Chapter Five: Economic and Financial

Analysis
1 Economic Feasibility:

• There is a significant difference between economics and finance.

• Finance is a fund management science

• The basic principle of finance is saving money and lending

money.

• These operations are accomplished with the help of financial institutions.

The science of finance deals with the interrelation of the concepts of
time, risk and money.

• Economics is a social science.

• The science of economics studies the production, consumption

10/29/2022 and distribution of services or goods. 1

 .
• Also we can find various types of economics too. The most

mentioned types of economics are :

▪ Microeconomics : microeconomics studies interactions between

individual markets.

▪ Beside the markets, microeconomics is focusing on

specialization and supply and demand relations.

Macroeconomics : macroeconomics is targeting the same

objects like microeconomics just on a larger scale.

▪ It is not focusing on single, individual markets but on large,

national variables. These variables can be national income and

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output, price inflation and unemployment rate
 .
▪ The government and government agencies
calculate the economic indicators of a
project before permitting the project or
financing it.

▪ There are two levels of influence:

 Internal Or Micro-economic: The internal economics
relate to the viability of the project and the soundness of
the business case.

 Financial models and proven accountancy techniques are

applied during the evaluation phase to ensure the

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economic viability of the project. 3
 .
▪ A typical example is the case of an oil-fired power station which had
to be mothballed over halfway through construction, when the price
of fuel oil rose above the level at which power generation was no
longer economic.
▪ It is not uncommon for projects to be shelved when the cost of
financing the work has to be increased and the resulting interest
payments exceed the foreseeable revenues.
 The external economics, often related to the political climate, can
have a serious influence on the project.
 Higher interest rates or exchange rates, and additional taxes on
labour, materials or the end product, can seriously affect the viability
of the project.
 Thus, factors which can affect a project are
 Tariff barriers, interest rate, taxes, temporary embargoes, shipping
restrictions.

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 Economic justification

• Are Total Benefits higher than Total Costs?

• Which are there better alternatives?

• ➔ Cost-benefit analysis

Economic Evaluation Tools

• Benefit-Cost Analysis
• Cost Effectiveness Analysis
• Financial Analysis
• Fiscal Impact Analysis
• Economic Impact Analysis
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2 .Financial Feasibility:
• Financial feasibility involves the capability of the project organization to

raise the appropriate funds needed to implement the proposed project.

• In many instances, project proponents choose to have additional

investors or other sources of funds for their projects.

• In these cases, the feasibility, soundness, sources and applications of

these project funds can be an obstacle.

As appropriate, loan availability, credit worthiness, equity, and loan

schedule still be reviewed as aspects of financial feasibility analysis.

• Also included in this area are the review of implications of land

purchases, leases and other estates in land.

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 • Basically, financial analysis should accompany the design
of the project from the very beginning.

• This is only possible when the financial analyst is

integrated into the feasibility study team at an early stage.

• From a financial and economic point of view, investment

can be defined as a long term commitment of economic
resources made with the objectives of producing and
obtaining net gains (exceeding the total initial investment)

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in the future. 7
 .
▪ You need to lay out the capital you require to
start the business.

▪ The objective of financial analysis is to

determine the financial viability of the project.
1. Startup costs

2. Means of financing

3. Projected profitability

4. Cash flow of the project

5. Investment worthiness- using criteria

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 • Financial analysis and final project appraisal involves
. the assessment ,analysis and evaluation of the required
project input, the output to be produced and the future net

benefit ,expressed in financial terms.

Cost of project
• Cost of project is costs incurred for which the goods
(service) are believed to serve the project for a long period of
time.

• Cost of project represents the total of all items of

outlays associated with a project which are supported by
long term funds.

• It’s the sum of the outlays on the following.

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 2.1 Total investment costs
• Investment required during plant operation
• The economic life time is different for the various
investments (buildings, plant, machinery and equipment,
transport equipment etc).
• In order to keep a plant in operation, each item must
therefore be replaced at the appropriate time and the
replacement costs must be included in the feasibility
study.

