Chapter-3
Feasibility Analysis and Appraisal
of Projects
Content
•
Aspects of Investment Feasibility Analysis
o Steps in investment analysis
o Financial analysis
o Technical analysis
o Marketing Analysis
o Socio-economic Aspect
• Method of Financial feasibility analysis
o Cash flow method
o Payback method
o Accounting rate of return
o Discounted cash flow measures
▪ The NPV method
▪ Benefit-cost ratio / Profitability Index
▪ The IRR method
• Accounting for risk in project decisions
o Risk- Adjustment Cut-off rate
o Certainty equivalent approach
o Probability Approach
o Sensitivity technique
Investment Analysis
❑ What is Investment Analysis?
➢ Investment Analysis:
• is the method adopted by analysts to evaluate the investment
opportunities, profitability and its associated risks in their portfolio. It
helps them to determine whether the investment is worth or not.
• is the process of evaluating an investment for profitability and risk. It
ultimately has the purpose of measuring how the given investment is a
good fit for a portfolio. Furthermore, it can range from a single bond in
a personal portfolio , to the investment of a startup business, and even
large scale corporate projects.
• is a broad term that encompasses many different aspects of investment.
It can come in handy for predicting about future returns.
• can facilitate how an investment is likely to be executed and how great
the opportunity is for a given investor. Investment analysis is essential
to any sound portfolio management strategy.
• involves researching and evaluating a security or an industry to
predict its future performance and determine its suitability to a specific
investor.
What is Investment Analysis
➢ Investment analysis:
• is the process of judging an investment for income, risk, and resale
value. It is important to anyone who is considering an investment,
regardless of type.
• Investment analysis methods generally evaluates three factors: Risk, Cash
flows, and resale value.
1. Risk
•
•
•
The first factor evaluated in any investment analysis is risk. The reason for this is simple:
if the risk of the investment is too great then loss is quite likely. In this case, cash flows
and resale value generally do not matter because the investment is worth nothing.
To evaluate risk, one simply uses a variation of the following formula:
Risk = Rate of occurrence X the impact of the event
= Probability of Occurrence X The Consequence
Despite this, risk is not a definite factor. One must evaluate all the factors related to
the investment: market, industry, governmental, company, and more. In this way evaluating
risk is as much of an art as a science.
Investment Analysis
2. Cash Flow
➢ The second factor of investment analysis is cash flows.
➢ Cash flows occur in many ways:
•
•
•
•
•
Cash Flow From Operating: Cash received from the sale of goods and services, Interest
payments, Salary and wages paid, Payments to suppliers for inventory or goods needed for
production, Income tax payments, etc.
Cash Flow From Financing: Dividend payments, Stock repurchases Bond offerings–
generating cash
Cash Flow From Investing: Purchase of fixed assets–cash flow negative,
Purchase of investments such as stocks or securities–cash flow negative, Lending
money–cash flow negative, Sale of fixed assets–cash flow positive, Sale of
investment securities–cash flow positive, Collection of loans and insurance
proceeds–cash flow positive
Cash flows are one of the methods of repayment on an investment. Thus, an investor
will want to evaluate cash flows to see if they repay the investment while also repaying
the assumed value of the risk on the investment.
Many methods of evaluating cash flows exist: future value (FV) of cash flows
and Discounted Cash Flow Analysis. Others provide each investor with a method of
analysis based in the type of investment they are considering. Regardless, ignoring the
analysis of cash flows is a quick path to loss of investment capital.
Investment Analysis
3. Resale Value
•
The third factor of investment analysis is resale value.
•
Is the price of investment assets when sold in the future. It refers to the sale of
goods that were purchased for the purpose of being resold.
•
Profit from resale is made through a gain in the market value of the asset. When the
asset is sold to another investor for a value higher than the original purchase
price, profit from resale value has occurred
•
In the process of investment analysis, an investor will want to measure the expected rate of
growth on the asset to make sure that the value of this and any associated cash flows are
larger than the loss of investment and the estimated value of the risk of the investment.
•
All of these methods of investment analysis are applicable to any investment: stocks on the
stock market, treasury bills, the purchase and growth of a business, or even currency trading.
Though each has a purpose-built method for investment analysis, each requires this if the
investor is to be sure that the risk is worth the reward.
❑ Steps in Investment Analysis:
•
The three steps in investment analysis are the following:
1. Identify the investment opportunity,
2. Find the Present Value (PV )of the future cash flows, and
3. Compare the present value (PV) of the cash flows to the cost of the investment.
Project Apprsisal
❑ What is Project appraisal ?
• means assessment of a project.
• is an important activity to evaluate the key factor of the project to decide and
proceed with the project proposal and ability.
• is made for both proposed project and executed projects. In case of former
project appraisal is called Ex-ante analysis and in case of letter Post-ante
analysis’. Here, project appraisal is related to a proposed project.
• is a cost and benefits analysis of different aspects of proposed project with an
objective to decide its viability.
•
is process of assessing the following types of the Appraisal Aspects. And these
Key aspects of appraisal will be evaluated before committing a Project.:
Technical Aspects; Financial Aspects, Socio-Economic Aspects ; Marketing
and demand Aspects; Managerial Aspects; Organizational and institutional
Aspects.
PROJECT APPRAISAL
❑ What is Project appraisal ?
➢ A project involves employment of scarce resources. A project needs to appraise
various alternative before allocating the scarce resources for the best project.
Thus
• Project appraisal helps select the best project among available alternative
projects.
• Project appraisal means a pre-investment analysis of a project to
determine whether the project should be implemented or not
• A project Appraisal involves detailed pre-investment analysis of market
& technical feasibility, financial soundness, economic desirability and ,
finally, measuring its investment worth.
• It requires the combined efforts of a team of persons from various
discipline
➢ is or should be an independent assessment of the project to identify the
weaknesses and strengths of the study that have a bearing on the
decision to invest, and/ or to finance the project.
Project Appraisal…
❑ What is Project appraisal ?...
➢ Project Appraisal is a second look by a team of professions,
• Who were not participated in the preparation of the study but qualified
and experienced to evaluate such studies
• Appraisal factors are evaluated by groups of specialist of different fields
who are not involved in the preparation of the Project Proposal.
➢ Appraisal is the comprehensive and systematic assessment of all
aspects of a project study, addressing particularly issues like:
•
•
•
Specificity of objectives;
Clarity of problems
Methodology: type and source and appropriateness of data
collection and analysis techniques
• Project specific factors
Project Appraisal…
❑ Objectives of Project Appraisal:
•
The key objectives of the Appraisal Process of a Project:
• Assessment of a project in terms of specificity of objectives; clarity of
problems; methodology and project specific factors.
• Assessment of a project in terms of its Technical and market, economic,
social , financial, etc. Viability
• Decide to Accept or reject a Project
❖ Project Appraisal is necessitated because the resources or means are limited
as compared to the needs of the society
❖ As a result, any investment undertaken implies depriving other projects
resources
❖ Hence, it is very important to appraise each project before investment decision
so that scare resources are utilized in the best possible ways.
❖ In other words, before allocation of resources for a particular project, the
decision making authority must convince itself that the proposed project is the
best and most economical way of achieving the desired objective ( in terms of
socio-economic benefits)
❖ For this and for ensuring economic use of resources, we have to appraise
each project very minutely from different angles.
Project Appraisal…
❑ Significance/Usefulness/ Importance of Project Appraisal:
•
Appraisal process of a project is a very important activity to perform before
accepting a project. And this will help you to check if you can complete the project.
So that you can accept and reject the Project Proposal.
•
Project appraisal is an important activity to evaluate the key factor of
the project to check the Viability of a project proposal. We can use
various Appraisal methods and tools to accept or reject the project. For example,
economic or financial appraisal analysis, and other decision techniques.
• Project appraisal is useful in following ways;
1. It helps in arriving at specific & predicted results.
2. It evaluates the desirability of the projects.
3. It provides information to determine the success or failure of a project.
4. It employs existing norms to predict the rate of success or failure of a
project.
5. It verifies the hypothesis framed for the project.
Aspects of Feasibility Analysis and Appraisal
❖ A complete feasibility analysis of a project must cover the following
important aspects study areas before committing a project:
(1) Technical analysis: including manpower and technological requirements;
(2) Market analysis including Demand
(3) Financial Analysis: for funding needs and sources
(4) Economic Analysis: such as the economic costs and benefits ;
(5) Environmental Analysis: including present baseline data and the impact of
those data
(6) Social/political Analysis: including demographic data and social need
(7) Sensitivity Analysis
(8) Administrative/managerial Analysis: including external linkages and internal
organization;
Feasibility Study: A Schematic Diagram
Generation of idea
Initial Screening
Is the idea prima facie promising
Yes
Plan Feasibility analysis
Conduct market
Analysis
NO
Terminate
Conduct Technical
Analysis
Conduct Financial Analysis
Conduct Economic, Social and
Environmental, etc. Analysis
Is the project worthwhile?
Yes
Preparing Funding Proposal
NO
Terminate
Technical Analysis
Technical Analysis
❑ Fundamental Objectives of Technical Analysis
❖ Primary Objective technical analysis is to see whether the project idea is
feasible or not from technical point of view.
❖ The fundamental objectives of technical analysis is
•
•
•
To justify the present choice provide an insight into future
technological development .
To ensure that the project is technically feasible , i.e. all inputs required
are available
To facilitate the most optimal formulation of the project in terms of
technology, size, location and so on.
❖ Other Objectives are
• To justify the goal compatibility of a project with the preferred
technology
• To check a better available alternative technology which is both Cost
effective and efficiently manageable
• To seek such a technology that can go with existing skill levels of team
members or requires little orientation and training programs
• To seek a better technology that is not detrimental to the overall
environment
• The technology that is used in projects can be classified on the basis of
purpose for which it is applied; level in which it is used; nature of skill
applied while using the technology, etc.
Technical Analysis…
❑ Essential of Technological Appraisal
❖ While performing a technological appraisal, some of the vital ingredients
that need attention are:
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•
•
•
•
The state of existing available technology
Training needs of personnel for the present technology and for the new
technology
Availability of technical know-how
Input base the technology or its compatibility with the input substitutions
Factor intensity: The factor intensity of the techniques of production chosen by
a cost-minimizing firm depends on the relative prices of different factors of
production. For any given set of relative factor prices, some goods are produced
with a low capital–labour ratio: such goods are labour-intensive
•
•
•
•
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Future progressive integration of the technology for modification or
refinements
Wider product-mix ( and its by-products)
Minimization of waste, loss or scrap in the process or its development
Stability to change and its relative obsolescence rate
Other techno-economic considerations ( side effects of technology transfers
on the labor lay-off , etc.).
Technical Analysis…
❑ Essential of Technical Appraisal…
❖ Generally, while apprising technical feasibility of any project, the following points
are carefully considered
1. Availability of critical inputs: availability of land, utilities, skilled labor,
facility of disposal , market (nearness), etc.
2. The capacity of the plant and manufacturing process and suitability of the
technology employed
3. Suitability of plant and machinery for the manufacturing process to be
adopted
❖ Technical Analysis: Additional reviews areas of
•
The engineering feasibility of the project: including structural, civil and other
relevant engineering aspects necessitated by the project design.
•
The technical capabilities of the personnel as well as the capability of the
projected technologies to be used in the project are considered.
•
In some instances, particularly when projects are in third world countries,
technology transfer between geographical areas and cultures need to be
analyzed to understand productivity loss ( or gain) and other implications due
to differences in topography, geography, fuels availability, infrastructure
support and other issues
Technical Analysis …
❖ The technical analysis of a project idea includes:
• designing the various processes,
• installing equipment,
• specifying material, and
• prototype testing.
❖ Technical aspects relate to the production or generation of the project output in the form of goods and
services from the projects inputs.
❖ Technical analysis represents study of the project to evaluate technical and engineering
aspects when a project is being examined and formulated.
❖ Technical Analysis is a continuous process in the project appraisal system which determines the
prerequisites for meaningful commissioning of the project.
❖ Technical Appraisal: focuses on issue like
a. Availability of inputs at reasonable cost
b. Consistency & soundness of engineering design
c. Economics of scale in production (occurs when more units of a good or service can
be produced on a larger scale with (on average) fewer input costs, efficient production,
d. Appropriate technology & alternative way of production
e. Advantageous location of the project
f.
Maintenance & Repairs
g. Provision for expansion
h.
:
Balancing of equipment
a process in which the equipment used for construction are
not allowed to remain idle for a long duration of time. Remaining idle may further increase
its maintenance cost and it also reduces efficiency of work by considerable amount.
Aspects of technical Analysis
❑ Technical analysis broadly involves a critical study of the following aspects
1. Selection of Process/Technology:
❑ The choice of technology based on the type of technology, quantity and quality of
product proposed to be manufactured , etc.
❑ Determinants of choice of technology/process: plant capacity, principal inputs,
investment outlay and production cost, use by other units, product mix, latest
development and ease of absorption.
❑ The choice of a suitable technology for a project calls for identifying what is called
the ‘appropriate technology’. The term ‘appropriate technology’ refers that
technology that is suitable for the local economic, social and cultural conditions
❑ Appropriateness of Technology is a function of whether the technology
➢ utilizes the local raw materials?
➢ utilize local man power?
➢ protects ecological balance?
➢ is harmonious with the social and cultural conditions ? and
➢ Whether the goods and services produced cater/provide to the basic needs?
