
Financial Analysis consider the financial features of a project to
ensure that the disposable finances shall permit the smooth
implementation and operation of the project.

Financial Analysis is carried out on a year to year basis. It
includes liquidity analysis and capital structure analysis.
Section 1:
 Section 2:
 Section 3:
 Section 4:
 Section 5:
 Section 6:
 Section 7:
 Section 8:
 Section 9:
 Section 10:

Cost of Project
Means of Finance
Estimates of Sales & Production
Cost of Production
Working Capital Requirement & Its Financing
Liquidity Analysis
Capital Structure Analysis
Cost of Capital
Projected Financial Position
Uncertainty Analysis
7. Capital
Structure
Analysis
1. Cost of
Project
6. Liquidity
Analysis
4. Cost of
Production
2. Means of
Finance
5. WC
Requirement
8. Cost of
Capital
3. Estimation of
Sales &
Production
9. Projected
Financial
Position
10. Uncertainty
Analysis
Fig: Financial Projections
The cost of project represents the total of all items of outlay
associated with a project which are supported by long term funds.
It is the sum of the outlays on the following:
Land and site development:
 Cost including conveyance and other allied charges
 Premium payable on leasehold
 Cost of leveling and development, laying approach roads and
internal roads
 Cost of compound wall and gates, tube wells.
Building and civil works:
 Buildings for the main plant and equipment.
 Buildings for auxiliary services like steam supply, workshops,
laboratory, water supply etc.
 Godowns, warehouses, garages and open yard facilities
 Non-factory buildings like canteen, guesthouses, team office,
excise house, etc.
 Sewers, drainage, etc.
 Other civil engineering works
Plant and machinery:
 Cost of imported machinery: This is the sum of
i. FOB value,
ii. Shipping, freight, and insurance cost,
iii. Import duty and
iv. Clearing, loading, unloading and transportation charges.
 Cost indigenous machinery: This consists of
i. FOR cost,
ii. Sales tax and other taxes, if any, and
iii. Railway freight and transport charges to the site.
 Cost of stores and spares.
 Foundation and installation charges.
Technical know-how and engineering fess:
The amount payable for obtaining the technical know-how and
engineering services for setting up the project is a component of
the project cost, the royalty payable annually, which is typically a
percentage of sales, is an operating expense taken into account in
the preparation of the projected profitability statement.
Expenses on foreign technicians:
Expenses on their travel, boarding, and lodging along with their
salaries and allowances must be shown here.
Miscellaneous fixed assets:
Items like furniture, office machinery and equipment, tools,
vehicles, railway siding , diesel generating sets, transformers,
boilers, piping systems, laboratory equipment, workshop
equipment, firefighting equipment, and so-on. Expenses incurred
for the procurement or use of patents, licenses, trademarks,
copyrights, etc. and deposits made with the electricity board may
also be included here.
Preliminary and capital issue expenses:
The major components of capital issue expenses are: underwriting
commission, brokerage, fees to managers and registrars, printing
and postage expenses, advertising and publicity expenses, listing
fees, and stamp duty.
Pre-operative Expenses:
The following types of expenses are incurred till the
commencement of commercial production:
I.
Establishment expenses,
II.
Rent, rates, and taxes,
III. Travelling expenses,
IV. Interest and commitment charges on borrowings,
V.
Insurance charges,
VI. Mortgage expenses,
VII. Interest on deferred payments,
VIII. Start-up expenses, and
IX. Miscellaneous expenses.
Provision for Contingencies:
1)
2)
Dividing the project cost items into two categories- ‘firm’ cost
items and ‘non-firm’ cost items
Setting the provision for contingencies at 5 to 10 percent of
the estimated cost of non-firm cost items.
Margin Money for Working Capital:
To mitigate this problem, financial institutions stipulate that a
portion of the loan amount, equal to the margin money for
working capital, be blocked initially so that it can be released
when the project is completed.
Initial Cash Losses:
Failure to make a provision for such cash losses in the project cost
generally affects the liquidity position and impairs the operations.
Hence prudence calls for making a provision, over or covert, for
the estimated initial cash losses.
Share Capital: There are two types of share capital- equity capital
and preference capital. Equity capital represents the contribution
made by the owners of the business, carries no fixed rate of
dividend. Preference capital represents the contribution made by
the preference shareholders and the dividend paid on it is generally
fixed.
Term Loans: It represents secured borrowings provided by
financial institutions and commercial banks which are a very
important, sometimes the major source for financing new projects.
Debenture Capital: Debentures are instruments for raising debt
capital, having categories of convertible debentures and nonconvertible debentures.
Deferred Credit: It is the facility of credit purchase under which
the payment may be made over a period of time.
Incentive Sources: Government and its agencies may provide
financial support as an incentive to certain types of promoters or
for setting up industrial units in certain locations.
