Chapter V Financial analysis and projection

There are three basic questions to be answered in a

project appraisal exercise. These are,
 Shall we produce goods or provide need based services
 Shall we sell the product
 Can we earn a satisfactory return on the investment
made in the project.
In order to answer these questions we have to undertake
 Market and demand appraisal
 Technical appraisal
 Financial appraisal
In the previous parts we have tried to look at the
first two appraisals and this part will try to see the
remaining aspect
1
 Financial analysis and projection

Specifically here we will focus on the estimation

and projection required for financial appraisal.

Issues focused in this part are,

 Estimating Cost of project
 Means of Financing the project
 Estimation of sales and production
 Cost of production
 Estimation of working capital requirement
 Cash flows in financial analysis
2
 5.1. Cost of project
The cost of project represents all cost items
associated with a project
It is the sum of the outlays on the following
items,
1. Land and Site development: This includes
costs related to
 Basic cost of land
 Lease payment
 Cost of leveling and development
 Cost of road (internal), Etc
 Cost of land varies from one location to another.
Similarly cost of developing the land varies as well
3
 Cost of project (Cont…)
2.Buildings and civil works:
Costs of building and civil works include costs like,
 Cost of building for the main plant and equipments
 Building for auxiliary service like workshop,
laboratory, etc.
 Warehouse, and open yard facility
 Non factory buildings like canteen, gust house,
offices etc.
 Silos, tanks, wells, bins, and other structure
 Garage
 Drainage, etc
The cost of building and civil work depends up on the
kinds of structure required
4
 Cost of project (Cont…)
3. Plant and machinery:
This is the most significant component of project
cost which includes,
 Cost of imported machinery which might include
the FOB value, shipping freight and insurance
costs, import duty, clearing, loading, unloading,
and transportation costs )
 Cost of locally produced machinery
 Cost of spares
 Foundation and installation charges
These cost estimation has to be based on the
latest price quotation 5
 Cost of project (Cont…)

4. Technical know-how and engineering fees:

 Either local or foreign consults will be required
to advice and help in different technical matters
such as,
 preparation of project report,
 choice of technology,
 selection of the plant and machinery etc.
Thus, the amount payable for such technical know-
how is one of the components of the project
cost and is included in cost estimation
6
 Cost of project (Cont…)

It also include cots like expenses on

foreign technicians and training of local
staff
Here belongs costs like
 Travel expense
 Boarding and lodging
 Salary and allowances

7
 Cost of project (Cont…)
5. Miscellaneous fixed asset :
This include costs like
 Furniture
 Office machinery and equipment
 Tools
 Vehicles, etc.

6) Preliminary expenses:
 Expenses incurred for identifying the project
 Conducting market survey
 Preparing feasibility report
 Expenses related to the raising of funds 8
 Cost of project (Cont…)
7. Pre-operative expenses:
These are expenses incurred till the
commencement of production. These are costs
like
 Rents and taxes
 Traveling expenses, interest and commitment
charges on borrowings
 Insurance charges
 Mortgage expenses and interest on differed
payments,
 Miscellaneous expenses
9
 Cost of project (Cont…)

8) Provision of contingency:
A provision for contingencies is made to
provide for certain unforeseen expenses
and price changes
9) Margin of money for working capital

10
 5.2. Means of finance (Project
financing)
 After projecting or estimating the cost of the
proposed project , the next step is to identify
means of financing the project.
That is, to identify the sources of finance.
The major sources of finances are
 Capital (equity) financing
 Loan financing (debt financing)
 Supplies credit (credit financing)
 Debenture capital
 Incentive sources
11
 Project financing (Cont…)
1. Capital (Equity Financing):
On way of financing the project is by issuing
equity.
 Equity and long term investment are often
used to cover the initial capital investment
for an industrial project and to meet working
capital requirements.
 When institutional capital is scarce and cost
of borrowing is very high, equity capital
covers the initial capital investment and
working capital requirement.
12
 Project financing (Cont…)
2. Loan (debt) financing:
 Another way of financing the project is trough
external sources, i.e., debt financing.
 In many countries it is relatively easy for a
sound project to get loans from financial
institutions
 the financial analysis will identify such sources
and the extent to which loan capital can be
secured, (with the interest rate)
 Short and medium term loan can be obtained
from commercial banks or from suppliers credit
for working capital
13
 Project financing (Cont…)
If the cash flow suggests that sufficient liquid funds
are available, bank borrowings could be reduced or
entirely eliminated, without harming the liquidity of
the project
 Long Term Loans: Such loan is usually subjected to
certain regulations (convertibility to share).
Investment may also be financed partly by issuing
bonds.
 An important source of finance is also available at
government-to-government level. This can be a
bilateral credit or tied credit, which may be
related to the purchase of machinery and
equipment from particular country or sources.
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 Project financing (Cont…)

