated with a
project costs related to:
A. capital expenditures/and
B. operation &maintenance of the project.

A) Capital expenditures.
 This include expenditures of those items needed to
establish the project so that it can be operated.
• It cover items related to construction of facilities (site
preparation and other civil costs), plant and equipment,
comprising not only the acquisition cost but also the cost
of transport, installation and testing; vehicles; and
working capital.
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 The Costs of a Project-Cont’d
B. Costs related to operation of a project:
• Operating expenditures are those incurred in operating
and maintaining the project.
• typically comprise raw materials, labor and other
input services, repairs and maintenance.
• It is collected at the time of material and input
analysis
3. Cost of production refers to all costs involved in
acquiring goods and services required as input for
producing a product
• Cost of production comprises three main cost
elements: = Material cost + labour cost + overhead cost.
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Cont...
Material Cost: are part of Direct coststhat include materials,
and equipment machineris etc

Labour cost: Labour costs represent the total expenditure

incurred by employers for the employment of employees.
They represent a cost of salaried labour force, that is why they
are sometimes referred to as salary costs

Overhead cost refers to all costs in the organizational

budget of an NGO that are not directly related to a project
activity
Overhead costs are: Rent. Utilities. Insurance.
• Office supplies. Travel. Advertising expenses. Accounting and
legal expenses. Salaries and wages for director and
executive levelEjarra
employees,
Batu (PhD) benefits, insurance, taxes, etc.
9
 Project cash flows Definition
Project cash flow is the net cash flow associated
with the project for a particular year.
So, it’s the cash that is likely to be generated by the
project (i.e. the revenue) and the cash that is likely to
be needed to sustain the project (i.e. the cost).

The money received /cash inflow/and money paid

out /cash outflow/by the firm at particular points in
time.

The financial analysis of a project is based on “cash

flow analysis.
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Project cash flows Definition
Project cash flow refers to the movement of
cash in and out of a project over time.
It is an important aspect of project
management, as it helps in understanding
the financial implications of a project.

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A project cash flow statement typically
includes the following elements:
1. Cash Inflows: This includes all the sources of cash coming into the
project, such as:
1. Revenue from sales or services provided
2. Grants or funding received
3. Investments
4. Interest or other income
2. Cash Outflows: This includes all the uses of cash flowing out of the
project, such as:
1. Costs and expenses (materials, labor, overheads, etc.)
2. Interest payments on loans
3. Taxes and other statutory payments
4. Capital expenditures (investments in fixed assets)
5. Payments to suppliers and creditors
6. Dividends or Ejarra
distributions
Batu (PhD) to owners 12
 Cont...
3. Net Cash Flow: This is the difference between the cash inflows
and cash outflows, which can be either positive (cash surplus) or
negative (cash deficit).
4. Cash Position: This is the amount of cash the project has at a
given point in time, which is the cumulative result of all the cash
flows.

So, project cash flow statement is usually prepared on a monthly

or quarterly basis to track the financial performance of the project
and can be used for decision-making, such as whether to proceed
with the project, reallocate resources, or seek additional funding. It
is also useful for forecasting future cash needs and ensuring that
the project remains financially viable.
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 Categories of a project cash flow
(i) Capital cash flows, &
(ii) operating cash flows

I. Capital cash flows may be disaggregated into three

groups:
i. the initial investment: refer to the cash outlays for the
equipment and other assets that you need to execute a project.
ii. additional ‘middle-way’ investments such as upgrades and
increases in working capital investments/reserve/, and
iii. terminal flows.

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Initial investment
refer to the cash outlays for the equipment and other assets
that you need to execute a project.
The largest capital flow
the ‘initial capital outlay’ or just ‘capital expenditure’.
The amount to ‘initiate’ or ‘start’ the project, and
Involves the cash outflows required to start a project by
purchasing or creating assets.

The installation costs of the machines purchased

are included in the initial capital outlay.

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 Working capital requirements
The cash required to purchase the current
assets needed for startup and subsequent
support.
The amount carried in cash, accounts
receivable, and inventory that is available to
meet day-to-day operating needs.
Examples of working capital include
materials in inventory, spare parts, tools,
and personnel training.
Working capital is recovered at the end
of the project
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 Terminal cash flows
Terminal cash flow is the final net inflows and outflows of a
project or investment after disposing of necessary equipment
and paying all expenses and taxes.

So, it is a set of capital flows at the end of the project’s economic life.
For example:
the terminal cash inflows :
 the sale of the project as a going concern,

 the salvage value of the asset net of tax, and

 recovery of any remaining working capital.

Terminal cash outflows could be:

 The cost of asset disposal or demolition,

 the cost of environmental rehabilitation, and

 compensation payments to employees.

