3.

3 PROJECT
FEASIBILITY
STUDY
 7. FINANCIAL AND ECONOMIC ANALYSIS
Financial Analysis
 Financial analysis should accompany the design of the
project from the very beginning.
 Important aspects of financial analysis covers such as
criteria for investment decisions, pricing of project inputs
and outputs, the planning horizon and project life, as well
as risks and uncertainty.
 Objectives of financial analysis:
 The financial analysis and appraisal involves the
assessment, analysis and evaluation of the required
project inputs, the outputs to be produced and the
future net benefits, expressed in financial terms.
 The scope and objectives of financial analysis are to
analyze and interpret all the financial consequences
of an investment that may be relevant to and
significant for the investment and financing decisions.
 The analysis should ensure that the objectives
determined by the decision makers and within the
scope of the feasibility study and also fulfill the
following conditions:
 The most attractive choice in project selection under the
conditions of uncertainty.
 The critical variables and possible strategies for
managing or controlling risks are identified.
 The flow of financial resources require during the
project cycle is determined and the lowest cost of
financial resources are identified.
 Principal aspects of financial analysis:
• The analysis should also accompany the various alternatives
that basically determine the marketing strategies, project
scope, resources, location, production capacities and
technology.
 Interest of parties Involved:
• The parties participating in a project expects benefits
differently and values them accordingly. Basically, the equity
provided by the investors and the loans of financial
institutions.
 Public interest:
• To be successful, investments also have to serve the needs &
development objectives of the socio-economic system.
 Basic criteria for investment decisions:
 Investment is also the transformation of liquidity into
productive assets.
 The decision should be based on the following criteria :
 Possible conflicts between the basic project objective and the
development objectives
 Suitability of the proposed strategy
 The matching of project parts
 Efficiency in utilizing the economic resources
 Total costs are in line with acceptable confidence level.
 Sufficiency of the total investment
 The cash flows met the requirements of investors and financiers
 The availability of local and foreign currency
 Identification of critical variables
 The financial consequences of the risks
 The minimum condition for the investment to be appraised by
investors, financing institutions etc.
 Methods of Financial analysis and investment
appraisal:
 Financial analysis relies on a systematic presentation and
processing of relevant business data on assets and
liabilities, costs and income, and the related flow of
goods, services and financial resources.
o Accounting
o Cost accounting
o Budgeting
 Pricing of project inputs and outputs:
 Prices may be defined in various ways:
o Market [explicit] or shadow [imputed] prices
o Absolute or relative prices
o Current or constant prices
 Planning horizon and project life:
 When determining the economic life span of the project
various factors [following] have to be discussed:
o Duration of demand
o Duration of the raw material deposits
o Rate of technical progress
o Life cycle of the industry
o Opportunities for alternative investment
o Administrative constraints [urban planning horizon]
 Risk and uncertainty:
 A project analyst cannot forecast with certainty
 Risk is present when the probabilities associated with
various outcomes may be estimated on the basis of
historical data.
 Analysis of cost estimates:
 It covers the corresponding costs of initial investment,
production, marketing and distribution, plant and
equipment replacement, working capital requirements
and decommissioning at the end of the project life.
 Pre-production expenditures
 Preliminary capital-issue expenditures:
 Expenditures for preparatory studies:
 Other pre-production expenditures:
 Trial runs, start-up and commissioning of expenditures:
 End- of- life costs:
 Fixed assets:
 It comprises fixed investment costs and pre-production
expenditures
 Net working capital:
 It is the difference between current assets and current
liabilities
 Calculation of net working capital requirements:
 Steps in calculating net working capital requirements,
1. The minimum coverage of days for current assets and
liabilities has to be determined first.
2. Annual factory costs, operating costs, and costs of
products should then be computed.
3. The next step is to determine the coefficient of turn over
for the components of current assets and liabilities by
dividing 360 days by the number of days of minimum
coverage.
4. Subsequently the cost data provided from each item of the
current assets and liabilities are divided by the respective
coefficients of turnover.
5. Finally, the net working capital requirements for the
different production stages are obtained by deducting the
current liabilities from the sum of current assets.
