Development

planning and
project Analysis
PART II
 CHAPTER
TWO

Financial Analysis and Appraisal

of Projects
 2.1. Scope and Rationale for Financial
Analysis of Projects
 What is commercial/financial analysis?
 the financial analysis is all about the assessment, analysis and
evaluation of
o the required project inputs, the outputs to be produced/generated/ and
the future net benefit
 It is concerned with assessing the feasibility of a new project from
the point of view of its financial results.
 It aims at verifying that under prevailing market conditions the
project will become and remain viable.
 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 in
monetary terms at the prevailing (expected) market prices.
 This analysis is applied to appraise the soundness and acceptability
of a single project as well as to rank projects on the basis of their
profitability.
 Cont…
 The commercial analysis deals with two issues:
1. Investment profitability analysis, with different methods of analysis;
a. Simple methods of analysis of rate of return/static methods/ non-
discounted techniques/. This include:
 Simple rate of return;
 Pay-back period;

b. Discounted-cash-flow methods/dynamic methods

 Net Present Value/NPV/;

 Internal Rate of Return/IRR/

2. Financial analysis/ ratio analysis/.

 Liquidity analysis;
 Capital structure analysis (debt-equity ratio).
 The two types of analysis are complementary and not
substitutable.
 financial 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.
 Why or when to undertakes Financial Analysis?
 Commercial profitability analysis is the first step in the
economic appraisal of a project.
 It has to be noted that the financial analyst should be able to
communicate and know what to ask from the different team
members to collect relevant information on:
a) Revenue, both forecasted sales and selling price; (from Demand and
Market Study)
b) Initial investment costs distributed over the implementation of the
project; (Engineering, Site Development as well as Materials and
Inputs);
c) Operating costs of the envisaged operational unit/firm/ over its
operating life. (on Engineering,
d) Site Development as well as Materials and Inputs);
 Cont…
 The issues and concerns of financial analysis are:
◦ Identification of required data;
◦ Analysis of the reliability of data;
◦ Analysis of the structure and significance of costs and
benefits/incomes/;
◦ Determination and evaluation of the annual and accumulated
financial net benefits; expressed as profitability, efficiency or yield of
the investment;
◦ Consideration of the spread of flows of the costs and benefits over
time, the economic life of the envisaged economic unit/firm/public
entity/;
◦ Costs of capital over time;
 2.2. Identification and Analysis of the Estimates of
Costs and Benefits

 In project analysis, the identification of costs and benefits is

the first step. This involves
 the specification of the costs and benefit variables for which data
should be collected,
 identification of the sources of information, collection of it and
 then assessment of the quality and reliability of the collected
information.
 Objectives and the Identification of Costs and Benefits
 A cost is anything that reduces an objective
 a benefit is anything that contributes to an objective
 The costs and benefits of a project depend on the objectives the
project wants to achieve.
 Cont…
 However, each participant in a project has many and different
objectives.
◦ For a farmer, a major objective of participating may be to maximize
family income
◦ For a private business firm or government corporations a major
objective is to maximize net income,
 yet both have significant objectives other than simply making the
highest possible profit.
 Both will want to diversify their activities to reduce risk.
◦ A society as a whole will have as a major objective increased national
income, but it clearly will have many significant, additional objectives.
Those are
 income distribution.
 increase the number of productive job opportunities so that unemployment may be
reduced
 increase the proportion of saving for future investment.
 increasing regional integration, raising the level of education, improve rural health, or
safeguard national security.
 Cont…
 Quantification:
◦ once costs and benefits are enumerated the next step is accurate
prediction of the future benefits and costs which then be quantified in
monetary units/Birr/.
◦ Thus, quantification involves the quantitative assessment of both
physical quantities and prices over the life span of the project.
 The financial analysis of projects is typically based on accurate
prediction of market prices, on top of quantity prediction.
 It is worth thinking about the impact of the project itself on the level of
prices; and the independent movement of prices due to other factors.
 The same principle applies in the case of economic analysis the only
difference being the price needs to be changed to reflect net efficiency
benefits to the nations at large.
Cont…
 One widely accepted „‟efficiency‟ measure is its actual or potential
value as an import or export;

 similarly the opportunity cost of any input is related to the question

of its potential contribution to (or claims on) foreign exchange.