Miscellaneous Sources: A small portion of the project may come
from miscellaneous sources like unsecured loans, public deposits,
and leasing and hire purchase finance.
For planning the project, following guidelines and considerations
should be kept in mindNorms of regulatory bodies and financial institutions:
In some countries, the proposed means of finance for a project
must either be approved by a regulatory agency or conform to
certain norms laid down by the government or financial
institutions to protect the investors.
Key business considerations: The key business considerations
which are relevant for the project financing decision are- cost, risk,
control and flexibility.
• Cost: Cost of debt funds is lower than the cost of equity.
Because, the interest payable on debt capital is tax deductible
expense whereas the dividend payable on equity capital is not.
• Risk: The two main sources of risk for a project are business risk
and financial risk. Business Risk refers to the variability of return
on invested capital and arises mainly from fluctuations in demand
and variability of prices and cost. Financial risk represents the risk
arising from financial leverage.
• Control: From the point of view of the promoters of the project,
control is very important. They would ordinarily prefer a scheme
of financing to maximize control over the affairs of the firm.
• Flexibility: this refers to the ability of a firm to raise further
capital from any source it wishes to tap to meet the future
financing needs.
High Rate of Capacity Utilization:
It is sensible to assume that capacity utilization would be
somewhat low in the first year and rise thereafter gradually to
reach the maximum level in the third and fourth year of operation.
Adjustment of Stocks of Finished Goods:
It is not necessary to make adjustments to stocks of finished goods.
For practical purposes, it may be assumed that production would
be equal to sales.
Consideration of Selling Prices:
The selling price considered should be the price realizably by the
company net of excise duty. It shall, however, include dealers’
commission which is shown as an item of expense.
Changes in Selling Price:
The selling price used may be the present selling price-it is
generally assumed that changes in selling price will be matched by
proportionate changes in cost of production.
The major components of cost production are:
Materials: The requirements of various material inputs per unit of
output may be established on the basis of one or more of the
following:
a. Theoretical assumption norms,
b. Experience of the industry,
c. Performance guarantees, and
d. Specification of machinery suppliers.
Utilities: Utilities consist of power, water, and fuel. The
requirements of power, water, and fuel may be determined on the
basis of norms specified by the collaborators, consultants, etc. or
the consumption standards in the industry, whichever is higher.
Labor: Labor cost is the cost of all the manpower employed in the
factory. Labor cost naturally is a function of the number of
employees and the rate of remuneration. This cost may be
calculated for the year in which the maximum capacity utilization
is first achieved. For the earlier years, when the capacity utilization
tends to be low, somewhat lower labor costs, but not
proportionately lower in relation to capacity, may be assumed.
Factory Overhead: The expenses on repairs and maintenance,
rent, taxes, insurance on factory assets, and so on are collectively
referred to as factory overheads. Repairs and maintenance expense
depends on the machinery-the expense tends to be lower in the
initial years and higher in the later years. Rent, taxes, insurance,
etc. may be calculated at the existing rates.
The difference between current assets and current liabilities.
Working capital includes:
 Cash
 Marketable securities
 Accounts receivable
 Inventories
 Accounts payable
 Accrued wages and taxes
WCR = [Accounts Receivable + Inventory + Prepaid Expenses]
– [Accounts Payable + Accruals]
Star world Group
End of Year
Year 1
Year 2
Year 3
Accounts Receivable
232
278
362
Inventory
97
116
151
Prepaid expenses
35
20
55
Total
364
414
568
Accounts Payable
116
139
181
Accruals
36
45
55
Total
152
184
236
WCR
+ 212
+ 230
+ 332
Decision: The WCR is positive, that means a Net Requirement of funds. As the
variation of WCR is positive, that means a Net Requirement of funds: 18 in
2000 and 102 in 2001.
 The working capital requirement consists of following:
(a) raw materials and components (indigenous as well as
imported),
(b) stocks of goods-in-process (also referred to as work-inprocess),
(c) stocks of finished goods,
(d) debtors, and
(e) operating expenses, and
(f) consumable stores.
 The principal sources of working capital finance are:
a) working capital advances provided by commercial banks,
b) trade credit,
c) accruals and provisions, and
d) long term sources of financing.
 There are limit of obtaining working capital advances from
commercial banks. They are in two forms:
a) the aggregate permissible bank finance in specified as per
the norms of lending followed by the lending bank,
b) against each current asset a certain amount of money has
to be provided by the firm.
 The principal sources of working capital finance are:
a) working capital advances provided by commercial banks,
b) trade credit,
c) accruals and provisions, and
d) long term sources of financing.

