PROJECT ANALYSIS AND MANAGEMENT
Lecture 8
Course leader : Asst.Prof Tadele T
Brain storming and Discussion
Explain the Purpose of the financial analysis?
Assessment of project viability and implement ability for
the municipal utility and the local community and
economy
A tool for analyzing, structuring and selecting different
project options
Assessment of project returns on overall investment and
capital
A tool for identifying appropriate types of project financing
Analysis of project broader socio-economic impact to the
community
Since reliable cost estimates are fundamental to the
appraisal of an investment project it is necessary to
check carefully all cost items that could have a significant
impact on financial feasibility.
Cost estimates cover:-
Initial investment cost
Cost of production
Marketing and distribution costs
Plant and equipment replacement costs
Working capital requirements and
decommissioning at the end of the project
life.
A) Initial Investment Cost
Initial investment costs are the total of fixed assets (fixed asset costs
plus pre-production expenditures) and net working capital, with fixed
assets constituting the resources required for constructing and
equipping an investment project, and net working capital corresponding
to the resources needed to operate the project totally or partially.
Pre-production Expenditures:
In every industrial project certain expenditures are incurred prior to
commercial production.They are:-
i. Preliminary capital – issue expenditures: these are
expenditures incurred during the registration and formation
of the company. Eg. Legal fees, preparation and issue of a
prospectus, ad, public announcement, brokerage commission,
etc.
ii. Expenditures for preparatory studies: these includes
expenditures for pre-investment studies like opportunity and
feasibility and other expenses for planning the project.
iii. Other pre-production expenditures: like
- Salaries, fringe benefits and social security contributions of
personnel engaged during the pre-production period.
- Travel expenses
- Preparatory installations, such as work camps, temporary
offices and stores.
iv. Cost of trial-runs, start up and commissioning expenditures.These
include:
Fees payable for supervision or start up operations,
wages, salaries, social security contributions of personnel
employed,
consumption of production materials and supplies, utilities and
other incidental start up costs.
Fixed Assets
Fixed investment costs should include the following main
cost items:
Land purchase, site preparation and improvements,
Building and civil works
Plant machinery and equipment including auxiliary
equipment
Other assets like industrial property rights and lump sum
payments for know-how and patents.
Net working capital
Net working capital is defined as current assets (the sum of
inventories, marketable securities, prepaid items, Accounts
Receivable and cash) minus current liabilities.
B) Production Cost
It is essential to make realistic forecasts of production and
manufacturing cots for a project proposal in order to
determine the future viability of the project.
Production costs should be determined for the different
levels of capacity utilization. The production costs are
classified into four major categories. They are:
Factory costs
Administrative overhead costs
Depreciation and cost of financing
Operating Cost (the sum of factory and administrative
overhead costs).
C) Marketing Costs:
Marketing costs comprise the costs for all marketing
activities and may be divided into direct marketing costs
and indirect marketing costs.
Direct marketing costs – are costs for packaging and
storage, sales, product advertisement, transport and
distribution costs.
Indirect marketing costs – are costs related to
marketing department. They are salaries for personnel,
materials and communication, market research, public
relation and promotional activities.
D) Cash Flow Statement
The cash flow statement shows the movement of
cash into and out of the firm and its net impact on
the cash balance within the firm.
Financial Appraisal Criteria
Financial Appraisal Criteria
includes discounted cash flow and non-discounted cash
flow methods.
Discounted cash flow is the value of future
expected cash receipts and expenditures on a
common date. It uses net present value and internal
rate of return.
Non-discounted cash flow does not consider future
changes in the value of money. It uses payback
period and Accounting rate of return.
Financial Appraisal Criteria
NPV
IRR
BCR
PBP
ARR
BEP
Payback Period (PBP)
It is defined as the number of years required for an
investment’s cumulative cash flows to equal net initial
investment.
Thus, PB can be looked upon as the length of time
required for a project to recover on its net initial
investment from project’s expected cash inflows.
Cont…
Computation of Payback period.When an investment’s
cash flows are in annuity form, payback period can be
computed by dividing the value of net annual cash inflow
into the project’s net initial investment.
Example: 1
An investment has the following net initial investment
and net annul cash inflows:
Year NII Yearly Cash Inflows
0 12,000 4,000
1
2
3
4
5
Cont…
PB period = Net Initial Investment
Net Annul cash inflows
= Br. 12,000 = 3 years
Br. 4,000
Example: 2
Compute the PB for the following cash flows, assuming a
NII of Br. 13,000:
Year NII Yearly Cash Inflows CCF
0 13,000 0 0
1 5,000 5,000
2 6,000 11,000
3 4,000 15,000
4 5,000 20,000
PBP = 2 years + Br. 2000/ Br. 4,000
= 2 years + 0.5 =2.5 years
INDEPENDENT vs. MUTUALLY
EXCLUSIVE
Independent: PROJECTS:
A project that has nothing to do with other
projects under investigation.