 In other words world price are considered as efficiency price

indicators compared to domestic prices.

 However, to take account of the distribution impact of projects

further adjustment of such price is required.

 This lends itself to the social cost benefit analysis.

2.3. Classifications of Cost and Benefits
 There are alternative ways of classifying costs and benefits of a
project. One is to categorize both costs and benefits into:
◦ tangible and
◦ intangible once.
 Another classification is in terms of:
1. Total investment costs;
2. Operational/running costs;

 Another classification:
1. Total investment costs including:
a. Initial investment costs;
• Fixed investment costs;
• Pre-Production expenditures;
b. Investment required during plant operation / rehabilitation and
replacement investment costs/
c. Net working capital
2. Operating costs/costs of goods sold
 Cont…
 Initial Fixed Investment costs
 The initial fixed investments constitute the major resources
required for constructing and equipping an investment
project.
 These include the following tangible initial fixed
investments.
1) The cost of land and site development
• Land charges
• Payment for lease
• Cost of leveling and development
• Cost of laying approach roads and internal roads
• Cost of gates
• Cost of tubes wells
2) The cost of buildings and civil works
• Buildings for the main plant and equipments
◦ Buildings for auxiliary services (steam supply, workshops,
laboratory, water supply, etc.)
◦ Warehouses and show rooms
◦ Non factory buildings like guest house, canteens, residential
quarters, staff rooms
◦ Garages and workshops
◦ Other civil engineering works
3) Plant and machinery
◦ Cost of imported machinery
◦ Cost of local or indigenous machinery
◦ Cost of stores and spares
◦ Foundation and installation charges
4) Miscellaneous fixed assets
◦ Expenses related to fixed assets such as furniture, office machines,
tools, equipments, vehicles, laboratory equipments, workshop
equipments
 Cont…
 Pre-production Expenditures
 Another component of the initial investment cost which includes both
tangible and intangible costs is the pre-production expenditures. This
includes the following investment cost items.
1. Intangible assets; these assets represent expenditures which yield
benefits extending over a long time period. These include:
a. Patents, licenses, engineering fees, copy rights, and goodwill.
b. Preparatory studies, like
 feasibility studies, specific functional studies and investigations,
 consultant fees for preparing studies, supervision costs, project
management services, etc.
2) Preliminary expenses; these costs include
◦ preliminary establishment expenses, (registration and formation
expenses),
◦ legal fees for preparation of memorandum and articles of associations
and similar documents.
◦ costs of advertisements, brokerage for mobilizing resources,
shareholders, expenses for loan application and its processing.
3) Other Pre-operation expenses. These include:
◦ Rents, taxes, and rates
◦ Trial runs, start-ups and commissioning expenditures (raw materials)
◦ Pre-production marketing costs, promotional expenses, creation of sales
network, etc;
◦ Training costs, including all fees, travel, living expenses etc;
◦ Traveling expenses interest and commitment charges on borrowings
◦ Insurance charges
◦ Mortgage expenses interest on differed payments,
◦ Miscellaneous expenses
 Sunk costs - sunk costs are those incurred in the past and upon
which the proposed new investment will be based.
◦ Such costs cannot be avoided
 Tangible Benefits
◦ Tangible benefits can arise either from increased production or
from reduced costs.

◦ However, the specific forms, in which tangible benefits appear

are not always obvious and valuing them might be difficult.

 In general the following benefits can be expected

• Increased production
• Quality improvement
• Changes in time of sale changes in location of sale
• Changes in product form (grading and processing)
• Cost reduction through technological advancement
• Reduced transport costs
• Looses avoided
• Other kinds of tangible benefits
 2.4. The Valuation of Financial Cost 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.