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 II. Operating cash flows
Once the initial investment is made and the project is in
operation, the project is expected to generate cash flows
over its economic life.
So, Project cash flow refers to how cash flows in and out of
an organization in regard to a specific existing or
potential project. Project cash flow includes revenue and
costs for such a project
Lifetime of a project can be expressed as:
 Economic life
 The period over which an asset is expected to be usable, with
normal repairs and maintenance, for the purpose it was acquired,
rented, or leased. [Expressed usually in number of years, process
cycles, or units produced]
 Physical life
 The life for which the facility is designed under given operating
conditions. Ejarra Batu (PhD) 18
Operating cash flows
Two major components:
1. Revenue: estimate of sales revenues (benefit);
• Revenue valuation is then simply a matter of estimating
the sales values of products and services from a project.
• Information source: Market analysis

2. Expenditures: Estimates of costs:

• Information Source: Input, location, technology
analysis.

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 Classification of investment projects
Principle of the stand-alone project- cont’d
 This is influenced by the classification of investment
projects: Independent project, mutually exclusive &
contingent project

An independent project is one the acceptance or rejection

of which does not directly eliminate other projects from
consideration or affect the likelihood of their selection.
mutually exclusive projects .
the acceptance of one prevents the acceptance of the
alternative proposal.
Therefore, mutually exclusive projects involve ‘either-or’
decisions – alternative proposals cannot be pursued
simultaneously.
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 Classification of investment projects-Cont’d
A contingent project is one the acceptance or rejection
of which is dependent on the decision to accept or reject
one or more other projects.
Contingent projects may be complementary or
substitutes.

Substitute projects, the rejection of one will definitely

boost the cash flows of the other.
Contingent projects should be analyzed by taking into
account the cash flow interactions of all the
projects.

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Essentials in cash flow identification-Cont’d
1. Opportunity cost principle
Opportunity cost is what you give up as a
consequence of your decision to use a scarce resource
in a particular way.
The opportunity cost, in the context of capital
budgeting, is the value of the most valuable
alternative that is given up if the proposed
investment project is undertaken.

This opportunity cost should be included in the

project’s cash flows.

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 Essentials in cash flow identification-Cont’d
2. Sunk costs
Sunk costs are cash outlays that have already occurred
or have been committed.

The concept of sunk costs is particularly relevant when

making a decision on whether to approve a project.

The rule is quite simple: Sunk costs must not be included

in any financial analysis.
Therefore, it should not be included in the project’s cash
flows.

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 Essentials in cash flow identification-Cont’d
3. Overhead costs: The indirect costs or fixed
expenses of operating a business (that is, the costs not
directly related to the project)
examples of overhead costs are utilities (such as electricity,
gas and water) and executive salaries.
Very often, overhead costs occur whether or not a given
project is accepted or rejected.
Only the incremental cash flows resulting from
changes in overhead expenses should be included in
evaluating a project proposal.
For example, WXY Ltd Co. currently incurs utility overheads
of Birr 500,000 from the operation of its main office complex
The new project is not expected to affect main office
utility overheads.
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 Essentials in cash flow identification-Cont’d
4. Treatment of working capital
the amount carried in cash, accounts receivable, and
inventory that is available to meet day-to-day operating
needs.
Returnable/ has Residual value
When the project terminates, any working capital recovered
is treated as a cash inflow.
The flows of working capital must be treated as

capital flows and not operational flows

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Essentials in cash flow identification-Cont’d
Treatment of depreciation
the loss of value of an asset over its useful life/project’s
economic life.
a non-cash expense/ a not a cash flow
it increases free cash flow while decreasing reported earnings.
The common technique: The ‘straight-line’ method allocates
an equal amount of the initial cost to each year of the asset’s
life.

Tax payable
Tax payable is a cash outflow.
The form of tax encountered in project analysis is corporate
tax.
 It is calculated as a percentage of taxable income.
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Essentials in cash flow identification-Cont’d
Terminal cash flow
In the final year of a project’s economic life

The typical format for calculating the terminal cash flow

is:
+ Proceeds from sale of assets
− Taxes on sale of assets
= After-tax salvage value
+ Recovery of working capital
= Terminal cash flow
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 Sources of Financing: HOW ARE PROJECTS FINANCED?

Raising the capital needed to fund projects can come from

many different sources.
Two basic types—debt and equity.
Debt financing refers to how much money the company has
borrowed from financial institutions to finance its operations
and invest in asset creation.
 The cost of debt financing : the current borrowing rate.

Equity financing refers to how much money a

company has received from the owners of stock
(shareholders), plus the amount of money that the
company has kept for the purpose of reinvesting in
the company on the shareholder’s behalf (retained
earnings). 28

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 projected cash flow Statement-Cont’d
The cash flow statement measures only the cash inflow
and outflow of the business.
Net cash flow starts with the net income amount, makes
adjustments for all non-cash items, then adjusts for all
cash-based transactions.

Projected Income Statement:

Revenues
- Depreciation (D)
- All other costs
EBT
- Taxes
Project NI (PNI)
Cash flow = PNI + Non-cash expenses
= PNI + Depreciation
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