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 Pre-production expenditures
• In every industrial project certain expenditure due, for
example, to the acquisitions or generation of assets are
incurred prior to commercial production.
• These expenditures, which have to be capitalized, include
a number of items originating during the various stages of
project preparation and implementation.
• These are:

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 i. Preliminary capital-issue expenditures.
These are expenditures incurred during the
registration and formation of the company, including
legal fees for preparation of the memorandum and
articles of association and similar documents and for
capital issues.
ii. Expenditures for preparation studies.
There are three types of expenditures for preparatory
studies:
✓ Expenditures for pre-investment studies; consultant fees for
preparing studies,
✓ engineering and supervisor of erection and construction;
✓ other expenses for planning the project

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 iii. Other pre-production expenditures
. Included among other pre-production expenditures are the following:

✓ Salaries, fringe benefits and social security contributions of personnel engaged

during the pre-production period.

✓ Travel expenses

✓ Preparatory installation, such as workers, camps, temporary offices and stores.

✓ Pre-production marketing costs, promotional activities, creation of the sales

network etc.

✓ Training costs including fees, travel, living expenses, salaries and stipends of the
trainees and fees payable to external institutions;

✓ Know-how and patent fees

✓ Interest on loans accrued or payable during construction

✓ Insurance costs during construction

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 iv. Trial runs, start-up and commissioning expenditures.

• This item includes fees payable for supervision of

starting-up operation, wage, salaries, fringe benefits
and social security contributions of personnel
employed, consumption of production materials and
auxiliary supplies, utilities and other incidental start-
up costs.

• Operating losses incurred during the running period up

to the stage when satisfactory levels are achieved also
have to be capitalization.

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 .
• In allocating pre-production expenditures one
of two practices is generally followed:
All pre-production expenditures may be capitalized
and amortized over a period of time that is usually
shorter than the period over which equipment is
depreciated.

A part of the pre-production expenditures may be

initially allocated, where attributable to the
respective fixed assets and the sum of both
amortized over a certain number of years
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 v. Plant and equipment replacement costs .
Such costs included all pre-production expenditure as
described above and related to investment needed for
the replacement of fixed assets.

• A gain the estimates include the supply, transport,

installation and commissioning of equipment, together
with any costs associated with down time, production

losses as well as allowance for physical contingencies.

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 Fixed assets
• As indicated above fixed assets comprise fixed investment
costs and pre-production expenditures.

Fixed investment costs :

• Fixed investment should include the following main cost

items, which may be broken down further, if required
✓ Land purchases, site preparation and improvements

✓ Building and civil works

✓ Plant machinery and equipment, including auxiliary equipment

✓ Certain incorporated fixed assets such as industrial property

rights and lump – sum payments for know-how and patents.
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 Net working capital
• Net working capital is defined to embrace current
assets (the sum of inventories, marketable securities,
prepaid items, accounts receivable and cash) minus
current liabilities (accounts payable).

• It forms an essential part of the initial capital outlays

required for an investment project because it is
required to finance the operations of the plant.

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 Accounts receivable (debtors )
• Accounts receivable are trade credits extended to
product buyers as a condition of sale; the size of this
item is therefore determined by the credit sales policy
of the company.
• It is given by the following formula

credit , terms(in, months)

Debtors =  value, of , annual , gross, sales
12

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 2 .2 Production Costs
• It is essential to make realistic forecasting of
production or manufacturing costs for a project
proposal in order to determine the future viability of
the project
• Definition of production cost items
• The definition of production costs divides production
costs in to four major categories;
1. Factory costs,
2. Administrative overhead costs,
3. Depreciation costs, and
4. Cost of financing.
• The sum of factory and administrative over head
costs is defined as operation costs.

