CHAPTER TWO

FINANCIAL ANALYSIS AND APPRAISAL OF

PROJECTS

2.1. Introduction: Scope & Rationale
2.1.1. What is commercial/financial analysis?
• Financial analysis of a project amounts to
reviewing it from the angle of the entity (private or
public) that will be responsible for its execution.
• The necessity to determine the financial
profitability of a project to the project implementer
calls for undertaking financial analysis.
• It aims at verifying that under prevailing market
conditions the project will become and remain
viable. It is concerned with assessing the
feasibility of a new project from the point of view
of its financial results.

1
• The commercial analysis deals with two
issues:
 Investment profitability analysis, with
different methods of analysis;
A) Simple methods of analysis of rate of
return/static methods/ non-discounted
techniques/. This include: Simple rate of
return, Pay-back period, urgency, etc.
B) B) Discounted-cash-flow methods/dynamic
methods. This includes: NPV, IRR, etc.
 Financial analysis/ ratio analysis/.
A) Liquidity analysis;
B) Capital structure analysis (debt-equity ratio).

2
• The issues and concerns of financial
analysis are:
Identification of required data;
Analysis of the reliability of data;
Analysis of the structure and significance of
costs and benefits/incomes/;
Determination and evaluation of the annual and
accumulated financial net benefits; expressed
as profitability, efficiency or yield of the
investment;
Consideration of the spread of flows of the
costs and benefits over time, the economic life
of the envisaged economic unit/firm/public
entity/;
Costs of capital over time;
3
2.2 The Valuation of Financial Costs and
Benefits
 In almost all project analysis, costs are
easier to identify and value than benefits.
 T h e c o s ts an d b e n e f its o f a p r o j e c t
depend on the objectives the project
wants to achieve.
 So, the objectives of the analysis provide
the s tandard agains t which cos t and
benefits are defined.
A c o s t i s a n y t h i n g t h a t r e d u c e s a n
objective, and a benef it is anything that
contributes to an objective (Gittinger
1982).
4
 For the sake of simplicity we assume that
the objective of project is income
maximization.
 The justif ic ation for this is that in most
developing countries increased income is
p r ob ab l y th e s i n g l e m os t i m p or tan t
objective of individual economic effort,
and increased national income is probably
the most important objective of national
economic policy.

5
♦
 To this end;
In every instance of examining costs, we
will be asking ourselves does the item
reduce the net income of the f ir m (our
objective in f in ancial analysis), or the
national income (our objective in

♦economic analysis).
Likewise for examining benef its, we will
be asking ourselves is the item increases
the net income of the firm (our objective in
f inancial analysis), or the national income
(our objective in economic analysis).

6
 However, in real world a society as whole
may have many additional objectives to
address broader development issues than
narrowly defined economic considerations.
 The additional objectives of the society
might include:
 Equitable income distribution
 Increased regional integration
 To upgrade the general level of education
 To improve rural health
 To safe guard national security.

7
 Any of these objectives might lead to the
choice of a project that is not an
alternative to the one regarded as superior
to the narrowly def in ed national income
objective.
F i n a n c i a l a n a l y s i s o f a p r o j e c t i s
concerned about reviewing monetary
costs and benef its of the project from the
angle of the entity (private or public) that
will be responsible for its execution.
 A c o m p re h e n s i ve f in a n c i a l a n a l y s i s
provides the basic data needed for the
economic evaluation of the project and the
starting point for such evaluation.
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T h e p r o c e d u r e a n d m e t h o d o l o g y i n
f in ancial analysis is basically the same
with that of economic analysis.
 There are, however, some differences
between the two.
 The following three points are the main
d i f f e r e n c e s b e t w e e n f in a n c i a l a n d
economic analysis of projects:

9
a. Treatment of taxes and subsidies: these
i tems a r e tr ea ted a s tra nsfer s i n the
eco no mi c anal y si s whi l e i n f in anci al
analysis taxes are usually treated as cost
and subsidies are treated as return income.
 The reason for this distinction is basically
due to the viewpoint (society as opposed
t h e f ir m ) a n d o b j e c t i v e o f a n a l y s i s
(national income as opposed to f ir m’s
i ncome) consi dered i n economi c and
financial analysis.