Example: The days of coverage for the following items in
your project are given below
Items Minimum days of coverage The annual requirements are
2011 2012
Cash 60 days Br.40,000 Br.45,000
Raw materials 20 days 60,000 70,000
Accounts Receivable 35 days 100,000 120,000
Work in process 10 days 15,000 17,000
Finished Goods 40 days 80,000 100,000
Accounts Payable 50 days 200,000 90,000

The total net working capital for the construction period is Br.50,000
Required:
1) Compute the Net Working Capital requirements of each period
2) Compute the increase in Net Working Capital for each period
Answer
1
Minimum The annual requirements
Items days of DCR
coverage Construction 2011 2012
pd.
Cash 60.00 6.00 6,666.67 7,500.00
Raw materials 20.00 18.00 3,333.33 3,888.89
Accounts Receivable 35.00 10.29 9,722.22 11,666.67
Work in process 10.00 36.00 416.67 472.22
Finished Goods 40.00 9.00 8,888.89 11,111.11
Total requirement 29,027.78 34,638.89
Accounts Payable 50.00 7.20 27,777.78 12,500.00
Net Working capital 50,000.00 1,250.00 22,138.89
Increase in working
capital 50,000.00 (48,750.00) 20,888.89
 Production costs: It is essential to make realistic
forecasts of production or manufacturing costs for a
project proposal in order to determine the future viability
of the product.
 Production costs should be calculated as total annual costs
and preferably also as cost per unit produced.
 Production costs must be determined for the different
levels of capacity utilization
 Marketing costs:
 It comprises the costs for all marketing activities
• may be divided into direct marketing costs for each product such as
packaging and storage, sales costs, transport, interim storage, and
distribution costs, indirect marketing costs, such as overhead costs
of the marketing department
 Basic accounting statements:
 Income statement
 Balance sheet
 Cash flows statement
 Projection of Cash Flows: Once a potential capital
budgeting project has been identified, its evaluation involves
the following steps:
1. First, the cost of the project must be determined.
2. Next, estimate the expected cash flows from the project,
including the salvage value at the end of its expected life.
3. Third, the riskiness of the projected cash flows must be
estimated. (uncertainty of the cash flows)
4. Given the project’s riskiness, determine the cost of capital at
which the cash flows should be discounted.
5. Next, the expected cash flows are put on a present value
basis.
6. Finally, the present value of the expected cash inflows is
compared with the required outlay, or cost.
 If the PV of the cash flows exceeds the cost, the project should be accepted.
Otherwise, it should be rejected.
 Estimation of Cash Flows
 Cash flows should be determined on an after-tax basis.
 Operating cash flows is a project’s operating income plus
depreciation.
 Sunk costs are not incremental and therefore must be ignored
 All relevant opportunity costs must be included in the
analysis.
 In estimating cash flows, anticipated inflation must be taken
into account.
 When a depreciable asset is sold, the actual sales price minus
the book value is multiplied by the tax rate to determine the
applicable taxes. The net salvage value, salvage value minus
the applicable taxes, is then added to after-tax operating
income.
 It is helpful to place project cash flows into three
categories based on timing:
1. The initial cash flow (initial Investment).
2. Interim incremental net cash flow (operating cash
flows).
3. The terminal cash flow.
1. The initial Cash flow
 Cost of equipment, facilities and land purchased.
 All other costs related to investment
 Additional net working capital.
 Opportunity costs, net of taxes (Ex- land used for this
project that could have been sold).
2. Interim Incremental Net cash Flows (Operating
cash flows):
 Basic format for determining interim incremental net
cash flow (per period)
 Net increase (decrease) in operating revenue less (plus)
any net increase (decrease) in operating expenses,
excluding depreciation.
 - + Net increase (decrease) in tax depreciation charges
 = Net changes in income before taxes.
 - + Net increase (decrease) in taxes.
 = Net changes in income after taxes.
 + - Net increase (decrease) in tax depreciation charges.
 = Incremental net cash flow for the period.
 3. Terminal Cash flow:
 Terminal Cash Flows
 Calculate the incremental net cash flow for the terminal
Period.
 + - Salvage value (disposal/reclamation costs) of any Sold
or disposed assets.
 - + Taxes (Tax savings) due to the asset sale or disposal of
new assets.
 + - Decreased (increased) level of networking capital.
 = Terminal year incremental net cash flow