Aspects of technical analysis ( Cont…)
2. Scale of operation: Scale of operations is signified by the size of the plant.
3. Raw material: A product can be manufactured using alternative raw materials
and with alternative process. Hence the cost of capital investments required on plant
and machinery should also be studied before arriving at a decision on the choice of raw
material
4. Technical Know-How: When technical know-how for the project is provided by
expert consultants, it must be ascertained whether the consultant has the requisite
knowledge and experience and whether he has already executed similar projects
successfully
5. Collaboration Agreements: If the project promoters have entered into agreement
with external collaborators, the terms and conditions of the agreement may be studied
as explained above for know-how supply agreement.
6. Product Mix: Customers differ in their needs and preferences. Hence, variations
in size and quality of products are necessary to satisfy the varying needs and
preferences of customers, the production facilities should be planned with an element
of flexibility. Such flexibility in the production facilities will help the organization to
change the product mix as per customer requirements, which is very essential for the
survival and growth of any organization.
Aspects of technical analysis ( Cont…)
7. Selection and Procurement of Plant and machinery:
•
Selection of machinery: The machinery and equipment required for a project depends upon
the production technology proposed to be adopted and the size of the proposed. Capacity of
each machinery is to be decided by making a rough estimate.
8. Location of Projects:
•
•
•
Choosing the location for a new project is to be done taking many factors into
account.
The study for plant location is done in two phases.
• First a particular region/ territory is chosen that is best suited for the project.
• Then, within the chosen region, the particular site is selected.
Thus, we may say that there are two major factors, viz., Regional factors and site
factors, to be considered.
❖ Location and site concerned with :
• Site selection
• Critical assessment of Demand
•
Size of plant
• Input requirement
• Proximity to raw materials
and market
• availability of infrastructure
• labor situation
• government policies
Aspects of technical analysis ( Cont…)
9. Project Scheduling:
•
Scheduling is the arrangement of activities of the project in the order of time in which
they are to be performed.
•
The schedule which broadly indicates the logical sequence of events would be as under:
1.
Land acquisition,
2.
Sit development,
3.
Preparing building plants, estimates, designs, getting necessary approvals
and entrusting the construction work to contractors,
4.
Construction of building, machinery foundation and other related civil
works and completion of the same Placing order for machinery,
5.
Receipt of machinery at site,
6.
Erection of machinery,
7.
Commissioning of plant and taking trial runs,
8.
Commencement/beginning of regular commercial production.
Aspects of technical analysis ( Cont…)
10. Environmental aspects : that need to be assessed are: Surface water quality;
Air quality; Seismology; Erosion; Land quality; Forest; Fisheries;
Terrestrial wildlife; Noise; Archaeological/ historical significance; Public
health; etc.
❖ Thus technical analysis enables to find out
•
•
•
The most optimal formulation of the project technology, size, location, etc.
The cost of project, so that profitability can be calculated.
Technology selection influenced by
- material and utilities input requirement,
- Plant capacity
- production cost
- flexibility Product mix ( depend on market requirement,
quality of product, flexibility in production)
- Technology obsolescence/uselessness/
- Ease of adoption
❖ SELF ASSESSMENT QUESTIONS
1.
What aspects are considered in technical analysis?
2. What factors have a bearing on choice of technology?
3. What are the fundamental objectives of technical analysis of a project
Financial Analysis
What is Financial Analysis
➢ Finance is one of the most important prerequisites to establish an enterprise. It
is finance only that facilitates an entrepreneur to bring together the labor,
machines and raw materials to combine them to produce goods
➢ What is Financial Analysis ?
• defined as the process of discovering economic facts about a project on the
basis of an interpretation of financial data.
•
is the process of evaluating businesses, projects, budgets, and other finance-related
transactions to determine their performance and suitability.
• estimates the profitability of a project, from an investor's perspective (not from
nation’s economy or society perspective)
• compare the costs of the project to the expected revenue over the project
lifespan.
• is vital in the interpretation of financial statements. It can provide an insight
into two important areas —
1.
2.
return on investment and
soundness of the project's financial position.
What is Financial Analysis
➢ Financial analysis is analytical work required to identify the critical
variables which are useful to determine the success or failure of an
investment.
➢ The concern of financial analysis is to determine, analyze and interpret
all the financial consequences of an investment that might be relevant to
and significant for the investment and financing decisions.
➢ Financial Analysis is the assessment of the viability, stability and
profitability of a project or business
➢ Financial analysis compare the costs of the project to the expected
revenue over the project lifespan.
•
The costs of a project includes:
• Costs of financing including transfer payments & taxes,
• Operational expenditure ( OPEX), and
• Capital expenditure(CAPEX)
What is Financial Analysis ?
• The figure illustrates the elements in a financial analysis. The net financial
benefit is given by the difference of total revenue and total cost
• The goal of the financial analysis is to demonstrate the ability of a project to
generate a sufficient return on investment to be interesting for investors.
• The results of the financial analysis are typically presented as the NPV, IRR
and Benefit –Cost Ratio.
• Decision Criteria:
➢ Financial sustainability is ensured if the accumulated generated cash
per year is positive or, at most, equal to zero for all years considered.
➢ if this figure is negative at any point in time, the project is not
sustainable, meaning that there are not enough financial resources to
cover all the costs, and it will be necessary to reassess project financing
mechanisms
Purpose of financial analysis in project preparation
Financial analysis is essentially undertaken for the following purposes:
1. It provides an adequate financing plan for the proposed project/ investment
2. It determines the profitability of a project
3. It assists in planning the operation and control of the project by providing
management information to both internal and external users
4. It advises on methods of improving the financial viability of a project entity
5. It illustrates the financial structure of the project and its existing and
potential financial viability.
Significance of Financial Analysis
❑ The significance of financial analysis is
• To find out whether the project is attractive enough to secure funds needed
for its various constituent activities and once having secured the funds whether
the project will be able to generate enough economic values to achieve the
objectives for which it is sought to be Implemented.
•
Not only to deal with the financial aspects of a project but also with its
operational aspects.
• As such, it is necessary to undertake such an analysis not only in the
case of industrial projects but also in the case of non-industrial
projects.
• To reach on conclusions about the financial health, profitability and
efficiency of a project and also to compare one project with other similar
projects. For this
•
The technique of ratio analysis is the most important tool of financial
analysis. It helps in comparing the performance of various projects and judge
their financial soundness
Significance of Financial Analysis…
• Utility of financial analysis:
Financial Analysis…
❑ In order to determine and declare the financial viability of the project, the
following aspects need to be carefully analyzed
• Estimates of Cost of capital = the cost of purchasing land, equipment,
factory building, vehicles, etc.
• Means of finance
• Cost of production = capital expenditure, operational expenditure, cost
of financing
• Working capital requirement and its financing
• Estimates of sales and production
• Break-even point
• Projected cash flow = is the movement of money in and out of a
company
• Projected balance sheet.
Project Cost and Benefits valuation in Financial Analysis
❑ Cost and benefits of a project: may be distinguished as
• Primary and secondary costs and benefits
• Tangible and Intangible costs and benefits
1. Primary and secondary costs
1.1 Primary Costs and Benefits: in this approach,
❖ Financial benefits: are
produced by the project
revenue received from sales of goods or services
❖ Financial costs: are expenditure that are incurred by the implementer
agency/project which include capital costs for capital assets, Operating cost for
labor, raw materials, fuel and utilities.
❖ Primary costs involves those costs that arise from the consumption of goods and
services supplied to the project/ organization from external ( as opposed to
internal) source. Primary costs include: Labor costs, External services,
material costs, operating supplies, accrual costs.
Financial Analysis…
➢ Primary costs is concerned with direct project inputs cost. It is a firm’s
expenses directly related to the materials and labor used in production.
➢ Primary cost is a direct cost that a project /company incur in manufacturing a
product
Primary costs = Direct material cost + Direct labor Cost
➢ Primary cost elements reflect operating expenses such as: material cost,
personnel cost, labor cost, etc.
➢ Note that:
• In financial analysis all these receipts and expenditures are valued as they
are appear in the financial balance sheet of the project and measured in
market prices.
Market prices : are just prices in the local economy
Financial Analysis…
1.2 Secondary costs and benefits of a project:
➢ Primary or direct costs are those which are directly incurred on the
construction of a project but the Secondary costs include the cost
providing benefits to the people working on project such as cost of
constructing houses, schools, hospitals etc. at the sight of project
➢ Secondary costs exist where the project enables more efficient use of
resources to be made elsewhere or leads to external claims on resources
elsewhere.
➢ Primary cost elements arise through the consumption of production
factors that are sourced externally. Secondary cost elements arise through
the consumption of production factors that are provided internally.
➢ Secondary cost elements represent costs resulting from value flows within
the organization, such as internal activity cost allocations, overhead
allocations, and settlement transactions. Examples of secondary cost
elements include:
• Cost elements for overhead allocation (such as material
overheads, production overheads, etc)
• Cost elements for internal activity allocation
• Cost elements for order settlement
Financial Analysis…
➢ Generally, there are three major constituents of Total production /
manufacturing costs:
1. Direct raw material costs
2. Direct labour costs
3. Manufacturing overheads may include indirect material, indirect labour,
other common manufacturing expenses, cost of utilities, and all such
expenses. All these are overheads, as their direct identification to each unit
of production is challenging. Therefore, these expenses are allocated over
all the units produced
➢ Project might lead to benefits created or costs incurred outside the project it
self.
•
So project analyst must also consider the external or secondary costs so
that they can be properly attributed to project costs investment.
➢ This is more a problem of economic analysis and not a concern of financial
analysis
❑ Formula
•
One can calculate primary costs using any of the following formulas depending on
the type of information available. Generally, we use the first formula.
1. Primary Costs = Direct Materials Cost + Direct Labour Cost
2.
Primary Costs = Total Manufacturing Costs – Total Manufacturing
Overheads
Financial Analysis…
S.N
Particulars
Expenses ( in$)
1
Raw Material A
40000
2
Raw Material B
32000
3
20 workers @ 10 per hour for 400 hours
80000
4
Freight & Insurance for Raw materials A &B **
2000
5
Indirect labour cost
55000
6
Rent and Taxes for production unit
5000
7
Utilities
20000
** Since these are the costs incurred exclusively for the raw materials, hence, it
will be part of the primary cost
❑ The primary cost = 40000 + 32000 + 80000 + 2000 = 154,000
❑ Secondary cost = 55000 + 5000 + 20000 = 80,000
❑ If we want to calculate the Primary Cost with the second formula, we first need to
calculate the total manufacturing overheads. The total manufacturing expense is 234000.
Therefore,
Primary cost=Total Manufacturing Expenses – Total Manufacturing Overheads,
= 234000 - 80000 = 154000.
Financial Analysis…
2. Tangible and Intangible costs and benefits of a project
2.1 Intangible cost and benefit of a project
❑ Intangible benefits are benefits that are difficult or impossible to quantify like
improved customers goodwill, better employee morale, etc. On the other hand,
an intangible cost is any cost that's difficult to quantify. Examples
include declines in customer satisfaction, productivity, employee moral,
reputation or brand value,
❑ Intangible benefits cannot be quantified directly in economic terms, but still
have a very significant business impact. Similarly, an intangible cost is an
unquantifiable cost emanating from an identifiable source that can impact,
usually negatively, overall company performance. Many intangible costs
arise from causes that are social, legal, or political, and ignoring them can have
adverse implications.
❑ Tangible benefits can often be estimated before certain actions are taken,
while intangible benefits are virtually impossible to estimate beforehand.
Financial Analysis…
•
The intangible benefits may include: the creation of
•
Organizational Strategy support , Enhanced user experience, Increased
customer satisfaction, New employment opportunity,
•
Better health and reduced infant mortality as a result of projects such
as more rural clinics, Better nutrition, Reduced incidences of
waterborne diseases,
•
National integration or even national defense
•
Such intangible benefits do not readily lend themselves to direct valuation. Under
such circumstance one may have to resort to the least cost approach instead of the
normal benefit cost analysis.
•
Note that: Although such benefits are intangible, most of the costs are tangible.
•
Construction costs for school, hospital, pipes for rural water supply, etc. are
all quantifiable.
•
However, cost such as the disruption of family life, the increased pollution as
a result of the project , ecological imbalance, etc. are difficult to capture and
quantify. But effort should be made to identify and quantify wherever
possible.
Financial Analysis…
2.2 Tangible costs and benefits of a project
A) Tangible benefits of a project :
➢ Tangible benefits are benefits that can be easily quantified like increased
sales, reduced expenses, etc.
➢ Though its valuation is difficult, can arise from
• Increased production
• Quality improvement
• Changes in time of sale
• Change in location of sale
• Change in product form
• Cost reduction through technological advancement
• Reduced transportation costs
• Other kinds of tangible benefits.
Financial Analysis…
B) Tangible Cost of a Project
➢ In almost all project analysis costs are easier to identify and value than
benefits.
➢ The costs of a project depends on the exact project formulation, locations,
resource availability, or objective of the project.
➢ Conceptually, the cost of project represents the total of all items of out lay associated
with a project, which are supported by long-term funds. This include:
1. The cost of land and site development
• Land charges
• Payment for lease
• Cost of leveling and development
• Cost of laying approach reads and internal roads
• Cost of gates
• Cost of tubes wells, etc.
Financial Analysis…
2. The cost of building and civil works
• Building for the main plants and equipment
• Buildings for auxiliary service ( steam supply, work shops, laboratory,
water supply, etc.)
