Chapter 3

Financial Analysis of the

Projects
 3.1. What is Commercial/Financial Analysis of the project
 The financial analysis is all about the assessment, analysis and
evaluation of the required project inputs, the outputs to be
produced/generated/ and the future net benefits, (expressed in financial
terms) with the aim of determining the viability of a project.
 The necessity to determine the financial profitability of a project aims at
verifying that, under prevailing market conditions, the project will be
viable, from the point of view of its financial results.
 It will be worthwhile to carry out a financial analysis if the output of the
project can be sold in the market or can be valued using market prices.
 The project’s direct benefits and costs are, therefore, calculated at the
prevailing (expected) market prices.
 This analysis is applied to appraise the soundness and acceptability of a
project and to rank them on the basis of their profitability.
• The commercial analysis deals with two issues:
– Investment profitability analysis
– Financial analysis/ ratio analysis
• The two types of analysis are complementary and not
substitutable.
• Investment profitability analysis is the measurement and
assessment of the profitability of the resources put into a project.
• Financial analysis (ratio analysis) has to take into account the
financial features of a project to ensure that the disposable
finances shall permit the smooth implementation and operation of
the project.
 3.2. Why one undertakes Financial Analysis? or When to undertake
financial analysis?
 We undertaking financial analysis to justify financial sustainability of a
public project.
 We undertake financial and economic analysis of projects to compare
costs and benefits and determine which among alternative investments
have an acceptable return.
 The costs and benefits of a proposed project therefore must be
identified, priced and their economic values determined.
 Commercial profitability analysis is the first step in the economic
appraisal of a project.
 It provides the basic data needed for the economic evaluation of the
project and is the starting point for such evaluation.
 In fact economic analysis mainly involves of adjustments of the
information used in financial analysis and of a few additional ones.
3.3. Valuation/pricing of Financial costs and benefits
• This is an issue of pricing/valuing/ of the project’s inputs and
outputs.
• The inputs and outputs of a project appear in physical form and
prices are used to express them in value terms in order to obtain
common denominator.
• For the purpose of the feasibility study, prices should reflect 99
• For the purpose of the feasibility study, prices should reflect the
real economic values of project inputs and outputs for the entire
planning horizon of the decision makers.
• The financial benefits of a project are the revenues received and
the financial costs are the expenditures that are actually incurred.
• All these receipts and expenditures are valued as they appear in
the financial balance sheet of the project, and are therefore,
measured in market prices.
• Market prices are just the prices in the local economy, and
include all applicable taxes, tariffs, trade mark-ups and
commissions.
• Since the project implementers will have to pay market prices
for the inputs and will receive market prices for the outputs they
produce, the financial costs and benefits of the project are measured
in these market prices.
• The financial benefit from a project is measured in terms of the
market value of the project’s output, net of any sales taxes.
• Prices may be defined in various ways, depending on whether
they are:
1. Market/explicit/ or shadow/imputed/ prices;
2. Absolute or relative prices;
3. Current or constant prices. Market/Shadow prices:
• Market/explicit/
• Market or explicit prices are those present in the market, no
matter whether they are determined by supply and demand or by the
government.
• They are the prices at which the firm will buy the inputs and
sell the outputs.
• In financial analysis market prices are applied.
• In economic analysis we raise the question whether market prices
reflect real economic value of project inputs and outputs.
• If the market prices are distorted, then shadow or imputed prices
will have to be used for economic analysis.

