Project Analysis

FINANCIAL ANALYSIS
Financial analysis seeks to ascertain whether the proposed project will be
financially viable in the sense of being able to meet the burden of servicing
debt and whether the proposed project will satisfy the return expectations
of those who provide the capital.

A feasibility study is a tool that helps the project promoter to take a

decision on the investment proposal. To facilitate this decision, both
investment and production costs have to be arranged clearly, keeping in
mind that the profitability of a project will ultimately depend on the size
and structure of investment and production costs and their timing.

The basic components of investment and production costs of a project of

defined capacity are determined in the form of:
Land and site development
Building and civil works
Technology and equipment
Material inputs
Labour inputs
Project implementation costs
The study should then assemble these components so as to obtain an
estimate of the
Total investment cost,
Total production costs and
The financial and economic viability of the project.

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Once the size of the investment is known, an assessment of project

financing should be made. Assembling the components of investment and
production costs, particular attention should be paid to the timing of
expenditure and costs, as it influences the cash flow of the project and its
internal rate of return.

Investment and production costs should be planned on an annual basis in

line with the requirements of cash flow analysis. There is no exact formula
for computing the investment and production costs, thus various ways to
estimate these figures can be considered. However, calculations of;
Fixed cost,
Pre – production capital costs,
Working capital, and
Production costs,
should have scope for correction for contingencies and price escalation

Total Investment costs

Initial Investment Costs

Initial investment costs are defined as sum of fixed assets (fixed
investment costs plus pre – production expenditures) and net working
capital, with fixed assets constituting the resources required for
construction and equipping an investment project, and net working capital
corresponding to resources needed to operate the project totally or
partially.

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At the pre – investment stage, two mistakes are frequently made. Most
commonly:
Working capital is included either not at all or in insufficient amount, thus
causing liquidity problems for project.
Total investment costs are sometimes confused with total assets, which
correspond to fixed assets plus pre – production expenditures plus current
assets.
The amount of total investment costs is, in fact, smaller than total assets,
since it is composed of fixed assets and net working capital, the latter
being the difference between current assets and current liabilities.

11.1.2 Investment Required during Plant Operation

The economic lifetime is different for the various investments (buildings,

plant machinery and equipment, transport equipment et.), and, in order to
keep a plant in operation, each item must, therefore, be replaced at the
appropriate time, and the replacement cost must be included in the
feasibility study. A convenient starting point for establishing the period of
the analysis is the technical life of the major investment item.

In some projects, the technical life (physical life) of the major investment
item may be quite long, and the economic life of the item is expected to be
shorter because of the technological obsolescence (rapidly changing
technology will make a major investment obsolete over a period), changing
tastes, international competitiveness of the extent of a natural resource or
mineral deposit.

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A distinction may be made between the physical life and economic (or
optional) life of an asset. The physical life of an asset represents the
number of years it can be used to produce a certain output by regular
maintenance and repair, which of course, tends to cost more and more as
the years roll by. The economic life of an asset refers to the number of
years the asset should be used to produce a certain output.
Therefore:
Economic life – is the period during which a fixed asset is capable of
yielding service to the owner.
The economic life of an asset is conceptually defined as the period after
which the asset should be replaced to minimize the sum of operating and
maintenance costs and capital costs expressed on an annual basis.

Physical life – is a period often longer during which a fixed asset can
continue to function not withstanding its acquired obsolescence,
inefficient operation, high cost of maintenance or obsolete product.

Fixed Assets: Fixed assets comprise fixed

investments and pre – production capital costs.

Total Fixed Investment Costs

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No. Items Year

0 1 2 N
1 Land Purchase
2 Site preparation & development
3 Civil works, structures and buildings
4 Plant machinery and equipment
5 Auxiliary and service plant equipment
6 Environmental protection:
Site preparation
Civil works
Plant machinery & equipment

7 Incorporated fixed assets (project overheads):

Technology
Project implementation
Miscellaneous Project overhead costs

8 Contingencies
9 Total fixed investment cost

Foreign currency share (%)

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Fixed Investments: Fixed investments should include:

Land purchase and site preparation
Buildings and site preparation
Plant machinery and equipment including auxiliary equipment
Certain incorporated fixed assets such as industrial property rights
Total fixed investment can be projected for each year of the construction
period until full production is reached. The estimate includes supply,
packing and transport duties and installation charges.

Provision should also be made for physical contingency allowances

providing a safety factor to cover unforeseen or forgotten minor cost.
Contingency allowance: is an amount included in a project account to
allow for adverse conditions that will add to baseline costs.
Physical contingencies: allow for physical events such as adverse weather
during construction, etc. (They are included in both Financial and
Economic analysis)
Price contingencies: allow for general inflation. In project analysis they
are omitted both from financial and economic analysis when the analysis
is done in constant prices.
Constant price is a value, most often a price, from which the overall effect
of general price inflation has been removed.
A “constant price” is a price that has been deflated to
Real terms by an appropriate “price index” (a series
that records changes in a group of prices relative to a
given of base period).

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Pre – production Capital Expenditure: Pre – preparation capital

expenditures include the following.

Preliminary capital – issue expenditure

These are expenditures incurred during the registration and formation of
the company, including legal fee for preparation of the memorandum and
articles of association and similar documents, and for capital issues. The
capital – issue expenditures included advertising, public announcements,
underwriting commissions, brokerage, expenses for processing of share
applications and allotment.

Expenditures for Preparatory Studies:

There are three types of expenditures for preparatory studies.
Expenditures for pre – investment studies (opportunity, pre – feasibility,
feasibility and support or functional studies)
Consultant fees for preparing studies, engineering and supervision of
erection and construction
Other expenses for planning the project

Other pre – production Expenditures are:

Salaries, fringe benefit and social security contribution of personnel (for
project implementation team)
Travel expenses
Preparatory installation (workers camps, temporary houses and stores)
Pre – production marketing costs, promotional activities
Training costs (fees, travel, living expenses)
Interest and insurance during construction

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Trial runs, start – up and commissioning expenditure

are expenditures that include fees payable for
supervision of start – up operations, wages and
salaries, fringe benefits and social security etc.
In allocating pre – production expenditures, one of the following two
practices is generally followed
All pre – production expenditures may be capitalized and amortized over a
period of time that is usually shorter than the period over which equipment
is depreciated.
A part of the pre – production expenditures may be initially allocated,
where attributable, to the respective fixed assets and the sum of both
amortized. Pre – production expenditures that are not attributable are
capitalized as a total and also amortized over a certain number of years.

11.2 Net Working Capital:

Net working capital indicates the financial means
required to operate the project according to its
production program. Net working capital is defined
as current assets minus current liabilities.

11.2.1 Current assets comprise;

Receivable,
Inventories (raw material, auxiliary material, supplies, packaging
materials, spare parts and small tools),
Work in progress,
Finished products and

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Cash.

11.2.2 Current liabilities consist mainly of accounts payable (creditors)

and are free of interest.
Net working capital forms an essential part of the initial capital outlays
required for an investment project, because it is required to finance the
operation of the plant. Any change in current assets or liabilities, such as
an increase or decrease of production volumes or inventories has an
impact on the financial requirements.

Any net increase of working capital corresponds to a cash flow to be

financed, and any decrease would set free financial resources (cash
inflow).

Since the working capital is computed net of creditors, that is short-term

finance, it is quite logical that working capital should be financed from
equity or long-term debt. (short-term seasonal peaks occurring within a
production year may however, be financed by short term or medium term
capital).

The net concept is used in determining the amount and nature of asset
that may be used to pay current liabilities. The amount that is left after
these debts are paid may be used to meet future operational needs.

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If the analyst abstained from classifying permanent and temporary

working capital, then net working capital is used as the average long-term
level of working capital and has to be financed by medium or long term
financing or equity. The amount of working capital invested should be
optimal, that is, neither too large nor too small, to avoid penalties for the
concept.

