CHAPTER 4: FINANCIAL COST-BENEFIT

ANALYSIS
Financial analysis would cover the following
aspects
oCost of project
oMeans of finance
oEstimates of sales and production
oCost of production
oWorking capital requirements and its financing
oProfitability projections
oProjected cash flow statement
oProject Balance sheet Statement
 :Questions of financial feasibility
 What are the total start-up costs required in order to begin operations?
For instance,
– what are the capital costs of the land, plant and equipment, and
other start-up costs such as legal and accounting costs?
– What are the operating costs involved?
• These include the daily costs involved in running the business, such as:-
– wages,
– rent,
– utilities, and interest payments on outstanding debt. These will
determine the cash flow requirements of the decision maker .
– What are the possible sources of financing for project?
• who are potential lenders?
• What will be their required terms and limitations of borrowing?
– Based on the estimated revenues and costs, what is the projected
profit(loss) of the project? What is the break-even point?
 cont’d…

Fundamentals Of Financial Estimates

o Analysis of financial costs & benefits is a key
step in the project preparation process.
o Seeks to ascertain the financial viability of
the proposed project.
– Meet the burden of servicing debt.
– Satisfy promoters’ return expectations.
Commercial profitability is yardstick for
selection.
 Project Economic Life

Benchmark for estimating projects’

economic life:
– Small & Medium Sized Projects ….. 5 – 10
years
– Normal Industrial Projects ………… 10 – 15
years
– Heavy Industry Projects ……………. 15 – 25
years
– Infrastructure Projects ……………… 20 – 25
years
4.1Initial Investment Cost(Estimation of Project cost)
 Components of Initial Investment Cost(project Cost)

Land and Site Development Cost:

– Cost of land(payment for leasehold)
– Cost of leveling and site preparation
– Cost of laying internal roads
– Cost of gate ways, tube wells, etc
Buildings and Civil Works:
– Buildings for the main manufacturing plant
– Buildings for auxiliary services like
workshops, etc
– Laboratory, water supply, etc
 Cont’d…
– Warehouses
– Non-factory buildings (guesthouse, cafeteria,
clinics, etc)
– Garages, sewage, drainage, etc
 Cost of Plant & Machinery:
o Costs of Imported Machineries & Equipments:
– CIF import value
– Clearing charges (customs, import tariffs, etc)
– Loading & unloading charges, local
transportation & insurance charges, etc
o Costs of Indigenous Machineries & Equipments:
– Purchase price of machinery and equipment
 Cont’d…

–taxes (if any)

– Railway freights & transportation charges up
to the site
Miscellaneous Fixed Assets & Expenditures:
o Furniture & office equipments
– Tools, vehicles, diesel generators
– Transformers, boilers, piping system
– Laboratory & workshop equipments
– Effluent(sewage) treatment plants &
fire fighting equipment.
 Cont’d…

– Expenses for acquisition of patents, licenses, trademarks, or

copyrights
 Establishment and Capital Issue Expenses
o Establishment Expenses:
– Expenditures incurred during the registration and formation of the
company.
– Legal fees for preparation of memorandum & articles of
association, costs incurred for capital issues, etc.
– Expenses for incorporating the company.
 Capital Issue Expenses:
– Underwriting commission & brokerage fees
– Fees to managers & registrars
– Printing & postage expenses
– Advertising & public announcements
– Listing fees & stamp duty expenses for processing of share
applications and allotment
 Cont’d…
 Pre-operating expenses
Expenditures for Preparatory Studies:
– Opportunity, pre-feasibility, feasibility, and support or functional
studies.
– Consultant fees while project preparation.
Other Pre-Operative Expenditures:
– Salaries, fringe benefits, and social security contributions for
personnel
– Travel expenses
– Preparatory installation (workers camps, temporary houses, and
stores)
– Engineering services & supervision of plant erections and
constructions
– Pre-production marketing costs and promotional activities
– Training costs (fees, travel, and living expenses)
– Interest and insurance during construction
 Cont’d…