Liquidity Analysis is also called the Profitability Projection.

Liquidity Analysis is done on a year by year basis and, therefore,
the annual cash positions are taken into consideration at their
nominal values.

A Profitability Projection provides management an idea of how
the company's profitability will look 12 months into the future.
This projected profitability rests in large part on management's
ability to forecast industry and customer demand, costs, as well
as many other macro and micro economic factors.
Year
Item
A. Cash Inflows (CI)
1. Sales Revenue
2. Residual Value
3. Financial Investment
3.1. Equity
3.2 Loans
B. Cash Outflows (CO)
1. Investment
2. Cash expenses excluding interest
3. Taxes
4. Financial Obligations
4.1. Repayment Installment
4.2. Interest Charges
4.3. Dividends
C. Net Cash Balance (Surplus or deficit)
t0
100
t1
100
100
100
100
20
80
100
100
100
100
t2
70
70
t3-t10
100
100
t11
100
100
t12-t19
100
100
t20
120
100
20
40
92
78
78
82
40
60
5
27
10
5
12
8
60
6
12
60
6
12
60
10
12
12
22
12
22
12
35
30
Source: Manual for Evaluation of Industrial Projects. Table: 14

Capital structure analysis is important to measure or predict
projected financial position.

It is done through the debt to equity ratio.

The Debt to Equity Ratio measures how much money a company
should safely be able to borrow over long periods of time. It
does this by comparing the company's total debt (including short
term and long term obligations) and dividing it by the amount of
owner's equity.
Debt to equity ratio:
Long-term liabilities/Shareholders equity(Equity
capital)
Suppose, a company has capital structure with 100% equity in the
initial investment year. In the next year its additional investment
was consist of 15% equity and 85% debt.
So, the Debt to Equity ratio
= 85/115
= 0.74
Source: Manual for Evaluation of Industrial Projects. Table: 8
Decision: 0.74 may not be satisfactory at all if the project is not
sounds enough and if borrowing is on too short a term. If
repayments already have to be made during the construction period
or before the project generates significant cash earnings, a debt
equity ratio of 0.74 may not assure sufficient cash surplus during
the running period.
Generally, any company that has a debt to equity ratio of over 40 to
50% should be looked at more carefully to make sure there are no
liquidity problems. If you find the company's working capital, and
current / quick ratios drastically low, this is a sign of serious
financial weakness.

The rates of interest on loans may be lower than the expected rate
of return of the project. In such circumstances it may be attractive
for the investor, taking into account the risk involves, to keep
equity low, thus increasing the actual rate of return on equity.

By seeking finance through loans, there may be final advantages
since interest charges may be deductible from taxable profits.

Interest charges are fixed obligations which have to be paid
regardless of whether a project earns a profit.

If annual repayments of principal approach the cost of
depreciation per year, financial management may become
increasingly tight and difficult.

A low debt equity ratio is desirable as far as circumstances
permit in order to avoid undue interference by lenders.
The company cost of capital is the rate of return expected by the
existing capital providers. It reflects the business risk of existing
assets and the capital structure currently employed.
The project cost of capital is the rate of return expected by capital
providers for a new project or investment the company proposes.
If a firm wants to use its company cost of capital popularly called
the weighted average cost of capital (WACC), for evaluating a new
investment, two conditions should be satisfied-
1. The new investment will not change the business risk
complexion of the firm
2. The capital structure of the firm will not be affected by the
investment.
Given the cost of specific sources of finance and the scheme of
weighting, the WACC can be readily calculated by the formulaWACC= were + wprp + wdrd (1-tc)
Where we, wp and wd are the proportion of equity, preference, and
debt and re, rp and rd are the component cost of equity, preference
and debt and tc is the corporate tax rate.
Suppose that a company uses equity, preference and debt in the
proportion of 50, 10 and 40. If the component cost of equity,
preference and debt are 16%, 12%, and 8% respectively the
weighted average cost of capital will be:
WACC =(proportion of equity) (cost of equity) + (proportion of
preference) (cost of preference) + (proportion of debt) (cost
of debt)
= (0.5) (16) + (0.10) (12) + (0.4) (8) l
=12.4%
Source: “Projects” by Prasanna Chandra. Page-10.2
The cost of capital is affected by several factors from two main
sourcesFactors outside a firm’s control:
 The level of interest rates
 Market risk premium
 Tax rates
Factors within a firm’s control:
Investment policy
Capital structure policy
Dividend policy.