Accounts Receivable (Debtors)

Accounts receivable are trade credits extended to product buyers as a
condition of sale, and the size of this item is therefore determined by the
credit sales policy of the company.

The ratio of credit sales to gross sales differs from company to company,
thus it is difficult to come up with a valid generalization. Therefore, each
should be assessed using the following formula.

A/R (Debtors) = credit terms (in month) x (value of annual gross sales)
12
In the case of accounts receivable the value of annual gross sales should
be calculated as cost of the product sold (that is production costs plus
marketing and distribution costs) minus depreciation and interest, with the
understanding that the latter are to be covered by the sales revenues, and
not by the working capital.

Inventories:

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Working capital requirements are considerably affected by the amount of

capital immobilized in the form of inventories. Every attempt should be
made to reduce inventories to as low a level as justifiable.

Production Materials: In computing inventories of production materials,

consideration should be given to the sources and modes of supplies of raw
materials and factory supplies location.
If the materials are locally available and in plentiful supply and can be
rapidly transported, then only limited stocks should be maintained unless
there are special reasons for keeping a higher stock (such as price
fluctuations).
If the materials are imported and import procedures are dilatory, then
inventories equivalent to as much as six months consumption may have to
maintained.
Other factors influencing the size of inventories are the reliability and
seasonally of supplies, the number of supplies, possibilities of substitution
and expected price changes.

Spare Parts: Level of spare-parts inventories depend on the local

availability of supplies, import procedures and maintenance facilities in
the area and the nature of the plant. The plant is usually provided with an
initial set of spare parts.

Work – in – progress

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To assess capital requirement for covering work-in-progress, the

production process should be analyzed. The requirements are expressed in
months (or days) of production, depending on the nature of the product. In
machinery production this can extend to several months. The valuation is
based on the factory costs of work-in-progress.

Finished Products:
The inventory of finished products depends on a number of factors, such
as the nature of the product and trade usage. The valuation is based on
factory costs plus administrative overheads, which is operating costs.

Cash-in-hand and cash in bank

Interest is sometimes added to the working capital. If
the interest is charged on a half yearly basis, which is
often the case, no provision is normally necessary.
However, if at the end of such a six – month period the surplus of receipts
over payments does not fully cover the interest payments, additional short
– term finance would be required. It may also be prudent to provide for
certain amount of cash-in-hand. Including a contingency reserve on
working capital, which could be around 5%, could do this.

Accounts payable (Creditors)

Accounts payable will depend on credit terms provided by suppliers.
Hence raw materials, factory supplies and services are usually purchased
on credit with a certain period elapsing before payment is effected.

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Accrued taxes are paid after a certain period has elapsed and may be
another source of finance similar to accounts payable. The same holds
true for wages payable. Such credited payments reduce the amount of net
working capital required.

It is very important to understand that creditors

related to investment are to be excluded from the
computation of working capital requirements,
because by definition investments are long-term
commitments and must therefore be financed by
long-term resources (equity or debt).
11.2.3 Calculation of Net Working Capital Requirements

When calculating the working capital requirements, the minimum

coverage of days for current assets and liabilities has to be determined
first.
Annual factory costs, operating costs and costs of products sold should be
then computed, since the values of some components of the current assets
are expressed in these terms.
Since working capital requirements increase as a project gradually
becomes fully operational, it necessary to obtain the above cost data for
the complete-start-up period until and including production at full
capacity. If, however, the project generates sufficient cash surpluses (self-
financing capacity), it may not be necessary to finance any net increase in
working capital from outside resources.

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The next step is to determine the coefficient of turnover for the

components of current assets and liabilities by dividing 360 days by the
number of days of minimum coverage.
Finally, the net working capital requirements for different production
stages are obtained by deducting the current liabilities from the sum of
current assets.
The required cash in hand is calculated separately

11.3 Schedules for Total Investment Costs and Total

Assets
From the figures of:
Fixed investments
Pre-production expenditures and
Net working capital estimates, the total initial investments of the project
can be calculated.
The phasing of such cost, including plant and
equipment replacement costs and end-of-life costs
are indicated.
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
project. Deficiencies in the estimation of production costs usually leads to
unexpected losses, which coupled with low capacity utilization caused by
wrong sales forecasts may quickly push a nascent establishment out of
operation.

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Production costs should be calculated as total annual costs and preferably

also as cost per unit produced. Overall production costs should be broken
down at least into the main cost items such as:
Raw materials
Factory supplies
Personnel
Overheads
Production cost must be determined for the different levels of capacity
utilization and for an operational period.

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Total Annual Cost of Product

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Production
Yr1 Yr2 Yr3 Yr“n”
Capacity Utilization _____% ____% ____%
1 Raw Materials:
Raw material A
Raw material B
2 Factory Supplies
3 Spare parts consumed
4 Repair, maintenance,
material
5 Royalties
6 Labour:
Skilled labour
Unskilled labour
7 Labour overheads (taxes
etc.)
8 Factory overhead costs:
Salaries, wages
Social costs etc. (on
salaries)
Materials and services
Rents, leasing costs
(factory)
Insurance
9 Factory Costs (1 up to 8)
10 Administrative Overhead

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Costs:
Salaries, wages
Social costs etc. (on
salaries)
Materials and services
Rents, leasing costs
(factory)
Insurance

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11 Operating costs (9 + 10)

12 Depreciation
13 Financial Costs:
Interests
Leasing costs
14 Total Production Costs
(11+12+13)
15 Direct Marketing Costs:
Salaries, etc.
Rents, leasing costs
Other direct costs
16 Market overhead costs:
Salaries, etc.
Rents, leasing costs
Other direct costs
17 Costs of Products Sold
(14+15+16)
Foreign currency share (%)
Variable cost share (%)

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Production costs are divided into four major categories:

Factory costs
Administrative overhead costs
Depreciation costs
Cost of financing
The sum of factory and administrative overhead cost is defined as
operating costs.

Factory costs: include the costs of

Materials, predominantly variable costs such as raw materials, factory
supplies and spare pars.
Labour (production personnel) (fixed or variable costs)
Factory overheads (in general, fixed costs)

Administrative Overheads: Administrative overhead costs include

Salaries, wages
Social costs etc. (on salaries)
Materials and services
Rents, leasing costs
Insurance
Depreciation Costs: Depreciation costs are charges made in the annual net
income statement (profit-loss account) for the productive use of fixed
assets.

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While depreciation costs have to be considered in accounting for the

computation of the balance sheet and net income projections, they present
investment expenditure (cash outflow during the investment phase) instead
of production expenditure (cash outflow during production).

Depreciation charges must therefore be added back if net cash flows are
calculated from the net profit after corporate tax, as obtained from the net
income statements. Depreciation cost do have an impact on net cash flows,
because the higher the depreciation charges, the lower the taxable income
and the lower the cash outflow corresponding to the tax payable on
income.

Financial Costs: Financial costs (interests) are sometimes considered as

part of the administrative overhead. For the purposes of financial analysis
and investment appraisal, however, it is necessary to determine financial
costs separately. With a declining amount of external finance there is a
decreasing financial costs.

11.4 Project Financing:

The allocation of financial resources to a project constitutes an obvious

and basic prerequisite for investment decisions, for project formulation
and pre-investment analysis, and for determining the cost of capital
(without which the decision to accept or reject a project on the basis of the
NPV and IRR cannot be made).

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A feasibility study would serve little purpose if it were not backed by

reasonable assurance that resources are available for a project if the
conclusions of the study proved positive satisfactory.

The capital outlay of a project can be appropriately determined only after

plant capacity and location have been decided, together with estimates of
the costs of a developed site, buildings and civil works, technology and
equipment.