Note: Size of pre-operative expenses directly

related to project implementation schedule.
– Delay in implementation push up these expenses.
– Financial institutions allow for delay in the
implementation schedule (20 to 25%)–permit
caution in estimating pre-operative expenses.
 Investment In Net Working Capital
o WC Requirement consists of the following:
– Raw materials & components (indigenous+
imported)
– Stocks of goods in process (WIP)
– Stocks of finished goods
 Cont’d…
– Debtors (accounts receivables)
– Operating expenses (prepaid insurances,
prepaid rents, etc)
– Consumable stocks (supplies)
Principal Sources of WC Finance:
– WC needs provided by commercial banks
(short term or medium term WC loans)
– Trade credits (account payables)
– Accruals & provisions (such as salaries & wages
payables, taxes payable, interest payables, etc)
– Long-term sources of financing (long-term debts
& equity)
 Cont’d…
 At least 25% of current assets must be supported by
long-term sources of finance.
– It is called Margin Money for Working Capital, i.e.,
WC requirement financed by long-term funds.
– NWC is part of the initial investment cost.
 The margin money for working capital is sometimes
utilized to meet overruns in capital cost.
– May lead to WC problem when the project begins
operation.
 Financial institutions stipulate a portion of the loan
amount equal to the margin money for working
capital initially blocked to mitigate this problem.
– Released when the project commences operation.
 Cont’d…
Margin requirement varies with the type of current
asset (CA) - no fixed formula available to determine
this amount.
Provision For Contingencies
o Contingency allowance is an amount included in a
project account to allow for adverse conditions that
will add to baseline costs.
o Includes allowance for price contingency.
o Price Contingencies:
– Allow for general inflation.
– Usually 5 to 10% of fixed investment cost for price
escalation during construction period.
4.2Means of Finance: Project Financing
Project finance may come from a variety
of sources. The main sources include equity,
debt and government grants.
The major sources of finance available to a firm
are shareholders and lenders.
 Capital structure means the proportion of debt
and equity financing in a given firm.
Financing from these alternative sources have
important implications on project's overall cost,
cash flow, ultimate liability and claims
to project incomes and assets.
 Cont’d…
To meet the project cost, the following are
the means of finances are available:

1. Share Capital

2. Term Loans

3. Deferred Payment/Suppliers

Credit

4. Leasing
 To Meet the Cost of Project
1. Share capital
 There are two types of share capital: equity capital and preference
capital.
 Equity capital:
-Represents the contribution made by the owners of the business, the equity
shareholders, who enjoy the rewards and bear the risks of ownership.
-Equity capital being risk capital carries no fixed rate of dividend.

 Preference capital:
-Represents the contribution made by preference shareholders and the dividend
paid on it is generally fixed.
-Preference shares, more commonly referred to as preferred stock, are shares of
a company's stock with dividends that are paid out to shareholders before
common stock dividends are issued. If the company enters
bankruptcy, preferred stockholders are entitled to be paid from company
 To Meet the Cost of Project…
2. Term loans
 It is provided by financial institutions and commercial banks’
 A term loan is a loan from a bank for a specific amount that has a
specified repayment schedule and either a fixed or floating interest rate.
 Term loans represent secured borrowings which are a very important
source (and often the major source) for financing new projects as well as
expansion, and renovation schemes of existing firms.
 There are two broad types of term loans available:
 Local currency term loans and
 Foreign currency term loans.
 Local Currency Term Loans: are given for financing land, building, civil
works, indigenous plant and machinery, and so on,
 Foreign Currency Term Loans: are provided for meeting the foreign
currency expenditures towards import of equipment and technical know-
how.
 SOURCES OF LOAN FUNDS
(A) Short-term & medium-term
borrowings from commercial banks for WC
financing or suppliers’ credit for
purchases of materials and inputs.
(B) Long-term borrowings from national or
international development finance
institutions for making investment in fixed
assets.
 3. SUPPLIER CREDITS (DEFERRED CREDITS)

Suppliers of plant & machinery provides

deferred credits.
– Payment made over a period of time
(not immediately).
 Suppliers of machineries in developed
countries are willing to sell on deferred-payment
terms to buyers in the developing nations.
Significant proportion of imported
machineries & spares often are financed on
deferred credit terms (payments may spread over
6 to 10 years).
 4. LEASING

