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CHAPTER 7 Financial Analysis Abbbb
CHAPTER 7 Financial Analysis Abbbb
Financial Analysis of
Project
5.1. Financial analysis basic
• P Retained profit
• Q Net cash accrual (P + I + L)
6.Estimates of working results
• P Retained profit
• Q Net cash accrual (P + I + L)
7.Break-even point
Financing Investment
Financing Investment
Financing Investment
project cash flow cashflow for firm with cashflow for firm without
for year t project for year t project for year t
C. Post-tax principle
0
1 2 3 4 5 6 7 8
150,000
1
PV FV t
(1 r )
• Where,
• r is the The value in the
discounted rate bracket is called
expressed as a discounted factor
fraction or (DF) for each year.
percentage and
• t is year
5.4. Discounted cash flow approaches
• The discount rate is a rate that
– reflects the opportunity cost of capital.
• It is the rate at which streams of expected costs and
benefits are discounted in estimating NPV and IRR.
• It is a national parameter that should be determined by
central authority of a government by considering
several conditions such as
– international borrowing,
– returns to past projects
– Commercial bank interest rates and
• The recently published National Economic Parameters
and Conversion Factors for Ethiopia indicate that the
discount rate is 10%.
5.4. Discounted cash flow approaches
Discounting measures of project worth or
investment assessment criteria
• The Net Present Value (NPV) and Internal
rate of Return (IRR)for a project can be
calculated from the net benefits of the
projects by applying the appropriate
discounted factors at the predetermined
discount rate (r).
5.4. Discounted cash flow approaches
• There are four distinct but inter-related
measures of project worth based on
discounted cost and benefit streams.
• These are:
A. Net Present Value (NPV)
B.Internal Rate of Return (IRR)
C.The Benefit Cost (B/C) Ratio
D. The net benefit to investment/cost ratio
(NBCR)
A. Net Present Value (NPV)
• The NPV is defined as the difference
between the present values of the future
benefits and costs.
• It is the simplest of all the four methods
• It is essentially a measure of the present
value of aggregate surplus generated by the
project over its expected operating life.
A. Net Present Value (NPV)
• It is calculated by subtracting the present values of
costs (PVC) from the present values of benefits
(PVB).
– Total cost is the sum of
• investment costs
• incremental working capital (incremental
stocks plus net incremental receivables,
account receivable less account payable), and
• operating cost.
– Note also that incremental stocks and net
incremental receivable figure are the difference in
values between the total stocks and net
receivables in certain year minus total stocks and
net receivables in the preceding year.
A. Net Present Value (NPV)
• This implies that NPV represents the net benefit over
and above the compensation for time and risk.
• This involves two steps of calculations as expressed
by the formula.
Where,
•n is the life of the project.
•PVC-present values of costs
n n •PVB -present values of
NPV PVB PVC benefits
t 1 t 1
•Ct-total cost
--… (5.8a) Or
n n
Bt Ct
NPV •Bt –Total benefit
(1 r ) t t 1 (1 r ) t
•r- discount rate
t 1 ------- (5.8b)
A. Net Present Value (NPV)
• Let us use this formula to calculate the NPV for the
hypothetical XYZ project we considered earlier to
show how cash flows are determined.
• Table 5.1: Cost and benefit streams discounted at
10% separately (Method 1)(all figures in million)
Yea 1.Tota 2.Discoun 3.Present 4.Total 5.Discount 6.Present
r l cost t factor at value of Revenues/Be factor at value of
10% costs (1*2) nefits 10% Benefits (4*5)
1 140 0.9091 127.3 0.0 0.9091 0.0
2 65 0.8264 53.7 100 0.8264 82.6
3 95 0.7513 71.4 150 0.7513 112.7
4 95 0.6830 64.9 200 0.6830 136.6
5 75 0.6209 46.6 150 0.6209 93.1
6 55 0.5645 31.1 100 0.5645 56.5
PVC=395 PVB=481.5
A. Net Present Value (NPV)
• Table 5.1: Cost and benefit streams discounted at
10% separately (Method 1)(all figures in million)
( Bt Ct )
n
NPV ----- (5.9b)
t 1 (1 r ) t
A. Net Present Value (NPV)
• Table 5.2: Cost and benefit streams discounted at
10% (Method 2)(all figures in million)
n
( Bt Ct )
NPV
(1 r )
t
t 1 ----- (5.9b)
A. Net Present Value (NPV)
• If the information given is only cash flow like under
PBP instead of costs and benefits then the formula
for the NPV will be
n
CFt
NPV initial investment
t 1 (1 r ) t
Project X Project Y
Year Cash flow Discoun NPV Cash Discount NPV
t factor flow factor
0 (1,000,000) 0 (1,000,000 (1,000,00 0
) 0)
1 65,000 0.9091 59,091.5 35,000 0.9091 31,818.5
2 55,000 0.8264 45,452.0 45,000 0.8264 37,188.0
3 45,000 0.7513 33,808.5 55,000 0.7513 41,321.5
4 35,000 0.6830 23,905.0 65,000 0.6830 44395.0
-837,743.0 -845,277.0
n
CFt
NPV initial investment
t 1 (1 r ) t
A. Net Present Value (NPV)
• Other things being equal,
– the project’s NPV increases with
• larger benefits and number of years
– but project’s NPV decreases with
• a higher discount rate and higher costs.
A. Net Present Value (NPV)
Decision Rule:
a. Accept the project if the NPV is positive.
b.If the NPV is zero, is a marginal case and hence
the decision may need to be informed by
other criteria particularly for public sector
projects. NPV equal to zero means the project
will return the capital utilized, but it will not
generate any surplus.
c.Reject the project if the NPV is less than
zero or negative because the project will not
recover its cost at the specified rate of discount.
B.Internal Rate of Return (IRR)
• IRR is defined as the rate o discount that reduces the
net present value of a project to zero.
• In calculating the IRR, the discount rate is adjusted
until the NPV becomes zero or at least as close to zero
as possible.
• Thus the rate is derived by trial and error or
interpolation.
– The interpolation is could be done arithmetically
using two discount rates,
• one which gives a positive NPV and
• the other which gives a negative NPV.
• IRR is expressed by the following formula.
NPV1
IRR r1 (r2 r1 ) * ------ (5.11)
NPV1 NPV2
C.The Benefit Cost (B/C) Ratio
• The benefit-cost ratio is defined as the ratio of the
discounted values of benefits to the discounted
value of costs.
• A ratio of least one is required for acceptability and
a B/c ratio of one indicates that the NPV of zero at a
particular discount rate.
• The formula for B/C ratio is expressed as
PVB
B/C
Ratio
PVC
5.5. Project financing alternatives
Thank you
Assignment