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 Factory costs:
• Factory costs include the following:
✓Materials predominantly variable costs such as raw materials
factory supplies and spare parts.
✓Labor (production personnel) fixed or variables costs depending
on type of labor and cost elements)
✓Factory overheads (in general fixed costs).
• Administrative overheads:
• This include salaries and wages, social costs rents and
leasing costs etc

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 Depreciation costs.
• Depreciation costs are charges made in the annual net
income statement (profits loss account) for the productive
use of fixed assets.
• Depreciation costs present investment expenditures (cash
outflow during the investment phase) instead of
production expenditures (cash outflow production).
• Depreciation charges must therefore be added back to net
cash flows

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 .
• Net cash flows are calculated from the net profits after
corporate tax, as obtained from the net income
statement.
• Depreciation costs do have an impact on net cash flows
because higher the depreciation charges, the lower the
taxable income and the lower the cash outflow
corresponding to the payable on income.
• Financial costs. Financial costs (interests) are sometimes
considered as part of the administration overheads.

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 Unit costs of production
• For the purpose of cash flow analysis it is
sufficient to calculate the annual costs.

• At the feasibility stage, however, an attempt

should also be made to calculate unit costs to
facilitate the comparison with sales prices per
unit.

• For single product projects units costs are

calculated simply by dividing production costs by
the number of units produced (therefore unit

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costs usually vary with capacity utilization). 24
 Direct and indirect costs
• Direct costs are easily attributable to a production unit or
service in terms of costs of production, materials and
production labor.

• Since indirect costs (factory administration overheads such

as management and supervision, communications,
depreciation and financial charges) cannot be easily
allocated directly to a particular unit of output, They must
first be apportioned to cost centers and thereafter to the
unit’s cost price by way of surcharges obtained from the
cost accounting department

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 .
• Direct costing is an accounting method that avoiding the
problem of determining surcharge rates.
• The direct variables and direct fixed costs are deducted
from the revenue generated by a certain products (or
product group) and the remaining surplus or margin
together with the margins generated from other products
is then available to cover the indirect costs.
• The surplus then remaining is called the operational
margin (excluding costs of finance).

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 2.3 Marketing costs
• Marketing cost comprises the costs for all
marketing activities. It may be divided into

1. direct marketing costs for each product or

product group, such as:
✓ packaging and storage (if not included in the production
costs)

✓sales costs (salesmen commissions, discounts, returned

products, royalties, product advertisement etc)

✓transport, and distribution costs.

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 Indirect marketing costs such as:
✓ overhead costs of the marketing department (personnel material and communications,

✓ markets research,

✓ public relations, and

✓ promotional activities, not directly related is a product etc).

• The analysis of these costs involves their assignments to various cost

group such as territories, certain classes of customers (wholesalers,

retailers, government institutions etc) and products or product group.

• Marketing and distribution costs fall into the category of period costs

even if variable and as such are charged against the operations of the

accounting period in which they are occurred.

• For depreciable investments as required, for marketing and distribution

(for example delivery trucks), depreciation charges are to be included in

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the computation of total marketing costs
 .2.4 Project Cash Flows
• Cash flows are basically either receipt of cash (cash
inflow) or payments (cash outflows)

• Typical operational cash flows for a project are shown

below.

• Operational cash outflows

✓ Increase in fixed assets (investment)
✓ Increase in net working capital
✓ Operating costs (less depreciation)
✓ Marketing expenses
✓ Production and distribution costs

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 .
• Operational cash inflows
✓ Revenues from selling of fixed assets
✓ Recovery of salvage value (end of project)
✓ Revenues from decrease of net working Capital
✓ Sales revenues
✓ Other income due to plant operations

• Basic assumptions underline cash flow

discounting in financial evaluation
• The basic assumption underlying the discounted cash-
flow concept is that money has a time value.
• A sum of money available now is worth more than an
equal sum available in the future
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 .
• This difference can be expressed as a percentage rate
indicting the relative change for a given period which,
for practical reasons, is usually a year.

• Considering that a project may obtain a certain amount

of funds (F).