Instead of borrowing, it is sometimes possible to

lease plant equipment or even complete
production units.
Productive assets could be borrowed on a long-
term basis – through a lease contract.
– Represents a contractual arrangement.
– The lessor grants the lessee the right to use an
asset in return for periodic lease rental payments.
– Usually requires an initial down payment and
periodic payments (often annual rents) – lease fee.
 CONT‘D...
Debt capital Equity capital

Creditors have fixed Shareholders have

claim residual claim

Interest is tax Dividend is not tax

deductible deductible
Has a fixed maturity  Has indefinite life

 equity and debt

Creditors do differ in many respectsexercise
not Shareholder’s
exercise control over the control over affairs of the
firm firm
22
 ESTIMATE OF SALES AND PRODUCTION
COSTS
ESTIMATE OF SALES/REVENUE
o Starting point for profitability projection.
o Derived from the market analysis.
Considerations:
 Not advisable to assume higher level of
capacity utilization in the 1st year of operations:
– Raw materials shortages
– Production & technological difficulties
– Limited power
– Marketing problems, etc
 Cont’d…

 Reasonable assumption with respect to capacity

utilization is needed.
– Note that the installed capacity is different from
optimum level.
General guideline:
– 40-50% of installed capacity in the 1st year
– 50-80% of installed capacity in the 2nd year
– 80-90% of installed capacity from 3rd year on
 Production would be assumed to equal sales
 Use the present price (current market price) as a
selling price.
– A change in the selling price assumed to offset with a
proportionate change in the cost of production.
 Estimates of Revenues…
 In order to make estimates of Revenues the following details must
be furnished for each product and until the maximum capacity
utilization of the plant:
1. Installed Capacity
2. Number of working days
3. Number of shifts
4. Estimated production per day
5. Estimated annual production
6. Estimated output as a percentage of plant capacity
7. Sales after adjusting stocks
8. Value of sales
Example: Format of Sales Schedule for
Product X
 ESTIMATE PRODUCTION COSTS
 Production costs should be calculated as total
annual costs as well as cost per unit produced.
 The overall production costs should be broken down
at least into main cost items/categories:
– Factory costs
– Overhead costs (administrative & marketing
overheads)
– Depreciation costs
– Financing costs
 Production costs must be determined for the
different levels of capacity utilization and operating period.
 Operating costs: is the sum of factory costs and
administrative overhead costs.
 Cont’d…
 Total Production Cost: is the sum of operating costs,
depreciation charges, and financial costs.
 Cost of Products Sold: is the sum of total production costs, direct
marketing costs, and marketing overhead costs.
1. FACTORY COSTS
o Total cost required to manufacture the product.
o Includes the costs of the following:
– Materials costs (mainly variable): costs of raw materials, factory
supplies, and spare parts
– Labor (production personnel) costs
– Factory overheads (indirect materials, indirect labor, factory
supplies & utilities, etc)
Eg-equipment maintenance, -factory rent, factory utilities, material
handlings staff wages, production supplies, quality assurance staff
wage and supervisors salary
SCHEMATIC VIEW OF PRODUCTION COSTS
 2. OVERHEAD COSTS

 Frequently computed as a % charge on total material & labor

inputs or other basis of allocation.
Types of overhead costs:
– Factory overhead (part of factory costs)
– Administrative overhead
– Marketing overhead
A. Administrative Overheads:
 This represents all indirect expenses incurred in the organization
including estimates for
– salaries of all indirect staff
– postage, telephone, fax, e-mail etc
– traveling expenses
– insurance other than for the factory assets
– rent, rates, taxes, electricity etc and
– depreciations of all fixed assets other than factory assets other than factory
fixed assets
 B. Marketing Overheads

 This represents estimated expenses in marketing divisions as per projected

organizations and include the items:
– salaries and personnel cost for mkg staff and managers as planned
– publicity, advertisement, exhibitions, etc.
– subsidies, commissions, discounts to dealers, etc.
-administrative expenses of sales office including rent.
 Direct selling & distribution costs (special packaging & forwarding costs,
commissions & discounts, etc) should be calculated separately for each
product.
 Indirect marketing costs are usually treated as marketing overhead
costs.
– Often included under administrative overheads.
 Marketing costs should be shown in the study as a separate cost group if
the total represents a significant share of the total costs of products sold.
– Wages, salaries, benefits, etc of employees involving in marketing
activities.
– Office supplies, utilities, communications,, paid advertising,
training, and promotional materials etc.
 3. DEPRECIATION COSTS

o Charges made in the annual income statement for

the productive use of fixed assets.
o Calculated based on the original value of fixed
investments according to the methods applicable.
o Reflected in the projected I/S.
o Frequently included under overhead costs.
4. FINANCIAL COSTS
 Financial costs such as interest on term loans
should be shown as a separate item for financial
analysis & investment appraisal, although
sometimes considered as part of administrative
overheads.
TOTAL ANNUAL COST OF PRODUCTS
Cont’d…
Projected Financial Statements statements :

 It is the measure of the profitability of the project.

