Financial Aspects of

Project Analysis
References:
1.  J. Price Gittinger, (1982), “Economic Analysis of Agricultural
Projects,” 2nd Edition, Economic Development Institute of the World
Bank, John Hopkins University Press, Baltimore and London.
2.  “A Guide to Project Analysis,” Economic Development Institute of
the World Bank (1992)
Major Tasks
Ø  Identify and value the costs and benefits
Ø  Prepare the required financial statements
Ø  Conduct financial analysis
Financial Costs and Benefits
Ø  A cost is anything that directly reduces an objective of a
project, while a benefit is anything that contributes to it.
Ø  In financial analysis, costs and benefits are normally
valued using current market prices – the price actually
paid for a good or service.
Ø  Costs may include physical goods, labor, land,
contingency allowances, taxes, debt service.
Ø  Benefits may include increased production or quality
improvement. Change in time of sale, location value or
product form. Savings due to reduced in production
costs, transport costs, or losses.
Financial Statements
Ø  Income Statement – summarizes the revenues,
expenses, and profits of an enterprise during an
accounting period.
Ø  Funds Flow Statement – highlights the management of
cash by measuring the in flow-out flow of financial
resources during an accounting period.
Ø  Balance Sheet – shows what the enterprise owns
(assets), what it owes (liabilities), and thus, its net worth
(owner’s equity) at a single moment, rather than over a
period.
 Income Statement
Revenue (e.g., sales)
Less:
Cash operating expenses (e.g., fixed, variable costs)
Selling, general, and admin expenses (e.g., training, research)

Funds from operation

Less:
Noncash operating expenses (e.g., depreciation)

Operating Income
Less: Nonoperating income and expenses (e.g., interests)
Income before taxes
Less: Income taxes