• If this sum is repaid after one year including the

agreed amount of interest (I) the total sum to be paid
after one year would be (F+I) where, F+I= F (1+r) and
r is defined as the interest rate (in percentage per
year) divided by 100 (if the interest rate is, for
example 12.0 per cent then r equals 0.12).
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PROJECT EVALUATION/APPRAISAL CRITERIAS

➢There are several criteria that have been suggested by economists, accountants,
and others to judge the worthwhileness of capital projects.
➢The important investment criteria, classified into two broad categories:
➢Non-discounting criteria or traditional techniques:
➢Payback period
➢Accounting rate of return
➢Discounting criteria or time adjusted techniques:
➢Net present value
➢Benefit cost ratio or profitability index method
➢Internal rate of return

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 ❑Non-discounting criteria or traditional techniques:
❖Payback period:
➢The payback period is the length of time required to recover the
initial cash outlay on the project.
➢Decision rule:
➢Accept the project if the actual or computed payback period is less
than the maximum PB period set by the firm, otherwise the project
is rejected.
➢In ranking projects, the project with shorter payback period should
be chosen because it pays for itself more quickly.

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 ➢A. Payback period with equal cash inflows:
➢When the project generates constant annual cash inflows,
the following one is the formula to calculate payback
period.
➢PBP = Net investment/Annual cash inflows
➢For example, the information provided below pertains to
project “A” of XYZ corporation. The maximum payback
period set by the firm’s management is 4 years.
Net investment = $12,000
Annual cash inflows = $4000
Estimated life = 5years
➢ Required:- Compute the payback period and give your decision.
Solution:

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 ➢B:Payback period with unequal cash inflows:
➢If the expected cash inflows are unequal, the PBP is
calculated by determining the length of time that requires
for cumulative cash inflows to equal the net investment.
➢PBP = Year before recovery + Unrecovered cost at start of
year/Cash flow during the next year.
➢Case-1: Determine the pay-back period and give your
decision for a project which requires a cash outlay of
$10,000 and generates cash inflows of $2,000, $4,000,
$3,000 and $2,000 in the first, second, third and fourth
year respectively. Predetermined Max. payback period is 3
years.
Solution:

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 ➢Case-2: There are two projects ‘x’ and ‘y’. Each projects
requires an investment of $56,000. You are required to
rank these projects according to the pay-back period
method from the following information.
Cash inflows
Year Project ‘X’ Project ‘Y’
1 $14,000 $22,000
2 16,000 20,000
3 18,000 20,000
4 20,000 14,000
5 25,000 17,000
Solutions:

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 ➢Limitations of payback period method:
➢Though payback period method is the simplest, oldest
and most frequently used method, it suffers from the
following limitations.
➢It does not take into account the cash inflows earned
after the payback period and hence the true profitability
of the projects cannot be correctly assessed.

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 ➢For example, there are two projects ‘x’ and ‘y’. Each project
requires an investment of $25,000. The cash inflows from the
two projects are as follows:

Year Project ‘X’ Project ‘Y’

1 $5,000 $4,000
2 8,000 6,000
3 12,000 8,000
4 3,000 7,000
5 - 6,000
6 - 4,000
➢According to the payback method, project ‘x’ is better because of
earlier payback period of 3 years as compared to 4 years payback
period in case of project ‘y’.

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 ➢But it ignores the earnings after the payback period.
➢Project ‘x’ gives only $3,000 of earnings after the payback
period while project ‘y’ gives more earnings i.e. $10,000
after the payback period.
➢It may not be appropriate to ignore earnings after the
payback period especially when these are substantial.
➢It is a measure of the project’s capital recovery, not
profitability.

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 ➢Another limitation of this method is that it ignores the
time value of money and does not consider the
magnitude and timing of cash inflows.
➢It treats all cash flows as equal though they occur in
different periods.
➢It ignores the fact that cash received today is more
important than the same amount of cash received after
some years.
➢For example:

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 Year Annual cash inflows

Project-1 Project-2
1 $10,000 $4,000
2 8,000 6,000
3 7,000 7,000
4 6,000 8,000
5 4,000 10,000
Total $35,000 $35,000
➢According to the payback method both the projects may be treated equal
as both have the same cash inflows in 5 years.
➢ But in reality project no.1 gives more rapid returns in the initial years and is better than
project no.2.