Determining the financial requirements of a project at the operational

stage in terms of working capital is equally necessary. The determination
of working capital can be only done once estimates are made of production
cost, on one hand, and sales and income, on the other. These estimates
should cover a period of time and be reflected in a cash flow analysis.

Unless both estimates are available and unless the available resources are
sufficient to meet the fund requirements, both in terms of initial capital
investment and working capital needs over a period of time, it would not be
prudent to proceed to the financing decision and project implementation.

11.4.1 Sources of Finance

Equity
A generally applied financing pattern for an industrial project is to cover
the initial capital investment by equity and long-term loans to varying
extents, and to meet working capital requirements by additional short and
medium term loans from national banking sources.

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The minimum net working capital requirements should be financed from

long-term capital. In situation where institutional capital is scarce and
available only at high cost, equity capital covers the initial capital
investment and net working capital.

Anyway, a balance needs to be struck between long-term debt and equity.

The higher the proportion of equity the less the debt service obligations
and the higher the gross profit before taxation.
The higher the proportion of loan finance, the higher the interest payable
on liabilities.
Therefore, in every project, the implications of alternative patterns and
forms of financing must be carefully assessed: a financing pattern should
be determined that is consistent with both availability of resources and
overall economic returns.

Issuing two types of shares can raise equity: Ordinary shares and
preference shares. Preference shares usually carry a dividend at least
partly independent from profit, without or with only limited voting rights.

They can be convertible to common shares, they can be cumulative or non

– cumulative in terms of dividend or can be redeemable or non-
redeemable, with the redemption period varying between 5 and 15 years.
Dividends on ordinary shares with full voting rights, however, depend on
the profitable operation of the company.

Loan Financing

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Since it is relatively easy for a sound project to obtain loans, the process of
project financing may well start by identifying the extent to which loan
capital can be secured, together with the interest rate applicable. Such
loan capital need to be separately defined.
Short and medium term borrowings from commercial bank for working
capital or suppliers credit and
Long-term borrowings from national or international development finance
institutions
Short Term Loans: Short-term loan from commercial banks and local
financial institutions are available against hypothecation or pledging of
inventories. Bank borrowing for working capital can be arranged on a
temporary basis. If the cash flow suggests that sufficient liquid funds are
available, such bank borrowings should be reduced or entirely eliminated,
without harming the liquidity of the project.

Working capital needs should even be partly net out of long-term fund,
since the largest portion of working capital is tied in inventories (raw
material, work progress, finished goods and spare parts).
Long Term Loans: Loan financing is usually subject to certain regulations
(convertibility of shares and declaration of dividends). Certain ratios in the
capital structure of the company need to be maintained. Investment may
also be financed partly by issues of bonds and debentures.

An important source of finance is also available at government-to-

government level in developing countries. This can be a bilateral credit or
tied credit, which may be related to the purchase of machinery and
equipment from particular country or sources.

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In addition to share capital and loan finance, an important financial

category at the operational stage is the internal cash generated by the
project itself. This can take the form of accumulated reserve (retained
profits and depreciation).

Supplier Credits

Imported machinery and spares can often be financed

on deferred credit term. Machinery suppliers in
developed countries are willing to sell machinery on
deferred – payment terms with payments spread over
6 to 10 years.

Leasing:
Instead of borrowing financial means it is sometimes possible to lease
plant equipment or even complete production units that is productive
assets are borrowed. Leasing (borrowing of productive assets) requires
usually a Down payment and the payment of an annual rent, the leasing
fee. These are, however, contained in balance sheet of the lessor and not
in the lessee – which is off – balance sheet financing.

The problem is basically to decide which alternative should be preferred,

leasing or purchasing of capital assets. To evaluate the two alternatives,
the discounted cash flow should be applied.

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The initial down payment, the current leasing fees and additional
payments under the leasing agreements are part of the cash outflow
(replacing the investment costs).

Since the duration of leasing contracts is in general much shorter than the
technical and economic life of an asset, it is necessary to include the
residual value (cash inflow) of the leased asset when comparing with loan
financing.

The inflow for the lessee would usually not be the book value, but either
the book value or the market value (minus the lessors cost of setting the
used items) which ever is lower.

If the investor has a choice between loan and leasing financing, he would
compare the discounted cash flow for both flow arrays to determine which
alternative would bring the higher yield (IRR, NPV).

Cost of Capital: Lending means a long medium or short-term commitment

reducing the liquidity of the lender and would also imply uncertainty
concerning the full return of the funds lent. To obtain finance, an
investor must, therefore, pay a charge, the cost of capital or finance for the
funds lent. This charge comprises an interest rate, usually expressed as a
percentage per annum, as well as certain fixed charges (Commitment fee,
charge on capital not drawn, commissions et.). Interest is usually
computed for the outstanding balance of the corresponding liabilities of a
firm, for example, interest payable on current account.

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11.5 Basic Accounting Statements

Although the cash flow analysis has been adopted as the principal
instrument of investment appraisal, it is to have an understanding of basic
accounting principles and statements.

The accounting statements are also important for the analysis of the
structure of project financing and for the computation of the capital costs
of a company. There are basically two categories of accounting
statements:
The net income statement or profit and loss account, which is linked to the
balance sheet, and
The cash flow table for financial planning.

11.5.1 Net Income Statement

The net income statement is used to compute the net income /net earnings/
or deficit of the project arising each year.
The projections are required for the entire duration of the planning period
chosen for the project. The net income statement differs from the cash
flow statement in as much as it shows costs and incomes (and not
expenditures and revenues) by period.

For the purpose of a feasibility study the net income statement should
show at least how the net earnings are divided between different classes of
equity shareholders, the different suppliers of loan capital and the tax
authorities.

11.5.2 Balance Sheet

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A balance sheet is a statement showing the accumulated assets the wealth-

of a company and how this wealth is financed.

The sources of finance are treated as the aggregated liabilities of the

company, the sources being the investors (equity shareholders) and the
group of creditors, banks and debenture holders. By definition both sides
of a balance sheet, representing assets and liabilities are equal.

11.5.3 Cash Flow Table for Financial Planning

(Source and Application of Funds)

It is not sufficient to determine the total amount of financial means

required and to identify source of available finance. Therefore, the timing
of the inflow of funds (paid in equity, loan disbursements, sales revenue,
short-term loans, bank overdraft or creditors) must be synchronized with
the various expenditures (cash outflow) for investments and plant
operation.

If this timing of financial flows is not properly done, the project may
experience periods with accumulated financial surpluses not employed but
costing interest or face sudden shortages of funds and liquidity problems.

It is, therefore, necessary to prepare a cash flow schedule showing the

sources and applications of funds, in particular, the overall cash inflows
and outflows.

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Just as financial planning for investment phase should ensure that capital
is available to finance investment expenditures, and that financial inflows
and expenditures (cash outflow) are synchronized, financial planning for
the operational phase must ensure that cash inflows or sales revenues,
from operations will be adequate to cover all production costs and
financial commitments such as debt services (both interest and principal),
taxes and payment of projected dividends.

Financial Evaluation
As far as the entrepreneur is concerned, the investment criterion is the
financial return on the invested capital, that is, the profit. Consequently,
the investment profitability analysis consists essentially of determining the
ratio between the profit and the capital invested.

An investor, as a rule, finances a project partly through equity capital and

partly through borrowed funds. His primary interest is to know the
profitability of the equity capital, that is, the net profit after taxes divided
by the total equity. It is advisable to prepare the profitability analysis not
only of equity capital, but also of the total investment (equity and loans)
that is net profit after taxes plus financial costs divided by the total
investment.

Cash – Flow Concept:-

Investment has been defined as a long-term commitment of economic
resources made with the objective of producing and obtaining net gains in
the future.

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The conventional methods of investment appraisal basically evaluate the

expected net profit (sales income less costs and incomes taxes) against the
capital invested. For the purpose of investment appraisal it is necessary to
assess and evaluate over a certain period, all inputs required and all
outputs produced by the project.