3. Suppliers credit (credit financing):

 Imported machinery and spares can often be
financed on deferred credit term.
 Machinery suppliers are usually willing to sell
machinery on deferred – payment terms with
payments is spread over 6 to 10 years
This means, payment for the purchase of plants
and machinery can be made over a period of
time
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 Project financing (Cont…)
4. Debenture capital:
Akin to promissory notes they are an instrument to
raise fund (debt financing). These are two types,
 Non convertible and convertible debenture
 Non-convertible debenture: these are debt
instruments which will be redeemed at the date
of maturity.
 They pay a fixed amount of interest and usually
have 5 to 10 years of maturity.
 Convertible debenture: these are partly or
entirely convertible into a certain amount of
equity (share) after certain period of time
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 Project financing (Cont…)
5. Incentive Sources:
The government and its agencies may
provide financial support as an incentive
to certain types of projects or for
setting up industrial units in certain
location
This incentive may have a form of
 Seed money (seed capital investment)
 Capital subsidy
17
 5.3. Estimation of sales and production

 The starting point for profitability projection

is an estimation of production and sales.
 This helps to estimate potential revenue of the
project
In estimating sales revenue the following issues
should be considered
a) It is advisable not to assume a high capacity
utilization level in the first year of operation.
 This is because, even for simple technology and
with no technical problem, firms may face
other constraints like,
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 Estimation of sales and production (Cont…)

 Row materials
 Limited power supply
 Marketing problem
 And other unexpected constraints
Thus, it is advisable to assume that the
capacity would be somehow lower in the
first year of operation.
Gradually the level is increased year by
year and at third and fourth years of
operation the full capacity utilization
can be assumed. 19
 Estimation of sales and production (Cont…)

 A reasonable assumption with respect to

capacity utilization would be,
 40-50% in the first year
 50-80% in the 2nd year of operation
 80-90% year three and above
b) It is not necessary to make adjustment for
stock in the first year of operation.
That is, it is better to assume that production =
sales
c) Selling price considered should be realistic and
the price considered should be on the basis of
the current price
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 Estimation of sales and production (Cont…)

Production
S.N Items 1st year 2nd 3rd 4th
year year year

1 Installation Capacity (Qt per

day)
2 Number of working days

3 Number of shifts

4 Estimated production per day

5 Estimated annual production

(Qt)
6 Estimated output as % of plant
capacity
7 Sales (quantity) after 21

adjustment
 5.4. The cost of production

Given the estimated level of production, the cost

of producing the estimated amount can be
worked out
The major components of cost of production are:
 Material Cost
 Utilities cost
 Labor cost
 Overhead cost
 Other costs
 For instance, for an agricultural project the
following costs can be considered as costs of
production
22
 The cost of production (Cont…)

Material cost: These costs are comprise of

the cost of raw materials such as
 seeds,
 chemicals,
 fertilizerand
 pesticides ,
 concrete for irrigation canal construction,
 material for the construction of buildings
 and consumable supplies required for
production.
23
 The cost of production (Cont…)

Utilities: consisting of power, water, and fuel are

production cost components.
Labor: this is the cost of all manpower employed
in the farm.
 It will not be difficult to identify and quantify
labor required for the production process.
 From the highly skilled manager to the unskilled
daily laborer requirement can easily be
identified.
 Problems may be in the case of valuing unskilled
labor and family labor
24
 The cost of production (Cont…)

Farm’s Overhead: the expense on repairs and

maintenance, rent, taxes, insurance on farm’s
assets, etc. are collectively referred as farm
overheads
Land: The land needed for the project can also be
easily identified and quantified.
 It will not be difficult to know how much land is
need and its location.
 However, problems might arise in valuing land
because of the special kind of market conditions
that exist when land is transferred from one owner
to another. 25
 The cost of production (Cont…)

Contingency allowances: are usually included as a

regular part of the project cost.

In general project costs estimates are assume

that there will be no relative changes in
domestic or international prices and no inflation
during the investment period is expected.