• Ware houses and shower rooms
• Non-factory buildings like guesthouse, canteens
• Silos, tanks, wells, basins, etc.
• Garages and work shops
• other civil engineering works
3. The cost of plant and Machinery: typically the most significant component
of project cost, consists of
• Costs of imported machinery: this is the sum of (i) FOB ( Free on
Board) value, (ii) shipping , freight and insurance cost, (iii) Import duty
and (iv) clearing, loading, unloading, and transportation charges
• Cost of local machinery
• Cost of stores and spares
• Foundation and installation charges
NB: The cost of plant and machinery is based on the latest available quotation
adjusted for possible escalation.. Generally, the provision for escalation i.e. equal
to the following product: ( latest rate of annual inflation applicable to the plant
and machinery)x ( length of the delivery period)
Financial Analysis…
4. Technical know-how and Engineering fees
• Payment for Consultant or collaborators from local or abroad for advice and
help is a component of project cost
5. Expenses on foreign technicians and training of local technicians abroad
• Expenses on their travel, boarding, and loading along with their salaries and
allowance must be shown here
6. Miscellaneous fixed assets
• Fixed assets and machinery, which are not part of the direct manufacturing
process may be referred to as miscellaneous fixed assets. These includes:
furniture, office machinery and equipment, tools, vehicles, etc.
7. Preliminary and capital issue expenses:
• Expenses incurred for identifying the project, conducting market survey,
preparing feasibility report, etc.
• Expenses borne in connection with the raising of capital from the public.
The major are under writing commission, brokerage, fee to managers,
registrar, printing and postage expenses, etc.
8. Pre-Operating Expenses : Include establishment expenses, rents, taxes and
rates, traveling expenses, insurance charges, mortgage expenses, interest on
deferred payment, start up expenses, etc.
9. Provision of Contingencies foe the unforeseen expenses and price increases
Financial Analysis…
❑ Treatment of Transfer Payment in Financial Analysis
❖ Some payments that appear in the cost stream of the financial analysis do not
represent direct claims on the nation’s resources but merely reflect a transfer
of the control over resources allocation from one member or sector of society
to an other.
• For example, the payment of interest by the project entity on a domestic
loan merely transfers purchasing power from the project entity to the
lender.
1. Taxes
•
•
•
•
•
Taxes are a direct transfer of payment from the firm to the government.
In financial analysis, tax is a cost to the firm b/s when a firm pays tax its
net income reduces.
Taxes do not represent real resource flow, it represent only the transfer of a
claim to real resource flow.
Taxes transfer income from firm to government, which can be used for some
social purpose, so it does not reduce the national income. It is a transfer from
firm pocket to government pocket. So in economic analysis taxes will not be
treated as a cost in the project account
The same holds true for indirect tax such as sales tax, an excise tax, or tariff
or duty on imported inputs for production. All are treated as transfer payment.
Financial Analysis
…
2. Subsidies:
• are a transfer of payment form government to firms;
• are provided either on the input side or output side;
• If subsidies are on the input side, it reduces the cost of a
project b/s the firm purchase inputs at the subsidized price
that will reduce his costs and thereby increase his net benefits.
But the cost of the input in the use of the society’s real
resources remain the same;
•
If subsidies are on the output side, it increases the revenue
of the project;
❑ Note That:
• In financial analysis subsidies increase the benefits of the firm,
but in economic analysis does not.
• In financial analysis Taxes increase the Costs of the firm,
but in economic analysis does not.
Non-discounting Methods of Financial Feasibility Analysis…
❑ How to calculate financial cash flow?...
➢ Tax and subsidies elements in cost (and revenue) components will be considered in the
calculation of financial analysis. But from nation point of view ( Economic analysis), tax
and subsidy elements will normally not considered in the calculation (since these are
transfer payments to and from the government).
➢ Depreciation will also be omitted this being no more than an accounting device for putting
aside funds for replacement
➢ Note that: when detail economic analysis is done the cost break down used in the standard
procedure will not be sufficient. We need to reclassify all project inputs and outputs into
traded and non-traded goods and basic factors of production. This is another part of project
analysis.
❖ The three basic steps in determining whether a project is worthwhile or not are:
1. Estimate project cash flows
2. Estimate the cost of capital
3. Apply a suitable decision or appraisal rule or criterion
❖ Note that:
1. When one is working with market price, the cash flow stream is referred to as
financial cash flow.
2. When these prices are adjusted to reflect national efficiency and equity objective ( i,e,
shadow price are used) it is referred to as Economic Net Benefits (ENB) stream and
Social Net Benefit (SNB) stream , respectively.
Financial Analysis…
❑ The main traits of the financial and economic analysis respectively are:
❖ Financial Analysis:
• Investor's perspective
• Based on market prices
• Including taxes, tariffs, subsidies etc.
• Does not include externalities
❖ Economic Analysis:
• Society's economic perspective
• Applies economic prices also called shadow price
• Excluding taxes, tariffs, subsidies etc. to reflect the value of the
project to society.
• Externalities (positive and negative) are included and quantified
in monetary terms.
Methods of Financial Feasibility Analysis
❑ Capital budgeting is the process by which investors determine the value of a
potential investment project. The method of capital budgeting are the
techniques which are used to make comparative evaluation of profitability of
investment.
❑ There are two broad criteria of capital budgeting :
I. Non-discounting criteria
• Non-discounted cash flows are not adjusted to incorporate the time value of
money. Non-discounting cash flow does not take into consideration opportunity
cost of capital. The non-discounting methods of capital include :
1. Cash Flow Method
2. Payback Period Method (PBP)
3. Accounting Rate of Return Method (ARR)
II. Discounting Criteria
• Discounted cash flows are cash flows adjusted to incorporate the time value of
money. Discounted cash flow is nothing but the opportunity cost of capital.
The discounting methods of capital are:
1. Net Present Value Method (NPV)
2. Benefit- Cost Ratio or Profitability Index Method (PI)
3. Internal Rate of Return Method (IRR)
Non-Discounting Method
Non-discounting Methods of Financial Feasibility Analysis…
I) The Cash Flow in Financial Analysis
❖ The financial cash flow of a project is the stream of financial cost and benefits that
will be generated by the product over its economic life and will not be produced in
its absence.
❖ Cash flow is a measure of how much cash a business brought in or spent in total
over a period of time. Cash flow is typically broken down into cash flow from
operating activities, investing activities, and financing activities on the statement
of cash flows, a common financial statement
❖ Thus, cash flow statement components provide a detailed view of cash flow from
operations, investing, and financing:
1. Cash Flow from Operating Activities: The net amount of cash coming in or
leaving from in the day to day business operations of an entity is called Cash
Flow From Operations.
•
Cash from operating activities represents cash received from customers less
the amount spent on operating expenses, such as salaries, utilities, supplies
and rent.
• There must be more operating cash inflows than cash outflows for
a company to be financially viable in the long term.
Non-discounting Methods of Financial Feasibility Analysis…
2.
Cash Flow From Investing Activities: would include the Outflow of cash for
long term assets such as land, buildings, equipment, etc., and the Inflows from
the sale of assets, businesses, securities, etc.
•
reports how much cash has been generated or spent from various investment-related
activities in a specific period. Investing activities include purchases of
speculative assets, investments in securities, or the sale of securities or assets.
3. Cash flow from finance activities :
•
•
•
Cash flow from financing activities (CFF) is a section of a company’s cash flow
statement, which shows the net flows of cash that are used to fund the company.
Financing activities include transactions involving debt, equity, and dividends.
Investors and analyst will use the following formula to determine if a business is on
sound financial footing.
CFF = CED − (CD + RP)
where: CED = Cash in flows from issuing equity or debt
CD = Cash paid as dividends
RP= Repurchase of debt and equity
•
Cost of financing include Cash transaction that involve raising capital, borrowing
capital and repaying capital
Non-discounting Methods of Financial Feasibility Analysis…
❑ Financing cash flow …
• is funding that comes from a company’s owners, investors and creditors.
• shows the net flows of cash that are used to fund the company and its capital.
• include transactions involving issuing debt, equity, and paying dividends.
Cash flow from financing activities provide investors with insight into a
company’s financial strength and how well a company’s capital structure is
managed
• Examples of common cash flow items stemming from a firm’s financing
activities are:
• Receiving cash from issuing stock or spending cash to repurchase
shares
• Receiving cash from issuing debt or paying down debt
• Paying cash dividends to shareholders
•
Financing cost is the Cash Out flow from the entities investors (i.e. interest to bond
holders) and shareholders (i.e. dividends, etc) and cash inflows from sales of bonds or
issuance of stock equity. Most cash flow finance activities are cash outflows since most
entities only issue bonds and stocks occasionally
Non-discounting Methods of Financial Feasibility Analysis…
❑ How to Calculate Simple Financial Cash Flow?
➢ Record by year through out the expected life of the project all expected
expenditure payments of goods and services for the project (including capital
expenditure) and all receipts from the project.
➢ For each year subtract the cost from benefits
➢ In this particular example case, Costs are normally broken into
investment cost and operating costs.
• Investment cost: basically cover Capital expenditure ( such as
plant and machinery) while operating cost ( incurred only when the
project is under way) is in turn divided into Variable cost and
Fixed cost components.
• Variable cost covering such things as raw material and labor
inputs (which varies with output) while the Fixed Cost includes
items such as maintenance, administration and managerial
charges ( which will be relatively fixed with respect to volume of
production).
Non-discounting Methods of Financial Feasibility Analysis…
Simple Financial Cash Flow for X Project ( in million Birr)
Cost
Capital Costs
Fixed Assets
Pipes
pumps
Storage tanks
Jack hammers
Construction
Total Fixed Cost
Working Capital
Total capital cost
Operation cost
Project management
Fuel
Maintenance
Total cost
Benefits (sales revenue)
Net Benefits ( Benefit - Costs)
Year1
Year2
Year3
Year 4
Year 5
400
50
140
20
200
810
20
830
500
100
230
10
250
1090
30
1120
300
90
160
0
190
740
40
780
0
0
0
0
0
0
0
0
-70
-30
-100
-5
0
-205
-90
295
80
5
30
945
0
-945
100
7
40
1267
200
-1067
120
8
50
958
250
-708
90
10
50
150
500
350
90
10
50
-145
500
645
Non-discounting Methods of Financial Feasibility Analysis…
II) Payback (PB) Period Method :
• The payback period also called the pay off period. It is one of the simplest and
apparently one of the most frequently used method to measure economic value
of an investment.
• The PB period is defined as the length of time required to recover the initial
cash out lay on the project, Or It as the length of time that is required for a
stream of cash inflows from the investment to recover the original cash outlay
invested in the project.
• The PB is the period necessary to earn back the initial capital investments. The
shorter the payback period, the stronger is the financial viability of the project
• The investment proposal which has the least payback period is considered
profitable.
• Actual payback is compared with the standard one. If actual payback period is
less than the standard the project will be accepted and in case, actual payback
period is more than the standard payback period, the project will be rejected.
• So, payback period is the number of years required for the original investment
to be recouped.
Non-discounting Methods …
❑ Payback Period method…
PB
=
𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
𝑨𝒏𝒏𝒖𝒂𝒍 𝒄𝒂𝒔𝒉 𝒊𝒏 𝑭𝒍𝒐𝒘
❑ Decision Rule:
•
•
•
The shorter the payback period, the stronger is the financial viability of the project
The investment proposal which has the least payback period is considered profitable.
Actual pay back is compared with the standard one.
• If actual payback period is less than the standard the project will be accepted and
• If actual payback period is more than the standard payback period, the project will
be rejected.
❑ Merits of Payback Period Method:
❖ Payback period method has following merits:
1.
2.
3.
Simplicity- It is simple to understand and easy to calculate.
Emphasis on early returns- This method lays emphasis on early returns. Investments
with shorter payback period will be less risky.
Based on cash flows- The evaluation of capital expenditures is carried out on the
basis of cash inflows arising from the investments
Non-discounting Methods …
Payback Period method…
❑ Limitations of Payback Period Method:
❖ Though the payback period method is simple and lays emphasis on
liquidity and risk, it has following limitations:
I.
No consideration of time value- This method ignores time value of the
earnings. It does not take into account the timings of the proceeds (time value
of money).
II. Overlook of remaining cash flows - Cash flows from the project after the
recovery of cost are ignored. It fails to consider earnings after the payback
period. Hence payback period is an inadequate criterion for the choice
between these two alternatives,
III. Inconsistent with the objective- This method is inconsistent with the
objective of maximizing shareholders’ wealth as it does not take into
consideration all cash flows.
IV. Supplementary technique- Payback period method does not say
anything about selection or rejection of projects. It can be used as
supplementary technique to discounted techniques.
Non-discounting Methods of Financial Feasibility Analysis…
❑ For example,
1.
If the investment required for a project is Birr 20,000 and it is likely to generate
cash flow of Birr 10,000 for 5 years. What is the payback period of the
investment?
2.
If a project require an original out lay of Birr 300 and is expected to produce a
stream of cash proceeds of Birr 100 per year for 5 years , what is the payback
period of the investment?
Non-discounting Methods of Financial Feasibility Analysis…
For example,
1. if the investment required for a project is Birr 20,000 and it is likely to generate
cash flow of Birr 10,000 for 5 years. What is the payback period of the
investment?