Therefore, the discounted cash-flow concept has become the generally

accepted method for investment appraisal. Similarly, the cash – flow
concept is needed for planning of the flow of financial means, in other
words; of the sources and application of funds.

Definition and Computation of Cash Flows:

The financial cash flow of a project is the stream of financial costs and
benefits, or expenditure and receipts that will be generated by the project
over its economic life.
Cash flows are basically either receipts of cash (cash inflows) or payments
(cash outflows).

The financial costs and benefits of a project, referred to popularly as

project cash flows, are defined with the help of inputs provided by
marketing, production, engineering, costing, purchase, taxation and other
departments.

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It must be emphasized that our focus is on cash flows, which are different
from accounting revenues, cash outflows, not expenses in accounting
terms, and the relevant measure of financial cost, likewise, cash inflows
not revenue as determined by accounting conventions reflect financial
benefits. The cash flow of a project usually has three components:
An initial investment
Operating cash inflows
A terminal cash flow
The initial investment represents the relevant cash outflows when the
project is set up.
The operating cash inflows are the cash inflows that arise from the
operation of the project during its economic life.

The terminal cash flow is the relevant cash flow occurring at the end of
the project life on account of liquidation of the project. As cash flows have
to be forecasted far into the future, errors in estimation are bound to
occur. Yet, given the critical importance of cash flow forecasts in project
evaluation, adequate care should be taken to guard against certain bases,
which may lead to over-estimate or under statement
of project profitability.

The basic assumption under laying the discounted cash-flow concept is

that money has a time value in so far as a given sum of money available
now is worth more than an equal sum available in the future. One Birr
today is more valuable than one Birr a year hence. This is because:
Individuals, in general, prefer current consumption to future consumption

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Capital can be employed productively to generate positive return. An

investment of one Birr today would grow to (1 + r) a year hence (r is the
rate of return earned on the investment)
In an inflationary period, one Birr today represents a greater real
purchasing power than one Birr a year hence.
Many financial problems involve cash flows occurring at different points
of time. For evaluating such cash flows an explicit consideration of time
value of money is required.

This difference can be expressed as a percentage rate indicating the

relative charge for a given period, which is usually a year. Considering
that a project may obtain a certain amount of funds F, if this sum is repaid
after one year including an agreed interest I, the total sum to be paid after
one year would be (F + I), where
F + I = F (1 + r)
And r is defined as the interest rate (in % per year) divided by 100 (if the
interest rate is, for example, 12.0 percent, then r equals 0.12).
Supposing that CFn is the nominal value of a future cash flow in the year
n, and CFp the value at the present time (present value) of this expected
inflow or outflow, then (assuming the r is constant):

CFp = CFn/ (1 + r) n or CFp = CFn (1 + r) –n

The general formula for the future value of a single amount is
FV = PV (1+k)n
Where:
FV = Future value n years hence
PV = Amount today (present value)

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K = Interest rate per year

n = Number of years for which compounding is done.

11.6 Main Discounting Methods

Once the stream of costs and benefits for a project is defined in the form of
cash flows, the attention shifts to the issue of project worth whiling. There
are three main discounting methods used in practice for appraisal of
investment projects, as far as the evaluation of financial feasibility is
concerned:
The net-present-value method (NPV),
Benefit – cost ratio and
The internal-rate of return (IRR)

Net Present Value (NPV)

The net present value of a project is defined as the value obtained by
discounting, at a constant interest rate and separately for each year, the
differences of all annual cash outflows and inflows accruing throughout
the life of a project.

This difference is discounted to the point at which the implementation of

the project is supposed to start. The NPVs obtained for years of the project
life are added to obtain the project NPV as follows:
n
NPV = CF0 + CF1 + …. + CFn =  CFt
(1 + K) 0 (1 + K) 1 (1 + K) n t=p (1 + K) t

NPV = Net present value

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CFT = Cash flow occurring at the end of year t (t = 0 ….n)

n = Life of the project
K = Cost of capital
The formula could also be written as:
n
NPV =(B0 – C0) + B1 – C1 + B2 – C2 + B3 – C3 + ... + (Bn – Cn) = ∑ (Bt –
C t)
(1 +r) (1 + r) 2 (1 + r)3 (1 +r)n t=0
(1+r)t

Where:- Bt – are project benefits in period t

Ct – are project costs in period t
r - is the appropriate financial or economic discount rate
n – is the number of year for over it operate

Considering the following cash flow stream of a project, and the cost of
capital k to be 10 percent, the net present value (NPV) of the project is
calculated as follows;
Year Cash flow
0 -1,000,000
1 200,000
2 200,000
3 300,000
4 300,000
5 550,000
Therefore NPV =

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- 1,000,000 + 200,000 + 200,000 + 300,000 + 300,000 +550,000 =

118,750
(1.10) 0 (1.10) 1 (1 + 10) 2 (1.10) 3 (1.10) 4 (1.10) 5

OR
n
NVP = NCF0 + (NCF1 x ai) + (NCF2 x a2) + - - - + (NCFn x an) ∑ NCFn
0 (1 + r)n

Where NCFn is the annual net cash flow of a project in the years n=12,
and an is the discount factor in the corresponding year, relating to the
discount rate applied through the equation. an = (1 + r) -n
Discount factors (an) may be obtained from present value tables.

Year Cash flow Discount Factor NPV

0 -1,000,000 1 (1,000,000)
1 200,000 .909091 181,818
2 200,000 .826446 165,259
3 300,000 .751315 225,395
4 300,000 .683013 204, 904
5 550,000 .620921 341,507
NPV
118,913

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The discount rate or cut-off rate should be equal either to the actual rate
of interest on long-term loans in the capital market or to the interest rate
(cost of capital) paid by the borrower. The cut – off –rate is the rate below
which a project is considered unacceptable, often taken to be the
opportunity cost of capital.

The cut – off – rate would be the minimum acceptable internal rate of
return for a project or the discount rate used to calculate the net present
worth, the Net Benefit Investment Ratio or the Benefit Cost Ratio.

The discount rate should basically reflect the opportunity cost of capital,
which corresponds to the possible returns an investor (financier) would
obtain on the same amount of capital if invested elsewhere, assuming that
the financial risks are similar for both investment alternatives.

In other words, the discount rate should be the

minimum rate of return, below which an entrepreneur
would consider that it does not pay for him to invest.

If the computed NPV is positive, the profitability of the investment is above

the cut – off discount rate, which implies that the project earns an excess
return. Since the return to the providers of debt capital is fixed, the excess
return accrues solely to equity shareholders, thereby accumulating their
wealth. In the example, the NPV the project has represents a direct
measure of the Birr benefit (in present value term) of the project for the
firms shareholders.

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If the NPV is zero, the profitability is equal to the cut – off rate. An NPV
of zero signifies that the benefits of the project (project cash flows over
time) are just enough to;
Recoup the capital invested and
Earn the required return on the capital invested

A project with a positive NPV can thus be considered acceptable, provided

a sufficient margin of error above zero NPV to account for uncertainty
has been included.

If the NPV is negative, the profitability is below the cut – off rate and the
project should be dropped.

An important decision criterion of the investor is often not only the

profitability of his investment, but also the answer to the question: How
long does it take to get the money back including a certain minimum
interest rate. He may decide, for instance, to invest only if the investment
is repaid in five years at an interest rate of 15%, which would mean that
the NPV must not be negative for a discounting rate of 15% and a
planning horizon of five years. The net cash return on equity would have
to be used for discounting.

The working capital and the salvage value of fixed assets will be recovered
by the end of the project life. For the computation of the discounted return
on equity capital invested, any outstanding debt balance would have to be
deducted from these salvage values in order to obtain the real end-of-life
net worth for the shareholders.

