CHAPTER SIX

PROJECT FINANCIAL APPRAISAL/ANALYSIS

The analysis of financial costs and benefits is a key step in the project preparation process, which
seeks to ascertain whether the proposed project will be financially viable in the sense of being
able to meet the burden of servicing debt and satisfy the return expectations of the promoters.

6.1. Objectives of Financial Cost-Benefit Analysis

The basic objective of financial cost-benefit analysis is to ensure the financial viability of the
industrial project for the private investor, commercial profitability being the yardstick for
selection among competing projects.

6.2. Components of Financial Analysis

The major components of the financial cost-benefit dimension and the aspects that require
detailed analysis are the following:
 Investment cost estimation
 Revenue estimation
 Estimation of production costs & expenses
 Profitability analysis
 Cash flow estimation and evaluation
 Financial ratio analysis
 Uncertainty (or Risk) analysis
 Preparation of debt repayment (or loan amortization) schedule
 Preparation of various schedules & documentation of the associated working papers

6.3. General Guidelines for Estimating Financial Costs and Benefits

i. Project Inputs, Outputs, and Prices:
For the analysis of financial costs and benefits of a project, the starting point is the:
 Determination of project inputs to be used & outputs to be generated, and
 Identification of what price to use for making financial cost-benefit estimation
In general, in order to identify the prices of inputs and outputs to be used in the analysis, the
different alternative bases for pricing should be assessed. From the available pricing alternatives,
the analyst needs to choose the one most appropriate for valuation of inputs and outputs from the
perspective of a profit maximizing, private investor. In this regard, the following are the pricing
alternatives:
 Constant prices,
 Market (or explicit) prices, and
 Shadow (or imputed) prices, also called economic prices

1
Constant, and sometimes current, prices can be used to value project’s inputs & outputs in
financial cost benefit analysis. Although there is a general principle to use constant prices, it is
also common to use current (market) prices as well.
ii. Impacts of Inflation:
Inflation complicates the process of estimating financial costs and benefits and the investment
appraisal aspect
It is always difficult to forecast the level of inflation potentially existing in the planning horizon
 Smaller changes in the level of inflation affect the individual components of cash flows,
the impact of which is not easily visible to account for
Simplifying assumptions regarding inflation:
I. Inflation equally affects both future stream of cash inflows and outflows, the impact of
which, thus, offsets in the planning horizon; and
II. Price contingency allowed while making estimations would take care of unforeseen price
increases during the construction period.
If we have strong evidence regarding inflation (future price levels), however, we need to
examine its impact on cost of capital (i.e. opportunity cost of capital), opportunity cost of
equipments & machineries, level of revenue & operating costs, etc. If ignored, it is possible, in
this regard, that:
 NPV of the projects being appraised would be distorted
 Investment proposals may be ranked incorrectly
iii. Estimating the Economic Life of a Project:
A project’s economic life refers to the optimal period over which it would generate economic
gains.
1. The project’s life, to a maximum, may be set to equal the technical life of the machineries
& equipments; or else it should be less than this technical life of machineries and
equipments. The economic life, in this regard, should never exceed the technical life of
plant machinery and equipment.
2. Additional factors to be considered in determining project’s economic life include the
following:
o Duration of market demand (product life cycle);
o Change of taste & preference of customers;
o National/international competition;
o Technology change (obsolescence);
o Extent or duration of natural/mineral resource deposits; etc
The time horizon for cash flow analysis is generally the minimum of the following:
1. Physical life of the machineries and equipments (Technical life of Plant Assets)
 Period during which the plant remains in a physically usable condition
 The number of years the machineries & equipments in the plant would perform the
functions for which they had been acquired
 It depends on the wear and tear which the plant is subject to

2
  Suppliers of the plant’s machineries and equipments may provide information on the
physical life under normal operating conditions
 While the concept of physical life may be useful for determining the depreciation
charge, it is not very useful for investment decision making purposes
2. Technological life of the machineries and equipments in the plant
 New technological developments tend to render existing machineries and equipments
obsolete.
 The technological life of a plant refers to the period of time over which the present plant
would not be rendered obsolete by a new plant.
 It is very difficult to estimate because any law does not govern the pace of new
developments. Yet, an estimate of the technological life has to be made.
3. Product Market life of the plant (Product Life Cycle):
 A plant may be physically usable, its technology may not be obsolete, but the market for
its products may disappear or shrink and hence, its continuance may not be justified.