Answer: Payback Period will be 2 years. It means that investment will
be recovered in first 2 years of the project.
2.
If a project require an original out lay of birr 300 and is expected to produce a
stream of cash proceeds of birr 100 per year for 5 years , what is the payback
period of the investment?
Answer:
Payback PB= 300/100 y = 3years
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 out lay
Examples: On Non- Discounting Methods
Example 3 : Assume that two projects are being considered by a company. Each
requires a capital investment of $10,000. The marginal cost of capital is 10%. The
net cash flows ( i.e. net operating incomes after taxes plus the depreciation
allowance) from the investments A and B are shown in the following table. Based
on the PB period, which project is selected?
Year
Project A
Project B
1
5500
1000
2
4500
2000
3
2000
3000
4
10
4000
5
10
5000
Examples: Non- Discounting Methods
Solution:
• The PB period is the number of years it takes to recover the initial
investment from after tax cash flow profits. It is observed that project A has
2 years payback period, whilst project B has a 4 years payback period.
• If the firm employed, say, a two or three payback period selection
criterion, project A would be accepted, and project B would be rejected
Example 4: Assume that a project has Br.4,000,000 of cost of
investment and it generates the following cash flows over its five
years’ life – i.e. Br.1,250,000, 1,400,000, 1,350,000, 1,200,000
and Br 1,250,000, respectively. Find the payback period?
Non-discounting Methods …
Solution: The following table shows the calculation of cumulative Cash flow:
year
Cash flows
Cumulative Cash flows
1
1250000
1250000
2
1400000
1650000
3
1350000
4000000
4
1200000
1200000
5
1250000
1450000
• As you can see the payback period is three years because cumulative cash flows
are equal to initial investment of Br 4,00,000 at the end of three years.
• In the above example, cumulative cash flows are matched with the cost of
investment at the end of a particular year, however, it is also possible that
cumulative cash flows are not exactly matching with the cost of the project at the
end of a specific year. In such a case we make use of ‘Interpolation’.
Non-discounting Methods …
Example 5 : - Suppose there is a project which is expected to generate Br.5,000
for the next five years. If the cost of the project is Br.12,500 then calculate the
payback period for the project ?
Solution:
PB = 12,500 / 5,000
PB = 2.5 years
The PB period comes out to be 2.5 years. Thus, it will take 2 years and 6 months for
this project to cover the initial investment of Rs.12,500.
Example 6: Rank the four hypothetical projects based on their performance
Consider the following hypothetical projects
Investment
projects
A
B
C
D
Initial cost
Year I
Year II
10000
10000
10000
10000
10000
10000
5762
7762
1100
7762
5762
Rank by
inspection
Non-discounting Methods of Financial Feasibility Analysis…
III) Accounting Rate of Return(ARR) :
• This method is also called Average Rate of Return method. It is also known as
the return on investment, is calculated on the basis of accounting statements.
• The ARR is used to determine the potential profitability of long-term
investments over a period of time.
• The ARR formula takes the average yearly revenue generated by an asset, then
divides that figure by the initial cost investment
• The Accounting Rate of Return is equal to the average net operating profit
divided by the average investment.
• ARR is the average net income an asset is expected to generate divided by its
average capital cost, expressed as an annual percentage. The ARR is a formula
used to make capital budgeting decisions. It is used in situations where
companies are deciding on whether or not to invest in an asset (a project, an
acquisition, etc.) based on the future net earnings expected compared to the
capital cost.
• This method is based on accounting information rather than cash flows. It can be
calculated as
Non-discounting Methods of Financial Feasibility Analysis…
Accounting Rate of Return(ARR)…
• This method is based on accounting information rather than cash flows. It
can be calculated as
ARR =
=
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒂𝒏𝒏𝒖𝒂𝒍 𝒑𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙𝒆𝒔
X 100
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑨𝒏𝒏𝒖𝒂𝒍 𝑹𝒆𝒗𝒆𝒏𝒖𝒆
X100
𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
where
Average Annual profit after taxes =
𝑻𝒐𝒕𝒂𝒍 𝒐𝒇 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙 𝒑𝒓𝒐𝒇𝒊𝒕 𝒐𝒇 𝒂𝒍𝒍 𝒕𝒉𝒆 𝒚𝒆𝒂𝒓𝒔
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒚𝒆𝒂𝒓𝒔
Non-discounting Methods of Financial Feasibility Analysis…
❑ How to calculate ARR
• Doing an ARR calculation is relatively simple. Here’s what you need to do
to calculate ARR:
1. First, work out the annual net profit of your investment. This will be the
revenue remaining after all operating expenses, taxes, and interest associated
with implementing the investment or project have been deducted.
2. If the investment is a fixed asset, such as property, you’ll need to work out the
depreciation expense.
3. Then, to arrive at the final figure for annual net profit, simply subtract the
depreciation expense from your annual revenue figure.
4. Finally, you simply divide the annual net profit by the initial cost of the asset or
investment. The calculation will show a decimal, so multiply the result by 100
to see the percentage return
Non-discounting Methods …
❑ Merits of Average Rate of Return Method:
❖ The average rate of return method has the following merits:
(i)
Simplicity- This method of capital budgeting is simple to understand and use.
(ii) Accounting profitability- In this method, accounting profits over the
economic life of the project are considered in evaluating the project. The
required data are easily available from the firm’s financial statements.
❑ Demerits of Average Rate of Return Method:
❖ The average rate of return method has the following demerits:
(i)
No consideration of time value- This method ignores time value of the
earnings.
(ii) Overlook of cash flows- Accounting profit is taken into consideration instead
of cash flows from the project.
(iii) Inconsistent with the objective- This method is inconsistent with the
objective of maximizing shareholders’ wealth.
(iv) Arbitrary cut-off- Firms using average rate of return use arbitrary cut-off rate
in taking a decision about a project.
Non-discounting Methods …
❑ Example 1:
• XYZ Company is looking to invest in some new machinery to
replace its current malfunctioning one. The new machine, which
costs $ 420,000, would increase annual revenue by $ 200,000
and annual expenses by $ 50,000. The machine is estimated to
have a useful life of 12 years and zero salvage value. Find the
ARR?
NB: Salvage the estimated book value of an asset after depreciation is complete,
based on what a company expects to receive in exchange for the asset at the end
of its useful life.
Non-discounting Methods …
Example 1: XYZ Company is looking to invest in some new machinery to replace
its current malfunctioning one. The new machine, which costs $420,000, would
increase annual revenue by $200,000 and annual expenses by $50,000. The
machine is estimated to have a useful life of 12 years and zero salvage value
❑ Solution
1. Calculate the average annual profit?
• Inflows, years 1 -12,
• Expenses in 12 years,
200000 X 12 = 2,400,000
50000 X 12 = - 600,000
• Depreciation
= - 420000
• Total profit
=
2,400,000- 600,000-420,000 = 1,380,000
• Average Annual profit = 1380000/12 = 115000
2. Calculate Average investment
Average Investment = (420000 + 0 )/2 = 210,000
3. Find ARR
ARR = (115000/210000 ) 100% = 54.76%
•
Therefore, this means that for every dollar invested, the investment will return a
profit of about 54.76 cents.
Non-discounting Methods …
Example 2: XYZ Company is considering investing in a
project that requires an initial investment of $100,000 for some
machinery. There will be net inflows of $20,000 for the first two
years, $10,000 in years three and four, and $30,000 in year five.
Finally, the machine has a salvage value of $25,000. Find the
ARR?
NB: Salvage value is the estimated book value of an asset after depreciation
is complete, based on what a company expects to receive in exchange for the
asset at the end of its useful life.
Non-discounting Methods …
❑ Example 2: XYZ Company is considering investing in a project that
requires an initial investment of $100,000 for some machinery. There will
be net inflows of $20,000 for the first two years, $10,000 in years three and
four, and $30,000 in year five. Finally, the machine has a salvage value of
$25,000.
1. Calculate Average annual profit
Inflows = 20000X2 + 10000X2 + 30000 = 40000 + 20000 +30000 = 90000
Depreciation = 100000-25000 = - 75000
Total Profit = 90000-75000 = 15000
Average annual profit = 15000/5 = 3000
2. Calculate Average investment
Average investment = ( 100000 +25000)/2 = 62500
3.
Calculate ARR
ARR = 3000/ 62500 = 4.8%
Non-discounting Methods …
❑ Example 3:
• A Company wants to invest in new set of vehicles for the
business. The vehicles cost $350,000 and would increase the
company’s annual revenue by $100,000, as well as the
company’s annual expenses by $10,000. The vehicles are
estimated to have a useful shelf life of 20 years, with no
salvage value. Calculate the ARR?
Non-discounting Methods …
❑ Example 3: A Company wants to invest in new set of vehicles for the business.
The vehicles cost $350,000 and would increase the company’s annual revenue by
$100,000, as well as the company’s annual expenses by $10,000. The vehicles are
estimated to have a useful shelf life of 20 years, with no salvage value. Calculate
the ARR?
❑ Solution
1. Calculate the average annual profit?
•
•
•
•
•
Inflows, years 1 -20,
100000 X 20 = 2,000,000
Expenses in 20 years,
10000 X 20 = - 200,000
Depreciation
= - 350000
Total profit
=
2,000,000- 200,000-350,000 = 1,450,000
Average Annual profit = 1450000/20 = 72500
2. Calculate Average investment
Average Investment = (350000 + 0 )/2 = 175,000
3. Find ARR
ARR = (72,500 /175,000) 100% = 41.43%
•
Therefore, this means that for every dollar invested, the investment will return a profit of
about 41.43 cents.
Discounting Method
Introduction: Discounting Method
❑ What is Interest rate ?
• Interest rate ( r or i ) is also called a cost of capital
• An interest rate is the percentage of principal charged by the lender for the
use of its money. The principal is the amount of money loaned.
• The interest rate is the amount charged on top of the principal by a lender
to a borrower for the use of assets.
• It is the price paid for the use of credit.
• An interest rate is either the cost of borrowing money or the reward for
saving it. It is calculated as a percentage of the amount borrowed or saved
• The interest rate is considered as an exchange price between present and
future Birr.
• The interest rate can be of two type Simple and Compound.
• The interest rates are always positive because of the positive time
preference for money that is the sooner money is available, the greater its
value
Introduction: Discounting Method
❑ Time value of Money
•
The time value of money (TVM) is the concept that a sum of money is worth more
now than the same sum will be at a future date due to its earnings potential
•
A Birr or a Dollar on hand today is more worth than a prospect of receiving a Birr
or a Dollar at some future time ( say tomorrow).
•
This is because money can grow only through investing. An investment delayed is
an opportunity lost. This is true because money that you have right now can be
invested and earn a return, thus creating a larger amount of money in the future.
The strong preference for current receipts over future receipts is explained three
factors namely, uncertainty, alternative uses for money, Depreciation of value of
money of not used and inflation. Money grows over time when it earns interest
•
• The time value of money is sometimes referred to as the net present
value (NPV) of money.
•
The formula for computing the time value of money considers the amount of money,
its future value, the amount it can earn, and the time frame
•
The time value of money can be known through the processes of compounding and
discounting.
Introduction: Discounting Method
❑ Simple Compounding
• The two time value of money are FV and PV
• The process of finding the future value (FV) of a present sum (PV) is
called compounding. This is sometimes also called as growth in cash
outlay.
• The formula for this is
FV = P0 (1+i) t = PV (1+i) t
Where
FV = Future value of present investment
P0 = Present investment or Present value (PV) or principal
I = Interest rate or opportunity cost or cost of capital
t = Number of year for which the present investment is
allowed to grow
Introduction: Discounting Method
❑ Discounting
• The process of finding the present value (PV) of a future payment is
called discounting .
• The future value (FV) must be discounted to reflect the present value in
terms of today’s purchasing power or earnings lost by an individual by
not being able to immediately invest the future sum in alternative
investments.
• Present value of future earning is calculates by
PV
=
𝑭𝑽𝒕
(𝟏+𝒊 )𝒕
Where
PV= is present value, 𝐹𝑉𝑡 is future earning if year t, and i is
interest rate or discounted rate or cost of capital
❑ Example: What is the present value of 100 Birr you will received after
two years if the discounting rate is 10%?
Solution:
PV =
𝑭𝑽
(𝟏+𝒊)𝒕
=
𝟏𝟎𝟎
(𝟏+𝟎.𝟏)𝟐
=
𝟏𝟎𝟎
(𝟏.𝟏)𝟐
=
𝟏𝟎𝟎
𝟏.𝟐𝟏
= 86.64 Birr
Discounting Methods of Financial Feasibility Analysis…
❑ Features of Discounting Methods
• Consider the time value of money
• The projected future cash flows are discounted by a certain rate called
Cost of capital.
• Take into account all the benefits and costs accruing during the life time
of the project.
• Discounted cash flow method includes:
1. Net Present Value method (NPV)
2. Benefit-Cost Ratio method (CBR) or Profitability index
method (PI)
3. Internal rate of return method (IRR)
Discounting Methods …
1.
Net Present Value Method (NPV):
• Emphasis on time value of money.
•
•
In NPV method,
•
PVs of all cash flows are computed. That is, PV of cash flow is calculated
for which cash flows are discounted. It is consistent with the objective of
shareholders’ wealth maximization.
•
Cost of capital (required rate of return i ) is employed as discount rate.
•
The excess of PV of all inflows over PV of cost of investment is equal to
NPV of the investment made in the project .