• Absolute/relative prices:
• Absolute prices- reflect the value of a single product in an
absolute amount of money.
• Relative prices- express the value of one product in terms of
another.
• For instance, the absolute price of 1 tone of coal may be 100
monetary units and an equivalent quantity of oil may be 300
monetary units.
• In this case the relative price of coal in terms of oil would be
0.33, meaning that the relative price of oil is three times the price of
coal.
• The level of absolute prices may vary over the lifetime of the
project because of inflation or productivity changes.
• This variation does not necessarily lead to a change in relative
prices.
• In other words, relative prices may sometimes remain
unchanged despite variations in absolute prices. Both absolute
and relative prices can be used in financial analysis.
• Constant Vs Current prices
• Current and constant prices differ over time due to inflation,
which is understood as a general rise of a price levels in an
economy.
• If inflation can have a significant impact on project inputs and
output prices, such an impact must be dealt with in the financial
analysis.
• Wherever relative input and output prices remain stable, it is
sufficiently accurate to compute the profitability or yield of an
investment at constant prices.
• Only when relative prices change and project input prices grow
faster (or slower) than output prices, or vice versa, then the
corresponding impacts on net cash flows and profits must be
included in the financial analysis.
• If inflation impacts are negligible, the planner may use either
current or constant prices.
 3.4. Investment Profitability/Financial Appraisal of the projects
2.5.1. Non-Discounted Measures of Project Worth
Ranking by Inspection
 It is possible, in certain cases, to determine by mere inspection which of
two or more investment projects is more desirable.
There are two measures of investment appraisal:
The undiscounted and
discounted measures.
6.1 Undiscounted measures of project worth
They are the project evaluation techniques which don’t use time value of
money for analysis the status of the project.
Undiscounted measures of project worth includes the following methods:
i. Ranking by inspection
ii. pay back period
iii. Rate of Return on Investment
Weakness of undiscounted measures:
→ they fail to take into account the timing of the benefit and the cost stream.
→For the same data of the project, we get different rankings, hence, the choice
process becomes useless.
 i. Ranking by inspection: It is based on the size of costs and length of
cash flow stream.
 There are two cases under which this might be true.
I. Two investments have identical cash flows each year up to the final
year of the short-lived investment, but one continues to earn profits
in subsequent years.
 The investment with the longer life would be more desirable.
 Accordingly project B is better than investment A, since all things
are equal except that B continues to earn proceeds after A has been
retired.
II. Two investments may have the same initial outlay, the same
earning life and earn the same total proceeds (profits), but one
project has more of the flow earlier in the time sequence.
 In this situation, we choose the one for which the total proceeds
is greater than the total proceeds for the other investment earlier.
 Thus investment D is more profitable than investment C, since
D earns 2000 more in year 1 than investment C, which does not
make up the difference until year 2.
Limitation
It leads to bias, in the choice, due to the absence of more elaborate
and appropriate analysis.
All projects can’t be rejected or (ranked) accepted using ranking by
inspection.
 Example:
 More analysis is required to decide between C and D.
 ii. Payback period/payoff period(P)
 The payback period is defined as the length of time or 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 project’s initial capital investment cost.
 The rule is to choose the project which recovers its capital costs in
the shorter period.
 This criterion is widely used
 As a rough guide to assessing the relative desirability of two or
more projects, and
 To establish the number of years required to recover the initial
investment outlay.
 Payback period is estimated by P = I/E;
I is initial investment outlay (the investment of the project in Birr), and
E is the sum of annual cash flow (Total profit)
Example: Consider the two projects A & B each with initial outlay
and expected cash flow as indicated below.

Question: a) What is the payback period for each project?

b) Which of the two projects would you choose?
Why?
Payback period of project A = Birr 15000 = 0.9 Year.
Birr 15800
Payback period of project B = Birr 12000 = 1 Year.
Birr 12000
Limitations
 It fails to give any considerations to cash earned after the payback
date.
 It is biased against long lived projects having a low initial yield
which only gradually builds up to a maximum.
 It is a measure of the project’s capital recovery, not profitability.
 It fails to take into account the time value of money like other
types of undiscounted methods
 Example: if a project requires an original outlay of Birr 300 and is expected to
produce a stream of cash proceeds of Birr 100 per year for 5 years, the payback
period would be
 300/100 = 3 years.
Note: if the expected proceeds are not constant from year to year, then
the payback period must be calculated by adding up the proceeds
expected in successive years until the total is equal to the original
outlay.
iii. Rate of Return on Investment (Proceeds /unit of outlay)
 This refers to ranking of investments by dividing the total net
value of incremental production by the total amount of
investment.
 It refers the rate at which the project regain from its own
investment activity with in the projects life time.