6.4. Financial Analysis Period

A convenient starting point for establishing the period for financial analysis is the technical life
of the major investment item. In some projects, the technical life (physical life) of the major
investment item may be quite long.
However, the economic life of the same item might be shorter because of expected technological
obsolescence (as rapidly changing technology will make a major investment obsolete in short
period), frequently changing tastes and preferences of customers, international competitiveness,
and the extent of natural resources or mineral deposits available.
A distinction may be made between the physical life and economic (or optimal) life of an asset.
The physical life of an asset represents the number of years it can be used to produce a certain
output by regular maintenance and repair, which, of course, tends to cost more and more as the
years roll by. The economic life of an asset, however, refers to the optimum number of years the
asset should be used to produce a certain output. In short:
⇒ Physical life is a period, often longer, over which a fixed asset can continue to function,
notwithstanding its acquired obsolescence, inefficiency in operations, high costs of maintenance,
or the obsolescence of its products.
⇒ Economic life is the period during which a fixed asset is capable of yielding service to the
owner. The economic life of an asset is defined, conceptually, as the period after which the asset
should be replaced to minimize the sum of operating and maintenance costs and capital costs
expressed on an annual basis.

6.5. Project Costs

1. Initial Investment Costs
Initial investment costs are defined as the sum of fixed assets (fixed investment costs plus pre-
production expenditures) and investment in net-working capital. Fixed assets constitute the

3
resources required for construction and equipping an investment project whereas the net-working
capital corresponds to resources needed to operate the project totally or partially. At the pre-
investment stage, in this regard, the following two mistakes are frequently made:
 Networking capital, meaning current assets minus current liabilities, is either excluded at
all or included in insufficient amount that, in turn, might be causing liquidity problems
for projects.
 Total investment costs are sometimes confused with total assets, the latter constituting
fixed assets plus pre-production expenditures plus current assets.
The amount of total investment cost is, in fact, smaller than total assets, since it is composed of
fixed assets and net working capital, the latter being the difference between current assets and
current liabilities. The section following discusses, in detail, the components of the total
investment cost.
i. Fixed Investment Cost
The fixed investment cost represents the total of all items of outlay associated with fixed assets
in the project, which are supported by long-term funds. It is the sum of the outlays on the
following major components:
A) Land and Site Development:
The cost of land & site development is the sum of broad range of costs, the following being the
major ones:
 Basic cost of land including conveyance (transfer) and other allied charges,
 Premium payable on leasehold,
 Cost of leveling and site preparation,
 Cost of laying approach roads and internal roads,
 Cost of gate ways,
 Cost of tube wells, etc.