Net income after taxes

 Cash Flow Statement
Funds from operation
Increase in equity
Long-term loans received
Increase (decrease) in short-term loans
Interest received
Increase (decrease) accounts payable
Total sources
Increase (decrease) in fixed assets
Debt service (STL/LTL)
Increase (decrease) in inventories
Increase (decrease) in accounts receivable
Income taxes
Dividends
Total uses
Current Surplus
Opening cash balance
Cumulative surplus (deficit)
 Balance Sheet
Current Assets
Cash and bank balance
Accounts receivable
Inventories
Fixed Assets
Buildings & equipment
Less: Depreciation
Total Assets
Long term and Short-term Liabilities
Accounts payable
Short-term/Long-term loans
Total Liabilities
Equity
Share capital
Retained Earnings
Total Equity
Financial Analysis
Ø  The objectives of financial analysis is to:
•  Judge efficient resource use (overall return of the project;
debt repayment)
•  Assess incentives for participants (sufficiency of returns to
investment)
•  Provide a sound financial plan (amount and timing of
investment and repayment of debt)
•  Coordinate financial contribution (availability of funds)
•  Assess financial management competence (required
management capability, structure, enhancement)
Financial Analysis
Ø  Perspective: project owner/investor/users
Ø  Costs and benefits are valued at market prices and net
revenue, respectively.
Financial Analysis
Ø  Types of financial analysis:
•  Financial Profitability Analysis
•  Funding Analysis
•  Cost Recovery Analysis
•  Financial Analysis of the Project Entity
Financial Profitability
Ø  Estimates the return on investment over the project’s
useful life.
Ø  Deals with the financial inflows and outflows of the
project from the point of view of the sponsor-entity.
Ø  It is relevant for either private or public revenue-earning
projects.
Financial Profitability
Ø  Financial profitability analysis consists of:
•  Defining the objectives of the analysis
•  Forecasting the demand for the project’s output – may
be constrained by data problems or uncertainty, in which
case, requires sensitivity analysis and regular data
updates.
•  Estimating the future streams of costs and benefits
based on market or administered prices
•  Measuring financial profitability by discounting financial
flows and then using appropriate measure of project
worth.
Measures of Project Worth
Ø  Net Present Value (NPV)
•  Shows the present value of benefits – present value of
costs
•  Formula:
T
NPV = Σ (Bt – Ct ) / (1+ i )t
•  Choice of 1discount rate may be equal the borrowing
rate, or the weighted average of both borrowed and
equity capital.
•  Projects with positive NPV may be accepted for
financing
Measures of Project Worth
Ø  Internal Rate of Return (IRR)
•  It is the maximum interest a project could pay and still
breakeven. Alternatively, it is the rate of discount at
which benefits are equal to costs (NPV = 0).
•  Rule of thumb: IRR ≥ discount rate. But, acceptable
level of IRR varies across industries depending on the
opportunity cost and the level of risk involved.
•  There is no formula for finding the IRR; computing is
done by trial and error.
Measures of Project Worth
Ø  Benefit-Cost Ratio (BCR)
•  It is the ratio of discounted benefits to discounted costs
•  Formula:
BCR = Total Benefits (PV) / Total Costs (PV)
•  Rule of thumb: BCR ≥ 1
•  Can be used to show how much costs could rise without
making the project economically unattractive.
Measures of Project Worth
Ø  Interrelation of the three measures of worth: IRR =
discount rate → NPV = 0 → BCR = 1
Ø  Implication: a positive NPV discounted at opportunity
cost → IRR > “cut-off” rate → BCR > 1
Ø  Caveats: NPV while straightforward, assumes a perfect
market, which is not true in developing countries. Thus,
in these cases, the use of the IRR is preferred as it is
readily comparable to interest rates on loans that might
finance the project.
Funding Analysis
Ø  Predicts all the project’s financial needs for the purpose
of formulating a financial plan that will ensure availability
of funds.
Ø  The financial plan considers the sources of funds,
recurrent costs, affordability of project outputs and users
willingness-to-pay.
Ø  The plan is prepared using current prices, and shows
capital and operating expenditures, and revenues and
other sources of funds available to pay for investment
and other project purposes.
Cost Recovery Analysis
Ø  Shows if the costs of outputs can be recovered from
project users.
Ø  Consists of two parts: projection if revenues from current
user fees will be sufficient to cost recovery targets; and,
if insufficient, an assessment of the level and structure of
fees that will yield the required results.
Ø  Cost recovery functions as a means for effective
resource allocation and revenue generation, the latter for
project continuity, self-sufficiency, and to attract private
sector investment.
Estimating User Fees
Ø  Estimate marginal cost (or average variable cost)
Ø  For partial cost recovery (subsidies) – costs may be
financed from general revenue. For full cost recovery –
may charge an “efficiency price” that would least distort
consumption patterns under marginal-cost charges.
•  Ramsay Pricing – inflates marginal cost rate in inverse
proportion to sensitivity of different users to price
increases.
•  Two Part Tariffs – directly reflects marginal costs and
takes the form of a fixed fee plus a fee-per-use.
Enterprise Financial Analysis
Ø  Looks at three things:
•  Sufficiency of revenue to earn reasonable return on all its
investment
•  Strength of capital structure to meet debt obligations
•  Level of liquidity to cover operational requirements when needed
Ø  Consists of preparing, analyzing and forecasting three
principal statements:
•  Income Statement
•  Funds Flow Statement
•  Balance Sheet
Financial Ratios
Ø  Liquidity and Creditworthiness Tests
•  Current ratio = Current assets / Current liabilities
•  Shows the margin an entity has to meet day-to-day obligations
•  Rule of thumb is 2:1
•  Quick ratio = (Cash + Receivables) / Current liabilities
•  Similar to the current ratio but includes cash only to repay debt
•  Rule of thumb is 1:1
•  Debt-to-equity ratio = Long term debt / Owner’s equity
•  Shows the extent to which equity cushions debt repayment against poor
financial performance
•  Rule of thumb differs across enterprise or industry
•  Debt service coverage = Annual income / Annual Debt service
•  Shows ability to repay debt from income
Financial Ratios
Ø  Efficiency Ratios
•  Days receivables = Total credit sales / Average sales per day
•  Shows the average number of days’ sale have not been paid
•  Reflects an entity’s financial mgt efficiency and credit policy
•  “old” accounts may in fact be uncollectible
•  Operating ratio = Operating expenses / Net sales
•  Shows the cost of sale, the trend of which reflects mgt efficiency
Financial Ratios
Ø  Profitability Ratios
•  Return on equity = Profit after taxes / (Share capital +
Retained earnings)
•  Shows whether enterprise owners made a good investment
•  Return on capital = (Net profit + Interest on long term debt) /
(Equity + Long term debt)
•  Tells whether owners and creditors made a good investment
Computing for NPV and BCR
Year Costs Discount Present Benefits Discount Present
Factor 12% Value 12% Factor 12% Value 12%