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 ➢C. Discounted payback period:
➢As we discussed above the serious limitation of the
payback period method is that it ignores the time value of
money.
➢Hence, an improvement over this method can be made
by employing the discounted payback period method.
➢Under this method, the present values of all cash
outflows and inflows are computed at an appropriate
discount rate,
➢The present values of all inflows are cumulated in order of
time.
➢The time period at which the cumulated present values of
cash inflows equals the present value of cash outflows is
known as discounted payback period.
➢The project which gives a shorter discounted payback
period is accepted.
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 ➢Case-3: The following information regarding to project ‘A’ and ‘B’ of XYZ
corporation.
Cost of the projects = $56,000
Life of the projects = 5 years
Cost of capital (cut off rate) = 10%
Annual cash inflows of projects are as follows:

Cash inflows
Year Project ‘A’ Project ‘B’
1 $14,000 $22,000
2 16,000 20,000
3 18,000 20,000
4 20,000 14,000
5 25,000 17,000
Total $93,000 $93,000

➢Required:- Compute discounted payback period and give your

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decision? 43
 ❖Accounting rate of return
➢This method takes into account the earnings expected
from the investment over their whole life.
➢It is called as ARR method for the reason that under this
method, the accounting concept of profit (net profit after
tax and depreciation) is used rather than cash inflows.
➢Decision rule:
➢Accept the project if the computed ARR is greater than
the maximum target ARR set by the firm, otherwise the
project is rejected.
➢In ranking projects having the same target ARR, the
project with the highest ARR should be selected because
it is more profitable.

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 Total profits (after dep. & taxes)
➢Therefore, ARR = × 100
Net investment × No. of years of profits

(or)

Average annual profits

ARR = × 100
Net investment

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 ➢Case-4: A project requires an investment of $500,000
and has a scrap value of $20,000 after five years. It is
expected to yield profits after depreciation and taxes
during the five years amounting to $40,000, $60,000,
$70,000, $50,000 and $20,000. Assume maximum target
ARR set by the firm is 9%.
➢Required:- Calculate ARR on the investment and give your
decision.

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 ➢ Case-5: Determine ARR from the following data of two projects ‘A’ and ‘B’ and
interpret your result assuming the target ARR is 10%.

Project ‘A’ Project ‘B’

Investment $60,000 $60,000
Profit before dep. & taxes:

First year $20,000 $29,000

Second year 22,000 27,000
Third year 25,000 25,000
Fourth year 27,000 22,000
Fifth year 29,000 20,000
Estimated life ……………….. 5 years 5 years
$123,000 $123,000
Estimated scrap value…… $5,000 $5,000
Income tax rate…………….. 55% 55%
Additional information: Depreciation is to be computed on straight line method basis.

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 Project A
Year PBD&T Depreciation PBT Taxes of 55% PAD&T
1 $20,000 11,000 $9,000 4,950 4,050
2 22,000 11,000 11,000 6,050 4,950
3 25,000 11,000 14,000 7,700 6,300
4 27,000 11,000 16,000 8,800 7,200
5 29,000 11,000 18,000 9,900 8,100
Total Profit after Dep. & Tax……………………………….………………………………………….$30,600
Dep. = 60,000 - 5,000 = 11,000
5

Total Profit……………………………….$30,6000
Average Annual Profit………………30,600/5 =6,120
Net INVESTEMENT…………60,000 - 5,000=55,000

ARR = Total Profit After Dep. & Tax X 100

Net Inv. X no. years profit

30,600 X 100 = 11.3%

55,000 X 5

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 Decision:-
Project A & B equally desirable thus both of them should be accepted b/c computed ARR is greater than (10%) standard set by the firm.