The rate of discount is called cost of capital and is equal to the minimum rate of return
which must accrue from the project. The discount rate is the interest rate used to
determine the present value of future cash flows in a discounted cash flow (DCF)
analysis.
•
NPV is the difference between PV of cash inflows and PV of cash outflows. That is, it is
used to calculate the difference between the present value of all future costs and the
present value of all future revenues.
•
The Net Present Value is a measure of profitability used in corporate budgeting to assess
a given project's potential return on investment.
Discounting Methods …
NPV-Method…
• Due to the value of time, the NPV takes into account the discount rate (i) over the
lifetime of the project, thus presenting the annual cash flows in present values.
NPV = Sum of all PV of Cash Inflows – Sum of all PV of Cash Outflow
NPV=Sum of all discounted Cash Inflow - Sum of all discounted Cash Outflow
NPV = (
𝑩𝟎
(𝟏+𝒊)𝟎
+
𝑩𝟏
𝑩𝟐
+
(𝟏+𝒊)𝟏 (𝟏+𝒊)𝟐
+ …+
𝑩𝒏
)
(𝟏+𝒊)𝒏
-
(
𝑪𝟎
(𝟏+𝒊)𝟎
+
𝑪𝟏
(𝟏+𝒊)𝟏
+…+
𝑪𝒏
)
(𝟏+𝒊)𝒏
• Where, NPV= Net Present Value, 𝑪𝟎 =Initial cost of investment, 𝑪𝟏 , 𝑪𝟐 , …
Cash outflow in period 1,2,…, 𝑩𝟎 = Initial benefit or inflow of Investment, 𝑩𝟏 ,
𝑩𝟐 , … cash benefit or inflow in period 1, 2,…..
• The NPV is calculated using the following formula:
NPV (i,N) = σ𝑵
𝒕=𝟎
(𝑩𝒕 −𝑪𝒕 )
(𝟏+𝒊)𝒕
• Where i = is the financial discount rate, Bt = the Benefit cash flow at time t,
Ct = the Cost cash flow at time t and N = the total number of time periods.
Discounting Methods …
NPV-Method…
❑ Decision Rule:
• If the NPV of a project is greater than or equal to zero, the project
should be accepted
• If NPV is less than zero ( Negative), it should be rejected.
• In case of mutually exclusive projects, the project with highest NPV is
accepted. The amount of NPV is the addition to the wealth of
shareholders.
•
Always select the project with greater NPV
• When NPV of two more projects under consideration is more than zero,
the project whose NPV is the highest should be accepted.
•
A NPV of zero (0) implies that the return on the investment equals the
discount rate . Therefore, a negative NPV can be found for a project with
a positive return, but where this return is lower than the investor’s
required return.
Discounting Methods …
NPV-Method…
❑ Merits of Net Present Value Method:
❖ Net Present Value method has following merits:
1. Recognition of time value of money- In net present value method,
present values of all cash inflows are computed. Decision is taken on
the basis of excess of present value of all cash flows over present value
of cash outflows.
2. Consideration of all cash flows- This method considers cash inflows
rather than accounting profits. All cash flows are considered. It
considers the total benefits arising out of the project proposal
3. Consistent with objective- Net present value method is consistent with
the objective of maximization of shareholders’ wealth. Net present
value of the project is addition to the shareholders’ wealth. It helps to
achieve the maximization of shareholders’ wealth
4. It is the best method for the selection of mutually exclusive projects
Discounting Methods …
NPV-Method…
❑ Demerits of NPV Method:
❖ Net Present value method has following limitations:
1. Difficult to compute- It is difficult to understand and calculate, Net present value
method is difficult to understand and calculation of net present value is difficult and
requires skills.
2. Work out of appropriate cost of capital difficult- It needs the discount factors for
calculation of present values. Net present value cannot be computed if cost of
capital is unknown. Weight average of capital is used to find the present values of
cash inflows. It is particularly difficult to measure cost of equity.
3. Not suitable in capital rationing- Net present value method is not suitable for
evaluating capital expenditure when funds are limited.
4. Misleading result in case of mutually exclusive projects- If projects having
different life span and capital size are to be evaluated, net present value method can
give the misleading results. In such situation, profitability index is more suitable.
Therefore, NPV is not suitable for the projects having different effective lives
Discounting Methods …
Examples:
1. The following are the net cash flows of an investment project :
Cash flows (Br.)
Calculate the net present value of the project at discount
rates of 10, 20, 30 and 35 percent?
2. Explain briefly the method of evaluating investment project?
3. Describe the meaning of NPV?
Solution
I) At the 10% discount rate, the NPV is given by
NPV = Initial cost + PV of future benefits = - 5000 +
3000
(1+0.1)1
+
4000
(1+0.1)2
NPV = -5000 + 2727.273 + 3305.785 = 1.033.058,
Decision: Since the NPV > 0 or positive, the project is accepted
II) At 20% discount rate, the NPV is given by
NPV = Initial cost + PV of future benefits = - 5000 +
3000
(1+0.2)1
+
4000
(1+0.2)2
NPV = -5000 + 2500 + 2777.778 = 277.778,
Decision: Since the NPV > 0 or positive, the project is accepted
III) At 30% discount rate, the NPV is given by
3000
4000
NPV = Initial cost + PV of future benefits = - 5000 + (1+0.3)1 + (1+0.3)2
NPV = -5000 + 2307.692 + 2366.864 = - 325.444,
Decision: Since the NPV < 0 or Negative, the project is rejected
IV) At 35% discount rate ,
Automatically it is possible to decide that the project not accepted b/s NPV
will be negative
Discounting Methods …
Example 4: A sum of $ 400000 Dollars invested today in an IT project may give
a series of below cash inflows in the future. $ 70000 in year 1, $ 120000 in year 2,
$140000 in year 3, $140000 in year 4 , and $40000 in year 5. If opportunity cost
of capital is 8% per annum, then should we accept or reject the project?
Solution
Step 1: Calculate the PV of year 1, year 2, year 3, year 4, and Year 5
Step 2: Sum up the PV of all years
Step 3: NPV = PV of all cash inflow – PV of all cash Outflow
Step 4: If NPV is positive, Accept the project, if not Reject the project
Answer : NPV = $ 8959 , so accept the project
Discounting Methods …
Example 5: A $ 61,446 investment will return $10,000 per year over a period of
10 years. If the required discount rate is 10%, Find its NPV?
Example 6: Compute the Net Present Value (NPV) given a required return of
12% and the following net cash flow
Year
Net Cash Flow (NCF)
0
($20,000)
1
$6,000
2
$7,000
3
$8,000
4
$5,000
5
$4,000
Discounting Methods…
Solution
NPV =
−20000
(1+.12)0
+
6000
(1+.12)1
7000
(1+.12)2
+
8000
5000
+
(1+.12)3 (1+.12)4
+
+
4000
(1+.12)5
NPV = -20000 + 5357.14 + 5580.36 + 5694.24 + 3177.59 + 2269.71
NPV = 2079.04 ( since the NPV > 0 , the project should be accepted)
2. Benefit-Cost Ratio(BCR) or Profitability Index(PI) Method
❑ Benefit Cost Ratio (BCR)
• is also called as Profitability Index (PI).
• is defined as a ratio of discounted cash Inflow to the discounted cash
Outflow.
• Discounted cash inflow is benefit in the project and the discounted
cash outflow of the investment is cost, that is why it also called benefit
to cost ratio.
• is a capital budgeting technique to evaluate the investment projects for their
viability or profitability. Discounted cash flow technique is used in arriving at
the profitability index.
• How to calculate the PI or BCR: The calculation of PI or BCR is easily
possible once we have the cash inflows and outflows with appropriate
discount rate are in place.
Discounting Methods …
❑ PI or BCR-Method…
• Calculation of profitability index is possible with a simple formula with inputs
as – discount rate, cash inflows ( Benefit), and outflows (cost).
• It is the ratio of PV of future net cash inflows over the life of the project to the
net-investment ( cash outflows). The method usually produces the same result
as the NPV in project evaluation, but it is very important in separating projects
of varying sizes.
• The BCR or PI is defined as the ratio of the sum of the project’s discounted
benefits to the sum of its discounted investment and operating costs. The
formula indicates the benefits in the numerator and costs in the denominator.
The formula for calculating PI or CBR is as follows.
PI or BCR
=
𝑩𝒕
(𝟏+𝒊)𝒕
𝑺𝒖𝒎 𝒐𝒇 𝒂𝒍𝒍 𝑷𝑽 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘
= 𝒏
𝑪
𝑺𝒖𝒎 𝒐𝒇 𝒂𝒍𝒍 𝑷𝑽 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑶𝒖𝒕𝒇𝒍𝒐𝒘
σ𝒕=𝟎 𝒕 𝒕
(𝟏+𝒊)
σ𝒏
𝒕=𝟎
Discounting Methods …
PI or BCR-Method…
❑ Steps in Calculating PI or BCR: The method used for arriving at PI or
BCR of a proposed project is explained stepwise below:
a)
b)
c)
d)
e)
f)
Find the expected cash Inflows of the project
Find the cash Outflows of the project (Initial Investment + any other cash
outflow)
Decide an appropriate discount rate
Discount the expected cash inflows using the discount rate
Discount the future cash outflows and add to initial investment
Divide step (d) by step (e)
❑ Decision rule of BCR
• A project should be accepted if its BCR is greater than or equal to 1 (
i.e. if its discounted benefits exceed its discounted cost).
•
If a project has a PI value greater than or equal to 1, (PI=1) it should
be accepted and should be rejected if the PI value is less than 1.
Discounting Methods …
❑ Comparison of PI and NPV
•
When PI > 1, the NPV will be positive, When PI<1, the NPV will be negative.
•
If more than one project have PI > 1, then the project whose PI is the highest will
be given first preference and the project with minimum PI will be given last
preference.
•
PI is closely linked with NPV. Both will present same results as far as acceptance
and rejection are concerned.
•
•
In situation of capital rationing,
•
•
•
It is because, almost same calculation is followed in both. In PI, we divide our
benefits by our costs whereas, in NPV, we deduct our costs from the benefits.
PI will give a relative value and contrarily
PI method is preferred to NPV method.
In case of limited capital, NPV method may give misleading decision. PI
method removes this limitation of NPV method
If unlimited capital is available, the NPV method is suitable.
Discounting Methods …
❑ PI or BCR – Advantages and Disadvantages
❖ Advantage of PI or BCR method :
• Considers the time value of money and
• Presents a relative profitability of the project.
• Relative profitability allows comparison of two investments
irrespective of their amount of investment. A higher PI would
indicate a better IRR and a lower PI would have lower IRR.
❖ The main disadvantage of the PI or BCR method is also its relative
indications. Two projects having the vast difference in investment
and dollar return can have the same PI. In such situation, therefore,
the NPV method remains the best method.
Discounting Methods …
• Example 1: XYZ company wants to assess the profitability of
a new project in which it builds a community centre inside a
growing neighbourhood. Assume that the company leases the
equipment it needs for $100,000, at interest rate is 4% and that
the company expects to see a $200,000 annual profit increase
over the next three years. If XYZ use the BCR formula to
calculate the overall value of this new project, what will be its
BCR?
Discounting Methods …
Example 1: XYZ company wants to assess the profitability of a new project in which it
builds a community centre inside a growing neighbourhood. Assume that the company
leases the equipment it needs for $100,000, at interest rate is 4% and that the company
expects to see a $200,000 annual profit increase over the next three years. If XYZ use the
BCR formula to calculate the overall value of this new project, what will be its BCR?
Solution
➢ Sum of PV of expected Benefits=
= ($200,000 /(1+0.04)1 ) + ($200,000 /(1+0.04)2) + ($200,00 /(1+0.04)3)
= ($200,000 / (1 + 0.04)1 ) + ($200,000 / (1 + 0.04)2 ) + ($200,00 / (1 + 0.04)3)
= $555,118
➢ PV of expected costs= $ 100000
➢ Then, BCR =$555,018 / $100,000 = $5.55
Conclusion: XYZ considers this project a good financial decision because the BCR is
above one. This BCR tells XYZ that for every $1 it spends to build the new community
centre, it can expect to see $5.55 in benefits, meaning the cash flow from the project is more
than the cost of the project.
Discounting Methods …
Example 2: If the Cash flow projections for a project are provided
below. The relevant discount rate is 10%. What is the benefit-cost ratio
of the project?
Discounting Methods …
Example 2: If the Cash flow projections for a project are provided below. The relevant
discount rate is 10%. What is the benefit-cost ratio of the project?
Solution:
The benefit-cost ratio would be calculated as $97,670.72 / $33,625.09 = 2.90.