• Table 3: proceeds per unit of outlay

Shortcoming: like other un discounting methods, it does not

consider timing; money to be received in the future weighted as
heavily as money in hand today.
 3.5. Discounted measures of project worth
 Discounted measures consider time value of money for
analyzing the status of the project.
 Thus, it can overcomes the limitation of undiscounted measures
of project worth.
 It is the weighted average return to the entity’s own capital
engaged over the life of the project.
 Discounting is essentially a technique by which one can reduce
future benefits and cost stream to their present worth.
 Discounted measures of project worth includes:
i. Net present value (NPV)
ii. Benefit cost ratio (BCR)
iii. Internal rate of return (IRR)
 i. Net present value (NPV)
 It is defined as the value obtained by discounting the difference of
all annual cash inflows(benefits, B) and outflows (costs, C) for
each year at a fixed interest rate.
 The NPV amount is simply the present worth of the incremental
net benefit or incremental cash flow stream and obtained by
reducing the present value of cost stream from the discounted
benefit stream during the life-span of the project.
• The net present value formula is:

Where Bt = the project benefits in period t, Ct = the project costs in

period t, r = discount rate, n = the number of years for which the
project will operate
• The discount rate used is normally the interest rate at which
bank loans are available, or the rate which banks pay on deposit
or investor's own funds opportunity cost’.
• The selection criteria is ‘accept if NPV > 0.
• If NPV= 0 the project could be selected.
• At this point, even though the absolute return is zero, it could
be possible to undertake the project as it pays the capital outlay
or at least able to repay its loan.
• Note that a project’s NPV clearly varies with the discount rate
used. Usually the higher the discount rate, the smaller the NPV
will be.
Drawback of NPV
• Ranking of acceptable alternative projects is not possible in
NPV because it is an absolute measure; not relative. A small but
highly attractive project will have a small NPV than a large but
less acceptable project.
• If the levels of investment are different deciding the
acceptability of the project only on the basis of NPV is
misleading. NPV is employed only when the projects are of the
same size.
• The discount rate needs to be obtained externally to the method
of calculation. That is r is determined exogenously.
• The opportunity cost of capital (r) is assumed to remain
constant throughout the life of the project. But usually the cost
of capital changes over the lifespan of the project.
• It does not show the exact profitability rate of the project.
 ii. Benefit cost ratio (BCR) (profitability index)

 This is obtained by dividing the present worth of the benefit stream

by the present worth of the cost stream.
 The formal mathematical statement is given as:

 The selection criteria for the BCR measure of project worth are:
i. If BCR > 1, we accept the project, b/c NPV>0
ii. If BCR < 1, we reject the project, b/c NPV <0, and
iii. If BCR = 1, indifferent, b/c NPV =0
Example of NPV & BCR
From the above project information calculate the BCR with 8% discount rate.

 Thus, ΣPV (Benefits) = 20616 and ΣPV (Costs)= 20308

 Therefore, BCR = 20616/20308 = 1.015 and our decision is we
accept the project since it has a BCR > 1;
NBV = ΣPV (Benefits) - ΣPV (Costs) = 20616 - 20308 = 308.
 The decision is we accept the project since it has a NBV > 0.
 BCR indicates a relative and not absolute measure of surplus.

• Thus, it is considered superior to NPV method as it indicates the

relative measure of return. It serves as a measure of efficiency to
convert costs into benefits (measures the value of benefit per Birr of
expenditure).

• Since BCR indicates the benefit per Birr of investment it can be

considered as better method for ranking projects.

Disadvantages of BCR

• As with NPV, it requires a discount rate to be determined externally.