B) Buildings and Civil Works:
The cost of buildings & civil works depends on the following two basic factors:
 The kind of structures required, and
 The specific requirements of the manufacturing process
It covers the costs of the following major items:
• Buildings for the main manufacturing plant;
• Buildings for auxiliary services like steam supply, workshops, etc;
• Laboratory, water supply, etc;
• Warehouses, open yard facilities, etc;
• Non-factory buildings (e.g. guesthouse, cafeteria, clinics, etc);
• Garages, sewage, drainage, and other civil engineering works.
C) Cost of Plant & Machinery:
It is fundamental component of the project cost.
 Costs of Imported Machineries and Equipments:
 CIF import value (including shipping, freight, and insurance costs)
4
  Import duty (if any),
 Clearing, loading & unloading, and local transportation & insurance charges
Costs of Indigenous Machineries and Equipments:
 FOR (Free on Rail ) costs (in other words, purchase price plus freight charges),
 Sales taxes (if any),
 Rail way freights and transportation charges up to the site
 Cost of stores and spares acquired with machineries and equipments
 Foundation & Installation charges (depending on the specific requirements of the
project)
The cost of plant equipments and machineries is based on the latest available price quotations
being adjusted for possible escalation. The provision for escalation is equal to:
[Latest rate of annual inflation applicable to the Plant Equipment and Machinery]
Multiplied by [Length of the delivery period]
D) Technical Know-how and Engineering Fees: Technical consultants or collaborators, (local
or foreign), may involve for making:
 Project preparation report,
 Choice of technology,
 Selection of the plant machinery and equipments,
 Detailed engineering services, etc
The cost paid for these services in setting up the project is a component of the project cost.
However, any royalty payable (annually) on transfer of technology, which is typically a
percentage of sales, is an operating expense and hence, accounted in the projected profitability
statement.
E) Expenses on Foreign Technicians and Training of Local Technicians Abroad
 Travel expenses of technicians to- and -from abroad,
 Boarding and lodging,
 Salaries and allowances, etc
F) Miscellaneous Fixed Assets and Expenditures:
These are not parts of the direct manufacturing process but necessary to run the organization as
an entity. For instance, the following costs are classified under this major group:
• Furniture and office equipments;
• Tools, vehicles, railway siding, diesel generators;
• Transformers, boilers, piping system;
• Laboratory and workshop equipments;
• Effluent treatment plants and firefighting equipment;
• Expenses for procurement (acquisition) of patents, licenses, trademarks, and copyrights (for
using a given technological package);
• Deposits made with the electricity board, and so on.
ii. Pre-Production Expenditures
Pre-production capital expenditures include the following:
A. Establishment and Capital Issue Expenses
5
􀂙 Establishment Expenses: These are expenditures incurred during the registration and
formation of the company, including: Legal fees for preparation of the memorandum & articles
of association, similar documents, capital issues and Expenses for incorporating the company
􀂙 Capital Issue Expenses include:
 Underwriting commission and brokerage fees,
 Fees to managers and registrars,
 Printing and postage expenses,
 Advertising and public announcements,
 Listing fees and stamp duty expenses for processing of share applications and allotment,
etc
B. Pre-Operative Expenses
􀂃 Expenditures for pre-investment studies such as opportunity, pre-feasibility, feasibility, and
support or functional studies
􀂃 Consultant fees while project preparation, Pre-production marketing costs and promotional
activities and Training costs (fees, travel, and living expenses);
(Note also that preliminary expenses for identifying the project, conducting the market survey,
and preparing the feasibility report can be presented under this heading as well.)
iii. Working Capital (WC) Requirements
In estimating the working capital requirement and planning for its financing, the following points
have to be born in mind:
The WC requirement consists of the following:
 Raw materials & components ( indigenous as well as imported)
 Stocks of goods in process (WIP)
 Stocks of finished goods
 Debtors (receivables)
 Operating expenses (prepaid insurances, prepaid rents, etc)
 Consumable stocks (supplies)
iv. Provision for Contingencies
Provisions should also be made for physical contingencies as an allowance, which is providing a
safety factor to cover unforeseen or forgotten minor costs. Contingency allowance is an amount
included in a project account to allow for adverse conditions that will add to baseline costs.
These are:
⇒ Physical Contingencies: Allow for physical events such as the effects of adverse weather
condition during construction, etc. (They are included in both Financial and Economic analysis)
⇒ Price Contingencies: Allow for general inflation. In project analysis, they are omitted both
from financial and economic analysis when the analysis is done in constant prices. Constant
price is a value, most often a price, from which the overall effect of general price increase
(inflation) has been removed.
By definition, a “constant price” is a price that has been deflated to real terms by an
appropriate “price index”, a price index being a series that records changes in a group of
prices relative to a given base period.
6
6.6. Project Benefits
Any project whether it is relatively simple, such as purchasing and operating a taxicab, or
complex, such as creating and operating a sophisticated global communication network, involves
costs and benefits. At the beginning of a project an investment is usually required. Equipment
has to be purchased, buildings have to be constructed, and a host of other activities have to be
conducted. All of these activities require expenditure of resources. As soon as the project gets
into its operating phase, some function, such as producing a product or performing a service, that
has tangible or intangible costs and benefits will be performed.
If the system is producing an end item, such as a factory producing motor vehicles, then the
revenue received by selling the produced items is the benefit obtained. If the project is an energy
producing system, such as a utility power station, then it receives income by selling its generated
power. The benefits or costs are not always given directly in monetary terms but they can be
converted to monetary terms for comparison purposes. For example, in the case of a public
project such as a new highway, even if there are no tolls taken, time saved, lives saved, or the
convenience received by the users can be transferred into monetary benefits. In the case of
defense systems, the value received is deterrence or national security which is not easily
measurable in monetary terms.
Costs and benefits do not always occur at one time; they occur at different points of time during
the life of the project. In most cases, the lifetime worth, that is the lifetime aggregate of all the
costs and benefits, taking into account the time of their occurrence, is used to compare different
projects and to decide which alternative to choose.
Let us look at the example of a housing development project. The cost items are purchase of land
and design and construction of the sites and buildings. As soon as the developer starts selling the
houses, benefits start coming in. Since all of the houses are not sold at the same time, the
developer has to bear the cost of maintaining the unsold buildings until all of the houses are sold.
This is the end of the project. The aggregate of these costs and benefits, taking into account the
time of their occurrence, is the lifetime worth of this project that will determine its economic
viability.