10
b. Treatmen t of i n teres t on c api tal : I n
economic analysis interest on capital is
never separated and deducted from the
gross return since it is part of the return
from capital, which is available for the
society as a whole.
 Such interest is deducted from benef it
stream in f in ancial analysis whose point
of view is the f irm and hence interest rate
on loan is a cost to the firm.

11
c. Use of prices: in the f in ancial analysis we use
actual market prices.
 Market prices are just the prices in the local
economy, and include all applicable taxes, tariffs,
trade mark-ups and commissions.
 In economi c anal ysi s the market pri ces are
adjusted to accurately ref le ct social and /or
economic values.
 The latter prices are termed as shadow prices.
 Market prices fail to indicate the true value of
resources due to:
 monopoly in markets,
 externality effects,
 unemployed or underemployed resources,
 overvalued currency, and so on.
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 This implies that, the concept of f inancial
prof it is not the same as social prof it of
economic analysis since economic costs
and benef its might be larger or smaller
than financial costs and benefits.
 Therefore, in f inancial analysis the goal is
p r of itab i l i ty to th e i n v e s tor w h i l e i n
economic analysis the most important
question is whether or not the project
under examination is benef ic ial to the
national economy.
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2.3When to undertake financial analysis?
 A f inancial analysis must be undertaken in order
to determine the f inancial prof itability of a project
to the project implementer.
 It is usually undertaken to ensure the selection of
alternative methods of production based on cost
effectiveness and prof it maximization objective
during project preparation.
 And quantif ication of costs and benef its will be
valued using market prices.
 Therefore, we undertake f in ancial analysis of
projects to compare costs with benef it s and
determine which among alternative projects have
an acceptable return (f in ancial viability) during
project preparation and analysis stage of the
project cycle.

14
Identif ic ation and quantif ic ation of costs
and benefits
Identification:
 In project preparation and analysis, the
identif ication of costs and benef its is the
first step.
 T h e c o s ts an d b e n e f its o f a p r o j e c t
depend on the objectives the project
wants to achieve.
 So, the objectives of the analysis provide
the s tandard agains t which cos t and
benefits are defined.
15
A c o s t i s a n y t h i n g t h a t r e d u c e s a n
objective, and a benef it is anything that
contributes to an objective (Gittinger
1982).
 Most often, the maximization of income is
taken as the dominant objective of the
f ir m because the single most important
objective of an individual economic agent
is to in creas e in come an d in creas ed
national income is the most important
objective of national economic policy.

16
Quantification:
 Once the costs and benefits are enumerated
the next step is accurate prediction of the
future benef its and costs that then will be
quantified in Birr and Cents.
 Thus, quantification involves assessment of
both physical quantities and prices over the
life span of the project.
 T h e f in a n c i a l a n a l y s i s o f pr o jec t s i s
typically based on accurate prediction of
market prices, on top of quantity prediction.

17
 It is worth thinking about the impact of
project itself on the level of prices; and the
independent movement of prices due to
other factors.
 For instance, the emergence of the project
may contribute to the rise of price for the
inputs (supplies) it requires and to the fail
of output (product) price it produces.
 Equally, the project may also result in
lower demand and prices for competing
products or services or higher demand
and prices for complementary
ones(Squire and Talk 1975).
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How to value project costs and benef it s in f inancial
analysis?
 The f in ancial benef it s of a project are just the
revenues rec eived and t he f in anc ial c ost s are
expendit ures t hat are act ually incurred by t he
implementing agency as a result of the project.
 Costs= expenditures made to establish and operate
the project. These include:
 C a p it a l C o st s ( t he c o st o f p ur c ha sing la nd ,
equipment, factory buildings, vehicles and of fic e
machines),
 Working capital and Operating Costs (for labour, raw
material, fuel, and utilities).
 Benefits= if the project is producing some goods and
services for sale, t he revenue t hat t he project
implementer expects from these sales will be the
benefits of the project.
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 In f in ancial analysis all these receipts
(benef its) and expenditures (costs) are
valued as they appear in the f in ancial
balance sheet of the project, and are
therefore, measured in market prices.
 Market prices are just the prices in the
local economy, and include all applicable
taxes, tariffs, trade mark-ups and
commissions.