 The financial benefits of a project are just the revenues received and
the financial costs are the expenditures that are actually incurred by
the implementing agency as a result of the project.
 The costs incurred are the expenditures made to establish and operate
the project.
 In financial analysis 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.
 Cont…
 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.
1) Market/Shadow prices
 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.
 In economic analysis, if the market prices are distorted, then shadow or
imputed prices will have to be used for economic analysis.
 2) Absolute/relative prices
 Absolute prices reflect the value of a single product in an absolute
amount of money, while 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.
 3) 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.
 If inflation impacts are negligible, the problem of choosing between
current and constant prices does not exist, since they are equal and the
planner may use either.
 The Treatment of Transfer Payments in Financial
Analysis
 Some entries in financial accounts represent shifts in claims to
goods and services from one entity in the society to another
and do not reflect changes in national income.
 So the definition of costs and benefits might be confusing.
 These payments are called direct transfer payments. These
direct transfer payments include
 taxes,
 subsidies,
 loans, and
 Credit/debt transactions
 The reduction of all of the above elements from one enterprise to
another would not reduce the national income
 2.5. Investment Profitability Analysis
2.5.1. Non-discounting (traditional) measures of project
worth
1) Payback Period (PBP)
2) Accounting Rate of Return (ARR)
2.5.2. Discounted Cash Flows (DCF) measures of project
worth
a) Net Present Value (NPV)
b) Internal Rate of Return (IRR)
c) Profitability Index (Benefit-cost ratio)
 2.5.1. Non-discounting (traditional) measures of project
worth
1) Payback Period (PBP)
 Payback period refers to the length of time it takes to recover initial
investment of the project.
 Depending on the nature of net cash flows, payback period may be
computed in two ways.
I. When cash flow is in annuity form (even cash flows)
II. When cash flows are not in annuity form (Uneven cash flows)

 When net cash flows are not annuity, payback period is

obtained by adding net cash flows for successful years
until the total is equal to initial investment.
 In the above example
 if the 1st three years‟ net cash flows are added, the sum is
equal to Br. 45,000. But the initial investment is Br. 60,000.
 If the fourth year net cash flows (Br. 20,000) is added to Br.
45,000, the sum is Br. 65,000 which is greater than the
initial investment.
 Thus, the payback period is between year 3 and year 4.
 To find the exact payback period, we take the three years
and divide the remaining cash flows by the fourth year net
cash flows.
 If the exact payback period is needed in months the fraction
can be computed as follows:
 Cont…
 Decision Rule for Payback Period
i. Accept the project if its payback period is less than or equal to the
required payback period (standard)
ii. Reject the project if its payback period exceeds the required
payback period. The shorter the payback period, the more desirable
the project.

 Advantages of Payback Period

1. It is simple both in concept and application
2. It is a rough and ready made method for dealing with risk
3. It may be a sensible criterion when the firm is pressed with
problems of liquidity
 Disadvantages of Payback Period
1. It fails to consider time value of money
2. It ignores cash flows beyond the payback period
3. It is a measure of the project‟s capital recovery, not profitability.
4. It does not indicate the liquidity position of the firm as a whole.
 2. Accounting Rate of Return (ARR)
 The accounting rate of return is a measure of profitability
which relates net income to investment.
 Also called the average rate of return on investment
 Both net income and investment are measured in
accounting terms. The methods of computing ARR method
is shown below:


 Decision Rule for Accounting Rate of Return

 Accept the project if ARR exceeds the required rate of return.
 Reject the project if ARR is less than the required rate of return.
Example
 Assume that a project has original investment of Br. 70,000, life of 4
years, and salvage value of Br. 6000. Straight-line method of
depreciation is used.
 Straight line depreciation method is allocating the cost of a capital asset
𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒
for useful life of project 𝐷𝑝 =
𝑦𝑒𝑎𝑟𝑠

 Income before depreciation and taxes for each of the four years are as
follows: year1, Br. 40,000; year 2, Br. 42,000; year 3, Br. 36,000; and
year 4, Br. 50,000. Income tax rate is 40%.
 NI=IAD-tax(or IAD*tax rate)

 Before ARR is determined, it is necessary to compute net income for

each of the four years as follows:
 The ARR for a proposal shall be compared with a required rate of return
or risk-free interest rate (normal saving interest rate).
◦ Therefore, if we compare the ARR of the project proposals in our
example, say with an interest rate of 36%, the proposal is good for
implementation.
Cont…
 Advantages of ARR
1. It is simple to calculate
2. It is based on accounting information, which is readily
available and familiar to businessmen.
3. It considers benefits over the entire life of the project.
4. It facilitates post-auditing of capital expenditures.
 Limitations of ARR
1. It is based upon accounting profit, not cash flow.
2. It does not take into account the time value of money.
3. Since there are numerous measures of accounting rate
of return, this may create controversy, confusion, and
problems in interpretation.
4. Accounting income is not uniquely defined because it
is influenced by various methods, such as depreciation
methods, inventory costing method etc.
2.5.2. Discounted Cash Flows (DCF) measures of project worth