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The NPV and IRR for the total investment show the yield of the project as
a whole. In case there is no loan financing, the NPV and IRR are the
same.

However, if part of the investment is financed from loan capital (outside

financing), the NPV and IRR are different because of the tax effect of the
debt service (interest is a cost item, and therefore the taxable profit is lower
in the case of interest payment).

Net – Present – Value Ratio

If one of several project alternatives has to be chosen, the project with the
largest NPV should be selected. They need some refinement, since the
NPV is only an indicator of the positive net cash flows or of the net
benefits of a project.

In cases where there are two or more alternatives, it is advisable to know

how much investment will be required to generate these positive NPVs.

The ratio of the NPV and the present value of investment (PVI) required is
called the net-present-value ratio (NPVR) and yields a discounted rate of
return. This should be used for comparing alternative projects. The
formula is as follows:
NPVR = NPV
PVI

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If the construction period does not exceed one year, the value of
investment will not have to be discounted. In summary, the NPV has great
advantages as a discriminatory method compared with the pay back period
or annual rate of return, since it takes account of the entire project life
and of the timing of the cash flows.

The NPVR can also be considered as a calculated investment rate, which

the profit rate of the project should at least reach. The shortcomings of
the NPV are the difficulty in selecting the appropriate discount rate and
the fact that the NPV does not show the exact profitability of the project.
For this reason the NPV is not always understood by business people used
to thinking in terms of a rate of return on capital. It is therefore advisable
to use the internal rate of return.

Benefit – cost – ratio

There are two ways of defining the benefit – cost ratio. The first
definition relates the present value of benefits to the initial investment
BCR = PVB
I
Where:
BCR = benefit – cost ratio
PVB = present value of benefits
I = initial investment
The second measure, a net measure, relates net present value to initial
investment.

NBCR = NPV = PVB - I = PVB - 1

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I I I
Where: NCBR = net benefit – cost ratio
NPV = net present value
PVB = present value of benefits
I = initial investment
To illustrate the calculation of these measures, let us consider a project,
which is being evaluated by a firm that has a cost of capital of 12 percent.
The initial investment Birr 100,000
Year Benefits
Year 1 25,000
Year 2 40,000
Year 3 40,000
Year 4 50,000
The benefit – cost ratio measures for this project are:

BCR = 25,000 + 40,000 + 40,000 + 50,000 = 1.145

(1.12) (1.12)2 (1.12)3 (1.12)4
100,000
NBCR = BCR - 1 = 0.145
The two benefits – cost ratio measures give the same
signals because the difference between them is
simply unity.
The following decision rules are associated with them.

When BCR or NBCR Rule is

> 1 > 0 Accept
= 1 = 0 Indifferent

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< 1 < 0 Reject

It is said that benefit – cost ratio measures net present value per Birr of
outlay, it can discriminate better between large and small investments and
hence preferable to the net present value criterion.

Internal Rate of Return:

The internal Rate of Return (IRR) is the discount rate at which the present
value of cash inflows is equal to the present value of cash outflows. In
other word, it is the discount rate for which the present value of the net
receipts from the project is equal to the present value of the investment,
and NPV is zero. Mathematically, it means that in NPV equation, the
value for r has to be found for which, at defined values for CFn – the NPV
equals zero. An iterative process, using either discounting tables or a
suitable computer program, finds the solution.

The procedure used to calculate the IRR is the same as the one used to
calculate the NPV. The same kind of table can be used, and instead of
discounting cash flows at a predetermined cut-off rate, several discount
rates may have to be tried until the rate is found at which the NPV is zero.
This rate is IRR, and it represents the exact profitability of the project.
The IRR calculation procedure includes:
Preparation of a cash flow table
An estimated discount rate is then used to discount the net cash flow to the
present value
If the NPV is positive, a higher discount rate is applied
If the NPV is negative at this higher rate, the IRR must be between these
two rates.

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However, if the higher discount rate still gives a positive NPV, the discount
rate must be increased until the NPV becomes negative
If the positive and negative NPVs are close to zero, a good approximation
of the IRR can be obtained, using the following linear interpolation
formula.

IRR = i1 + PV (i2 – i1)

PV + NV
Where PV is the positive NPV (at the lower discount rate i1), and NV is
the negative NPV (at the higher discount rate i2)

Difference
IRR =Lower + between the NPV at the lower
Discount rate discount rates discount rate
Sum of the NPVs
(PV and NV) at
The two discount
Rates, sign ignored

The absolute value of both PV and NV are used in the formula.

It should be noted that the lower discount rate (i 1) and the higher discount
rate (i2) should not differ by more than one or two percentage points
(absolute). The formula will not yield realistic results if the difference is
too large, since the discount rate and the NPV are not related linearly.

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Examples of Internal Rate of Return Calculation

The condition NPV = 0

The internal rate of return of a project is the discount rate, which makes
its net present value equal to zero.

In the net present value (NPV) calculation, we assume that the discount
rate (cost of capital) is known and determines the net present value of the
project. In the internal rate of return (IRR) calculation, we set the net
present value equal to zero and determine the discount rate (internal rate
of return), which satisfies this condition. To illustrate the calculation of
internal rate of return, consider the cash flows of a project:

Year Cash flow

0 -100,000
1 30,000
2 30,000
3 40,000
4 45,000
The IRR is the value of r, which satisfies the following equation.

100,000 = 30,000 + 30,000 + 40,000 + 45,000

(1+r) (1+r) 2 (1+r)3 (1+r)4
The calculation of r consists of a process of trial and 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, to begin with, try r = 12 percent. The
right – hand side of the above equation becomes:

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30,000 + 30,000 + 40,000 + 45,000 = 107,773

(1.12) (1.12)2 (1.12)3 (1.12)4

Since this is more than 100,000, we have to try a higher value of r. (In
general, a higher r lowers the right – hand side value and a lower r
increases the right – hand side value.) Let us try r = 14 percent. This
makes the right – hand side equal to:
30,000 + 30,000 + 40,000 + 45,000 = 103,046
(1.14) (1.14)2 (1.14)3 (1.14)4
Since this value is higher than the target value of 100,000, we have to try a
still higher value of r. Let us try r = 15 percent. This makes the right –
hand side equal to:

30,000 + 30,000 + 40,000 + 45,000 = 100,802

(1.15) (1.15)2 (1.15)3 (1.15)4

This value is a shade higher than our target value, 100,000. So we

increase the value of r from 15 percent to 16 percent. The right – hand
becomes:
30,000 + 30,000 + 40,000 + 45,000 = 98,641
(1.16) (1.16)2 (1.16)3 (1.15)4

Since this value is now less that 100,000, we conclude that the value of r
lies between 15 percent and 16 percent. For most of the purposes this
information suffices. However, if a single value is required, we have to
resort to interpolation.

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IRR Calculation by Discount Factor

Year Annual net cash Discount NPV Discount NPV
flow Factor at Birr,00 factor at 20% Birr,000
Birr,000 18% 0
1 (3,291) 1.00 (3,291) 1.000 (3,291)
2 (5,127) 0.847 (4,343) 0.833 (4,271)
3 (88) 0.718 (63) 0.694 (61)
4 1,722 0,609 1,049 0.579 997
5 2,700 0.516 1,393 0.482 1,301
6 3,343 0.437 1,461 0.402 1,344
7 2,259 0,370 836 0.335 757
8 1,208 0.314 339 0.279 337
9 2,192 0.266 583 0.233 511
10 2,170 0.225 488 0.194 421
11 2,170 0.191 414 0.162 352
12 1,995 0.162 323 0.135 269
13 1,805 0.137 247 0.112 202
14 1,805 0.116 209 0.093 168
15 1,805 0.099 177 0.078 141
16 1,805 0.085 152 0.065 117
17 1,805 0.071 128 0.054 97
18 1,723 0.060 163 0.045 123
Total - - 265 (486)

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For the total capital invested the NPV equals 3,801,000 at 12% discount
rate. In order to find the IRR several discount rates greater than 12% are
tried until the NPV is approximately zero. The NPVs at discount rates of
18% and 20% are shown above.
The example, shows that discounted at 18%, the net cash flow is still
positive, but it becomes negative at 20% consequently, the IRR must lie
between 18 and 20%.
IRR = 18 + 2 { 265 } = 18.71
{ 265 + 486 }

11.6.3 Interpretation of the IRR

Internal Rate of Return is the maximum interest that a project could pay
for the resources used if the project is to recover its investment and
operating costs and still bread – even. It is the rate of return on capital
outstanding per period while it is invested in the project.