Capital Operation Production Total

1 1.09 0 0 1.09 0.89 0.97 0 0.89 0.00

2 4.83 0 0 4.83 0.80 3.85 0 0.80 0.00

3 5.68 0 0 5.68 0.71 4.04 0 0.71 0.00

4 4.5 0 0 4.5 0.64 2.86 0 0.64 0.00

5 1.99 0 0 1.99 0.57 1.13 0 0.57 0.00

6 0 0.34 0.33 0.67 0.51 0.34 1.67 0.51 0.85

7 0 0.34 0.63 0.97 0.45 0.44 3.34 0.45 1.51

8 0 0.34 0.96 1.3 0.40 0.53 5.00 0.40 2.02

9 0 0.34 1.28 1.62 0.36 0.58 6.68 0.36 2.41

10-30 0 7.14 33.81 40.95 2.73 5.32 175.98 2.73 22.85

Total 18.09 8.50 37.01 63.60 8.06 20.06 192.67 8.06 29.64

Net present value at 12% = P29.64 – P20.06 = P9.58

Benefit-cost ratio at 12% = P29.64 / P20.06 = P1.48
Estimating the IRR
Ø  Required:
•  Number of years net benefit is positive
•  Number of years net benefit is negative
•  Annual average of net benefit where stream is positive
•  Total net benefits where stream is negative
Ø  Divide average net benefit with total net benefit
Ø  Use result to compare with the (Schaefer-Kehnert) table
for the initial estimates of the (lower and upper) discount
rate (DR)
Ø  Solve for the NPVs of both the lower and upper DR
Estimating the IRR
Years Costs Benefits Net Benefit

1 1.09 0 -1.09

2 4.83 0 -4.83 Total ( - ) net benefit stream =

3 5.68 0 -5.68 18.09
4 4.50 0 -4.50

5 1.99 0 -1.99

6 0.67 1.67 1.00

7 0.97 3.34 2.37

8 1.30 5 3.70 Annual average ( + ) net

9 1.62 6.68 5.06
benefit stream
10-30 40.95 175.98 135.03

Total 63.60 192.67 129.07

147.16 ÷ 25 = 5.89

5.89 ÷ 18.09 = 0.33

Estimating the IRR
# of yrs net benefit # of yrs net benefit
0.1 0.2 0.3 0.4 0.5
stream is negative stream is positive

5 - 0 12 22 30
1 10 0 12 21 28 34
20 7 16 23 28 34
5 - 0 19 19 25
2 10 0 11 18 24 29
20 6 14 20 25 29
5 - 0 9 15 21
3 10 0 10 16 21 26
20 6 13 18 23 26
5 - 0 7 13 18
4 10 0 9 15 19 23
20 6 12 17 21 24
5 - 0 7 12 16
5 10 0 8 13 17 21
20 5 12 16 19 22
Estimating the IRR
Discount Factor Discount Factor
Years Costs Benefits Net Benefit 16% Present Worth 16% 20% Present Worth 20%

1 1.09 0 -1.09 0.86 -0.94 0.83 -0.91

2 4.83 0 -4.83 0.74 -3.59 0.69 -3.35

3 5.68 0 -5.68 0.64 -3.64 0.58 -3.29

4 4.50 0 -4.50 0.55 -2.49 0.48 -2.17

5 1.99 0 -1.99 0.48 -0.95 0.40 -0.80

6 0.67 1.67 1.00 0.41 0.41 0.33 0.33

7 0.97 3.34 2.37 0.35 0.84 0.28 0.66

8 1.30 5 3.70 0.31 1.13 0.23 0.86

9 1.62 6.68 5.06 0.26 1.33 0.19 0.98

10-30 40.95 175.98 135.03 1.57 10.10 0.95 6.10

Total 63.60 192.67 129.07 6.18 2.21 4.98 -1.58

Estimating the IRR
Ø  Interpolate (range ≤ 5):

IRR = LDR + (UDR–LDR) [ NPVLDR / (NPVLDR+NPVUDR)]

e.g., LDR = 16%; UDR = 20%

NPV at 16% = 2.21; NPV at 20% = - 1.58

IRR = 16 + (20 – 16) [ 2.21 / (2.21 + 1.58) ]