 It was not also assumed that there will be

modification in design, no exceptional
conditions such as unanticipated
environmental conditions like, 26
 The cost of production (Cont…)

 flood,
 landslides,
 or bad weather
 It would be unrealistic to base project cost
estimates entirely on these assumptions of
perfect knowledge and complete price
stability
Thus, provision has to be made in advance for
possible adverse changes in physical
conditions or prices that would add to the
baseline cost
27
 The cost of production (Cont…)

Taxes: payment of taxes including tariffs and duties

are also considered
Debt service: the same approach applies to debt
service - the payment of interest and the repayment
of capital.
 Both are treated as an outflow in financial analysis.
Sunk costs: sunk costs are those incurred in the past
and upon which the proposed new investment will be
based. When we analyze a proposed investment, we
consider only future returns to future costs;
expenditures in the past or sunk costs do not appear
in our account
28
 5.5. Estimate of working capital requirement

 This is estimating working capital requirement

for operational purpose. The working capital
including components like,
 Row material requirement estimation
 Wage salary
 Cost of utilities and other expenses like,
 Fuel, power, insurance, taxes, rent etc
 Costs of maintenance
 Sales expenses
 Outstanding debtors
 Etc
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 5.6. Cash flows in financial analysis

Most of the analysis usually overlaps with the

aspects of project selection.
 The cash flow projection and analysis also one
criterion used for selecting the project
 Investment has been defined as a long-term
commitment of economic resources made with
the objective of producing and obtaining net
gains in the future.
 It is, therefore, necessary to prepare a cash
flow schedule showing the sources and
applications of funds, i.e., the overall cash
inflows and outflows
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 Cash flows analysis (Cont…)

 In order to evaluate a project, we must

determine the relevant cash flows associated
with the project
 The financial cash flow of a project is
 the stream of financial costs and benefits,
or
 the stream of expenditure and receipts
that will be generated by the project over its
economic life.
Cash flows are basically either receipts of cash
(cash inflows) or payments (cash outflows)
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 Cash flows analysis (Cont…)

 Cash out flows are typically broken into investment or

operating costs.
 The investment cost; basically covers capital
expenditure such as plant and machinery
 Operating costs; are costs incurred when the project
is underway.
 Operating cost can have variable and fixed
components
 The conventional methods of investment appraisal
basically involves projection of the expected net
profit (sales income less costs and incomes taxes)
. 32
 Cash flows analysis (Cont…)

 For the purpose of financial appraisal, it is

necessary to evaluate all inputs required and all
outputs produced by the project (over time)
 Therefore, the discounted cash-flow concept has
become generally accepted method for
investment appraisal.
 Similarly, the cash – flow concept is needed for
planning of the flow of financial resources,
 That is, the sources and application of funds.
33
 5.6.1.Basic principles of measuring project
cash flow

 As we have said earlier, cash flows are basically

either receipts of cash (cash inflows) or
payments (cash outflows).
 For estimating the stream of these financial
costs and benefits, the following principles may
be kept in mind
a) Incremental principle
The cash flow of the project must be measured in
incremental terms.
To determine a project’s incremental cash flows a
project analyst has to look at what happens to
the cash flows of the firm with the project and
without the project 34
 Basic principles for measuring project cash
flow (Cont…)

The difference between the two reflects the

incremental cash flows attributable to the
project
Project cash Cash flow for less Cash flow
flow from the the firm with for the firm at
time period t the project at time period t
equals time period t without the
project

35
 Basic principles for measuring project cash
flow (Cont…)

 In estimating the incremental cash flow of a project

the following guideline be considered
 Consider all incidental effects: In addition to the
direct cash flows of the project all indirect flows on
the rest of the firm must be considered.
 The project may enhance the productivity of some
of the existing activities (complementary Effect)
 Or it may distract from the profitability of some of
the existing activity ( competitive effect)
 Ignore sunk costs: These are an outlay already
incurred in the past or already committed
irrevocably. So these cost will not be affected by
the acceptance and rejection of the proposed
project 36
 Basic principles for measuring project cash
flow (Cont…)
 Include opportunity costs: If the organization uses
resources already available within the company their cost
in the form of opportunity cost has to be included as they
could be put in alternative uses
 Question the allocation of overhead costs: Costs which
are indirectly related to the project (production) are
called overhead costs and they should be considered in
the estimation of the project cash flow
 Estimate working capital properly : Working capital like
current asset, loans and advances should be properly
estimated and indicated in the project cash flow.
 Bear in mind that the requirements of working capital may
be changed overtime as the output of the project changes
37
 Basic principles for measuring project cash
flow (Cont…)

b) Post -tax principle

 The cash flow should be measured on an after tax
basis.
 Some people ignore taxes and will try to compensate
by discounting pre-tax cash flows at the rate which is
higher than the cost of capital of the firm.
 Actually their is no reliable mechanism that enable to
make such adjustment.
 Tax payments like other payments must be properly
deducted in deriving the cash flows.
 Thus, cash flows must be defined in post tax terms.
38
 5.6.2. Components of the cash
flow stream
As we have said earlier, the financial cash flow
of a project is
 the stream of financial costs and benefits, or
 expenditure and receipts that will be
generated by the project over its economic
life.
 The project cash flows are defined with the
help of inputs (information) provided by
marketing, production, engineering, costing,
purchasing, and other departments. 39
 Components of the cash flow stream (Cont…)

The cash flow of a project usually has:

