Ch: 6

Financial and Economic

Evaluation
 Introduction
• In the modern money oriented economy, finance is one of the basis
foundation of all kind of economic activities.
• Capital is necessary for an enterprise to keep it dynamic and covers money,
land,building,machinary,material etc.
• Develop products and keep workers and machines at work and it is
necessary for the firms progress and creating values.
• For the operation of any industry two types of capitals are requiered; one
for purchasing fixed assets like land, building, machinery etc.., and it is
known as fixed capital, while the other is required to meet day to day needs
and it is known as working capital. Fixed capital is associated with long
term assets and where as working capital is related to current operation.
 Total Investment Costs

 Investment costs are the sum of fixed capital

(fixed investments plus production capital costs)
and net working capital.

 Fixed capital constitutes the resource referred for

constructing and equipping an investment project
and working capital corresponding to the
resources needed to operate the project totally or
partially.
 Fixed Assets (Capital)
Fixed capital is invested in the plant, equipment, land, building etc. which
can’t be disposed of without breaking up the business

fixed assets (capital) comprise

 fixed investments and
 pre-production capital costs
i) Fixed Investments: include the following.
 Land and site preparation.
 Building and civil works.
 Plant machinery and equipment including auxiliary equipment.
 Certain incorporate fixed assets such as industrial property rights.
ii) Pre-production Capital Expenditure: These
include:
 Preliminary and capital issue expenditures.

 Consultant fees for preparing studies,

 Travel expenses

 Preparatory installations such as camps, temporary

offices, stores, etc.
 Training costs, including fees, travel and living
expenses; salaries and stipends of the trainees.
 Interest on loan during construction.
 Working Capital
 Working capital indicates the financial means required to operate the
project(to meet day to day needs )
 It is required for the purchese raw materials, meeting the day to day
expenses such as salaries,rent,sationary ,transportation,maintenace etc.
 It is defined as the current assets minus current liabilities

 Current assets comprise receivables, inventories (raw material, auxiliary

material, supplies packaging materials, spares and small tools), work in
progress, finished products and cash.
 Current liabilities consist mainly of accounts payable (creditors) and are free
of interest.
 Project Financing
 The financing of new projects continued to be a
problem, since corporate guarantees would usually be
required for loans to finance projects.
 Companies were therefore risking to the extent of
their total assets if a project failed.
 Development of project financing, therefore, emerged
from the need for companies to shield themselves
from such risks.
 This has led to non-recourse or limited option
financing.
 In this financing, creditors provide financing to a
project exclusively based on the merits of the project
itself, with limited or no option to the companies
sponsoring the project.
 The project implementation demands the
establishment of a separate project company by the
project sponsors.
 They also need to carefully analyze the financial
feasibility of projects, in the light of the risks
involved and their proposed distribution.
 Sources of Financing
 It is a normal trend that debt, equity and
mezzanine capital are obtained from
different sources.
 However, there are cases where a single
source provides more than one type of capital,
in which case separate departments may
handle the different types of capital
separately.

Mezzane=hybride of debt and equity

i) Equity Capital Providers: The main source of
equity capital for a project comes from the project
sponsors or other investors that have an active
interest in the project.
 This would include governments, contractors, equipment
suppliers, purchasers of output and entrepreneurs.
 Additional equity, if needed, would be sought from passive
sources, such as institutional investors and possibly the
general public through local or international capital markets.
 They are not normally involved in the promotion and
development or the management and operation of the projects
in which they invest.
 Their capital is used to top up the equity requirements of a
project that cannot be met by sponsors.
ii) Commercial Banks:
The most traditional source of debt financing
are commercial banks.
 To a lesser extent, they are also providers of
mezzanine capital.
 Their operations essentially revolve around the
creditworthiness of their borrowers and the security
of their loans.
 Much stress is put on prudential lending and actions
aimed at ensuring loan repayment.
Some of the considerations made by commercial banks
during the appraisal of a project are:
The level of commitment of the sponsors and other major
participants, in terms of investment and personnel
The completion and technical targets of the project’s budget, as
any slippage will have an adverse effect on the economic viability of
the project
The experience and capabilities of project management in
implementing this type of project
The degree of confidence in the project’s cost and revenue targets
will be determined by the reliability of the assumptions on which the
inputs supplies and demand projections are based
The strength of government support
iii) Export Credit Agencies:
Export credit agencies (ECA) are considered to
be an important source of long-term credit.
 As lenders, ECAs have the same concerns and requirements as
commercial banks and would also be signatories to the credit
agreement.
 However, ECAs are usually state-owned, and their primary objective
is the promotion of their country’s exports and the grants are
usually tied to the purchase of equipment from the ECA’s country.
 ECAs are usually substantially more generous than those of
commercial banks and highly suited to the financing of long-term
infrastructure projects.
iv) Bilateral and Multilateral Aid Agencies: Many
developing countries can also access debt, equity and
mezzanine financing from bilateral and multilateral
agencies, such as;
 United States Agency for International Development
(USAID),
 The Canadian International Development Agency
(CIDA),
 The Overseas Development Administration of the
United Kingdom (ODA),
 The World Bank,
 The Asian Development Bank (ADB) and
 The European Bank for Reconstruction and
Development (EBRD), etc.
v) Institutional investors: Institutional investors as a
source of debt, equity and mezzanine financing are
non-bank financial institutions such as insurance
companies, pension funds and investment funds.
 Institutional investors distinguish themselves
from commercial banks in that they mobilize long-
term contractual savings as opposed to short-
term deposits.
 By virtue of the long-term nature of the funds,
many institutional investors are able to provide
long-term debt, mezzanine and pure equity
financing.
 Institutional investors are therefore an important
source of long-term funds for large projects.
vi) National and Regional Development Banks
 Financial Structuring Techniques