1) Net Present Value Method

 The net present value of project is the difference between the present
value of net cash inflows and present value of initial investment.
 NPV represents the amount by which the value of (wealth of) the firm
will increase if the project is accepted. In formula,

𝐶1 𝐶2 𝐶𝑛
 𝑁𝑃𝑉 = [ + + ⋯+ ] − 𝐼0
(1+𝑟)1 (1+𝑟)2 1+𝑟 𝑛
𝐹𝑉
 𝑃𝑉 =
(1+𝑟)𝑡

 Where: NPV = Net present value n = Life of the project

 Ct = Net cash flows at the end of year t r = Discount rate
 I0 = Initial investment
 Decision Rule for NPV
1) If NPV is greater than zero (NPV > 0), the project is considered desirable.
2) If NPV is less than 0, the project is considered undesirable
 Example
 Imagine a project that costs $1,000 and will provide three cash
flows of $500, $300, and $800 over the next three years.
Assume there is no salvage value at the end of the project and
the required rate of return is 8%. The NPV of the project is
calculated as follows:

 Conclusion
 A positive NPV means the combined PV of all cash inflows exceeds
the present value of cash outflows
 The NPV of $355.23 suggests that the combined PV of cash inflows
exceeds the PV of cash outflows by $355.23
 This project is acceptable one since it adds $355.23 to the value of
the company
2) Internal Rate of Return (IRR)
 IRR is the discount rate which equates the project NPV equal to zero.
 It is the discount rate at which the present value of Net cash flows is
equal to the present value of initial investment.
 In other words, IRR is the rate of return on investments in the project.
 The determination of IRR is purely based on project cash flows.
Mathematically, at IRR,

 IRR is determined using trial and error

Cont…
 Rate of return is the rate at which money comes back to
investor and written in % per year
 Example 1.
 Invest $100 today
 Get back $5 every year, forever
 Rate of return is 5% per year.
2. Assume that a project has initial investment of Br. 100 and
will provide two cash flows of $60, and $70 over the next two
years. What is rate of return?
 In this case the rate of return is hidden. Another name for hidden is
“internal”. So it‟s now the internal rate of return.
 We can‟t estimate it simply as of the above example.
Cont…
 To do it first think about future cash outflow and inflow, and then think
about what is the value today, using the net present value formula,
𝐶1 𝐶2
𝐼𝑅𝑅 = 1
+ 2
− 𝐼0 = 0
(1 + 𝑟) (1 + 𝑟)