= 16 + 4 [ 2.21 / 3.79 ]
= 16 + 4 ( 0.58 )
= 18.32 ≈ 18 percent
 Financial Profitability Cost Recovery Enterprise Financial
Characteristics Funding Analysis
Analysis Analysis Analysis

Purpose To determine To plan the To estimate cost To determine

investment availability of funds recovery thru user financial and mgt
profitability needed fees soundness

Perspective Project Gov’t, Project, Gov’t, Project, Project enterprise

Users, Beneficiaries Users, Beneficiaries

Reporting System Discounted cash Financial plan Cost recovery rates; Income statement,
flow user fees or taxes Funds flow, Balance
sheet

Criteria IRR, NPV, BCR Debt service Structure and Level Financial ratios
coverage of fees

Applicability Private and public All projects Public service- Firms and public
revenue-earning specific project enterprise
project
Dealing with Risk and Uncertainty
Ø  Sensitivity Analysis
•  Helps analyst deal with risk and uncertainties by changing
one or a combination of assumptions and re-estimating the
project’s worth.
•  Indicates the critical areas of the project where special
attention should be made.
•  Disadvantages: limited because it cannot cope with all
possible circumstances; it does not specify the likelihood of
the occurrence.
 Farm Investment
Analysis: Small Farms
References:
1.  J. Price Gittinger, (1982), “Economic Analysis of Agricultural
Projects,” 2nd Edition, Economic Development Institute of the World
Bank, John Hopkins University Press, Baltimore and London.
2.  “A Guide to Project Analysis,” Economic Development Institute of
the World Bank (1992)
Farm Investment Analysis
Ø  Also known as “Benefit-cost Analysis of On-farm
Investments”
Ø  Involves arranging identified cost and benefit streams
into “pattern” accounts; and are always based on
market prices.
Ø  Pattern (model) farm budgets compare the situation with
the project to that anticipated without the project for the
duration of the project.
Ø  Enables formation of sound judgment about the benefits
of a specific agricultural practice to participants (i.e.,
farmers, public/private enterprises, and government
agencies).
Differences between Farm Investment Analysis and Farm
Management Analysis
Farm Income Farm Investment
Item Funds Flow Analysis
Analysis Analysis
Objective Current performance of Farmer’s liquidity Attractiveness of
farm additional investment
Period analyzed Individual years Loan payment period Useful life of
investment
Prices used Current prices Current prices Constant prices

Treatment of capital Annual depreciation Cash purchases and Initial investment,

charge sales residual value
Off-farm income Excluded Cash portion included Cash and non-cash
included
Home-consumed farm Included Excluded Included
production
Performance criteria Return on capital and Cash available to farm Return on additional
labor engaged family resources engaged
Time value Undiscounted Undiscounted Discounted

Performance indicators Profits as percentage of Cash surplus or deficit NPV, IRR, BCR, net
net worth, family benefit-investment
income ratio, net benefit
increase
Preparing the Farm Investment Analysis

Ø  Selection of model farm types (e.g., cropping pattern,

soil/water conditions, land holdings)
Ø  Assess attitude re: changes to cropping pattern, product
mix, work responsibilities, market risks.
Ø  Sources of information: professional colleagues, site
visits, farmers themselves.
Ø  Notes on accounting convention:
•  Reserving year 1 for investment only
•  Allocating incremental working capital at the end of the year
(usually a percentage of the projected incremental operating
expenditure of the preceding year)
 Elements of Farm Investment Analysis
Farm Resource Use
Land use
Labor use

Total cultivated area ÷ Total

cropland
 Elements of Farm Investment Analysis

Farm Production
Crops & pasture
Livestock
Valuation
Incremental residual value
 Elements of Farm Investment Analysis

TOE2 – TOE1 = IOE2

Farm Inputs
Investment
Operating expenditure
Incremental working capital

IOE2 x 0.9
 Elements of Farm Investment Analysis

Farm Budget
Without project
With project

Positive net benefit (PV)

÷ Negative net benefit
(PV)

[(Net benefit (PV) after

financing with project ÷
Net benefit (PV) without
project) – 1] x 100

What the farm will earn

without financing; Basis
for NPV, IRR, NBR;
Contribution to economy
as a whole

Family net benefit; Basis

for IRR, NBI
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