6.7. Criteria for Investment Decision

6.7.1. Net Present Value (NPV)
The NPV of a project is the sum of the present value of all the cash flows - positive as well as
negative that are expected to occur over the life of the project. It represents the net benefit over
and above the compensation for time and risk. The net present value of a project is also defined
as the value obtained by discounting, at a constant interest rate and separately for each year, the
differences of all annual cash outflows and inflows accruing throughout the life of a project. This
difference is discounted to the point at which the implementation of the project is supposed to
start. The present values of each of the annual cash flows, (be it negative or positive), over the
project’s economic life are added up (or aggregated) to obtain the total NPV of the project. That
is,
7
NPV = CF0 + CF1 + …. + CFn = Σ CFt
(1 + K) 0 (1 + K) 1 (1 + K) n t=0 (1 + K) t
Where: NPV = Net present value
CF t = Cash flow occurring at the end of year t, (t = 0, 1… n)
n = Economic life of the project
K = Cost of capital, (which is the discount rate)

When the cash flows exhibit conventional pattern, NPV simply means that present value of cash
inflows minus initial investment.
Considering the cash flow stream of a project given below and the cost of capital “k” being 10
percent, the net present value (NPV) of the project can be calculated easily as illustrated next:
Expected cash flows
Year Cash flows
0 -1,000,000
1 200,000
2 200,000
3 300,000
4 300,000
5 550,000

Given at representing the discount factor applicable to the respective cash flow in year n,
NPV = NPV0 = NCF0 + (NCF1 x a1) + (NCF2 x a2) + - - - + (NCFn x an)
n
= Σ NCFt
t=0 (1 + r) t
Where: NCFt: is the annual net cash flow of a project in year t at: is the discount factor in the
corresponding year, relating to the discount rate applied through the equation at = (1 + r) -t
Therefore, the NPV of the above project will be:

NPV=- 1,000,000 + 200,000 + 200,000 + 300,000 + 300,000 +550,000 = 118,750

(1.10) 0 (1.10) 1 (1.10) 2 (1.10) 3 (1.10) 4 (1.10) 5

Net Present Value Ratio

If one of several project alternatives has to be chosen, the project with the largest NPV should be
selected. They need some refinement, since the NPV is only an indicator of the positive net cash
flows or of the net benefits of a project. In cases where there are two or more alternatives, it is
advisable to know how much investment will be required to generate these positive NPVs. The
quotient obtained by dividing the NPV to the present value of investment (PVI) is called the net-
present-value ratio (NPVR). As the formula yields a discounted rate of return, this value should
be used for comparing alternative projects and choosing among them. The formula is as follows:

8
NPVR = NPV/ PVI

6.7.2. Profitability Index

There are two ways of defining the benefit-cost ratio. The first definition relates the present value
of benefits to the initial investment. That is,
BCR = PVB/ I
Where:
BCR = benefit-cost ratio
PVB = present value of benefits
I = initial investment
The second measure, a net measure, relates net present value to initial investment. The formula
is:
NBCR = NPV = PVB - I = PVB - 1
I I I
Alternatively, the computation may use the BCR as the starting point and deduct one from this
ratio as shown below:
NBCR = BCR - 1
Where: NBCR = net benefit-cost ratio
NPV = net present value
PVB = present value of benefits
I = initial investment
Decision Rules:
BCR NBCR Rule
>1 >0 Accept
=1 =0 Indifferent
<1 <0 Reject

To illustrate the calculation of these measures, let us consider a project, which is being evaluated
by a firm that has a cost of capital of 12 percent. In this regard, assume that the initial investment
on the project amounts to Birr 100,000 and the estimated cash flows over its economic life are as
given below:
Year Benefits
1 25,000
2 40,000
3 40,000
4 50,000
The two benefit-cost ratios (i.e. the gross and net measures) for this project are computed as
follows:
1. BCR = 25,000(1.12)-1 + 40,000 (1.12)-2 + 40,000(1.12)-3 + 50000(1.12)-4 = 1.145
100,000

9
 2. NBCR = BCR - 1 = 0.145
The foregoing benefit-cost ratios give the same decision signals, as the difference between them
is simply unity.