The Projected Balance Sheet allows management to know the
state of its asset, liability and equity base. As business expands or
contracts so too will the firm's assets, liabilities and equity. The
projected Balance Sheet allows the company to project debt
levels and covenants.
Liabilities
Assets
Share capital
Fixed assets
Reserve and surplus
Investments
Secured loans
Current assets, loans and advances
Unsecured loans
Miscellaneous expenditures and losses
Current liabilities and
provisions
Source: “Projects” by Prasanna Chandra. Exhibit- 6.7
 Share capital consists of paid-up equity and preference capital.
Reserves and surplus represent mainly the accumulated retained
earnings. Secured loans represent the borrowings of the firm against
which security has been provided.
Current liabilities are obligations which mature in the near future,
usually within a year. Provisions include mainly tax provision,
provision for provident fund, provision for pension and gratuity, and
provision for proposed dividends.
Fixed assets are tangible long-lived resources ordinarily used for
producing goods and services. Investments represent financial
securities owned by the firm.
Current assets, loans and advances consist of cash, debtors,
inventors of different kinds, and loans and advances made by the
firm.
Miscellaneous expenditures and losses represent outlays not
covered by the previously described asset accounts and accumulated
losses, if any.




Uncertainty Analysis is also known as Risk Analysis.
The future is always uncertain and risk is inherent in almost
every business decision.
All investment decisions are made under conditions of some
uncertainty.
In uncertainty Analysis the underlying sources of risk are
identified and the consequences are explored thereof.
There are several sources of risk in a project. Some variables are
common sources of uncertainty in evaluating investment projects.
These are:
• Size of investment
• Operating costs and
• Sales Revenue
The other important sources are:
Project-specific risk: The earnings and cash flows of the
project may be lower than expected because of estimation error
or due to some other factors specific to the project like the
quality of management.
Competitive risk: The earnings and cash flows of the project
may be affected by unanticipated actions of the competitors.
Industry-specific
risk:
Unexpected
technological
developments and regulatory changes, that are specific to the
industry to which the project belongs, will have an impact on
the earnings and cash flows of the project as well.
Market risk: Unanticipated changes in macroeconomic factors
like the GDP growth rate, interest rate, and inflation have an
impact on all projects, albeit in varying degrees.
International risk: In the case of a foreign project, the earnings
and cash flows may be different than expected due to the
exchange rate risk or political risk.
There are mainly three steps in uncertainty analysis:
 Break-Even analysis
 Sensitivity analysis whereby instead of using one estimate of
each variable several estimates are used under varying
conditions
 Probability analysis in which all the probable values of each
variable that have a significant chance of occurrence are used.
Break Even Point is the unit or dollar sales at which an
organization neither makes a profit nor a loss.
Accounting Break-even Analysis: A project that breaks even in
accounting terms is like a stock that gives you a return of zero
percent.
Financial Break-even Analysis: The focus of financial breakeven analysis is on NVP and not on accounting profit.
Break-Even in terms of Physical Units:
FC
BEP
=
SP-VC
Break-Even in terms of Sales Revenue:
FC
BEP
= SP
SP-VC
Dollars
Total Cost
BE Point
PROFIT
Variable Cost
LOSS
0
Fixed Cost
Unit Volume
Fixed Costs
Price per unit
Variable Cost
Contribution Margin
Breakeven Volume
Breakeven Dollars
=
=
=
=
=
=
=
=
$50,000
$5
$3
$5 - $3 = $2
$50,000  $2
25,000 units
25,000 x $5
$125,000
• Since the future is uncertain, one may like to know what will
happen to the viability of the project when some variable like
sales or investment deviates from its expected value.
• In this purpose, we do ‘what if’ analysis or ‘Sensitivity
Analysis’.
• Sensitivity analysis may be used in the early stages of project
preparation to identify the variables in the estimation of which
special care should be taken.
Cash flow forecast for Naveen’s Flour Mill Project
(Rs in thousands)
Year 0
1. Investment
2. sales
3. Variable cost
(66.67% of sales)
4. Fixed cost
5. Depreciation
6. Pre-tax profit
7. Taxes
8. profit after taxes
9. cash flow from
operation