When ever we select a higher discount rate, we are driving the NPV of the
project down to zero, or put another way, at a discount rate of 18.71%, this
project just breaks even, that is, it could earn back all the capital and
operating costs expended on it and pay 18.7% for the use of the money in
the meantime.

The formal selection criterion for the IRR measure of project worth is to
accept all independent projects having an internal rate of return equal to
or greater than the opportunity cost of capital.

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The investment proposal may be accepted if the IRR is greater than the cut
– off rate (the cost of capital plus any margin for risk), which is the lowest
acceptable interest rate for the invested capital.

If several projects or alternatives are being compared, it is not necessarily

the project with the highest IRR which should be selected, provided the
IRR is greater than the cut – off rate for at least two of the projects or
alternatives.

In this case, the ranking problem and the problem of mutually exclusive
investment projects is considered. Sometimes a government may have
more viable projects with positive NPV’s ready to implement than it has
available development capital to finance. In this case, the government can
Use the Net benefit investment ratio
The discount rate can be increased
Raise more funds from taxation or borrowing

In ranking projects, different cash flow arrays can produce an identical

IRR and a project with lower IRR may be accepted (being above the cut off
rate) and the one with a higher IRR but has undesirable cash flow
structure.

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Projects are mutually exclusive if the acceptance of one project means the
rejection of the other. A mutually exclusive project is defined as a project
that can only be implemented at the expense of an alternative project as
they are in some sense substitutes for each. (Two dams on one site or two
factories to supply the one market) By choosing one mutually exclusive
project, the opportunity to do the other will be lost. If both projects have a
positive NPV, it will be necessary to decide which of them to do on the
basis of some other criterion. The decision rule for mutually exclusive
projects is, therefore, to accept the project with the highest NPV. This
happens if only one site is available for the investor or if he has to choose
between the expansion of existing one or establishing additional one. It is
a question of determining which of two feasible alternatives should be
chosen.

11.7 Non – Discounted Measures of Project Worth

(Simple Methods of Financial Evaluation)

The methods involving the

pay – back period and
the simple rate of return are:

Usually called simple methods since they do not consider the entire life of
the project, but only brief periods or one year.
In addition the annual data used are taken at the actual, and not at the
discounted value.

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The project is assumed to be operating at the full capacity for the periods
considered, which mean that normally only the third, fourth or fifth year
of operation can be used for these calculations.

11.7.1 Pay – back Period

The pay – back period is defined as the period required to recover the
original investment outlay through the profits earned by the project
(through the accumulated net cash flow earned by the project). Or
payback period is defined as the number of years it is expected to take
from the beginning of the project until the sum of its net earnings
(Receipts minus operating costs) equals the cost of the projects initial
capital investment.

If a project involves a cash outlay of Birr 600,000 and generates cash

inflows of Birr 100,000, Birr 150,000, Birr 150,000 and Birr 200,000 in
the first, second, third and fourth years respectively its pay back period is
four years because the sum of cash inflows during four years is equal to
the initial outlay.

When the annual cash inflow is a constant sum, the pay back period is
simply the initial outlay divided by the annual cash inflow. A project,
which has an initial cash outlay of Birr 1,000,000 and a constant annual
cash inflow of Birr 300,000, has a payable period of 3 ½ years.
Profit is defined as net profit after tax, adding financial cost and
depreciation, and the calculation is given as follows.

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 Project Analysis

Item Year
3 4 5 6 7
Net profit -280 920 1,270 2,540 2,630
Interest 370 330 280 180 90
Depreciation 780 780 780 780 780
Profit 870 2,030 2,330 3,500 3,500

When calculating the pay – back period, the computation usually starts
with the construction period during which the initial investment will be
made.

Calculation of pay – back period

Total investments 10,300(8,000)
Annual net profit plus interest plus depreciation

Amount paid back Balance at the end of

“profit” year
Year 1 (construction - 10,300 (8,000)
period)
Year 2 (construction - 10,300 (8,000)
period)
Year 3 870 9,430 (7,130)
Year 4 2,030 7,400 (5,100)
Year 5 2,330 5,070 (2,770)
Year 6 3,500 1,570
Year 7 3,500 -

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The calculation indicated that the original investment costs would be

recovered after a little less than 6.5 years, including the construction
period. The same result can be obtained using the cumulative net cash –
flow. There are two ways of calculating the pay – back period.

Excluding the construction period

The pay – back period would be thus
6.5 - 2 = 4.5 years
The land value ($ 0.3 million) and working capital ($ 2.0 million) are
deducted from the total investment costs with the assumptions that these
values can be fully regained at the end of the project.
Thus only 8 million of investment outlay must be recovered. In this case
the pay – back period would be 5.2 years.

A single project proposal may be accepted if the pay – back period is

smaller than or equal to an acceptable time period – a period usually
derived from past experience with similar projects.

The major merit of the pay – back period as a project selection criterion is
its easy calculation. It is particularly useful for risk analysis, which is
relevant in politically unstable countries and in branches of industry that
face rapid technological obsolescence.

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The shortcomings are that it does not consider the project fate after it has
paid for itself and that it over emphasizes quick financial returns. It does
not measure the profitability of the project but is concerned with its
liquidity.

It ignores the time value of money. Cash inflows, in the pay back
calculation, are simply added without suitable discounting. It over looks
cash flows beyond the pay back period. This leads to discrimination
against projects, which generate substantial cash inflows in later years.

11.7.2 Simple or Annual Rate of Return

The simple rate of return method relies on the operational accounts. It is
defined as the ratio of the profit in a normal year of full production to the
original investment outlay (fixed assets, pre – production capital
expenditures and net working capital).

It is defined as the ratio of the annual net profit on capital and this ratio is
often computed only for one year, generally a year of full production. This
ratio can be computed either for the total investment outlay or the equity
capital. The simple rate of return thus becomes
The simple rate of return on total capital invested R is
R (%) = NP + I x 100
K
The simple rate of return on equity capital paid RE is
RE (%) = NP x 100
Q

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Where NP = the net profit (after depreciation, interest charges and

taxes)
I = the interest
K = the total investment costs (fixed assets, working capital)
Q = the equity capital (pre – production)

The simple rate of return method is based on accounting conventions that

frequently change from country to country depending on existing
legislation that has to be considered as far as the profitability is concerned
– to assess the project under prevailing conditions.

The net income statement shows the various types of profits (gross, taxable
and net) derived by applying accounting conventions. If depreciation
allowances are to be shown separately they should be deducted from
production costs and gross profit would become sales minus production
costs without depreciation charges. Taxable income would in turn become
gross profit `minus depreciation.

“Accounting profits” only become a meaningful way to evaluate a project

if they are compared with invested capital, which can be defined in two
ways:
As permanent capital (equity capital or equity + reserves, or equity +
reserves + long term loans)
As total investment cost (fixed assets + pre – production capital costs +
working capital).