60 70
+ − 100 = 0
(1 + 𝑟)1 (1 + 𝑟)2

 Remember, we still don‟t know the rate (r) which we are trying to find
out. So we have to find „r‟ by using trial and error.
 Let guess r =14% or 0.14
60 70
1
+ 2
− 100 = 0
(1 + 0.14) (1 + 0.14)
60 70
+ − 100 = 0
(1.14)1 (1.14)2
6≠0
 Since our NPV is not equal to zero, r is not 14%.
 Now let‟s see if r=12%
60 70
1
+ 2
− 100 = 0
(1 + 0.12) (1 + 0.12)
1.4 = 0,
∴ 𝑟 ≠ 12%
 Let try another number, if r=19%
60 70
+ − 100 = 0
(1 + 0.19)1 (1 + 0.19)2
0.14 = 0
 Since 0.14 is almost exactly equal with 0, the hidden or internal rate of
return is 19%.
3. Profitability Index (PI)
 The profitability index, also called benefit-cost ratio, is the ratio of the
present value of net cash flows and initial investment.
 2.6 Sensitivity Analysis
 A method popularly used for analysis of risk is called sensitivity
analysis.
 Sensitivity analysis is a techniques applied to uncertainties.
 These uncertainties are factors affecting project outcomes, which
cannot be quantified.
 The purpose of sensitivity analysis is to tell us the factors, which are
liable to have the greatest influence over project success and failure.
 Once these factors have been identified it is then possible to deign
appropriate mitigation measures.
 Sensitivity analysis (sometimes called „what if‟ analysis) shows how
the NPV or other criterion of merit changes with variations in the value
of any variable (sales volume, selling price per unit, cost per unit etc.).
 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.
 Cont…
 It is the process of seeing what changes in the value of the dependent
variable is consequent on a change in the value of one or more of the
variables that determine it.
 It generally involves considering the effect on the NPV of plausible
variations in some of the assumptions made.
 The common practice is to vary them by fixed percentage such as 10%
(instead of say by +-1SD).
 Such measures give us no information about the probability. The
purpose of the sensitivity analysis is:
 To enhance our understanding of the structure and working of the
project;
 To guide us in the design of the project so that high NPV or IRR are
obtained;
 To suggest areas and means by which risk can be reduced.
 The variables for sensitivity test should be selected
on the basis of:
(a) The degree of uncertainty associated with the variable; and
(b) The importance of the variable in determination of the NPV and
IRR.
 Hence it is not advisable to spend time in testing for sensitivity
of a variable that has an insignificant effect on the NPV and IRR.
 The key variables whose variations should be studied will be
different from project to project, but a number of standard test
will normally be considered.
 The variable that is most commonly varied in sensitivity analysis
is the discount rate because of the considerable uncertainty that
often attaches to the estimated discounting rate.
 But total investment costs, implementation times, output levels
and prices, the volume of demand, the level of capacity, and
operating cost are commonly varied by amounts or percentages
that seem reasonable on the basis of past experiences.
Approaches of Sensitivity Analysis
 There are two approaches in conducting sensitivity
analysis.
 The first is that a range of estimates can be made
where, a variable might be tested using three
different values:
 A „best estimate’
 An ‘optimistic’ value
 A ‘pessimistic’ value
 Such an approach is useful in defining the possible
impact of changes in a particular parameter but,
without further analysis,
 such tests do not provide any additional information and
 it is difficult to make comparisons of sensitivity to changes in
different variables if the percentage variations are different.
 Pessimistic and optimistic values will be tried and checked. This is
done to determine the sensitivity of the estimated NPV to changes in
these variables.
 A second approach is to choose a fixed percentage variation
and to test each important variable for that percentage
change.
 This approach has the advantage that it is possible to compare the
sensitivity of the project to changes in different variables and
 therefore to determine which variables are most important in
determining project profitability.
 We change the values of key variables, one at a time or in
combination by a certain percentage and calculate again the
NPV or IRR. A comparison between the previous and new
values of the NPV and IRR shows their sensitivity to value
changes in the variable involved.
 Some changes in variables have a linear relationship to the
NPV while others do not. To apply these tests the following
points have to be considered:
◦ Set up the relationship between the basic underlying factors (such as
the quantity sold, unit selling price, or the unit cost of major cost items)
and net present value (or some other criterion of merit.
◦ Estimate the range of variation and the most likely value of each of the
basic underlying factors.
◦ Study the effect on net present value of variations in the basic variables.
 Scenario I: Assume that the sales revenue of a Hides and Skins
Project goes down by 10% while the total cost of the project remains
the same. The NPV of the project at a discount rate of 10% is reducing
from 1,321,800 to – 3,654,000. To reduce the NPV to zero would
therefore require a change in sales revenue of:

 A reduction in sales revenue of 2.7% would therefore be sufficient to

reduce the NPV at 10% discount rate to an marginal figure. This
illustrates how sensitive projects with a single output are to changes in
the sales price.
 Where a linear relationship exists between the variable concerned and
the NPV the following formula can be used to calculate a switching
value that is the change in the value for the variable concerned
required reducing the NPV of the project to zero.

 Sensitivity analysis allows for the identification of those critical areas

that will influence the success or failure of the project.
 The application of switching values in sensitivity analysis
can be illustrated, taking the Hides and Skins Project as
follows.
 Scenario III: Assume that the production level achieved by
the project is 10% below the level expected. This involves
changing the sales value and all the variable costs items as
well as the associated working capital items. A 10%
reduction in the level of production reduces the NPV to –
6,700 (i.e., to just below zero). To reduce the NPV to zero
would therefore require a decrease of:

The project is less sensitive to changes in production level

than it is to changes in the price of the main raw material. This
is because the cost of unprocessed hides and skins is over
50% of the sales value and so when the production goes
down the costs go down significantly as well as the benefits. It
is quite common for agro – processing industries to be less
sensitive to production levels than to the price of the main
raw material.