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2.4 Classif ic ation: Tangible and Intangible
costs and benefits of a project
2.4.1 Tangible costs of a project
 In general, the tangible cost of a project
c ou l d be grou ped i n to th e c os t of a
project and the cos t of production
(Chandra 2002).
 These costs are sometimes termed as
direct costs/explicit costs/ financial costs
that occur ‘out of pocket’.

21
A. Cost of a project
The cost of a project (in Chandra 2002) is the

♦ sum of the total outlays on the following items:

Land and site development- this component
comprises of basic cost of land and costs
incurred for preparing the land for use. It
includes payment for land charges, for lease,
levelling and development, internal roads, gates

♦ and tube wells.

Building and civil works- These costs cover
expenses o n ma in building a nd a uxilia r y
buildings. Auxiliary buildings include laboratory,
workshop, warehouse, garage, canteen, staff
residence quarters, guesthouses and so on.

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♦ Plant and machinery- the most
signif ic ant component of project cost is
the cost of plant and machinery. These
cos ts include the cos t of impor ted
machinery, cost of indigenous machinery,
cos t of s pare par t, foundation and

♦
installation charge.
Technical know-how and Engineering
F e e s - Te c h n i c a l c o n s u l t a n t s a n d
engineers may be employed for assisting
in technical matters such as preparing
project report, choice of technology, detail
engineering and selection of plant and
machinery. The fees paid to them are part
of the project cost.
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♦ Pre-operative Expenses- these are expenses
incurred for identifying the project,
conducting the market survey, preparing the
fe asib ilit y st u d y an d in c orp orat in g t h e
c o m p a n y. T h e c a t e g o r y i n c l u d e s
establishment expenses, rents, taxes, interest
and commitment charges on borrowings,
in su ran ce ch arges, mor tgage expan ses

♦
interest and other miscellaneous expenses.
Provision for contingencies- It may range
from 10 to 20% of total project cost. It aims at
providing for certain unforeseen expenditures
an d price in creases over an d above th e
n o r mal in f lat io n rat e , w h ic h is alre ad y
incorporated in the cost estimates.

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B. The cost of production: categorized in

♦ four groups
Cost of materials- comprises cost of row
materials, chemicals, and consumable
stores required for production. In practice,
it is done by using the base year cost of
materials as a result the usually have a

♦ fixed value.
Cost of labour- it is the costs associated
with all employed human resource. The
cost estimation should include basic pay,
all allowances, expected increments,
pension/provident fund and other fringe
benefits.
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♦Cost of Utilities- they consist of outlays

♦
for power, water, telephone and fuel.
Cost of factory overheads- This includes
all expenses associated with repair and
maintenance, rent, taxes, and insurance
premiu m on factor y as s et. Note th at
repairs and maintenance costs tend to be
lower in the initial years and higher in the
later years of production. Rent, taxes and
insurance premium may be calculated at
the existing rates.

26
2.4.2 Tangible benefits
 Tangible benef it s can arise either from
increased production or from reduced costs.
 So me eco no mi sts cal l them “benef it s
induced by the project” and they are more of
a c o n c er n f o r ec o n o m i c c o s t ben ef it
analysis.
 T he speci f ic f o r ms, i n whi ch ta ngi bl e
benef it s appear, however, are not always
obvious and valuing them might be difficult.

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 I n g e n e ral , tan g i b l e b e n e f its c an b e

♦
expected from:

♦
Increased production
Quality improvement as a result of the

♦
project
C h an g e s i n ti me of s al e : i mp rov e d

♦
marketing facilities (storage project)
Changes in location of sale: e.g.
transport projects which give locational
value.

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♦C h an ges i n produ c t for m (gradi n g,

♦
packaging and processing projects)
Cost reduction through technological

♦
advancement
Reduced transport costs through better

♦
feeder roads and highways
Losses avoided

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2.4.3 Intangible costs and benefits
 There may be some costs and benef its
that are intangible.
 This may include:
T h e c r e a t i o n o f n e w e m p l o y m e n t
opportunities;
 Better health and reduced infant mortality
as a result of more rural clinics;
 Better nutrition as a result of agricultural
project and so on.