 Firms are required by law to prepare an income
statement at the end of each year to report to
stakeholders on the performance and
profitability of the project and at the same time it
is used to calculate the tax liability to the
government.
 Borrowers also use this income statement as the
base to grant loans.
 Given the estimates of sales revenue and cost of production, the next step is to
prepare the profitability projections
Note: Royalty and know how is the payment to an owner for using a patent or the
copyright of others.
Cont’d…
 Projected Cash Flow Statements
 The cash flow statement shows the movement of cash into and
out of the firm and its net impact on the cash balance with the
firm.
Finance is considered by many as the lifeblood of an
organization or any project.
A well designed project may fail due to insufficient
cash for its day to day operation.
Therefore, a project planner has to develop some
techniques of forecasting cash in flows and out
flows.
Cash flow statement is a basis for showing the cash
flows associated with operating resources, funding
and investment. 38
 Cont’d…

 Cash flows from long-term investments are classified into 3

parts:
o Operating activities
o Financing activities
o Investing Activities
1. Cash Flow from Operating Activities: Constitutes the cash
inflows from revenue sources and the cash outflows for
different expenditures over the operating period.
o The net operating cash flows could be positive or negative or
zero.
2. Cash Flow from Investing Activities: Expenditure that occur
at the beginning of the project life.
3. Cash Flow from Financing Activities: Occur when getting
and paying back finance from and to owners and debtors.
Cashinflows and outflows
from operations.

Operating Activities

Cash Inflow Cash Outflow

1) Cash Purchases
1) Cash Sales 2) Payment to Creditors
2) Received from Debtor 3) Payment of Wages
4) Income Tax

Net operating cash flow

Classification of Investing Activities :
Inflow and Outflow of Cash

Investing Activities

Cash Inflow Cash Outflow

1) Sale of Fixed Assets
2) Sale of investments 1) Purchase of Fixed Assets
3) Interest Received 2) Purchase of Investments
4) Dividend Received
 DEPRECIATION COSTS

Expenses made in the annual income

statement for the productive use of fixed
assets.
Represents investment expenditure (cash
outflows during the investment phase) instead
of production expenditure (cash outflow
during production).
Do have impacts on net cash flows.
Depreciation charges added back if net cash
flows are calculated from the net profit.
 Statement of Cash flows
1.Cash Flow from Operating Activities
o Net income/Loss………………………xxxx
Adjustments
o Depreciation--------------------------------+x
o Non Cash losses----------------------------+x
o Non Cash Gains----------------------------(-) x
↑in Acc Rec.(or↓in Acc Rec.)------------(- or +)
↑in inventories(or↓in inventories)------(- or +)
↑in prepayment(or↓in prepayment)---(- or +)
↑in Acc payable(or↓ Acc payable)-------(+or -)
↑in Accruals(or↓ in Accruals)------------(+ or -)
o Net cash flows from operating activities..xxxx
Cont’d…
 PROJECTED BALANCE SHEET
The balance sheet shows the way in which a
project is financed, whether by sponsors,
lenders or creditors and how these funds have
be employed.
The Balance Sheet is the key to understanding
the financial position of a project.
This is done by comparing assets (what the
project owns) and liabilities (what the project
owes).
 PROJECTED BALANCE SHEET…cont’d
Book value-the value is based on the original cost of the asset less any
depreciation.
 Cont’d…
Paid in capital in Excess of par-it’s the premium paid for an appreciated stock .
 Cont’d…

NOTE:
Projected Financial Statements are prepared
for each year of the project’s economic life.
Financial institutions often refer & evaluate
these statements before making decisions
(extending short-term or long-term loans).