 Establishing the appropriate mix of debt,

equity and mezzanine financing for a project,
which optimizes the use of financial resources
and ensures a sound financial structure for
the project is the challenge that financial
structuring faces.
 The security package for the project is
illustrated in figure
Security Package
 Financial Evaluation
 The study of a new enterprise, or the design of a new
plant, or the evaluation of two or more alternative
solutions always requires the consideration of
economic concepts.
 The decisions that are made each day in engineering
economy in industry, determine whether proposals
for investment in new plants and equipments should
be accepted or rejected.
 Interest formulas are developed for use in engineering
economy studies.
1. Non-DCF Methods: does not consider the time
value of money
 Payback Period

 Return on Investment

 Simple rate of return

 Return on Capital Employed (ROCE)

 Average Accounting rate of return

Payback Period
 The pay back period is defined as the length of
time required to recover one’s investment.
 The time period is usually expressed in years and
months.

Net investment
Pay back Period =
Net annual income from investment
Payback Period
 To calculate the pay back period, simply work out
how long it will take to recover the initial outlay.
However, this method fails to
 Give considerations to cash precedes earned after
the pay back period
 Take into account the difference in the timing of
proceeds earned prior to the pay back date.
 Cash flow of two alternative machines

Year 0 1 2 3 4
Machine A
Cash flow (Birr) -35,000 +20,000 +15,000 +10,000 +10,000
Machine B
Cash flow (Birr) -35,000 +10,000 +10,000 +15,000 +20,000

 Pay back period for machine A is two years where as

for machine B it is three years.
 That is machine A will recover its investment cost one
year sooner than machine B.
 Where project’s are ranked by the shortest pay back
period, machine A is selected in preference to
machine B.
The advantages of the payback method are:
It is simple and easy to use.
It uses readily available accounting data to determine
cash-flows.
It reduces the project's exposure to risk and
uncertainty by selecting the project that has the
shortest payback period.
Faster payback has a favorable short-term effect on
earnings per share.
Disadvantages of the Pay back Period:
It ignores the life of the project beyond the pay back
period.
It does not consider the profitability of the projects.
It dose not consider the time value of money.
Return on Investment (ROI)
This method first calculates the average annual profit,
which is simply the project outlay deducted from the
total gains, divided by the number of years the
investment will run.
The profit is then converted into a percentage of the
total outlay using the following equations:

Average Annual = (Total gains)-(Total outlay)

Profit Number of years

Return on Investment= Average Annual Profit

X 100%
Original Investment
 Using the machine selection project

Profit (A & B) = $55,000 - $35,000

Annual Profit = 20,000 = $5,000 per year (same for
both machines) 4

Return on Investment= 5,000 X 100% = 14%

35,000
 The return on investment method has the
advantage of also being a simple technique like pay
back period, but further, it considers the cash-flow
over the whole project.

 The main criticism of return on investment is that it

averages out the profit over successive years. An
investment with high initial profits would be ranked
equally with a project with high profits later if the
average profit was the same.
 It does not consider the time value of money
2. Discounted Cash flow Method(DCF)
 The discounted cash-flow (DCF) technique takes into
consideration the time value of money.
 For example, a 100Birr today will not have the same
worth or buying power as a 100Birr this time next
year.
 The basic DCF techniques which can model this
effect are Compound interest, net present value
(NPV) and internal rate of return (IRR).
 These discounting techniques enable the project
manager to compare two projects with different
investment and cash-flow profiles.
 There is, however, one major problem with DCF,
besides being dependent on the accurate forecast of
the cash-flows, it also requires an accurate
prediction of the interest rates.
Compound interest method
• Compounding
S = P (1 + r ) n where,
100
S = the sum owing at time t
P = principal (sum invested at time 0)
N = number of time periods, usually years
R = the percentage interest rate per time period
• Discounting
P = S
(1 + r) n