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 T hese intangible benef it s are real and
reflect true value.
 Such intangible benef its, however, do not
readily lend themselves to valuation.
 Under such circumstances one may have to
resort to least cost approach instead of
normal benefit cost analysis.
 T he “l east cost combi nati on” or “cost
effectiveness” approach compares projects
by considering intangible costs and benefits.

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 For example, the benef its of education
have been valued by comparing earnings
of educated man with uneducated.
 Finally, the least cost approach asks, for
example, can the same health benef its be
provided at less cost by constructing
fewer large hospitals instead of more
clinics manned by paramedical personnel?
(Gittinger 1982).

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 2.5 Financial Appraisal Criteria of Projects and
Selection of Investments
• The three basic steps in determining whether a project
is worthwhile or not are:
A) Estimate project cash flows;
B) Establish the cost of capital; and
C) Apply a suitable decision or appraisal rule or
criterion.
• This section deals with the third step.
• It is to be reminded that the theme of project
planning/study is to determine whether an investment
is feasible or not.
• costs and benefits have been identified, priced and
valued, the project analyst should work out to
determine on which project (s) to invest. To this effect,
the project analyst should have ways and
means/methods, tools, approaches/ to select more
profitable from less profitable or unprofitable projects
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1) Non-discounting criteria, including:
• Ranking by inspection
• Urgency;
• Payback period;
• Proceeds per unit of outlay
• Out-put- capital ratio
2) Discounting criteria, including:
• Net present value/NPV/
• Internal rate of return/IRR/
• Net benefit investment ratio /NBIR/
• Domestic resource cost ratio/DRCR/
• Benefit-cost ratio/BCR
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2.5.1. Non-Discounted Measures of Project Worth
• It should be noted that there might be no one best
technique for estimating project worth although some
may be better than others. We should also note that
these are only tools to improve decision-making.
1) Ranking by Inspection
A) Two investments have identical cash flows each year
up to the final year of the short-lived investment, but
one continues to earn cash proceed (financial results
or profits) in subsequent years. The investment with
the longer life would be more desirable
B) Two investments have the same initial out lay (the
total net value of incremental production may be the
same), the same earning life and earn the same total
proceeds (profits) but one project has more of the
flow earlier in the time sequence, we choose the one
for which the total proceeds is greater than the total
proceeds for the other investment earlier.
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2) Urgency
• According to this criterion projects which are
deemed to be more urgent get priority over
projects which are regarded as less urgent. The
problem with this criterion is: how can the
degree of urgency be determined? In certain
situations it may not be practically difficult to
determine the urgency of a certain project
proposal.
• Since it is not a systematic decision, this is not
something that can be encouraged. Rather it is
a practice that should be discouraged.

36
3) The Payback Period
• The payback period also called the payoff period
is one of the simplest and apparently one of the
most frequently used methods of measuring the
economic value of an investment.
• The payback period is defined as the length of
time required for the stream of cash proceeds
produced by the investment (project) to be equal
to the original cash outlay required by the
investment (capital investment).
• Example: if a project requires an original outlay
of Birr 300 and is expected to produce a stream
of cash proceeds of Birr 100 per year for 5 years,
the payback period would be 300/100 = 3 years.

37
• Thus it has two important limitations:
 It fails to give any considerations to cash proceeds earned after
the payback date. It simply emphasizes quick financial returns,
ignoring the performance of the project over its economic life.
 It fails to take into account differences in the timing of receipts
and earned proceeds prior to the payback date. For instance, if
we have two projects with the same capital cost and if they have
the same payback period then they are equally ranked. Yet we
know by the inspection method the project with earlier benefits
should be desirable and should be preferred since the earlier
benefit is received the earlier it can be reinvested or consumed.
4) Proceeds per Unit of Outlay
Under this method, investments are ranked according to their total
proceeds divided by the amount of the corresponding investments.
In other words the total net value of incremental production divided
by the total amount of the investment gives us the proceeds per
unit of outlay.

38
5) Output - Capital Ratio
• It is defined as the average (undiscounted) value
added produced per unit of capital expenditure.
• Under this criterion we select the project with the
highest output capital ratio or the lowest capital
output ratio (capital coefficient).
• The main problem with this approach is that it
ignores other factors of production such as labor
and land and concentrates only on the
productivity of capital.
• Further it does not consider the timely spread of
costs and proceeds.
• Output - Capital Ratio= Average Annual
Proceeds/ Original Outlay

39
2.5.2. Discounted Project Appraisal Criteria
• The undiscounted measures discussed so
far share common Weakness. They fail to
take into account adequately the timing of
benefits.
• A time dimension should be included in
our evaluation. That means we need to
express costs and benefits in terms of
value by discounting all items in the cash
flows back to year 0.

40
• Suppose one is offered the choice between
receiving birr 100 today and receiving the same
amount in a year's time. It will be rational to prefer to
receive the money today for several reasons.
a) One may expect inflation to reduce the real value of
birr 100 in a year's time
b) If there were no inflationary effect, it would still be
preferable to take the money today and invest it at
some rate of interest, r, hence receiving a total of
birr 100 (1+r) at the end of the year.
c) Even if no investment opportunities are available,
one might reason that birr 100 today would still be
preferable on the grounds that there is a finite risk
to collect the money next year.
d) Even where inflation, investment opportunities and
risk are ignored, there is pure time preference,
which would lead one to prefer the immediate offer.

41
• Discounting is a technique or a process by which one
can reduce future benefits and costs to their present
worth or present value.
• Any costs and benefits of a project that are received in
future periods are discounted, or deflated by some
factor, r, to reflect their lower value to the individual
(society) than currently available income. It’s usually
expressed as a percentage.
• Note that in order to clearly understand the principles of
discounting it will be helpful to have a clear
understanding of the principle of compounding.
Compounding is the technique of calculating the future
worth (F) of a present amount (P) at the end of some
period T at a given interest rate.
• the amount accumulated after t periods would be
A= P(1+r)t
• if we want to know the present value of this amount we
would be taking about discounting
P=A(1+r) -t
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A) The Net Present Value (NPV)
• The most widely used and straightforward
discounted measure of project worth is the net
present value (NPV).
• The NPV is defined as the difference between
the present value of benefits and the present
value of costs.
• The NPV can be obtained by discounting
separately for each year, the difference of all
cash outflows and inflows accruing throughout
the life of project at a fixed, pre-determined
interstate rate.

43
• The discounted rate should be equal either to the
actual rate of interest on long term loans in the capital
market or to the interest rate paid by the borrower.
• The discounting period should normally be equal to the
life of the project.
• Having set the discount rate, an investment project is
deemed acceptable if the discounted net benefits
(benefits minus costs) are positive.
• If two projects have positive NPV and there is no
budget constraint both should be accepted and you do
not need to choose the one with higher NPV.
• A mutually exclusive project is defined as a project of
that can only be implemented at the expense of an
alternative project as they are in some sense
substitutes for each other. The decision rule for such
projects is to accept the project with the highest NPV.

44
Advantages of NPV method
Conceptually sound, the net present value selection
criteria have considerable merits:
• It is simple to use and does not rely on complex
conventions about where costs and benefits are
netted out.
• It is the only selection criteria that can correctly be
used to choose between mutually exclusive projects,
without further manipulation
• It takes in to account the time value of money
• The net present value of various projects, measured
as they are in today's birr, can be added. For example,
the net present value of a package consisting of two
projects, A and B, will simply be the sum of the net
present value of this projects individually:

45
Limitations of the Net present value method
• Some projects could be deferred from implementation
although they show positive NPV, due to scarcity of funds.
Thus passing the NPV test may be a necessary condition but
not a sufficient condition
• If some projects were mutually exclusive then the
implementation of one would naturally exclude the execution
of the other. This will lead both the central authorities and the
sponsoring agency in to a dilemma which project should be
implemented. If funds are unlimited then both could be
implemented, but this is not always the case
• The selection of an appropriate discount rate is another
limitation
• It does not show the exact profitability rate of the project.
• For some projects the required information/data/ for
computing the NPV may not be available, or cheaply
accessible.
• It assumes the same class (type and degree) of risk for both
the costs and revenue sides of the cash flow of a project.
• When it is used to select among projects, it implicitly assumes
that all projects share common type and degree of risk
46
B) The Internal Rate of Return of a Project (IRR)
• The IRR of a project is probably the most
commonly used assessment criterion in project
appraisal. This is because the concept of an IRR
is in some way comparable to the long-term
profit rate of a project and is therefore easily
conceivable for non-economists. In fact, IRR is
defined as the “earning rate of a project”.
• The IRR is the rate of discount, which makes the
present value of the benefits exactly equal to the
present value of the costs. This is the interest
rate that a project could pay for the resources
used if the project is to recover its investment
and operating cost and still can be at the break-
even point.

47
Calculation of IRR
• The calculation procedure begins with the preparation of a cash
flow table. Estimated discount rate is then used to discount the
net cash flow to the present value. If the NPV is positive a higher
rate is applied. If it is negative at this higher rate the IRR must be
between those two rates. By iterations it is possible to determine
the discount rate that just makes the project’s NPV equal to zero.
This rate is the IRR of the project. Page 34
• According to the IRR Version of economic criterion we implement
all projects that show an IRR greater than the predetermined
discount rate (opportunity cost of capital), i.e. accept all
independent projects having an IRR greater than the opportunity
cost of capital (cut off rate). The reference discount rate, which is
also called the target rate, is predetermined by the central bank.
Once the IRR is identified, the decision rule is accept the project
if the IRR is greater than the cost of capital, say r.

48
C) The Net Benefit Investment Ratio (NBIR)
• It is the ratio of the present value of the projects benefits,
net of operating costs, to the present value of its
investment costs. This is given by,

• Where OC is operating costs in period t; IC is investment

costs in period t; r the appropriate discount rate, and B the
benefits in period t.
• The decision rule using NBIR is to accept the project if its
value is greater than 1. This criterion is especially
important for ranking investments that shows the benefit
per unit of investment. When we have a single period
budget constraint projects with the highest NBIR should
be selected up to the point where the budget exhausted.

49
D) The Domestic Resource Cost Ratio (DRCR)
• DRC is a measure of the economic efficiency of production of a commodity
or in other words the national comparative advantage in its production.
• It is defined as the value of domestic resources (primary, non-traded factors
of production) in domestic currency units required to earn or save a unit of
foreign exchange that is the cost per unit of foreign exchange saved for
imported competing goods and the cost per unit of foreign exchange earned
for exports.
• The DRC coefficient is a cost benefit ratio and it is essentially a measure of
the efficiency of domestic production relative to the international market.
• DRC < 1 implies that the productivity is economically profitable because its
production yields more than enough international value added to
compensate for the cost of domestic factors used.
• DRC = 1 implies a break-even situation, where it is only just economically
worthwhile to produce the commodity.
• DRC > 1 indicates that the cost of domestic resources needed to generate
one unit of foreign exchange exceeds the value of the foreign exchange.
This means the country is internally not competitive in the production of the
commodity or the country is better off to import rather than to produce the
commodity.

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• The main advantage of this approach is that non-
economists can readily understand its decision rule.
More substantially in economics with serious
balance of payment problem the DRCR clearly show
the potential of a project to earn foreign exchange.
• However, its disadvantages includes, like that of IRR
it cannot be used to rank projects. It cannot also be
used to choose between mutually exclusive projects
if both use less domestic resource to earn a unit of
foreign exchange. This is because it does not show
which of the two, or more, mutually exclusive
projects will generate the greatest net benefits for
the country.

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E) The Benefit Cost Ratio (BCR)
The benefit cost ratio is the earliest discounted project
assessment criterion to be employed. The BCR is defined as the
ratio of the sum of the project’s discounted benefits to the sum of
its discounted investment and operating costs. This is given as

• A project should be accepted if its BCR is greater than or equal

to 1
• One possible advantage of the BCR, on top of being easy to
show to non-economists is that it is easy to show the impact
of a percentage change in cost or benefits on the projects
viability.
• Its major disadvantage is the need to specify and adhere to
conventions regarding the designation of expenditures as
costs and benefits.

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