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In conclusion, the value of simple rate of return

really depends on how the terms “profit” and
“capital” are defined and to the ratio used should be
explained before a final judgment is taken.
Example of Different Rates of Return
The rates of return could differ as could be observed
from the next table considering year 4 as the first
year of full capacity and year 6 after the expiry of tax
holidays.
Year 4 (First year of full Year 6 (Expiry of
capacity) tax holiday)
Net profit plus interest 2,720 1,428
Total investment outlay 8,720 8,720
Rate of return (%) 31.2 16.4
Net of return plus interest 3,500 2,208
and Depreciation
Total investment outlay 8,720 8,720
Rate of return (%) 40.1 25.3
Net profit 2,381 1,292
Total equity capital paid 3,500 3,500
Return on equity (%) 68.0 36.9
Net profit 2,381 1,292
Total net worth 4,830 7,192
Return on total net 49.3 18.0
worth (%)

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The simple rate of return method has a few serious disadvantages.

Since the simple rate of return uses annual data, it is difficult and often
impossible to choose the most representative year of the project.
In addition to the varying levels of production (during initial years) and
the payment of interest (differing annually) there are other factors that
cause changes in the level of net profit in particular years (tax holidays).
In years in which a tax concession is to be applied, the net profit will
obviously be quite different from those years when the profit is subject to
normal taxation.
The main shortcoming of the simple rate of return is that it does not take
into account the time value of the equity payment and of the annual return
on equity (the timing of the cash inflows and outflows during the life of
the project). Obviously income obtained in an early period is preferable to
income obtained later.

In such case it is not sufficient to rely on an annual calculation of the

profitability. It is necessary instead to determine the overall profitability of
the projects and this is only possible to using discounting methods.

In conclusion, the simple rate of return method can be used for competing
the profitability of total investment cost when more or less equal gross
profit are expected throughout the lifetime of the project.

11.8 Financial and Efficiency Ratios

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The figures appearing in the balance sheet, the net income statement and
the cash flow tables convey a considerable amount of information in terms
of their absolute value. In financial analysis it is usual to refer to several
well – known ratios that facilitate the analysis and specially the
comparison of projects and alternatives.
1. Financial Ratios
1.1 Long – term debt – equity ratio:
The long – term debt – equity ratio is an indicator of the financial project
risk for both the equity and the loan capital.
Debt service represents a legally binding commitment of a firm, the
financial risk is higher for the firm as well as the bank or financing
institution, the higher the debt in relation to equity capital.

The ratio also indicates the extent to which the outstanding debt balance is
covered by the total assets of a firm in the event of liquidation of the
project before it goes into operation.

In case of an existing firm, the earned surplus and reserves (retained

profits) must be added to equity capital to reflect the true ratio between the
shareholders interest in the firm and the long – term debt. This sum of
equity and reserves is known as the net worth of the firm or the
shareholders interest.

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Usually, the ratio is expressed as a fraction; for example, debt to net worth
is 4:1 or 80:20, meaning that for this example the long – term debt is four
times the net wroth or one fifth or 20% of total liabilities. In large or
medium size, an ideal debt – equity ratio of 50:50 tends to be adopted, but
not a standard pattern.

The debt – equity is also a measure of investor leverage. The smaller the
equity capital, the higher the incomes per unit share. From the
profitability point of view, equity owners therefore favor high debt – equity
ratios, since such ratios give leverage to equity capital and allow equity
owners to control projects even with a small amount of capital.

However, since the financial risk is growing with an increasing debt

balance, it is also in the interest of the shareholders to establish a sound
balance between risk and loan capital.

Investment banks ask for a sound debt – equity ratio, since the largest
portion of equity capital is always tied in land, buildings and equipment,
which can be liquidated only with difficulty or only at a loss in case of
bankruptcy of the project.

Current ratio or current assets to current liabilities ratio

The current ratio is a liquidity measure computed by dividing current
assets by current liabilities.

Current Ratio = Current Assets

Current Liabilities

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In case the inventory could not be sold for cash, to guard against this
possibility, the quick ratio is frequently used in addition to the current
ratio. The quick ratio is computed by dividing cash plus marketable
securities and discounted receivable by current liabilities.

Quick Ratio = Cash + Receivables + Marketable Securities

Current Liabilities

Long – term debt – service coverage

The long – term debt – service coverage should be looked at in order to
make sure that all long – term loans and the related financial expenses
can be repaid in the agreed yearly installments without depriving the firm
of needed funds.

Debt – service coverage is defined as the ratio of cash generation to debt

service (interest plus repayment of principal).

Debt – Service Coverage = Cash Generation

Debt Service

This ratio often increases considerably if the long – term debt service
gradually decreases and no new borrowing is projected.

Debtors – Creditors Ratio

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The ratio between debtors (accounts receivable) and creditors accounts

payable), if determined for a number of consecutive periods, helps to
identify overtrading. Overtrading is a situation where too high a level of
production is maintained with insufficient cash resources.

The effects of overtrading can be disastrous for a company, and usually

lead to a complete failure of a business. Overtrading is in most cases the
result of rising prices (inflation) increasing stocks, heavy taxation,
depletion of working capital or over expansion of production in relation to
the market.

The cure for overtrading is the provision of additional (long – term) funds,
increasing marketing efforts to reduce stocks, and the reduction of
operations

2. Efficiency Ratios
The operational performance and profitability of an investment is
measured by relating the financial net benefits expressed as net cash flow,
profits before and after corporate tax or profit plus interest payable on
debt – to the corresponding capital investments.

Output – capital ratio

The efficiency of an investment may also be expressed in terms of the
annual output produced by investing one unit of capital.

Net present value ratio

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When the present value of the accumulated net

benefits of a project (i.e. the annual output of the
project net of annual operating expenditures and
income taxes, discounted and accumulated over the
planning horizon) is related to the present value of
the total capital invested the NPVR.

Relation between personnel employed and investment.

The relation between total initial investment and the

number of workers and staff employed is used when
comparing alternative technologies.

2..4 Turnover of inventories

The rate of turnover of products in stock is a measure
of the marketing capabilities of management. In
general, the faster the turnover, the better for the
finance of the company.

11.9 Financial Evaluation Under Conditions of Uncertainty

(Risk Analysis)

Forecast of demand, production and sales may not be exact because of

uncertainty about the future. Similarly, assumptions concerning the
estimates of production and investment costs, prices or the lifetime of the
project may not always be correct.

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When dealing with an investment under conditions of uncertainty, three

variables should particularly be examined:
Sales revenue
Production cost and
Investment cost
A host of individual items enter into these variables, all of which are
composed of a price and a quantity. The most common reasons for
uncertainty are inflation, changes in technology, false estimation of the
rated capacity and the length of the construction and running – in –
period.

Uncertainty analysis includes: Sensitivity analysis and break – even

analysis among others.

Sensitivity Analysis

Sensitivity analysis, sometimes called “what if” analysis answers question

like;
What will happen to NPV (or other criteria) if sales are reduced?
What will happen to NPV if the economic life of the project is reduced?

With the help of sensitivity analysis it is possible to show how the net cash
returns or the profitability of an investment alter with different values
assigned to the variables needed for the computation (unite sales price,
unit cost, sales volume etc).

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The element of uncertainty could be reduced at this stage by finding the

optimistic and pessimistic alternatives, and thus determining the
commercially most realistic combination of project inputs for the business
environment (or scenario) favored by the decision makers.

The variables having the greatest share of cash in flow and out flows are
then subject to variations of quantities or prices or both parameters at the
same time.
This exercise can be performed by assigning values to the critical variable
corresponding to reasonably pessimistic, normal and optimistic scenarios
and by the computation of the discounted cash flows (IRR or NPV) and
any ratios etc. chosen as a yardstick for investment appraisal.

With the help of sensitivity analysis it is possible to identify the most

important project inputs, such as raw materials, labour and energy, and to
determine any possibilities of input substitution as well as the critical
elements of the marketing concept.