6.7.3. Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is the discount rate at which the present value of cash inflows
is equal to the present value of cash outflows. It is the discount rate which makes its NPV equal
to zero or the rate which equates the present value of future cash flows with the initial
investment. In other words, IRR is the discount rate for which the present value of the net
receipts from the project is equal to the present value of the investment, and NPV is zero.
It is the value of r in the following equation:
n
Investment = Σ CFt
t =1 (1+r)t

Where: CFt = cash flow at the end of year t

r = internal rate of return (IRR)
n = life of the project
Mathematically, it means that in the NPV equation, the value of “r” has to be found for which at
defined values of
CFt, the NPV equals zero. An iterative process, using either table of present values or a suitable
computer program, finds the solution. The procedure used to calculate the IRR is the same as the
one used to calculate the NPV. The same kind of table can be used, and instead of discounting
cash flows at a predetermined cut-off rate, several discount rates may have to be tried until the
rate is found at which the NPV is zero. This rate is IRR, and it represents the exact
profitability of the project.
The calculation of IRR involves a process of trial and error. By using a technique called
“interpolation’’, we can approximately find the internal rate of return for a project. The IRR
calculation includes procedures:
a. Preparation of a cash flow table
b. An estimated discount rate is then used to discount the net cash flow to the present value
c. If the NPV is positive, a higher discount rate is applied
d. If the NPV is negative at this higher rate, the IRR must be between these two rates
e. However, if the higher discount rate still gives a positive NPV, the discount rate must be
increased until the NPV becomes negative
f. If the positive and negative NPVs are close to zero, a good approximation of the IRR can
be obtained, using the following linear interpolation formula:
Difference NPV at the lower
IRR = Lower discount rate + D/c b/n the discount rates x (VPV at lower Dr)
Sum of NPVs at the two Drs
IRR = i1 + [(PV)/ (PV + NV)] x (i2 – i1)
10
Where:
PV is the positive NPV (at the lower discount rate i1), and
NV is the negative NPV (at the higher discount rate i2).
Note that we need to ignore the negative sign, i.e. take the absolute value of the two NPVs
obtained at the lower and higher discount rates, in order to approximate the IRR value through
interpolation. To this effect, the above formula can be re-written as follows:
IRR= i1 + NPVi1 – NPVi x (i2 –i1)
NPVi1 + NPVi2
Where: NPVi1 and NPVi2 are the net present values obtained at i1 and i2 respectively. NPVi
represents the net present value obtained at IRR, which is always 0.
The absolute value of both NPV1 and NPV2 are used in the formula. It should also be noted
that the lower discount rate (i1) and the higher discount rate (i2) should not differ by more than
one or two percentage points (in absolute terms). In this regard, the formula will not yield
realistic results if the difference is too large, since the discount rates and the NPV are not related
linearly.
Interpretation of the IRR
Internal Rate of Return is the maximum interest that a project could pay for the resources used if
it has to recover the initial investment, the subsequent operating costs, and still break-even. It is
the rate of return on capital outstanding per period while it is invested in the project.
The rationale for this method is that, the IRR on a project is its expected rate of return. If the IRR
of a given investment project exceeds the cost of the funds used for financing the project (cost of
capital), there is a surplus remaining after paying for the capital, and this surplus adds up on the
wealth of the shareholders of the firm.
Therefore, selecting a project whose IRR exceeds its cost of capital increases the shareholders'
wealth.
Decision Rule:
 Accept the project if the IRR is greater than the cost of capital,
 Reject the project if the IRR is less than the cost of capital, and
 The decision maker will be indifferent if the IRR is equal to the cost of capital.

Example: Consider the following data:

Year 0 1 2 3 4
Cash flows -100,000 30,000 30,000 40,000 45,000

The IRR is the value of r, which satisfies the following equation:

100,000 = 30,000 + 30,000 + 40,000 + 45,000
(1+r) 1 (1+r) 2 (1+r) 3 (1+r) 4

11
The calculation of r consists of a process of trial and error. We try different values of r till we
find that the right hand side of the above equation is equal to 100,000. Let us, to begin with, try r
= 12 percent. The right- hand side of the above equation becomes:

30,000 + 30,000 + 40,000 + 45,000 = 107,773

(1.12)1 (1.12)2 (1.12)3 (1.12)4
Since this is more than 100,000, we have to try a higher value of r. (In general, a higher r lowers
the right-hand side value and a lower r increases the right-hand side value.) Let us try r = 14
percent. This makes the right-hand side equal to:

30,000 + 30,000 + 40,000 + 45,000 = 103,046

(1.14)1 (1.14)2 (1.14)3 (1.14)4
Since this value is higher than the target value of 100,000, we have to try still a higher value of r.
Let us try r = 15 percent. This makes the right-hand side equal to:
30,000 + 30,000 + 40,000 + 45,000 = 100,802
(1.15)1 (1.15)2 (1.15)3 (1.15)4
NPV = 802
This value is a slightly higher than our target value, 100,000. Therefore, we increase the value of
r from 15 percent to 16 percent. The right – hand becomes:
30,000 + 30,000 + 40,000 + 45,000 = 98,641
(1.16)1 (1.16)2 (1.16)3 (1.16)4
NPV = -1,359
Since this value is now less than 100,000, we conclude that the value of “r” lies between 15
percent and 16 percent.
For most of the purposes, this information suffices; however, if a single value is required, we
have to resort to interpolation. In this regard,
IRR = 15% + (16% - 15%) [2161802]
= 15.371%
IRR could also be obtained by trial and error using discount factors at different rates of return.
Assume that for a given level of capital invested, the NPV at 12% discount rate equals
6,967,000. In order to find the IRR for this investment, several discount rates greater than 12%
should be tried until the NPV is approximately zero.
In this regard, it is depicted in the table that discounted at 18%, the net cash flow is still positive,
but it becomes negative at 20%. Therefore, the IRR must lie between 18% and 20%.
IRR = 18% + 2% 265
265 + 486
= 18.71%

6.7.4. Payback Period (PBP)

The payback period is the length of time required to recover the initial cash outlay on a project. It
is defined as the number of years expected to take from the beginning of the project until the sum
12
of its net earnings, (i.e. receipts minus operating costs), equals the cost of the projects initial
capital investment. When the annual cash inflow is a constant sum, the payback period is simply
the initial outlay divided by the annual cash inflow. According to the payback criterion, the
shorter the payback period, the more desirable the project is. Firms using this criterion generally
specify the maximum acceptable payback period. Projects with a payback period equal to or less
than the specified period are deemed worthwhile.
Assuming a project that requires an initial cash outlay of Birr 1,000,000 and generating a
constant annual cash inflow of Birr 300,000, the payback period can be determined as
(1,000,000/300,000), which is 3 1/3 years.
When the cash flows from the project are not in an annuity, the payback period is computed as
follows:
Payback Period = Years before Full Recovery + Un-recovered cost
Cash Flow during the next year

Assuming a project that involves cash outlay of Birr 600,000 and generating cash inflows of Birr
100,000, Birr 150,000, Birr 150,000, and Birr 200,000 in the first, second, third, and fourth years
respectively, the payback period is four years because the sum of the cash inflows during the
four years is equal to the initial investment outlay. See the table below depicts this.
Year Annual CF Cumulative CF NCFs (Cumulative)
0 -600,000 _ -600,000
1 100,000 100,000 -500,000
2 150,000 250,000 -350,000
3 150,000 400,000 200,000
4 200,000 600,000 0

Illustration 2
The total initial investment for a given project is birr 10,800,000, of which birr 300,000 is
invested in land and birr 2,000,000 in net working capital. You are given the annual net
operating cash flows to be generated from the project from year 3 through 7. In this regard, the
periodic operating cash flows indicated in the table below are obtained in such a way that the
financial costs (net of tax) and the depreciation charges added back to the profit after tax balance
Items Years
3 4 5 6 7
Net profit -280,000 920,000 1,270,000 2,540,000 2,630,000
Net interest 370,000 330,000 280,000 180,000 90,000
Depreciation 780,000 780,000 780,000 780,000 780,000
Net operating CFs 870,000 2,030 2,330,000 3,500,000 3,500,00
Required:
a. Determine the total Payback Period (PBP).

13
 b. Determine the Payback Period (PBP) assuming the investment in land and
networking capital can be regained fully at the end of the project’s economic life.
Solution:
When calculating the payback period, the computation usually starts with the construction period
during which the initial investment is made. The initial investment, in this regard, can be seen in
terms of one of the following:
Total investments………………………………………... (10,300,000)
Initial investments, excluding cost of land and NWC….. (8,000,000)

Year Annual NCFs Balance at year end(case A) Balance at year end

(case B)
1 _ (10,300,000) (8,000,000)
2 _ (10,300,000) (8,000,000)
3 870,000 (9,430,000) (7,130,000)
4 2,030,000 (7,400,000) (5,100,000)
5 2,330,000 (5,070,000) (2,770,000)
6 3,500,000 (1,570,000) 730,000
7 3,500,000 1,930,000 4,230,000

There are two ways of calculating the payback period under case A. In this regard, including the
construction period, the total original investment costs would be recovered after a little less than
6.5 years [i.e. 6 years +
(1,570,000/3,500,000]. Excluding the construction period, the payback period would be (6.5
years – 2 years = 4.5 years).
Under Case B, the cost of land and the net working capital are deducted from the total
investment costs with the assumptions that these values can be fully regained at the end of the
project’s life. Thus, only 8 million of the investment outlay must be recovered. In this case, the
payback period would be 5.8 years [i.e. 5 years + (2,770, 000/3,500,000)].
A project proposal may be accepted if the pay-back period is smaller than or equal to an
acceptable time period, a period usually derived from past experience with similar projects. The
major merit of the payback period as a project selection criterion is its ease for calculation.

6.7.5. Discounted Payback Period (DPBP)

The discounted payback period is defined as the number of years that is required to recover the
amount of money invested in a project at the beginning, after the future cash flows being
discounted to their present value equivalent.
The discounted payback period is computed in the same manner as that of the regular payback
period except that discounted cash flows are used in place of the nominal cash flows. In this
regard, the expected future cash flows are discounted using the project‘s cost of capital.

14
To illustrate the computation of the discounted payback period, suppose a project being
considered requires initial investment of birr 30,000 the economic life which is 5 years. The
after-tax cash flows from this project during years
1, 2, 3, 4, and 5 are birr 15,000, birr 18,000, birr 12,000, birr 20,000, and birr 22,000
respectively. The cost of capital (the required rate of return) is 10 percent. What is the discounted
payback period for this project?
Solution:
Year Cash flows Discount factor Present value Cumulative
DCFs
1 15,000 0.909 13,635 13,635
2 18,000 0.826 14,868 28,503
3 12,000 0.751 9,012 37,515
4 20,000 0,683 13,660 51,175
5 22,000 0.621 13,662 64,837

As you can see from the cumulative discounted cash flows, the discounted payback period for
this project is between
2 to 3 years. This is because the cumulative discounted cash flow at the end of year 2 is less than
the initial investment of birr 30,000 and the cumulative discounted cash flow at the end of year 3
is greater than the net initial investment. The exact discounted payback period can be obtained as
follows:
Discounted Payback Period = 2 years + (1,497/9, 0120) years
= 2 years + 0.17 years = 2.17 years
Or = 2 years + (0.17 x 12 months)
= 2 years and 2 months
A period of 2 years and 2 months is required to recover the project’s initial net investment taking
the time value of money into account.

6.7.6. Accounting Rate of Return (ARR)

It is also referred to as the average rate of return on investment or a simple rate of return. It is a
measure of profitability that relates income to investment, both measured in accrual accounting
terms. This method relies on the operational accounts and is defined as the ratio of the profit in a
normal year of full production to the original investment outlay (fixed assets, pre-production
capital expenditures, and networking capital).
ARR = Average Income After tax (Annual)
Initial Investment
It is defined as the ratio of the annual net profit on capital and this ratio is often computed only
for one year, generally a year of full production. This ratio can be computed either for the total
investment outlay or for the equity capital. The simple rate of return, thus, can be computed as
follows:

15
1. The simple rate of return on total capital invested (R) is:
R (%) = NP + I x 100
K
2. The simple rate of return on equity capital paid (RE) is:
RE (%) = NP x 100
Q
Where: NP = net profit (after depreciation, interest charges, and taxes)
I = interest charge
K= total investment costs (fixed assets, working capital)
Q= equity capital (amount in the pre-production period)

16