100
E.g. A company receives USD 136 in 3 yrs. attaching a 13%
per annum time value of money. What amount would the
company receive today?
Present Value (PV) = discounted value
= 136 x 0.693
= USD 94.25
Discounting rate, cut-off rate, minimum rate of return
hurdle rate, cost of capital, opportunity cost of capital

1 = discount factor

(1 + r) n
Net Present Value
If you were offered $120 one year from now and the
inflation and interest rate was 20%, working backwards
its value in today's terms would be $100. This is called
the present value, and when the cash-flow over a number
of years is combined in this manner the total figure is
called the net present value (NPV).
Net Present Value
NPV = NCF0 + (NCF1 x DF1) + NCF2 x DF2) + …. + (NCFn x an)

Where, NCFn = annual net cash flow

n = number of years
an = discount factor

Net present value ratio (NPVR) = Profitability index

= PV of cash inflows
PV of investment
Net Present Value

The advantages of using NPV are:

It introduces the time value of money.
It expresses all future cash-flows in today's values,
which enables direct comparisons.
It allows for inflation and escalation.
It looks at the whole project from start to finish.
It can simulate project what-if analysis using different
values.
It gives a more accurate profit and loss forecast than
non DCF calculations.
Net Present Value
The disadvantages are:-
Its accuracy is limited by the accuracy of the
predicted future cash-flows and interest rates.
It is biased towards short run projects.
It excludes non financial data e.g. market potential.
It uses a fixed interest rate over the duration of the
project.
Internal rate of return (IRR)
 The IRR is the value of the discount factor when
the NPV is zero. It is assumed that the costs are
committed at the end of the year and these are
the only costs during the year.

IRR = I1 + PV (i2 – i1 ) , where

PV + /NV/
PV= positive NPV
NV= negative NPV
• Variable costs are those costs that vary
depending on a company's production
volume; they rise as production increases
and fall as production decreases. Variable
costs differ from fixed costs such as rent,
advertising, insurance and office supplies,
which tend to remain the same regardless
of production output.
Here are a number of examples of variable
costs, all in a production setting:
•Direct materials. The most purely variable cost of
all, these are the raw materials that go into a
product.
•Piece rate labor. ...
•Production supplies. ...
•Billable staff wages. ...
•Commissions. ...
•Credit card fees. ...
•Freight out.
• Here are a number of examples of variable costs, all in a production setting:
• Direct materials. The most purely variable cost of all, these are the raw materials that
go into a product.
• Piece rate labor. This is the amount paid to workers for every unit completed (note:
direct labor is frequently not a variable cost, since a minimum number of people are
needed to staff the production area; this makes it a fixed cost).
• Production supplies. Things like machinery oil are consumed based on the amount of
machinery usage, so these costs vary with production volume.
• Billable staff wages. If a company bills out the time of its employees, and those
employees are only paid if they work billable hours, then this is a variable cost.
However, if they are paid salaries (where they are paid no matter how many hours
they work), then this is a fixed cost.
• Commissions. Salespeople are paid a commission only if they sell products or
services, so this is clearly a variable cost.
• Credit card fees. Fees are only charged to a business if it accepts credit card
purchases from customers. Only the credit card fees that are a percentage of sales
(i.e., not the monthly fixed fee) should be considered variable.
• Freight out. A business incurs a shipping cost only when it sells and ships out a
product. Thus, freight out can be considered a variable cost
Here are several examples of fixed costs:
Amortization. This is the gradual charging to expense of the cost of an intangible
asset (such as a purchased patent) over the useful life of the asset.
Depreciation. This is the gradual charging to expense of the cost of a tangible asset
(such as production equipment) over the useful life of the asset.
Insurance. This is a periodic charge under an insurance contract.
Interest expense. This is the cost of funds loaned to a business by a lender. This is
only a fixed cost if a fixed interest rate was incorporated into the loan agreement.
Property taxes. This is a tax charged to a business by the local government, which
is based on the cost of its assets.
Rent. This is a periodic charge for the use of real estate owned by a landlord.
Salaries. This is a fixed compensation amount paid to employees, irrespective of
their hours worked.
Utilities. This is the cost of electricity, gas, phones, and so forth. This cost has a
variable element, but is largely fixed.
What is a 'Liability'
•A liability is a company's financial debt or obligations that arise during
the course of its business operations. Liabilities are settled over time
through the transfer of economic benefits including money, goods or
services. Recorded on the right side of the balance sheet, liabilities
include loans, accounts payable, mortgages, deferred revenues and
accrued expenses.
•
 Note
• The main objective of aid is to promote economic development and
welfare of developing countries.
• the main theoretical difference between these two types of aid is the way in
which the funds are transferred. Bilateral aid describes money which is
given directly from one government to another, whereas multilateral aid
comes from numerous different governments and organisations and is
usually arranged by an international organisation such as the World Bank
or the UN.