Sensitivity analysis as a popular method for assessing risk has certain

merits;
It forces management to identify the underlying variables and their
interrelationships
It shows how robust or vulnerable a project is to changes in the underlying
variables
It indicates the need for further work. If the NPV or IRR is highly
sensitive to changes in some variables, it is desirable to gather further
information about that variable.

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It is intuitively a very appealing as it articulates the concerns that project

evaluators normally have.
Notwithstanding its appeal and popularity, sensitivity analysis suffers from
several shortcomings:
It merely shows what happens to NPV when there is a change in some
variable, without providing any idea of how likely that change will be.
Typically, in sensitivity analysis only one variable is changed at a time. In
the real world, however, variables tend to move together.
It is inherently a very subjective analysis. The same sensitivity analysis
may lead one decision maker to accept the project while another may
reject it.

Scenario Analysis

In sensitivity analysis, typically one variable is varied at a time. If

variables are inter-related as they are most likely to be, it is helpful to look
at some plausible scenarios, each scenario representing a consistent
combination of variables. For example, a project may be evaluated under
three different scenarios:
The base case scenario where the demand and price are expected to be
normal.
The scenario where the demand is high, but the price low.
The scenario where the demand is low, but the price high.

The following table shows the net present value calculation for the three
scenarios.

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Net Present Value Calculation for Three Scenarios

(Rirr in
million)
Scenario Scenario Scenario 3
1 2
Initial investment 200 200 200
Unit selling price (in Birr) 25 15 40
Demand (in units) 20 40 10
Revenues 500 600 400
Variable cost 240 480 120
Fixed cost 50 50 50
Depreciation 20 20 20
Pre-tax profit 190 50 210
Tax @ 50% 95 25 105
Profit after tax 95 25 105
Annual cash flow 115 45 125
Project life 10 years 10 years 10 years
Salvage value 0 0 0
Net present value at a 377.2 25.9 427.4
discount rate of 15%

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In the above example, an attempt was made to develop scenarios in which

the values of variables where internally consistent. For example, high
selling price and low demand typically go hand in hand. Firms often do a
different kind of scenario analysis in which the following scenarios are
considered:
Optimistic scenario High demand, high selling price, low variable
cost, and so on.
Normal scenario Average demand, average selling price, average
variable cost, and so on.
Pessimistic scenario Low demand, low selling price, high variable
cost, and so on.
The objective of such scenario analysis may be to get a feel of what
happens under the most favorable or the most adverse configuration of
key variables, without bothering much about the internal consistency of
such configurations.

Scenario analysis may be regarded as an improvement over sensitivity

analysis because it considers variations in several variables together.
However, scenario analysis has its own limitations:
It is based on the assumption that there are few well-delineated scenarios.
This may not be true in many cases. For example, the economy does not
necessarily lie in three discrete states, viz., recession, stability, and boom.
It can, in fact, be anywhere on the continuum between the extremes.
When a continuum is converted into three discrete states some information
is lost.

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Scenario analysis expends the concept of estimating the expected values.

Thus in a case where there are 10 inputs, the analyst has to estimate 30
expected values (3X10) to do the scenario analysis.

Break – even analysis

In sensitivity analysis we ask what will happen to the project if sales
decline or costs increase or something else happens. A financial manager
will also be interested in knowing how much should be produced and sold
at a minimum to ensure that the project does not ‘lose money’. Such an
exercise is called break-even analysis and the minimum quantity at which
loss is avoided is called the break-even point. The break-even point may
be defined in accounting terms or financial terms.

Accounting Break-even Analysis

Suppose you are the financial manager of Flour Mills.
The promoter (owner) is considering setting up a new
flourmill near Addis Ababa. Based on owner’s
previous experience, the project staff has developed
the figures shown below.

Note that the ratio of variable costs to sales is

0.667(12/18). This means that every Birr of sales
makes a contribution of Birr 0.333. Put differently,
the contribution margin ratio is 0.333. Hence the
break-even level of sales will be:
Fixed costs +Depreciation = 1+2 = 9 million
Contribution margin ratio 0.333

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Cash Flow Forecast for the new Flour Mill Project

(Birr in ‘000)
Year 0 Years 1-10
1. Investment (20,000)
2. Sales 18,000
3. Variable costs (66.6% of 12,000
sales)
4. Fixed costs 1,000
5. Depreciation 2,000
6. Pre-tax profit 3,000
7. Taxes 1,000
8. Profit after taxes 2,000
9. Cash flow from operation 4,000
10. Net cash flow 4,000

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By way of confirmation, you can verify that the break-even level of sales is
indeed Birr 9 million.
Birr in million
Sales 9
Variable costs 6
Fixed costs 1
Depreciation 2
Profit before tax 0
Tax 0
Profit after tax 0

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A project that breaks even in accounting terms is like a stock that gives
you a return of zero percent. In both the cases you get back your original
investment but you are not compensated for the time value of money or the
risk that you bear. Put differently, you forego the opportunity cost of your
capital. Hence a project that merely breaks even in accounting terms will
have negative NPV.

Financial Break-even Analysis

The Focus of financial break-even analysis is on NPV
and not accounting profit. At what level of sales will
the project have a zero NPV?

To illustrate how the financial break-even level of sales is calculated, let

us go back to the flourmill project. The annual cash flow of the project
depends on sales as follows:
1. Variable costs : 66.67 percent of sales
2. Contribution : 33.33 percent of sales
3. Fixed costs : Birr 1 million
4. Depreciation : Birr 2 million
5. Pre-tax profit : (.333 X Sales) – Birr 3 million
6. Tax (at 33.3%) : .333 (.333 Sales – Birr 3 million)
7. Profit after tax : .667 (.333 X Sales – Birr 3 million)
8. Cash flow(4 + 7) : Birr 2 million + .667 (.333 X Sales – Birr 3
million)
Since the cash flow lasts for 10 years, its present value at a discount rate of
12 percent is:

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PV(cash flows) = 0.222 sales X PVIFA (10 years, 12%)

= 0.222 Sales X 5.650
= 1.255 Sales
The project breaks even in NPV terms when the present value of these
cash flows equals the initial investment of Birr 20 million. Hence, the
financial break-even occurs when
PV (cash flows) = Investment
1.255 Sales = Birr 20 million
Sales = Birr 15.94 million

Thus, the sales for the flourmill must be Birr 15.94 million per year for the
investment to have a zero NPV. Note that this significantly higher than
Birr 9 million which represents the accounting break-even sales.

The purpose of break – even analysis is to determine the equilibrium point

at which sales revenues equal the costs of products sold. When sales (and
the corresponding production) are below this point, the firm is making a
loss, and at the point where revenue equal costs, the firm is breaking even.

Break – even analysis serves to compare the planned capacity utilization

with the production volume below which a firm would make losses.

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The break – even point can also be defined in terms of physical units
produced, or the level of capacity utilization at which sales revenues and
production costs are equal. The sales revenues at the break – even point
represent the break – even sales value, and the unit price of a product in
this situation is the break – even sales price.
Before calculating the break – even values, the following condition and
assumptions should be satisfied.
Production and marketing costs are a function of the production or sales
volume (e.g. in the utilization of equipment)
The volume of production equals the volume of sales
Fixed operating costs are the same for every volume of production
Variable costs vary in proportion to the volume of production, and
consequently total production costs also change in proportion to the
volume of production
The sales prices for a product or product mix are the same for all levels of
output (sales overtime). The sales value is therefore a linear function of
the sales prices and the quantity sold.
The level of unit sales prices and variable and fixed operation costs remain
constant, that is the price elasticity of demand for inputs and outputs are
zero.
The bread – even values are computed for one product; in case of a variety
of products, the product mix, that is the ratio between the quantities
produced, should remain constant.
Since the above assumption will not always hold in practice, the break –
even point (capacity utilization) should also be subject to sensitivity
analysis, assigning different fixed and variable costs as well as sales
prices.

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