Discounting Methods …
Example 3: Assume an investment project want to replace a key
piece of manufacturing equipment. The equipment costs
$625,000 to purchase. The discount rate is 3 percent, and
upgrading the equipment is expected to boost benefits by
$220,000 a year for each of the next three years. Calculate
a)The net present value
b) b) The Benefit cost ratio
Discounting Methods …
Example 3: Assume an investment project want to replace a key piece of
manufacturing equipment. The equipment costs $625,000 to purchase. The discount
rate is 3 percent, and upgrading the equipment is expected to boost benefits by
$220,000 a year for each of the next three years. Calculate
a) The net present value
b) The Benefit cost ratio
Solution
(A)
•
•
•
•
Initial investment cost= $ 625,000
Discounted benefit of Year one: $220,000/(1+0.03)1 = $213,592.23
Discounted benefit of Year two: $220,000 / (1 + 0.03)2 = $207,371.1
Discounted benefits of Year three: $220,000 / (1 + 0.03)3 = $201,331.16
•
NPV = Sum of PV of inflow - Sum of PV of Outflow
NPV = $213,592.23 + $207,371.10 + $201,331.16 - $ 625000
= $622,294.49 - $625000 = - $ 2705.51
(B) BCR= Sum discounted benefits/ sum of discounted cost = $622294.49/$625000 = 0.995
Decision : since NPV< 0 and BCR< 1 , the investment is not profitable
Discounting Methods of Financial Feasibility Analysis…
3. Internal rate of return method (IRR) :
•
•
•
•
•
•
•
IRR is the discount rate which makes its NPV of all cash flows equal to zero. It is
the rate of interest that makes the sum of all cash flows zero, and is useful to
compare one investment to another. This means IRR is the rate of discount,
which makes the present value of the benefits exactly equal to the present value of
the costs
The IRR is the lowest level of return from the project that is acceptable in order to
justify the investment.
The method utilizes the 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.
It is possible to think a level of interest rate that could result in NPV of zero. This rate
of interest is termed as the Internal Rate of Return(IRR).
The internal rate of return is an estimate of the project’s rate of return. The internal
rate of return is also known as yield on investment and marginal efficiency of capital.
The output of IRR is an interest rate at which the project neither makes profit nor any
loss.
In order to assess project profitability compare Internal Rate of Return (IRR) against
the required interest rate (i). If a project is expected to have an IRR greater than the rate
used to discount the cash flows, then the project adds value to the business. If the IRR
is less than the discount rate, it destroys value. The decision process to accept or reject a
project is known as the IRR rule.
Discounting Methods …
IRR is calculated as follows :
NPV = 0 =
Where
(𝑩𝒕 −𝑪𝒕 )
𝑵
σ𝒕=𝟎
(𝟏+𝒊)𝒕
=
𝑪𝑭𝒕
𝑵
σ𝒕=𝟎
(𝟏+𝑰𝑹𝑹)𝒕
Bt = Benefit cash flow in various years
Ct = Cost cash flow in various years
N = number of years
i = rate of return which is to be calculated IRR
CFt = Cash Flow = 𝑩𝒕 − 𝑪𝒕
Discounting Methods …
• For calculating the IRR, the NPV value is set to zero, and then the discount
rate is found out. This discount rate is then the IRR value that we needed to
calculate.
• Due to the character of the formula, however, IRR can’t be calculated
analytically, and should instead be calculated either through trial-and-error or
by the use of some software system programmed to calculate the IRR.
• For financial analysis IRR would be an interest rate that the project could
afford to pay on its funds and still recover all its investment and operating
costs. While calculating the NPV we have used a pre determined discount rate
and a table. But the calculation of the IRR amounts to searching for the
discount rate that give a zero NPV. This is achieved through trial and error
using the standard discounting table.
❑ Decision rule for independent projects
• IRR Project Selection Criteria: Accept the project when IRR is greater than
predetermined discount rate (i) set by Central Bank. Reject the project when
IRR is less than i
Discounting Methods …
❑ Decision rule for independent projects…
• In order to assess project profitability compare IRR against the required
interest rate (i). If a project is expected to have an IRR greater than the rate used
to discount the cash flows, then the project adds value to the business. If the IRR
is less than the discount rate, it destroys value. The decision process to accept or
reject a project is known as the IRR rule.
• Note also that: When (1) NPV > 0 then IRR > I
(2) NPV = 0
(3) NPV < 0
•
•
then
then
IRR = I
IRR < i
All projects with an IRR greater than some target rate of return i, should be accepted.
The target rate is usually the same rate used as the financial or social discount rate
employed in the computation of the project NPV.
•
A project is selected if the IRR is more than the required rate of return (cost of
capital).
•
Investment with the highest internal rate of return is usually preferred.
NPV method is preferred in evaluating the capital projects. In small project, the IRR may
be higher, but its NPV may be lower than the NPV of large project. Since the objective in
financial management is to maximize the shareholders’ wealth, NPV method is preferred
to the IRR method of capital expenditure evaluation.
Discounting Methods …
• The IRR is the discount rate that makes the net present value (NPV) of a project
zero. In other words, it is the expected compound annual rate of return that will be
earned on a project or investment.
• In the example below, an initial investment of $50 has a 22% IRR. That is equal to
earning a 22% compound annual growth rate.
Discounting Methods …
Example 1: determine the internal rate of return of the following cash
flows of an investment?
Year
Cash flows
0
(300,000)
1
150000
2
150000
3
150000
4
10000
Solution:
NPV = 0 = - 300000 +
15000
(1+𝐼𝑅𝑅)
+
15000
15000
1000
+
+
(1+𝐼𝑅𝑅)2 (1+𝐼𝑅𝑅)3 (1+𝐼𝑅𝑅)4
• Even though it is difficult to solve for IRR and determine its value manually, it is
possible to get the value of IRR it using Microsoft excel and it is 24.31% . This
IRR makes the NPV equal to zero.
Discounting Methods …
Example 2: The cost of a project is $1000. It has a time horizon of 5 years and
the expected year wise incremental cash flows are: year 1: $200, Year 2: $300,
Year 3: $ 300, Year 4: $ 400, and Year 5: $500. Compute IRR of the Project. If
opportunity cost of capital is 12% and tell us , should we accept the Project?
Solution
NPV = 0 = - 1000 +
200
(1+𝐼𝑅𝑅)1
+
300
(1+𝐼𝑅𝑅)2
+
300
1+𝐼𝑅𝑅 3
+
400
(1+𝐼𝑅𝑅)4
+
500
(1+𝐼𝑅𝑅)5
➢ The usual way of determining IRR is by Trail and Error method using different
values of discount rate until the right hand side of the above question equal to
zero.
➢ But for simplicity use Microsoft excel to determine IRR which is close to
17.71. Since IRR is grater than the opportunity cost of capital or the standard
discount rate 12%, we should accept the project
Financial sustainability
• The project is financially sustainable when the risk of running out of
cash in the future, (both during the investment and the operational
stages), is expected to be nil.
• Project promoters (organizers) should show how the sources of
financing available (both from internal and external) will
consistently match disbursements year-by-year.
• In the case of non-revenue generating projects, whenever negativecash-flows are projected in the future (i.e. in years in which large
capital investments are required for asset replacements), a clear
long-term commitment to cover these negative cash flows must be
provided.
• The difference between inflows and outflows will show the deficit or
surplus that will be accumulated each year. Sustainability occurs if the
cumulated generated cash flow is positive for all the years considered .
Financial sustainability…
❖ The inflows include:
• Sources of financing;
• Operating revenues from the provision of goods and services; and
• Transfer, subsidies and other financial gains not stemming from
charges paid by users for the use of the infrastructure.
❖ The dynamics of the inflows are measured against the outflows. These
relate to the following:
• initial investment
• replacement costs
• operating costs
• reimbursement of loans and interest payments
• taxes on capital/income and other direct taxes
ECONOMIC ANALYSIS
Economic Analysis
❑ Economic analysis:
• is the process of identifying the economic benefits and costs associated
with a development project.
• is used to analyze and document the project net benefit with respect to
the society as a whole
• While The financial analysis is used to analyze with respect to the
investors
• takes a broader view of the profitability of the project.
• include external effects in the analysis such as environmental impacts,
health impacts , etc. The value of external effects is typically assigned
using economic opportunity costs or shadow prices.
• does not include transfer payments such taxes, tariffs, subsidies, etc.
• With respect to the whole economy or the society, these costs do not
add to economic productivity and are merely transactions between
entities within the economy.
Economic Analysis…
❑ Economic Feasibility analysis:
❖ involves the feasibility of the proposed project to generate economic benefits.
•
•
A benefit-cost analysis is required.
A break-even analysis when appropriate is also a required aspect of
evaluating the economic feasibility of a project. (This addresses fixed and
variable costs and utilization/sales forecasts).
❖ tangible and intangible aspects of a project should be translated into economic
terms to facilitate a consistent basis for evaluation. Even when a project is nonprofit in nature, economic feasibility is critical.
❖ An economic analysis is always a comparison between a base case – the expected
present and future situation without the project and with the project alternative.
• Without this comparison, it would be impossible to assess whether the
external effects are an improvement or not.
• Whenever the term "benefit" is used in an economic analysis it refers to the
change in external effects that can be attributed to the project.
Economic Analysis…
❑ Approach to economic Analysis: the figure illustrates the elements in an
economic analysis
Net
Benefits
to
Society
Economic
Benefits to
Society
External
costs to
society
CAPEX
OPEX
❑ Purpose of Economic analysis:
• A systematic process for calculating and comparing benefits and costs of a
project is needed for two purposes:
1. To determine if it is a sound investment (justification/feasibility)
• The goal of the economic analysis is to demonstrate that the project is a
net gain for society. This is typically mandatory whenever there is an
element of public financing or regulation, e.g. tariffs. Economic analysis is
also more and more frequently being used to brand private investments as
being socially responsible
2. To see how it compares with alternate projects (ranking/priority assignment)
Economic Analysis…
• Typically, there is a greater variation in how the results of the economic
analysis are reported – as opposed to the financial analysis.
• The financial analysis serves a very specific purpose, whereas
• The economic analysis is used to communicate the benefits of the project
to many different stakeholders.
❖ Thus, What Economic Analysis of project really is ?
• More than rate of return calculation
• Framework/tool to select and design good project
Relevant and responsive ( Economic rationale)
Feasible, result-delivering-contributing to welfare of country
and its people (Project Economic Analysis)
Economic Analysis…
The main difference b/n financial and economic analysis are:
Financial Analysis:
❑ Investor's perspective
❑ Based on market prices
❑ Including taxes, tariffs,
subsidies etc.
❑ Does not include
externalities
Economic Analysis:
➢ Society's economic perspective
➢ Applies economic prices
➢ excluding taxes, tariffs, subsidies
etc. to reflect the value of the
project to society.
➢ Externalities (positive and negative )
are included and quantified in
monetary terms.
Selected Steps in Project Economic Analysis
1. Macro context
2. Sector Analysis
3. Rationale for Public
validating the Economic
sector Involvement
Rationale
4. Choice of Modality
5. Demand Analysis
6. Alternative Analysis and least Cost
7. Valuation of Benefits & Costs
8. Financial & Institutional Sustainability
Project Economic
9. Distribution analysis
Analysis
10. Sensitivity Analysis
11. Monitoring & Evaluation
Economic Analysis…
1. Macroeconomic Context
❖ A project cannot be designed in isolation from the rest of the economy
• Project must be relevant vis-à-vis country objective
➢ link to country broader development objective
➢ Link to Country specific objective
• Country’s resource position must be carefully assessed
• Macroeconomic factor may affect project performance
➢ Identify factors most likely to influence target sector
➢ Economic outlook
2. Sector Analysis:
• What are key problems and issues that need to be addressed
➢
➢
➢
➢
Policy and regulatory environment
Who supplies & what constraint do they face
financing; who pays for the good or service
role of public versus private sector
*** Identify possible areas for investment and policy reform
Economic Analysis…
3. Public Sector Rationale and Choice of Modality:
➢ Why should there be public sector intervention?
•
•
•
•
Market or institutional failure
Public good
Equity Issue
What is counterfactual if government is not involved
➢ What Modality is the most appropriate?
4. Demand analysis:
➢ How much of the output is wanted? How much are users willing to pay for it?
• Project design should be demand-driven
• Assess demand for product or service
• Identify demand shifting factors
• Project growth rate of demand, influence of demand shifters (size of project)
Basis for identification of project size, timing and overall benefits
5. Alternative and Least Cost Analysis:
❖ What is the most efficient way of addressing the problem at hand?
▪ Evaluate alternative project design in terms of lending modalities, financial
arrangements, scale and timing, location, etc.
▪ Explain why proposed alternative chosen (least cost alternative)
Economic Analysis…
6. Valuation of Benefits and Costs:
• Assess what will happen without project (counterfactual )
• Identify project benefits and costs
• Value project benefits and costs
• Economic Viability : Benefits > Costs
• Cost effectiveness analysis if benefits cannot be valued
7. Financial and Institutional Sustainability:
➢ Are there enough resources to ensure flow of benefits?
• Assess financial performance of project entity for revenue generating
projects
• Assess self-financing capacity of project entity
• Fiscal impact (direct or indirect subsidy)
• Sources of funds to meet net financial requirements
• Institutional capacity assessment
Economic Analysis…
8. Distribution Analysis:
• Who benefits and by how much?
• Identify groups that gain or lose
•
•
Assess size of gains and lose
Target groups (poor, women, etc.
Shed light on likely impact of project, sustainability
9. Sensitivity and Risk Analysis:
➢ What are the chances that benefits and costs will be realized as anticipated?
• Identify variables to which project is sensitive
•
Assess change in parameters required to change project decision
•
Assess likelihood of these changes occurring
•
Consider mitigating actions against main sources of uncertainty
10. Monitoring and Evaluation:
➢ Do initial assumptions maintain validity throughout project life?
▪
Identify key variables necessary to measure
outcome/impact
▪
Establish system to collect data on all key variables
project
•
•
•
•
•
Overall Assessment
Is project relevant in country/sector context?
Has rationale for public sector intervention been clearly
established?
Does project incorporate best alternative design?
Is project economically sound?
Is project feasible/ sustainable?
Marketing Analysis
❑ Market Feasibility:
• This area should not be confused with the economic feasibility.
• The market needs analysis to view :
• The potential impacts of market demand, competitive activities, etc. and
market share available.
• The possible competitive activities by competitors, whether local,
regional, national or international, must also be analyzed for early
contingency funding and impacts on operating costs during the startup, ramp-up, and commercial start-up phases of the project.
• Demand and market analysis need to ensure the existence of effective demand
at exchange price, the size of market which will absorb the output without
effect on price.
• Before the production actually starts, the entrepreneur needs to anticipate
• the possible market demand for the product.
• who will be the possible customer for his product and where his product
will be sold.
• This is because production has no value for the producer unless
it is sold. Thus knowing the anticipated market for the product to
be produced become an important element in business plan
Marketing Analysis…
❑ Method to Estimate Demand
• The commonly used methods to estimate the demand for a product are as
follows:
1 Opinion polling method
2. Life Cycle Segmentation Analysis method
1. Opinion polling method: the method used the opinion of the ultimate users.
• This may be attempted with the help of either a complete survey of all
customers or by selecting a few consuming units out of the relevant
population
2. Life Cycle Segmentation Analysis: Every product has its own life span .
• In practice,
• a product sells increased slowly in the beginning.
• Then Barked by sales promotion strategies over period its sales pick up. In
the due course of time the peak sale is reached.
• After that point the sales begins to decline. After sometime, the product
loses its demand and dies. This is natural death of a product.
• Thus, every product passes through its life cycle. The product life cycle has been
divided into the following five stage : Introduction, Growth, Maturity,
Saturation and Decline.
Marketing Analysis…
• The sales of the product varies from stage to stage as shown in the
Product Life Cycle. The sale at different stages can be anticipated.
The figure shows the five stages of a product life cycle,
Information required for Market and Demand Analysis
1. Effective demand in the past and present:
• To gauge the effective demand in the past and present, the starting point
typically is apparent consumption ( c ) which is defined as:
C = Production + Import - Export - Changes in stock level
• In a competitive market, effective demand and apparent consumption are equal.
2. Demand analysis identifies the need for an investment by assessing:
• Current demand: based on statistics provided by service suppliers/
regulators/ ministries/ national and regional statistical offices for the
various types of users;
• Future demand: based on reliable demand forecasting models that take
into consideration macro- and socio-economic forecasts, alternative
sources of supply, elasticity of demand to relevant prices and income, etc.)
in both the scenarios with- and without-the-project.
➢ Both quantifications are essential
• To formulate demand projections, including generated/ induced demand
where relevant, and
• To design a project with the appropriate productive capacity. For
example, it is necessary to investigate which share of the demand for
public services, rail transport, or disposal of waste material can be expected
to be satisfied by the project.
Information required for Market and Demand Analysis
3.
4.
5.
6.
7.
8.
9.
10.
Consumer trend in the past and the present consumption level
Past and present supply position
Production possibility and constraint
Import and exports
Structure of competition(perfect or imperfect competition)
Cost structure
Elasticity of demand
Consumer behavior, intentions, motivation, attitudes, preference and
requirements
11. Distribution channels and marketing policies in use
12. Administration, technical and legal constraints
❑ The Key steps in demand and marketing analysis:
➢ Structural analysis and specification of objective
➢
➢
➢
➢
➢
Collection of secondary information
Conduct a market survey
Characterization of the market
Demand forecasting
Market planning
Managerial Analysis
• The success or failure of a project largely depends upon the ability of the
project holder to manage the project.
• For the success of a project, a manager has to coordinate all the activates in
such a way that the additive impact of different inputs can produce the desired
result
• There are three ways to measure the managerial efficiency
a. Existing skill level
b. skill acquired by training
c. Skill acquired course of work
❑ Social Analysis:
•
Social Analysis
involves examining the socio-cultural, institutional, historical and political
context of a project and its stakeholders.
• is a process that aims to identify the social dimensions of projects, as well
as analyze the different stakeholder perspectives and priorities.
• Social analysis not only allows to understand the opportunities and
constraints, and the likely social impacts associated with a project, but also
provides spaces to
- incorporate stakeholders' views,
- establish participatory processes and
- inform the design of strategies for inclusion, cohesion
and accountability.
• Understanding the social implications of projects and policies is critical in
ensuring that the proposed project or policy contributes to equitable and
sustainable development.
• provide insight into social diversity and gender, institutions, rules and
behavior, stakeholder dynamics, participation concerns and social risks
Sensitivity analysis
❑ Definition of Sensitivity Analysis
❖ A sensitivity analysis:
• Is a measure of the effect of Change in one variable over the dependent, keeping
other factors constant.
• determines how different values of an independent variable affect a particular
dependent variable under a given set of assumptions.
• is a tool used in financial modeling to analyze how the different values of a set of
independent variables affect a specific dependent variable under certain given
conditions /assumptions. Its usage will depend on one or more input variables
within the specific boundaries, such as the
• effect that changes in interest rates will have on a bond’s price.
•
Example
If
Output = f ( inputs)
Q = f ( x1 , x2 , ….)
•
The sensitivity of the dependent variable Q to the change in one of the
independent variable, say x1 , can be measured by a percentage change of Q to
the percentage change of x1 , keeping all other factors affecting Q constant.
•
Similarly, : Sensitivity Analysis can be used to study the effect of a change in interest
rates on bond prices if the interest rates increased by 1%. The “What-If” question
would be: “What would happen to the price of a bond If interest rates went up by
1%?”. This question is answered with sensitivity analysis.
Sensitivity analysis…
•
The Inverse Relationship Between Interest Rates and Bond Prices. Bonds
have an inverse relationship to interest rates. When the cost of borrowing money
rises (when interest rates rise), bond prices usually fall, and vice-versa.
❑ Sensitivity analysis works on the simple principle:
Change the model and observe the behavior.
❑ The parameters that one needs to note while doing the above are:
1)
Experimental design: It includes combination of parameters that are to be varied. This
includes
•
•
•
2)
3)
a check on which and how many parameters need to vary at a given point in time,
assigning values (maximum and minimum levels) before the experiment,
study the correlations: positive or negative and accordingly assign values for the
combination.
What to vary: The different parameters that can be chosen to vary in the model could be:
a) the number of activities
b) the objective in relation to the risk assumed and the profits expected
c) technical parameters
d) number of constraints and its limits
What to observe:
a) the value of the objective as per the strategy
b) value of the decision variables
c) value of the objective function between two strategies adopted
Sensitivity analysis…
❑ Measurement Step to conduct Sensitivity Analysis:
• Firstly, the base case output is defined; say the NPV at a
particular base case (initial) input value (V1) for which the
sensitivity is to be measured. All the other inputs of the model are
kept constant.
• Then, the value of the output at a new value of the input (V2)
while keeping other inputs constant is calculated.
• Find the percentage change in the output and the percentage
change in the input.
• The sensitivity is calculated by dividing the percentage change in
output by the percentage change in input.
❖ This process of testing sensitivity for another input (say cash flows
growth rate) while keeping the rest of inputs constant is repeated until
the sensitivity figure for each of the inputs is obtained.
❖ The conclusion would be that the higher the sensitivity figure, the
more sensitive the output is to any change in that input and vice versa.
Sensitivity analysis…
Methods and Approaches of Sensitivity Analysis
• There are different methods to carry out the sensitivity analysis: Modeling and
simulation techniques and Scenario management tools through Microsoft excel
• There are mainly two approaches to analyzing sensitivity:
•
•
Local Sensitivity Analysis
Global Sensitivity Analysis
❑ Local sensitivity analysis
•
is derivative based (numerical or analytical). The term local indicates that the derivatives
are taken at a single point. This method is apt for simple cost functions, but not feasible for
complex models, like models with discontinuities do not always have derivatives.
•
Mathematically, the sensitivity of the cost function with respect to certain parameters is equal
to the partial derivative of the cost function with respect to those parameters.
•
Local sensitivity analysis is a one-at-a-time (OAT) technique that analyzes the impact of
one parameter on the cost function at a time, keeping the other parameters fixed.
❑ Global sensitivity analysis
•
is the second approach to sensitivity analysis, often implemented using Monte
Carlo techniques. This approach uses a global set of samples to explore the design
space.
Sensitivity analysis…
❑ The various techniques widely applied include:
❖ Differential sensitivity analysis:
• It is also referred to the direct method.
• It involves solving simple partial derivatives to temporal
sensitivity analysis.
• Although this method is computationally efficient, solving
equations is intensive task to handle.
❖ One at a time sensitivity measures:
• It is the most fundamental method with partial differentiation, in
which varying parameters values are taken one at a time.
• It is also called as local analysis as it is an indicator only for the
addressed point estimates and not the entire distribution.
❖ Factorial Analysis: It involves the selection of given number of
samples for a specific parameter and then running the model for the
combinations. The outcome is then used to carry out parameter
sensitivity.
Sensitivity analysis…
❖ Through the sensitivity index one can calculate the output % difference when
one input parameter varies from minimum to maximum value.
•
•
•
Correlation analysis helps in defining the relation between independent and
dependent variables.
Regression analysis is a comprehensive method used to get responses for complex
models.
Subjective sensitivity analysis: In this method the individual parameters are
analyzed. This is a subjective method, simple, qualitative and an easy method to rule
out input parameter
❖ Uses of Sensitivity Analysis
•
•
•
•
•
•
•
The key application of sensitivity analysis is to indicate the sensitivity of simulation
to uncertainties in the input values of the model.
They help in decision making
Sensitivity analysis is a method for predicting the outcome of a decision if a
situation turns out to be different compared to the key predictions.
It helps in assessing the riskiness of a strategy.
Helps in identifying how dependent the output is on a particular input value.
Analyses if the dependency in turn helps in assessing the risk associated.
Helps in taking informed and appropriate decisions
Aids searching for errors in the model
Example of sensitivity Analysis
❑ Assume Mr. X is a sales manager who wants to understand the impact of
customer traffic on total sales.
• He determines that sales are a function of price and transaction volume.
The price of a widget is $1,000, and He sold 100 last year for total sales of
$100,000.
• He also determines that a 10% increase in customer traffic increases
transaction volume by 5%.
• This allows him to build a financial model and sensitivity analysis around
this equation based on what-if statements.
• It can tell him what happens to sales if customer traffic increases by
10%, 50%, or 100%. Based on 100 transactions today, a 10%, 50%, or
100% increase in customer traffic equates to an increase in transactions
by 5%, 25%, or 50% respectively.
• The sensitivity analysis demonstrates that sales are highly sensitive to
changes in customer traffic.
Sensitivity analysis …
❑ Scenario Analysis
• If one thing changes, lots of thing might change
• Measure the combination effects of Change of multiple variables.
• See how this changes a calculated value - NPV, IRR, Working
Capital needs…
❑ The difference between sensitivity and Scenario Analysis
Sensitivity vs. Scenario Analysis…
• In finance, a sensitivity analysis is created to understand the impact a range
of variables have on a given outcome. It is important to note that a
sensitivity analysis is not the same as a scenario analysis.
• As an example, assume an equity analyst wants to do a sensitivity analysis
and a scenario analysis around the impact of earnings per share (EPS) on a
company's relative valuation by using the price-to-earnings (P/E) multiple
• The sensitivity analysis is based on the variables that affect valuation,
which a financial model can depict using the variables' price and EPS. The
sensitivity analysis isolates these variables and then records the range of
possible outcomes. On the other hand, for a scenario analysis, the analyst
determines a certain scenario such as a stock market crash or change in
industry regulation.
•
He then changes the variables within the model to align with that scenario.
Put together, the analyst has a comprehensive picture. He now knows the
full range of outcomes, given all extremes, and has an understanding of
what the outcomes would be, given a specific set of variables defined by
real-life scenarios.
Institutional Analysis
❑ What are institutions and Organizations?
❑ Institutions can be understood as settled, widely prevalent and standardized
habits and conventions defining social practices and – more formally – as
constitutional and operational rules governing different kinds of
organizations.
•
Institutions are “rules and norms that constrain human behavior” and
organizations as “the players” (North 1993).
❑ Important features of organizations are:
• they have a structure and functions;
• they are designed to achieve specific goals;
• they have identifiable boundaries; they work within, or are influenced by,
the institutional context, while usually also attempting to influence the
‘rules of the game’; and
• they use resources, knowledge or technology to perform work-related
activities.
• Organizations are thus more closely associated with the ‘association’ and
‘action’ elements of the conceptual framework
Institutional Analysis
❑ Functional Elements:
➢
The four key functional elements or aspects of ‘institutions’ . These include:
• ways of making meaning in our lives
• the associations we make
• the basis for control over individuals and organization
• actions that are taken.
Institutional Analysis: Functional Elements…
1. Meaning related aspect : This aspect of institution
•
•
•
•
•
•
relates to the mental models we use to interpret our lives and the social and
natural world in which we live.
is about the way in which we make events, relationships, natural phenomena
and time meaningful.
Encompasses elements such as
• Our individual beliefs and values,
• the overall cultural values and beliefs within which we live,
• the social norms that define, restrict and explain our lives, our religious
beliefs, frameworks of scientific understanding and research, and so on.
Institutions can be formal and informal
Informal institutions:
• are deep-rooted and often undocumented.