 An initialinvestment
 Operating cash inflows
 A terminal cash flow
 The initial investment: represents the relevant
cash outflows when the project is set up.
 The operating cash inflows: are the cash inflows
that arise from the operation of the project during
its economic life.
 The terminal cash flow: is the relevant cash flow
occurring at the end of the project life on account
of liquidation of the project 40
 Components of the cash flow stream (Cont…)

 As cash flows have to be forecasted far into the

future, errors in estimation are bound to occur.
 Thus, in estimating the future cash flow of a
project, adequate care should be taken to minimize
biases, which may lead to over-estimate or under
statement of project profitability
 An important consideration is to discount all income
generated in the future
 The basic assumption underlying the discounted
cash-flow concept is that , sum of money available
now is worth more than an equal sum available in the
future.
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 Components of the cash flow stream (Cont…)

One Birr today is more valuable than one Birr a year

hence.
This is because:
 Individuals, in general, prefer current consumption to
future consumption (uncertainty about the future)
 There is an expectation that society will be better off in
the future than they are now: (people would gain less
extra utility from additional Birr of income if they were
rich than if they were poor)
 Capital can be employed productively to generate positive
return. An investment of one Birr today would grow to 1(1
+ r) a year.
 In an inflationary period, one birr today represents a
greater real purchasing power than one birr a year from
now. 42
 Components of the cash flow stream (Cont…)

Generally,
 Many financial transactions involve cash flows
occurring at different points of time.
 For evaluating such cash flows an explicit
consideration of time value of money is
required.
 Considering that a project may obtain a
certain amount of funds F, if this sum is
repaid after one year including an agreed
interest I, the total sum to be paid after one
year would be (F + I), where
F + I = F (1 + r)
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 Components of the cash flow stream (Cont…)

And r is defined as the interest rate (in %

per year)
For instance,
suppose that CFn is the nominal value of a
future cash flow in the year n, and CFp the
value at the present time (present value) of
this expected inflow or outflow, then
(assuming interest rate (r) is constant):
CFp= CFn/ (1 + r) n or
CFp= CFn (1 + r) –n 44
 Components of the cash flow stream (Cont…)

The general formula for the future value of a

single amount is
FV = PV (1+r)n
Where:
FV = Future value
PV = Amount today (present value)
r = Interest rate per year
n = Number of years for which compounding is
done. 45
 Example of Cash flows
Consider Cement Project with the following information,
 The initial investment outlay on the project is birr 100
million which is consists of 80 million plant and
machinery and the remaining 20million is on working
capital. The entire outlay will be made at the beginning
of the project
 The project will be financed with 50 million of equity
capital and the reaming 50 million of debt financing
 The life of the project is expected to be 5 years.
 At the end of the 5th years a fixed asset will fetch a
net salvage value of birr 30 million where as working
capital liquidated at its book value
46
 Example of Cash flows Cont…)

 The project is expected to increase the revenue of

the firm by 120 m per year.
 The increase in cost on account of the project is
expected to be 80 m per year (this includes all costs
items other than depreciation and tax). The
effective tax percent will be 30%
 Plant and machinery will be depreciated at the rate
of 25% per year as shown below
 First year 20m
 Second year 15m
 Third year 11.25m
 Fourth birr 8.44m
 Fifth year 6.33m
 Given the above information the cash flow of the
project can be shown as follows.
47
 5.6.3. Biases in cash flow estimation

Since cash flows have to be forecasted far into

the future, errors in estimation are bound to
occur.
However, given the importance of cash flow
forecasts in project evaluation, adequate care
should be taken to guard against certain biases,
which may lead to
 over statement or
 understatement of
future project profitability. Let us now look at
causes of such biases.
48
 Biases in cash flow estimation (Cont…)

I. Overstatement of Profitability
 Profitability is often overstated because the
initial investment cost is under - estimated and
the operating cash inflow exaggerated.
 The major reasons for such optimistic bias
appear to be
 Intentional overstatement: project promoters
may intentionally over-estimate the benefits
and under-estimate the costs.
 Lack of experiences: inadequate experience on
the part of project promoters generally leads
to over-optimistic tendencies..
49
 Biases in cash flow estimation (Cont…)

 Myopic Euphoria: individuals responsible for

preparing forecasts may become too involved and
lose their sense of proportion unintentionally.
(This lack of objectivity is not due to lack of
experience)
 Capital rationing: companies typically operate
under capital rationing which may be externally
determined or internally imposed. Awareness of
such constraint induces to exaggerate the
benefit of the project.
50
 Biases in cash flow estimation (Cont…)

II. Under-Statement of profitability

There could be an opposite kind of bias
relating to the terminal benefit which may
understate a project’s true profitability.
This can happen if:
 Salvage values are under-estimated
 Intangible benefits are ignored

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