• This method cannot be employed when a package of smaller

projects is to be considered in relation to a large project.
 iii. Internal rate of return (IRR)
 The IRR is the discount rate for which the NPV is zero. Equally, the
interest rate that will yield the BCR equal to one.
 It is the discount rate that equates the present values of benefits
with the present value of costs. Thus, it is the discount rate at which
it is worthwhile doing the project.
 IRR 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 break even.
 It is the weighted average return to the entity’s own capital engaged
over the life of the project.
 IRR is the best measure of project worth. Hence, it is the most
widely used method.
• The method utilizes present value concept but seek to avoid the
arbitrary choice of a discount rate.
• Hence an attempt is made to find that discount rate which just
makes the net present value of the cash flow equal to zero.
• We are forced to resort to a systematic procedure of trial and
error to find that discount rate which will make the NPV equal
to zero.
• The most difficult aspect of the trial and error is making the
initial estimate.
NB: An IRR of a series of values such as a cash flow can exist
only when at least one value is negative.
• If all the values are positive no discount rate can make them
zero.
• Thus, we need to treat the initial investment as negative.
 How do we compute IRR?
• The arithmetic rule for computing the IRR relies on using two
discount rates.
• In the NPV calculation we assume that the discount rate (cost of
capital) is known and determine the NPV.
• In the IRR calculation, we set the NPV equal to zero and
determine the discount rate that satisfies this condition.
• To illustrate the calculation of IRR, consider a project that has
cash flows of the following amount of Birr.

• The internal rate of return is the value of r, which satisfies the

following equation
• This project can earn back all the capital and operating costs
expended on it and pay 15.37% for the use of the money in the
meantime.
Advantages of IRR
• It is clearly understood and it is closer to business man’s rate of
return measure,
• It is determined internally as part of the calculation method, i.e, it
conveys direct message about the yield on the project
• It is a useful measure to calculate where there is uncertainty about
the correct discount rate.
Disadvantages of IRR
• It omits a consideration of the size or scale of an investment.
• It requires specification of an opportunity cost of capital to make a
decision.
• It might be tedious to calculate
3.6. Sensitivity Analysis
• Another method popularly used for analysis of risk is
what is called sensitivity analysis.
• This consists varying key parameters (individually or in a
combination) and assessing the impact of such changes or
manipulation on the project’s net present value.
• It consists of testing the sensitivity of the NPV or IRR to
changes of basic variables and parameters that enter the
project’s input and output streams.
• The common practice is to vary them by fixed percentage
such as 10%.
Exercise  Given r=10%, find payback period, NPV, BCR and IRR of
the hypothetical project(use three decimal number).

Descriptio 0 1 2 3 c 4 5 6 7 8 9 10
n/years
Cash Flow Projection for Dis ounting
Total - 2,822,400 3,018,528 3,228,838 3,454,493 3,696,660 3,956,340 4,235,028 4,534,056 4,854,920 4,854,920
Revenue
Inflow - 2,822,400 3,018,528 3,228,838 3,454,493 3,696,660 3,956,340 4,235,028 4,534,056 4,854,920 4,854,920
operation

Total Cost 3,040,000 2,310,183 2,468,898 2,638,570 2,820,084 3,014,327 3,243,064 3,465,430 3,703,437 3,958,224 3,973,819

Increase 3,040,000 - - - - - - - - - -
In fixed
assets
Operating - 2,195,912 2,330,174 2,473,657 2,627,094 2,791,224 2,966,685 3,154,415 3,355,258 3,570,157 3,589,841
costs

Income - 114,271 138,724 164,913 192,989 223,102 276,379 311,015 348,179 388,067 383,978
(corporate
) tax

Net cash (3,040,000 512,217 549,630 590,267 634,409 682,333 713,276 769,598 830,619 896,696 881,101
flow(PR 126
)
O FIT)
 Quiz-1

1. Write a three undiscounted measures of project

worth
2.Write a three discounted measures of project
worth
3. If the total initial cost of investment was $500,
& if the net amount proceeds is $100, for 10yrs,
the Payback Period would be ___