10.net cash flow
(Rs in thousands)
Year 1-10
(20000)
18000
12000
1000
2000
3000
1000
2000
4000
4000
(20000)
Source: “Projects” by Prasanna Chandra. Exhibit-11.2
Since the cash flow from operations is an annuity, the NPV of the
flour mill project is:
=(20,000,000)+4,000,000* PVIFA(r=12%,n=10)
=(20,000,000)+4,000,000*5.650
=2,600,000.
The NPV based on the expected values of the underlying variables
looks positive. However, the underlying variables can vary widely
this should affect the NPV. So, to do the Sensitivity analysis, we
should vary one variable at a time. That is, define the optimistic
and pessimistic values of each of the underlying variables.
Sensitivity of NPV to variations in the value of key variables
Variables
Rs. In millions
Rs. In millions
Range
NPV
Pessimistic
Expected
Optimistic Pessimistic Expected Optimistic
Investment
24
20
18
-0.65
2.60
4.22
Sales
15
18
21
-1.17
2.60
6.40
Variable
cost as a
percent of
sales
70
66.66
65
0.34
2.60
3.73
Fixed cost
1.3
1.0
0.8
1.47
2.60
3.33
Source: “Projects” by Prasanna Chandra. Exhibit- 11.3
For example, to study the effect of variation in sales, from the
expected Rs.18 million, to the pessimistic Rs. 15 million and
optimistic Rs. 21 million, the other variables should be unchanged.
The NPV will be:
At pessimistic sales: (1.17)millions
At optimistic sales : 6.40 millions, where
At expected sales : 2.60 millions.
• In sensitivity analysis, typically one variable is varied at a time.
• In scenario analysis, several variables are varied simultaneously.
• Most commonly, three scenarios are considered. Expected or
normal, pessimistic scenario, and optimistic scenario.
The NPV of the project of Naveen Flour Mills under these three
scenarios is given below:
Variables
1. Investment
2. Sales
3.Variable costs(%
of sales)
4. Fixed costs
5. Depreciation
6. Pre-tax profit
7. Tax
8. Profit after tax
9. Annual cash flow
from operation
10. NPV (9)*
PVIFA(12%,10
years)- (1)
Rs. In millions
Pessimistic
24
15
10.5(70%)
Rs. In millions
Expected
20
18
12(66.7%)
Rs. In millions
Optimistic
18
21
13.65(65%)
1.3
2.4
0.8
0.27
0.53
2.93
1.0
2.0
3.0
1.0
2.0
4.0
0.8
1.8
4.75
1.58
3.17
4.97
(7.45)
2.60
10.06
Source: “Projects” by Prasanna Chandra. Exhibit- 11.4
•Probability as used here refers to the frequency of occurrence of
an event, measured as a ratio of the number of different ways that
the specific event can happen to the total number of possible
outcome.
•The purpose of the probability analysis is to eliminate the need
for restricting judgment to a single optimistic, pessimistic or
realistic estimation by identifying the possible range of each
variable and attaching a probability of occurrence to each possible
value of the variables within this range
•Each possible value of each variable is associated with a number
between 0 and 1. So that for each variable, the sum of all these
numbers (probabilities) is equal to one.
For example, the findings of the analysis of X Company are as
follows:
Variables
1.Investment
Probability
2. Annual net cash
earnings from
t3 to t10
t11 to t19
Probability
Situation A
Situation B
2,00,000
70%
2,50,000
30%
35,000
34,000
31,000
30,000
60%
40%
Source: Manual for Evaluation of Industrial Projects. Table: 34
So, from this distribution we can calculate the probable values of
the variables:
Variables
1. Investment
2. Annual net
cash earnings
From t3 to t10
From t11 to T19
Alternative
probability
Estimated
values
Expected
values
2,00,000*0.70 =
2,50,000*0.30 =
1,40,000
75,000
2,15,000
35,000*0.60 =
31,000*0.40 =
21,000
12,000
33,400
34,000*0.60 =
30,000*0.40 =
20,400
12,000
32,400
Source: Manual for Evaluation of Industrial Projects. Table: 34
Risk refers to variability. It is a complex and multi-faceted
phenomenon. A variety of measures have been used to capture
different facets of risk.
The more important ones are:
range, standard deviation, coefficient of variation and semivariance.
NPV
Probability
200
0.3
600
0.5
900
0.2
Source: “Projects” by Prasanna Chandra. Page- 11.3
Range:
Obviously the simplest measure of risk, is the difference between
the highest value and the lowest value.
The range of above distribution is 900-200 =700
The probability weighted NPV works out to:
Standard Deviation:
The standard deviation of the NVP distribution presented
above is:
½
½
½
Coefficient of variation:
Standard Deviation
CV =
Expected Value
CV =
=
249.8 / 540
0.46
Semi-Variance:
The semi-variance is computed the way the variance is computed,
except that only outcomes below the expected value are taken into
account.
It is defined as:
The semi-variance or the investment in our illustration is: