CHAPTER Five 1.ppt, about the chapter on financial managment

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1. CHAPTER 5
Financial, Risk and socio economic
Analysis of Projects
Major contents:
i.Financial analysis
Measuring Project cash flows
Non-discounted cash flow approaches
Discounted cash flow approaches
Criteria for Investment Decision
Project financing alternatives
ii.Risk and uncertainty analysis
Project risk, uncertainty, assumption, issue and constraints
Environmental Impact Assessment
Risk response planning
Determination of contingency fund
iii.Socio-Economic Analysis
Rationale for Economic Analysis
Valuation and Shadow Prices
Basic Principle of Shadow Price

2. Financial analysis
•Financial analysis is analytical work required
to identify the critical variables which are
useful for likely to determine the success or
failure of an investment.
•Its concern is to determine, analyze and
interpret all the financial consequences of an
investment that might be relevant to and
significant for the investment and financing
decisions.

3. Purposes
Financial analysis is essentially undertaken for the
following purposes:
It provides an adequate financing plan for the
proposed investment
It determines the profitability of a project
It assists in planning the operation and control of the
project by providing management information to both
internal and external users.
It advises on methods of improving the financial
viability of a project entity.
It illustrates the financial structure of the project and
its existing and potential financial viability.

4. Costs of a project
•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.
•These costs are included:
Initial investment cost
 Production cost
 Marketing and administrative cost
Plant and equipment replacement,
decommissioning at the end of the project life.

5. Cont’d
1.Initial Investment Cost
 Fixed Assets costs: ( Land Purchase, site preparation and improvements;
Building and civil works Plant machinery and equipment including auxiliary
equipment)
 Pre-production Expenditures:
•In every industrial project a certain expenditures are incurred prior to main
commercial production. They are;
I.Preliminary Capital – issue expenditures (preparation and issue for a
prospectus, advertising, public announcements, underwriting commission,
brokerage, expenses for processing of share applications and allotments)
II.Expenditure for preparatory studies (pre investment studies like opportunity
and feasibility (Project design and reports) and other expenses for planning).
III.Other Pre-Production Expenditures (Salaries, fringe benefits & social
security contributions of personnel engaged during the pre production
period, expenses such as work camps, temporary offices and store)
IV.Trail runs, start up and commissioning expenditures (includes fees payable
for supervision of start up operations wages, salaries, fringe benefits and
social security contributions of personnel employed, consumption of
production materials and auxiliary supplies, utilities and other incidental
start up costs)

6. Operating Costs/Production Costs
Operating costs can be divided into two:
•Variable cost includes items such as materials, power,
labor inputs required for manufacture which will vary
directly with the volume of production.
•Fixed costs includes maintenance, administration and
managerial charges, etc. which will be relatively fixed with
respect to the volume of production.
•The total operating costs will then be the sum of the fixed
and variable costs.

7. Marketing and administrative Costs
Marketing costs:
•This represents estimated expenses in sales
divisions as per projected organizations and
includes the items:
–salaries and personnel cost for sales staff and
managers as planned.
–Publicity, advertisement, exhibitions, etc.
–Subsidies, commissions, discounts to dealers, etc.
–Administrative expenses of sales office including
rent.

8. Administrative costs
•This represents all indirect expenses incurred
in the organization including estimates for
•salaries of all indirect staff
•postage, telephone, fax, e-mail etc.
•traveling expenses
•insurance other than for the factory assets
•rent, taxes, electricity etc. and
•depreciations of all fixed assets other than factory assets

9. Financial Analysis criteria
•Ranking projects and measuring their profitability
have replaced evaluation based on inadequate
planning and subjective judgment. Quantitative
methods were developed to use in evaluating
proposed projects.
•The investment evaluating criteria, classified into
two broad categories, discounting criteria and
non-discounting criteria are shown in the
following.

10. Project evaluating
criteria
Discounting criteria Non-discounting criteria
It does not considers
Time value of money
Eg.
Pay Back Period
Accounting Rate of
Return (ARR)
It considers Time value of
money
Eg.
Net Present Value (NPV
Benefit Cost
Ratio/Profitability Index (PI)
Discounted payback period

11. Net Present Value
•In this method, all net cash inflow are discounted to
present value using the required rate of return and is then
compared with the initial outlay. This calculation can be
represented algebraically as:

NPV =

Where:
CF = Cash inflows at different periods
r = Discounting rate
C
0 = Cash outflow in the beginning
NPV = Net Present Value
t = Time period
The decision rule here is to accept a project if the NPV is
positive and reject it if it is negative.

12. Pay Back Period
•Sometimes called the Pay off or pay out method. It determines
the length of time required by the project to recover the initial
investment.
•It is simple and widely used evaluation method. Eg. The Payback
Period of a fixed asset tells us the number of years required to
recover the initial investment of the asset.
• Methods of Calculation PBP
-On the basis of Uniform /Regular Cash inflow
-On the basis of Non-uniform Cash inflow

13. •Uniform Cash inflow:
Net initial Investment
PBP = -------------------------
Annual cash flows
 
 
•Non Uniform Cash flows:
B
PBP = E + ------
C
E = Year immediately before Pay Back Period
B= Difference between earnings of earlier period & pay Back Period
amount
C= Difference between cumulative savings of earlier period and
subsequent period.
• Decision Criteria:
The PBP is less than some acceptable PBP amount= Accept the project
Or otherwise = Reject the project

14. Accounting rate of Return
•The Accounting rate of return referred to as the
average rate of return on investment is a
measure of profitability, which relates income
to investment, both measures in according
terms.
Average income after tax
ARR = -------------------------------
Initial Investment

15. Illustration and Class work
• ABC Co.
 invests $200,000 in machinery that
yields
 net after-tax cash flows of $90,000
at
 the end of each of the next three years. The
required rate of return is 10%
Calculate: PBP
NPV
BENEFIT COST RATIO

16. Project financing alternatives
Sources of
Capital
EquityDebt
Debentures/
Bonds
Term Loans
Short term
liabilities
Common
equity capital
Preference
equity capital
Retained
Earnings

17. Class Over!