Project Preparation and Financial Analysis

UNIER Development Projects Analysis Lesson Nov 22 29

Project Preparation: Feasibility and pre-feasibility Study

Preparation thus requires feasibility studies that identify and prepare preliminary designs of technical and institutional alternatives, compare their respective costs and benefits, and investigate in more detail the more promising alternatives until the most satisfactory solution is finally worked out.

The structure of the pre-feasibility study and the feasibility study is identical; the analytical details change
1
Executive Summary

5
Project Background and basic ideas

Engineering & Technology

Production program & plant capacity Tech acquisition & transfer Equip. & maintenance costs Plant management Overhead costs

2
Market Analysis

Market research Market strategy Market revenues Classification Availability and supply Distribution chain Costs

6
Organization & Overhead costs

3
Raw materials Supply

7
Human Resource

Categories and functions Socio-economic aspects Costs Implementation planning Cash flow analysis Investment appraisal Project financing Financial ratios Cost-benefit analysis

Location & Environment

Site and costs Infrastructure and costs Environment Impact Assessment

Financial Analysis

Note: the above is the structure of an industrial feasibility study, taken from the UNIDO Manual

The feasibility study is characterized by the more complex and detailed nature of the analysis and by the precise qualification and quantification of the project content

Project Appraisal
Appraisal covers four major aspects of the project-technical, institutional, economic, and financial.

Technical Appraisal
TECHNICAL: it has to be ensured that projects are soundly designed, appropriately engineered, and follow accepted agronomic, educational, or other standards. The appraisal mission looks into technical alternatives considered, solutions proposed, and expected results.

Technical Appraisal
More concretely, technical appraisal is concerned with questions of physical scale, layout, and location of facilities; what technology is to be used, including types of equipment or processes and their appropriateness to local conditions; what approach will be followed for the provision of services; how realistic implementation schedules are; and what the likelihood is of achieving expected levels of output

Technical Appraisal
In a family planning project, the technical appraisal might be concerned with the number, design, and location of Maternal and child health clinics and the appropriateness of the services offered to the needs of the population being served; in highways, with the width and pavement of the roads in relation to expected traffic and the trade-offs between initial construction costs and recurrent costs for maintenance, and between more or less labor-intensive methods of construction; in education, with whether the proposed curriculum and the number and layout of classrooms, laboratories, and other facilities are suited to the country's educational needs.

Technical Appraisal
A critical part of technical appraisal is a review of the cost estimates and the engineering or other data on which they are based to determine whether they are accurate within an acceptable margin and whether allowances for physical contingencies and expected price increases during implementation are adequate.

Technical Appraisal
Procedures for obtaining engineering, architectural, or other professional services are examined. In addition, technical appraisal is concerned with estimating the costs of operating project facilities and services and with the availability of necessary raw materials or other inputs. The potential impact of the project on the human and physical environment is examined to make sure that any adverse effects will be controlled or minimized.

Institutional Appraisal
Experience indicates that insufficient attention to the institutional aspects of a project leads to problems during its implementation and operation. Institutional appraisal is concerned with a host of questions, such as whether the entity is properly organized and its management adequate to do the job, whether local capabilities and initiative are being used effectively, and whether policy or institutional changes are required outside the entity to achieve project objectives.

Institutional Appraisal
Of all the aspects of a project, institution building is perhaps the most difficult to come to grips with. In part, this is because its success depends so much on an understanding of the cultural environment. There is a need for a continuing reexamination of institutional arrangements, an openness to new ideas, and a willingness to adopt a long-term approach that may extend over several projects.

Economic Appraisal
ECONOMIC. Through cost-benefit analysis of alternative project designs, the one that contributes most to the development objectives of the country may be selected. This analysis is normally done in successive stages during project preparation, but appraisal is the point at which the final review and assessment are made. During economic appraisal, the project is studied in its sectoral setting. The investment program for the sector, the strengths and weaknesses of public and private sectoral institutions, and key government policies are all examined.

Economic Appraisal
In transportation, each appraisal considers the transportation system as a whole and its contribution to the country's economic development. A highway appraisal examines the relationship with competing modes of transport such as railways. Transport policies throughout the sector are reviewed and changes recommended, for example, in any regulatory practices that distort the allocation of traffic.

Economic Appraisal
Whenever the current state of the art permits, projects are subjected to a detailed analysis of their costs and benefits to the country, the result of which is usually expressed as an economic rate of return. This analysis often requires the solution of difficult problems, such as how to determine the physical consequences of the project and how to value them in terms of the development objectives of the country.

Economic Appraisal
Use methodology of economic appraisal: "Shadow" prices are used routinely when true economic values of costs are not reflected in market prices as a result of various distortions, such as trade restrictions, taxes, or subsidies. These shadow price adjustments are made most frequently in the exchange rate and labor costs used in the calculations.

Economic Appraisal
The distribution of the benefits of a project and its fiscal impact are considered carefully, and the use of "social" prices to give proper weight in the cost-benefit analysis to the government's objectives of improved income distribution and increased public savings is passing through an experimental phase. Since the estimates of future costs and benefits are subject to substantial margins of error, an analysis is always made of the sensitivity of the return on the project to variations in some of the key assumptions.

Economic Appraisal
Some of the elements of project costs and benefits, such as pollution control, better health or education, or manpower training, may defy quantification; in other projects, for example electric power or telecommunications, it may be necessary to use proxies, such as revenues, that do not fully measure the value of the service to the economy. In some cases, it is possible to assess alternative solutions that have the same benefits and to select the least-cost solution. In other cases, for example education, alternatives are likely to involve different benefits as well as different costs, and a qualitative assessment must suffice.

Financial Appraisal
FINANCIAL. Financial appraisal has several purposes. One is to ensure that there are sufficient funds to cover the costs of implementing the project. The Bank does not normally lend for all project costs; typically, it finances some of the costs and expects the borrower or the government to meet some or all of the local costs. In addition, other cofinancers, such as the European Development Fund, the several Arab funds, the regional development banks, bilateral aid agencies, and a growing number of commercial banks, are joining to an increasing extent in cofinancing projects that, in many instances, are appraised and supervised by the Bank.

Financial Appraisal
Therefore, an important aspect of appraisal is to ensure that there is a financing plan that will make funds available to implement the project on schedule. When funds are to be provided by a government known to have difficulty in raising local revenues, special arrangements may be proposed, such as advance appropriations to a revolving fund or the earmarking of tax proceeds.

Financial Appraisal
. For a revenue-producing enterprise, financial appraisal is also concerned with financial viability. Will it be able to meet all its financial obligations, including debt service to the Bank? Will it be able to generate enough funds from internal resources to earn a reasonable rate of return on its assets and make a satisfactory contribution to its future capital requirements? The finances of the enterprise are closely reviewed through projections of the balance sheet, income statement, and cash flow. Where financial accounts are inadequate, a new accounting system may be established with technical assistance financed out of the loan. Additional safeguards of financial integrity may include establishing suitable debt-to-equity ratios or limitations on additional long-term borrowing.

Financial Appraisal
Costs can be recovered in a variety of ways-by charges for irrigation water, through general taxation, or by requiring farmers to sell their crops to a government marketing agency at controlled prices. Some countries apply lower standards of cost recovery; thus, arriving at a common judgment on what is desirable and practicable can be one of the more difficult aspects of the appraisal and subsequent negotiation.

The financial analysis of projects

refers to the evaluation of the investment, from the point of view of every operator, corporate body and enterprise (public or private) uses prevailing market prices (current and/or projected ) to verify and appraise the economic effects of the project based on market conditions, both during the construction and running phase

Financial Indicators
Net Present Value
Where t - the time of the cash flow n - the total time of the project r - the discount rate Ct - the net cash flow Net Benefits: (Revenues Operating costs C0 Investment Cost in time ( t = 0 or in construction period)

Net Present Value

If NPV >= 0
the investment is profitable the project should be accepted

If NPV < 0
the investment is at loss the project should be rejected

Financial Internal Rate of Return

Rate for which NPV=0
The return on the investment instead of investing in someting else The IRR is the return rate which can be earned on the invested capital, i.e. the yield on the investment. A project is a good investment proposition if its IRR is greater than the rate of interest that could be earned by alternative investments (investing in other projects, buying bonds, even putting the money in a bank account). The IRR should include an appropriate risk

Financial Indicators
Mathematically the IRR is defined as any discount rate that results in a net present value of zero of a series of cashflows. In general, if the IRR is greater than the project's cost of capital, or hurdle rate, the project will add value for the company.

Financial analysis documentation

The profit and loss account, the balance sheet, and the account showing the origin and uses of funds

The profit and loss account

analyzes the costs and benefits for the operator over a given period, includes the amortization of durable goods is included as annual costs, includes, among the financial costs, the yearly interest payments for loans contracted by the agent in question, includes among the financial proceeds, the payments received for loans to others.

The balance sheet

Illustrates the financial position of the economic agent from the point of view of his claims on other parties and of other parties towards the agent The BS numbers measure all values of these two sets of claims at one particular point in time This value is incorporated in the evaluation of the project as investment costs or residual values of capital goods

The account of the origin and the use of funds

a document that integrates the profit and loss account with the balance sheet, it may be used as an intermediate step to construct the cash flow account

The calculation of financial returns

It is based on the calculation of the cash flow of the enterprise, for every year of project life, giving a decreasing weight to the future flows in comparison to the present flows according to an appropriate rate of discount

The discount rate in financial analysis

It should reflect the financial opportunity cost of the resources from the point of view of the economic agent, i.e. the return the agent must forego to use the resources to finance the project (the rate of interest on loans, the interest paid on time deposits, or the return on government bonds)

Differences between financial and economic analysis

Costs and benefits identification, costs and benefits evaluation, adjustments and corrections (transfers, project risks, sunk costs, inflation and price revisions, external effects).

Differences between financial and economic analysis

Identification effects of the project external to the agent or internal to the national economy (social and merit goods) Transfers They do not represent costs in terms of resource use but they do affect the income distribution and savings

Differences between financial and economic analysis

Evaluation Market prices versus shadow prices Project risks must be included in the economic analysis under three alternative forms as general costs (safety margins); as costs of insurance; as costs of risk

Differences between financial and economic analysis

Sunk costs They have already been incurred at the time of project evaluation They appear in both the situation with and without the project They may encourage the financing of noneconomic operations Inflation and price revisions For financial and economic analysis, inflation is irrelevant, because calculations are effected at constant prices Changes of relative prices, however, must be taken into account (they may reflect real changes of factor and product values)

Example: Major Projects EU

EU Regulation 1083/2006 Article 39 Content As part of an operational program, the ERDF and the Cohesion Fund may finance expenditure in respect of an operation comprising a series of works, activities or services intended in itself to accomplish an indivisible task of a precise economic or technical nature, which has clearly identified goals and whose total cost exceeds EUR 25 million in the case of the environment and EUR 50 million in other fields (major projects).

CBA Major Projects EU

Article 40(e) of Regulation 1083/2006 stipulates that the presentation to the Commission of major projects for financial support under the Structural Funds or the Cohesion Fund must be accompanied by information concerning the cost benefit analysis. The Commission is required to provide indicative guidance on the methodology for the cost benefit analysis.

CBA Major Projects EU (2)

With regard to revenue-generating projects, the Commission has proposed to simplify and realign the method (the so-called funding-gap method) for determining the rate of assistance from the Funds for revenue-generating projects.

CBA Major Projects EU (2)

The purpose for requiring CBA for major projects is twofold. First, it must be shown that the project is desirable from an economic point of view and contributes to the goals of EU regional policy. Second, evidence should be provided that the contribution of the Funds is needed for the project to be financially viable. The appropriate level of assistance should be determined on this basis.

CBA Major Projects EU (2)

CBA is an essential tool for estimating the economic benefits of projects. In principle, all impacts should be assessed: financial, economic, social, environmental, etc. The objective of CBA is to identify and monetize (i.e. attach a monetary value to) all possible impacts in order to determine the project costs and benefits; then the results are aggregated (net benefits) and conclusions are drawn on whether the project is desirable and worth implementing. Costs and benefits should be evaluated on an incremental basis, by considering the difference between the project scenario and an alternative scenario without the project.

Why CBA is required for major projects

1) To assess whether the project is worth co-financing Does the project contribute to the goals of EU regional policy? Does it foster growth and boost employment? In order to check this, it is necessary to carry out an economic analysis and look at the effect on economic indices estimated by the CBA. A simple rule is: if the projects economic net present value (ENPV) is positive, then the society (region/country) is better off with the project because its benefits exceed its costs. Therefore, the project should receive the assistance of the Funds and be co-financed if needed

Why CBA is required for major projects

2) To assess whether the project needs co-financing

The fact that a project contributes positively to EU regional policy objectives does not necessarily mean that it has to be cofinanced by the Funds. Besides being desirable from an economic standpoint a project may also be financially profitable, in which case it should not be co-financed by the Funds. To check whether a project needs co-financing requires a financial analysis:
if the financial net present value of the investment without the contribution of the Funds (FNPV/C) is negative then the project can be co-financed; the EU grant should not exceed the amount of money that makes the project break even, so that no over-financing occurs.

FINANCIAL ANALYSIS The main purpose of the financial analysis is to compute the projects financial performance indicators. This is usually done from the point of view of the owner of the infrastructure. However, when the owner and the operator are not the same entity, a consolidated financial analysis should be considered. The methodology to be used is discounted cash flow (DCF) analysis.

FINANCIAL ANALYSIS (2)

There are two main features of the DCF method: 1. Only cash flows are considered, i.e. the actual amount of cash being paid out or received by the project. Thus, for instance, non-cash accounting items like depreciation and contingency reserves must not be included in the DCF analysis. However, if the proposed project is supported by a detailed risk analysis, contingencies can be included in the eligible cost, without exceeding 10% of the total investment cost net of contingencies. Yet, contingencies should never be included in the costs considered for the determination of the funding gap, as they do not constitute cash flows.

FINANCIAL ANALYSIS Major Projects(3) Cash flows must be considered in the year in which they occur and over a given reference period (see box below). When the actual economically useful life of the project exceeds the reference period considered, a residual value should also be taken into account. Ideally, this should be calculated as the present value of expected net cash-flows during the years of economic life outside the reference period.

FINANCIAL ANALYSIS Major Projects(3)

2. When aggregating (i.e. adding or subtracting) cash flows occurring in different years, the time value of money has to be considered. Therefore, future cash flows are discounted back to the present using a time-declining discount factor whose magnitude is determined by the choice of the discount rate to be used in the DCF analysis (see box below on choosing a discount rate).

FINANCIAL ANALYSIS Major Projects(4)

CBA uses the incremental method: the project is evaluated on the basis of the differences in the costs and benefits between the scenario with the project and an alternative scenario without the project. However, when the project falls under a pre-existing revenuegenerating infrastructure, the application of the incremental method may prove to be difficult or even unworkable. In such a case, the Commission suggests that the method of remaining historical costs is used in the financial analysis:
the scenario without the project is that without any infrastructure; the scenario with the project takes into consideration, on the one hand, the cost of investment not only of the new element of infrastructure but also of the infrastructure that already exists estimated at its current residual value and, on the other hand, all the income generated by all infrastructure after the project.

Operating costs and revenues considered for the entire infrastructure must be those of a scenario of efficient operation

FINANCIAL ANALYSIS Major Projects(5)

The financial profitability of the investment can be assessed by estimating the financial net present value and the financial rate of return of the investment (FNPV/C and FRR/C). These indicators show the capacity of the net revenues to remunerate the investment costs, regardless of the way these are financed. For a project to require the contribution of the Funds, the FNPV/C should be negative and the FRR/C should thus be lower than the discount rate used for the analysis

FINANCIAL ANALYSIS Major Projects (6) The determination of the level of Community assistance is based on the funding gap rate of the project, i.e. the share of the discounted cost of the initial investment not covered by the discounted net revenue of the project. The identification of the eligible expenditure according to Art. 55(2) ensures that the project has enough financial resources to be implemented and avoids the granting of an undue advantage to the recipient of the aid, i.e. over-financing of the project.

FINANCIAL ANALYSIS Major Projects (7)

STEPS TO DETERMINING THE EU GRANT 2007-2013 PROGRAMMING PERIOD Step 1. Find the funding-gap rate (R): R = Max EE/DIC Where Max EE is the maximum eligible expenditure = DIC-DNR (Art. 55.2) DIC is the discounted investment cost DNR is the discounted net revenue = discounted revenues discounted operating costs + discounted residual value

FINANCIAL ANALYSIS Major Projects (8)

Step 2. Find the decision amount (DA), i.e. the amount to which the cofinancing rate for the priority axis applies (Art. 41.2): DA = EC*R where EC is the eligible cost.

FINANCIAL ANALYSIS Major Projects (9)

Step 3. Find the (maximum) EU grant: EU grant = DA*Max CRpa where Max CRpa is the maximum co-funding rate fixed for the priority axis in the Commissions decision adopting the operational programme (Art. 53.6).

Example: Finding the Funding Gap

Y e a rs 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 T o ta l T o t a l d is c o u n t e d In v . C ost -2 5 -2 5 -2 5 -2 5 -2 -2 -2 -2 -2 -2 -2 -2 -2 -2 -2 -2 -2 -2 -2 -2 -1 0 0 -8 9 -3 2 -1 8 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 64 36 O p e r. C o s ts O p e r. R evenues R e s id u a l v a lu e

5 5 2

Example: Finding the Funding Gap (2)

Example: Finding the Funding Gap (3)

Step 1) Find the funding-gap rate (R): We first need to determine the eligible expenditure (EE) in accordance with Art. 55.2: EE = DIC-DNR EE = 89 20 = 69 Then, the funding-gap rate (R) is found as: R = EE/DIC R = 69/89 = 78%

Example: Finding the Funding Gap (4)

Step 2) Find the decision amount (DA), i.e. the amount to which the co-financing rate for the priority axis applies (Art. 41.2): DA = EC*R where EC is the eligible cost DA = 80*78% = 62

Example: Finding the Funding Gap (5)

Step 3) Find the (maximum) EU grant EU grant = DA*CRpa where CRpa is the maximum co-funding rate fixed for the priority axis in the Commissions decision adopting the operational programme (Art. 53.6). EU grant = 62*75% = 47