CHAPTER FIVE

Financial Analysis of Project

 Financial Appraisal

 Projects can be appraised from the view point of their beneficiaries

or losers (financial analysis) or from the viewpoint of the entire
society (economic analysis).
 Financial analysis answers the question “is the project
financially profitable to a given individual, group or business?
 In financial analysis costs and benefits are valued at market prices.
 Economic analysis answers the question- “is the project
profitable to the society or to a target population as a whole?
what is its impact (in terms of job creation and linkages with
the other sectors) on the whole economy?
 In economic analysis costs and benefits are valued at shadow prices
 Financial Analysis

 Financial analysis consists determination of the following:

1. Cost of project

2. Means-off financing

3. Estimates of sales and production

4. Cost of production

5. Working capital requirement and its financing

6. Breakeven point

7. Projected cash flow statements

Project Appraisal methods

 When costs and benefits have been identified,

quantified and priced (valued), the analyst is trying to
determine which among various projects to accept,
which to reject.
Methods of analysis

(A) Traditional methods (or Non-discount methods)

 Payback Period
 The Accounting Rate of Return
(B) Modern methods (or Discount methods)
 Discounted Payback Period
 Net Present Value
 Profitability Index
 Internal Rate of Return
 Modified Internal Rate of Return
 Traditional methods (or Non-discount methods)
1-6

A) Pay-back Period: Pay-back period is the time required

to recover the initial investment in a project.
 Pay-back period with uniform cash flow:

= Initial investment
Annual cash inflows
 Payback period with uneven Cash Inflows:

 Normally the projects are not having uniform cash inflows.

 In those cases, the pay-back period is calculated by cumulating cash
inflows up to the initial investment level.

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Exercise 1
 Project cost is br. 30,000 and the cash inflows are br. 10,000 per year,

the life of the project is 5 years. Calculate the pay-back period.

 Solution = 30,000 = 3 Years

10,000
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Exercise 2
 Certain project requires an initial cash outflow of br. 25,000. The cash

inflows for 6 years are:

br. 5,000, 8,000, 10,000, 12,000, 7,000 and 3,000.

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Year Cash inflows(br) Cumulative cash inflows (br)

1 5,000 5,000
2 8,000 13,000
3 10,000 23,000
4 12,000 35,000
5 7,000 42,000
6 3,000 45,000
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 The above calculation shows that in 3 years br. 23,000 has been
recovered; br. 2,000, is balance out of cash outflow.
 In the 4th year the cash inflow is br. 12,000. It means the pay-back
period is three to four years, calculated as follows:

 Pay-back period = 3 years+2000/12000×12 months

= 3 years and 2 months.
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 Accept /Reject criteria:

 If the actual pay-back period is less than the predetermined

pay-back period, then the project would be accepted.

 If not, it would be rejected
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B) Accounting Rate of Return(ARR)

 Is also known as return on investment;
 Uses accounting information from financial statements to

measure profitability;
 Is found by dividing the average after –tax return by

average investment.
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ARR on investment = (average Net profit of the project) /

(initial investment or average investment) * 100%
 Example: a project will cost br. 40,000. Its stream of

earnings before depreciation, interest and taxes for 5 years

is expected to be br.10,000, 12,000, 14,000, 16,000 and
20,000. Assume a 50% tax rate and depreciation on
straight line basis, compute the ARR for the project.

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 Thus, ARR = 3,200*100 %= 16%

20,000
 Accept/reject criteria: if the project’s ARR is greater than

the ARR set by mgt., then accept the project, otherwise,

reject it. Project having greater ARR will be ranked 1st.
 (B) Modern methods (Discount methods)
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A) Discounted payback method:

 One of the serious shortcomings of payback period

was its inability to discount the cash flows.

 The number of periods taken in recovering the

investment outlay on the basis of present value is
called discounted payback period.
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 Example: Certain project requires an initial cash outflow of br. 25,000.

The firm cost of capital is 10 %. The cash inflows for 6 years are:
br. 5,000, 8,000, 10,000, 12,000, 7,000 and 3,000.
Year Cash Discounted cash Cumulative discounted
inflows(br) inflows cash inflows
1 5,000 4,545.46 4,545.46
2 8,000 6,611.57 11,157.03
3 10,000 7,513.15 18,670.18
4 12,000 8196.16 26,866.34
5 7,000 4346.45 31,212.79
6 3,000 1,693.42 32,906.21
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3 years + 6329.82/8196.16 = 3.77 years

Decision of discount of payback period or Accept/Reject criteria
If the payback period is less than the maximum acceptable discount
payback period, accept the project; if the discount payback period is
greater than the maximum acceptable payback period, reject the project.
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B) Net Present Value (NPV)

 The method is one of the modern methods for evaluating

capital projects.
 In this method, cash flows are considered with the time

value of money.
 NPV describes as the difference b/n the present value of

cash inflow and present value of cash outflow.

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The formula for computation of NPV is given below:

Where, CFt is the expected net cash flow at period t,

K is the project’s RRR or the firm’s cost of capital,
Io is initial outlay cost, and
n is the project’s life.
Since NPV can be positive, zero, or negative, attention must be paid to
its algebraic sign.
Decision criteria: if NPV is positive, accept the project; if NPV is
negative reject the project.
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Example 1
 From the following information, calculate the net present value of the

two projects and suggest which of the two projects should be

accepted. Cost of capital is 10%. The profits before depreciation and
after taxation (cash inflows) are as follows:

Initial Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Scrap
investment value

Project 20,000 5,000 10,000 10,000 3,000 2,000 1,000

X 30,000 20,000 10,000 5,000 3,000 2,000 2,000
Project
Y
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 Solution:
year Cash inflows PV of br. 1 PV of cash inflows
@10%

Project X Project Pro. X Pro. Y

1 (br.) Y(br.) 0.909 4,545 18,180
2 5,000 20,000 0.826 8,260 8,260
3 10,000 10,000 0.751 7,510 3,755
4 10,000 5,000 0.683 2,049 2,049
5 3,000 3,000 0.621 1,242 1,242
Scrap 2,000 2,000 0.621 621 1,242
1,000 2,000
Total PV 24,227 34,728
Initial investment 20,000 30,000

NPV 4,227
04/16/2024 4,728
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 Project Y should be selected as its NPV is greater than

that of project X if the projects are mutually exclusive. If
the projects are independent, both are acceptable as NPV
of both projects are positive.

Note: if cash out flows occur at any time over the course of
the project implementation period, it should also be
discounted and added to initial investment to calculate
NPV.
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C) Profitability Index(PI)
 Another method that involves time value of money;

 It is the ratio of benefits to costs or

 the ratio of present value of cash inflows to the

initial investment.
 Thus, PI = Present value of cash inflow

Initial cash outflows

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Example: The initial cash outlay of a project is 100,000 br and it can generate
cash inflow of 40,000 br, 30,000 br, 50,000 br, and 20,000 br in year 1 through
4. Assume a 10% discount rate. Determine the profitability index of the project.
 PV = 40,000 + 30,000+ 50,000 + 20,000
(1+.1) (1+.1)2 (1+.1)3 (1+.1)4
=
112,350br
 Hence, PI = 112,350 =1.1235

100,000
Acceptance criteria:
 Accept the project if PI>1

 Reject the project if PI<1

 PI>1 means NPV is positive; and PI<1 means NPV is negative.

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D) Internal Rate of Return (IRR)

 Is another discounted cash flow method;
 It provides a single number summarizing the merits of a project;
 It does not depend on the rate prevailing on the capital market;
 It is based on the cash flows of a project;

 Is the rate that equates the NPV of a project to zero.

 Is the breakeven rate where there is no creation and destruction of value
to the firm.
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Decision criteria:
 Accept the project if the IRR is greater than cost of capital (market
rate); reject the project if IRR is less than cost of capital.

Example: a project costs 16,000 br. and is expected to generate cash

inflows of 8,000 br, 7,000 br, and 6,000 br at the end of each of the next
three yrs. Calculate the internal rate of return for the project.
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 Solution: it is obtained through trail and error.

 Let us begin with16%:

 Initial investment………………….…………16,000br

 PV = 8000 + 7,000 + 6,000 = 15,943br

(1 + 0.16) (1+0.16)2 (1+0.16)3
NPV ……………….……………………...….. -57br
 At 16% NPV is not zero, it is –ve (-57).
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 Let us look at 15% as PV and discounting rate are inversely related.

 Initial investment……………………………….16,000

 PV = 8000 + 7,000 + 6,000 = 16,195

(1+0.15) (1+0.15)2 (1+0.15)3
NPV......................................................... = 195br
Therefore, the true rate lies b/n 16% and 15%.
Hence, the true rate can be found by linear interpolation as follows:

LR +(HR – LR) × PV at LR –PV required

PV at LR- PV HR
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LR + (HR – LR)×PV at LR – PV required

PV at LR- PV HR
 LR – lower rate; HR – higher rate; PV present value

 Thus, IRR = 15%+(16%-15%) ×16,195- 16,000

16,195 – 15,943
= 15%+1%(195/252) = 15.77%.
Alternatively:
 Let us find range between -57 and 195 = 254:

 Thus, IRR = 16%- 57/254 or 15% + 195/254 = 15.77%

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 Therefore, IRR for this project is 15.77%. Using this rate as a

discounting rate, you will arrive at zero NPV.

 If the cost of capital is 15%, this project is acceptable as it adds value

to owners by the amount of IRR minus cost of capital
End of the
Chapter!