• may also be called ‘exogenous institutions’, as they are external to the
overall economic system and exist at the ‘socially-embedded’ level.
• Although these informal institutions can change, this is usually a lengthy
process, measured in decades, or even longer periods.
The meaning-related aspects of institutional and organizational analysis have
often been overlooked when designing development interventions.
Functional Elements
2. Association: This aspect of institution
• involves the associations that people make with each other to work towards
achieving social, economic and political objectives.
• These might be formally organized, such as governments, businesses, civil
society or non-governmental organizations (NGOs).
• encompass the relationships, agreements and interactions between
organizations, representing the informal aspect of association.
• includes most of the types of organizations that are typically the target of
capacity-building or strengthening interventions
• Organizations such as governments may be formal expressions of the
informal values and beliefs of a society, for example in the way they are
structured and how they operate. This makes them ‘deep’ or slow-changing
entities.
Functional Elements
3. Control : This aspect if institution
•
is often the one that comes to mind when the term ‘institution’ is used, and refers to the ways
of maintaining control over what individuals or organizations should or can do.
•
covers formal aspects such as laws, rules, regulations, as well as mandates, strategies and
policies.
•
also covers informal rules, which may be deeply intertwined with meaning-making systems.
•
Institutions, as a set of rules, can only be effective and sustained when they are legitimate,
consistent and compatible with other institutions, and when they can be implemented and
reviewed.
4. Action
•
Actions carried out regularly by individuals or organizations are also an element of institutions.
•
include regular patterns of behavior by organizations or individuals, as well as the regular
provision of services, functions and products that take place according to agreed-upon rules,
laws and norms (formal and informal).
•
describes the functional, real-world results of institutional and organizational interaction –
what people do.
Risk Assessment:
Accounting for Risk in Project Decision
• For the approval of a major project a risk assessment must be
included in the CBA (Cost-Benefit Analysis).
• This is required to deal with the uncertainty that always
permeates investment projects, including the risk that the
adverse impacts of climate change may have on the project.
• The recommended steps for assessing the project risks are as
follows:
• sensitivity analysis;
• qualitative risk analysis;
• probabilistic risk analysis;
• risk prevention and mitigation.
Risk Assessment…
Sensitivity analysis
• Sensitivity analysis enables the identification of the ‘critical’ variables of the
project. Such variables are those whose variations, be positive or negative, have
the largest impact on the project’s financial and/or economic performance.
• The analysis is carried out by varying one variable at a time and determining
the effect of that change on the NPV.
• As a guiding criterion, the recommendation is to consider ‘critical’ those
variables for which a variation of ±1 % of the value adopted in the base case
gives rise to a variation of more than 1 % in the value of the NPV.
• The tested variables should be deterministically independent and as
disaggregated as possible.
• Correlated variables would give rise to distortions in the results and doublecounting. Therefore, before proceeding to the sensitivity analysis, the CBA
model should be reviewed with the aim of isolating the independent variables
and eliminating the deterministic interdependencies (e.g. splitting a variable
in its independent components).
Risk Assessment…
For example, ‘revenue’ is a compound variable, which depends on
the two independent items ‘quantity’ and ‘tariff’, both of which
should be analyzed. Table below gives an illustrative example.
FNPV= financial net present value, ENPV= Economic net present Value
Risk Assessment…
Switching Value:
• is an important and relevant value in the sensitivity analysis
calculation .
• This is the value that the analyzed variable would have to take
in order for the NPV of the project to become zero, or more
generally, for the outcome of the project to fall below the
minimum level of acceptability.
• The use of switching values in sensitivity analysis allows
making some judgments on the risk of the project and the
opportunity of undertaking risk-preventing actions.
• For instance, in the example below, one must assess if a 19 %
investment cost increase which would make the ENPV equal
to zero thereby means that the project is too risky. Thus, the
need to further investigate the causes of this risk, the
probability of occurrence and identify possible corrective
measures (see next section).
Risk Assessment…
Risk Assessment…
• Finally, the sensitivity analysis must be completed with a
scenario analysis, which studies the impact of combinations of
values taken by the critical variables. In particular,
combinations of ‘optimistic’ and ‘pessimistic’ values of the
critical variables could be useful to build different realistic
scenarios, which might hold under certain hypotheses. In order
to define the optimistic and pessimistic scenarios it is necessary
to choose for each variable the extreme (lower and upper)
values (within a range defined as realistic). Incremental project
performance indicators are then calculated for each
combination. Again, some judgments on the project risks can be
made on the basis of the results of the analysis. For example, if
the ENPV remains positive, even in the pessimistic scenario, the
project risk can be assessed as low.
Probabilistic risk analysis
• The probabilistic risk analysis is required where the residual risk exposure
is still significant. In other cases it may be carried out where appropriate,
depending on project size and data availability.
• This type of analysis assigns a probability distribution to each of the critical
variables of the sensitivity analysis, defined in a precise range of values
around the best estimate, used as the base case, in order to recalculate the
expected values of financial and economic performance indicators.
The End
Feasibility Study: A Schematic Diagram
Generation of idea
Initial Screening
Is the idea prima facie promising
Yes
Plan Feasibility analysis
Conduct market
Analysis
NO
Terminate
Conduct Technical
Analysis
Conduct Financial Analysis
Conduct Economic, Social and
Environmental Analysis
Is the project worthwhile?
Yes
Preparing Funding Proposal
NO
Terminate
Feasibility Analysis and Appraisal Report
Feasibility report should have the following structure:
1. Executive summary: : it provides a quick overview of the main
points of the assessment, helping to form a picture of the
proposal along with the recommendations. It should be concise
and include the major findings covered in the main body of the
report
Feasibility Analysis and Appraisal Report
2. Need Analysis: need analysis provide a context to the business
proposition. It analyzes the justification of the idea, with a study of
possible alternatives. It links the business idea to the current
circumstances and helps to inform evaluation of the business idea.
3. Engineering: Description of the technical aspects of the business
idea, including any changes needed to be made to existing processes or
the need to add items to existing range of products and services.
4. Cost Estimate: This involves estimating project cost to a suitable
level of accuracy
- Level of around -5% to +5% are common at this level of
a project plan
- Estimates of capital investment, recurring and nonrecurring
costs must be there
- Sensitivity analysis can be carried out on the estimated cost
values to see how sensitive the project plan is to the estimated
cost values.
Feasibility Analysis and Appraisal Report
5. Financial Analysis: This involves an analysis of the cash flow profile of the
project.
- The analysis should consider rates of return, inflation, sources of capital, payback
period, breakeven, residual values, and sensitivity
- This is a critical analysis since it determines whether or not and when funds will
be available to the project.
6. Project Impact: This portion of the feasibility study provides an assessment of
the impact of the proposed project.
- Environmental, social, cultural, political and economic impacts may be some of
the factors that will determine how a project is perceived by the public.
7. Conclusion and recommendations: The feasibility study should end with
the overall outcome of the project
- This may indicate an endorsement or approval of the project
- Recommendation on what should be done, should be included in this section
of the feasibility report
A feasibility study is a management oriented activity. After a feasibility study,
management makes a “go/no –go” decision. It helps examine the problem in the
context of broader business strategy
Project Appraisal …
• Financial institutions carry out project appraisal to assess its creditworthiness
before extending finance to a project. A wide range of appraisal criteria have
been developed to judge the worthwhile of a project. They are divided into two
broad categories, viz
• Non-discounting criteria and
• Discounting criteria.
• Non- Discounting Criteria: The principal non-discounting criteria's are
the payback period and the accounting rate of return.
• Discounting Criteria: The key discounting criteria's are the net present
value, the internal rate of return and the benefit cost ratio.
• When the appraisal is completed, the findings and final recommendations
are put together in the form of an appraisal report. The recommendation
may be to approve, reformulate, postpone or abandon the project under
review.
Steps in Investment Analysis
❑ Steps in Investment Analysis:
• The three steps in investment analysis are the following:
1. Identify the investment opportunity,
2. Find the present value of the future cash flows, and
3. Compare the present value of the cash flows to the cost of
the investment.
❑ What are the types of investment decision?
• There are four main financial decisions1. Capital Budgeting or Long term Investment decision (Application
of funds),
2. Capital Structure or Financing decision (Procurement of funds),
3. Dividend decision (Distribution of funds) and
4. Working Capital Management Decision in order to accomplish
goal of the firm viz., to maximize
Steps in Investment Analysis
❑ What are the four steps of capital investment analysis?
(1)
(2)
(3)
(4)
Estimate the expected cash flows,
assess the riskiness of those flows,
estimate the appropriate opportunity cost of capital, and
determine the project's profitability and breakeven characteristics
❑ What are the steps in investment process?
• The investment process is summarized in five key stages:
1. Establishing portfolio objectives;
2. Developing the strategic and tactical asset allocation;
3. Manager research, selection and configuration;
4. Portfolio implementation; and.
5. Ongoing monitoring and due diligence.
❑ What are the elements of investment?
•
Elements of Investment
• There are three factors that are considered as elements of investment.
• a) Reward (return);
• b) Risk and return; and.
• c) Time
• We have seen above that investment is made with the intention to gain profit.
Financial Analysis…
•
A tangible cost is the money paid to a new employee to replace an old one.
An intangible cost is the knowledge the old employee takes with them when they leave.
• What’s the difference between tangible and intangible benefits?
❖ Tangible benefits are those that can be measured in financial terms, while intangible
benefits cannot be quantified directly in economic terms, but still have a very
significant business impact.
❖ The intangible benefits, sometimes also called “soft benefits”, are the profits ascribable
to the improvement project that cannot be reported for formal accounting purposes.
❖ These benefits are not included in financial calculations because they are not monetary
or are difficult to quantify and calculate.
❖ Material benefits are physical in nature and may represent long-term or short-term
benefits, while intangible benefits usually represent long-term assets that are not
physical property but rather the intellectual property of an organization.
❖ Another difference between these two benefits is that intangible benefits can increase or
decrease over time, while the tangible benefits of a process are unlikely to fluctuate.
❖ And, again, tangible benefits can often be estimated before certain actions are taken,
while intangible benefits are virtually impossible to estimate beforehand.
❖ Here we will see specifically what the tangible and intangible benefits of a project can
be.
Institutional / Organizational Analysis and Strengthening
• Institutional and organizational analysis (IOA) refers to the research and
analysis of, and generation of understanding about, institutions and
organizations.
• Institutional assessment should usually be understood as assessing the formal
and informal ‘rules of the game’ that influence society, organizations and
individuals.
• Organizational assessment is focused on the nuts and bolts of how
organizations are structured and organized, their values and culture, their
capacity and performance, and so on.
• Capacity-building is a means to institutional and organizational strengthening
• Different levels of capacity can also be identified.
• Competency is defined as the individual’s set of skills, knowledge,
abilities and experience.
• Capabilities are generally identified at the organizational level – the
sum of both individual competencies and organizational elements such
as vision, mission, structure, resourcing, and so on.
• Capacity then refers to the macro level of systems as a whole – i.e. the
sum of individual competency, organizational capabilities, and
institutional elements such as culture, laws, rules, guidelines, etc.
Institutional / Organizational Analysis and Strengthening
According to North and Thomas (1973) institutional
analysis and development focus on those institutional
arrangements which enable units to
• realize economies of scale (joint stock companies,
corporations)
• encourage innovation (prizes, patent laws),
• improve the efficiency of factor markets (enclosures,
bills of exchange, the abolition of serfdom), or
• reduce market imperfections (insurance companies).
• ensuring property right
Such institutional arrangements have served to increase
efficiency.
Framework for analysis of institutional
/organizational development
(1) Human resource development (training and education)
which are concerned with how people are educated and
trained, how knowledge and skills are transferred to
individuals, competence built up and people prepared for
their current or future careers.
(2) Institutional/ Organizational development which seeks
to change and strengthen structures, processes and
management systems in specific organizations in order to
improve organisational performance. There are variations
between theories and strategies, but they have in "pure"
form the following characteristics: (a) focus on individual
formal organizations and particularly their internal
functioning, (b) less attention paid to external contextual
influences on performance, (c) concern with internal
organisational changes, and (d) activities include education,
training, advice.
Framework for analysis of institutional /organizational
development
(3) Systems development is a broader concept than organisational
development. In addition to a concern with human resources and the
development of particular organizations, it includes an emphasis on
linkages between organizations and the context or environment within
which organizations operate and interact. It is useful to make a
distinction between three system levels:
• (i) The network and linkages among organizations, which include
the network and contact between organizations that facilitate or
constrain the achievements of particular tasks.
• (ii) The regulatory environment referring to the policy environment
of the public, private and civil sector that constrains or facilitates
organisational activities and affects their performance, including e.g.
laws, regulations and policies.
• (iii) The value framework - including the economic, social, cultural
and political milieu in which organizations operate, and the extent to
which conditions in this broader environment facilitate or constrain
the functional capacity of organizations.
Introduction
❑ Formulation/ preparation of a project
• It is the second task in the planning process
• It involves the articulation of objectives or goals and outputs.
• It must also provide an estimate of the various resources required to
achieve the objectives.
• This makes it possible to develop a preliminary design as the basis for
conducting feasibility studies to determine if the project can be
implemented according to the standards and criteria set forth in the
preliminary design.
• Appraisal consists of an evaluation of all of the feasibility studies to
determine the ability of the project to succeed. Thus, feasibility analysis
and appraisal form the critical juncture in the integrated project cycle.