30,600 X 100 = 11.3%

55,000 X 5
Project B
Year PBD&T Depreciation PBT Taxes of 55% PAD&T
1 $29,000 11,000 $18,000 9,900 8,100
2 27,000 11,000 16,000 8,800 7,200
3 25,000 11,000 14,000 7,700 6,300
4 22,000 11,000 11,000 6,050 4,950
5 20,000 11,000 9,000 4,950 4,050
Total Profit after Dep. & Tax……………………………….………………………………………….$30,600
Dep. = 60,000 - 5,000 = 11,000
5

Total Profit……………………………….$30,6000
Average Annual Profit………………30,600/5 =6,120
Net INVESTEMENT…………60,000 - 5,000=55,000

ARR = Total Profit After Dep. & Tax X 100

Net Inv. X no. years profit

30,600 X 100 = 11.3%

55,000 X 5
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 ❑Discounting criteria or time adjusted techniques:
➢The traditional methods of project investment appraisal i.e.,
payback method as well as ARR method, suffer from the
serious limitations that give equal weight to present and
future flow of incomes.
➢These methods do not take into consideration the time value
of money, the fact that a Birr earned to day has more value
than a Birr earned after five years.
➢The time adjusted or discounted criteria methods take into
account the profitability and also the time value of money.
❖Net present value
➢The NPV method is a modern method of evaluating
investment project proposals.
➢This method takes into consideration the time value of money
and attempts to calculate the return on investments by
introducing the factor of time element.
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 ➢It recognizes the fact that a Birr earned today is worth
more than the same Birr earned tomorrow.
➢The net present values of all inflows and outflows of cash
occurring during the entire life of the project is
determined separately for each year by discounting these
flows by the firm’s cost of capital or a pre-determined
rate.
➢Therefore, symbolically, NPV =Pv of cash inflow - PV of
cash outflow (initial investment)
➢Decision Rule:
Accept if NPV > 0
Reject if NPV < 0
if NPV = 0 (Indifference) may accept or reject
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 ➢Case-6: Consider a project which has the following cash
flow stream.
Year Cash flow ($)
0 -1,000,000
1 200,000
2 200,000
3 300,000
4 300,000
5 550,000

➢If the cost of capital is 10 per cent.

➢Required:- Calculate NPV of the project and give your
decision whether the project is accepted or rejected?

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 ➢Case-7:From the following information, calculate the NPV
of the two projects and suggest which of the two projects
should be accepted assuming a discount rate of 10%.
Project ‘X’ Project ‘Y’
Initial Investment $20,000 $30,000
Estimated Life 5 years 5 years
Scrap value $1,000 $2,000
➢The cash inflows are as follow:
Year 1 ($) Year 2 Year 3 ($) Year 4 ($) Year 5
($) ($)
Project ‘X’ 5,000 10,000 10,000 3,000 2,000

Project ‘Y’ 20,000 10,000 5,000 3,000 2,000

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 ❖ Benefit cost ratio or profitability index method
➢ BCR is the relationship between present value of cash inflows and
the present value of cash outflows.
➢ BCR is a slight modification of the NPV method.
➢ The NPV method has one major drawback that is not easy to rank
projects on the basis of this method particularly when the costs
(cash outflows) of the projects differ significantly.
➢ To evaluate such projects BCR is most suitable.
➢ BCR = PV of cash inflows/PV of cash outflows
Decision Rule:
Accept if BCR > 1
Reject if BCR < 1
if BCR = 1 (Indifference) may accept

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 ➢Case-8: Refer to the above case (Case-7) and calculate
benefit cost ratio and also give your decision.

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 ❖Internal rate of return
➢In the NPV method the net present value is determined by
discounting the future cash flows of a project at a
predetermined or specified rate called the cut-off rate.
➢he Internal Rate of Return (IRR) is the discount rate that
makes the net present value (NPV) of a project zero.
➢Under this method, since the discount rate is determined
internally, this method is called as the IRR method.
➢Internal rate of return is a discount rate that is used in
project analysis or capital budgeting that makes the net
present value (NPV) of future cash flows exactly zero.
➢Symbolically, NPV=0, Pvcif- PV of cash outflow=0
➢Decision Criterion:
➢If IRR is greater than the cost of capital, accept the project.
➢If IRR is less than the cost of capital, reject the project.
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 ➢Case-9: Consider the cash flows of project being
considered by ABC Company. Assume that cost of capital
is 13%.
Year Cash flow ($)
0 -100,000
1 30,000
2 30,000
3 40,000
4 45,000
➢Required:- Calculate internal rate of return.

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 “The end of chapter 5“

Thank you for your Attentions!!

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