Example: Replace copy machine and build a new
plant.
Mutually Exclusive: You only need one of these alternative
projects.
Example: Buy IBM or Apple PC?
Decision rule:
Accept project if the PB years < years set by corporate
policy
For two mutually exclusive projects, choose the one
that pays you back your initial cost the sooner.
Limitations of the PB Period Criterion
Ignores the time value of money.
Ignores CF occurring after the PB period.
Merits of the Payback
Period
1. Payback is Criterion
an easy concept to understand.
2. It is easy to compute.
3. It is extremely easy to apply.
4. It has a straightforward interpretation.
5. It avoids making projections into the more distant future.
The more uncertain the future is, the stronger may be the
case for the use of the payback period criterion.
Accounting Rate of Return
The ratio does not take into account the concept of time
value of money.
When comparing investments, the higher the ARR, the
more attractive the investment.
ARR= Average NI
Average Investment
Cont…
If the ARR is equal to or greater than the required rate
of return, the project is acceptable.
If it is less than the desired rate, it should be rejected.
When comparing investments, the higher the ARR, the
more attractive the investment.
Merits of ARR Method
It is very simple to understand and use.
Rate of return may readily be calculated with the help of
accounting data.
They system gives due weight age to the profitability of
the project if based on average rate of Return.
It takes investments and the total earnings from the
project during its life time.
Demerits of ARR Method
It uses accounting profits and not the cash-inflows in
appraising the projects.
It ignores the time-value of money which is an
important factor in capital expenditure decisions.
It considers only the rate of return and not the
length of project lives.
The method ignores the fact that profits can be
reinvested.
Net Present Value (NPV)
NPV is the present value of an
investment project’s net cash flows
minus the project’s initial cash outflow. It
is measured in Birr.
CF1 CF2 CFn - ICO
NPV = + +...+
(1+k)1 (1+k)2 (1+k)n
Cont…
Since NPV can be positive, zero, or negative,
attention must be paid to its algebraic sign.
Decision rule:
If independent project: Accept project if NPV > 0
Reject project if NPV < 0
If mutually exclusive project: Accept the project with the
highest NPV
Example: 1
An investment alternative has a net initial investment of
Br. 100,000 and produces a cash inflow annuity of Br.
14,000 for 16 years. Compute the NPV of the
investment if the required rate of return (cost of capital)
for the investment is 10 percent. Would you recommend
accept or reject this project?
Solution
The present value factor corresponding to a 16 years
payment annuity discounted at 10 percent is 7.824 (see
present value for annuity case table or your
calculator). NPV is calculated as follows:
NPV = 14,000/(1.10) 1 + 14,000/(1.10) 2 +… +
14,000/(1.10) 16 - Br.100, 000
NPV = Br. 14,000(7.824) – Br. 100,000
= Br. 9,536
Example 2
Refer the following data for project L and S. Compute
NPV for both & decide which is acceptable
If the projects are independent
If the projects are mutually exclusive
The minimum required rate of return or discounting
rate or the project’s cost of capital is 10%
Expected Net Cash Flow
Year Project L Project S
0 (100) (100)
1 10 90
2 60 30
3 80 50
(9.09 +49.59 + 60.11) -100 = NPVL = 18.79
(81.82+24.79+37.57) -100 NPVS = 44.18
If the projects are independent, accept both
If the projects are mutually exclusive, accept Project S since
NPVS > NPVL.
Interpretation of the NPV Criterion
If NPV equals zero, the project’s rate of return equals the
minimum required rate of return.
If NPV is negative, the project’s rate of return is less than
the minimum required rate of return.
A positive NPV represents the amount by which time
adjusted profits exceed the minimum required profits.
A negative NPV represents the amount by which time
adjusted profits fall short of the minimum required
profits.
Merits of the NPV Criterion
takes into account the time value of money
takes into account the CF of a project over its entire life
span unlike PB period criterion.
NPV is measured in dollars or in birr, it provides a
common denominator for:
- Evaluating individual investments.
- Choosing from competing investment proposals.
- Measuring the impact on shareholder wealth
produced by the set of investments that constitutes
the firm’s capital budget.
Limitations of the NPV Criterion
more difficult to compute than PB period.
a careful interpretation is required because it does
not provide a measure of a project’s actual rate of
return.
It may not give good results while comparing
projects with unequal lives and unequal net initial
investment costs.
Internal Rate of Return (IRR)
IRR is the discount rate that equates the present
value of the future net cash flows from an
investment project with the project’s initial cash
outflow. Or It is defined as the discount rate that
produces a zero NPV.
CF1 CF2 CFn
ICO = + +...+
(1+IRR) (1+IRR)2
1 (1+IRR)n
Cont…
the IRR is the actual rate of return that a project
earns when profits and the time value of money
are taken into account.
Note that it is stated as a percentage rate.
