Financial and Economic Evaluation

Introduction

Project preparation should be geared towards the requirements of financial and economic evaluation.

Once all the elements of a feasibility study are prepared, the next step is to compile the total investment costs.

Financial evaluation should preferably rely on discounting methods and incorporate sensitivity analysis.

Projects should also be, evaluated from the aspect of their direct and indirect effects on the national economy.

Total Investment Costs

Investment costs are defined as 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 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: This expenditure, which has to be capitalized, includes a number of items that originated during the various stages of project formulation and implementation. These include: Preliminary and capital issue expenditures. Consultant fees for preparing studies, Travel expensesPreparatory 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 according to its production program.

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 recourse financing.

In this financing, creditors provide financing to a

project solely based on the merits of the project

itself, with limited or no recourse 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.

Types of Capital

There are, in principle, three types of capital available to all projects: equity, debt and mezzanine capital.

Each plays a specific role in project financing and has its own risk characteristics.

The return on each type of capital is determined largely by its risk characteristics.

i) Equity Capital: It represents the funds provided by the owners and is the lowest-ranking capital of all in terms of its claims on the assets of a project. Normally, any distributions that can be made to

equity investors is done after all other project obligations are satisfied.

If a project fails, therefore, all other claims must be met before any claims can be made by equity investors.

Equity investors therefore bear a higher degree of risk than any other providers of capital.

Moreover, if after all other obligations are met, the value of the remaining assets is less than the initial equity capital of the project; the investors will bear the loss.

Equity capital is also referred to as risk capital.

ii) Debt Capital: Senior debt has first claim over all the assets of a project and must be repaid first, according to a predetermined schedule. In contrast to equity capital, a project’s senior

debt has the highest ranking of all capital. The claims of others can be considered only

after the claims of senior debt are satisfied. It bears the lowest risk of all capital and correspondingly, the returns are usually limited to just the interest payments on the loans, irrespective of how successful the project may be.

Equity investors would prefer a debt-equity ratio as high as possible.

iii) Mezzanine Capital: The key characteristic of mezzanine capital is that it has both debt and equity features and, correspondingly, it has a risk profile that is somewhere between debt and equity capital. Examples of mezzanine financing are subordinated

loans and preference shares. Both have the characteristics of debt, in that

regular payments of interest and/or capital are involved.

However, payments are subordinated to senior debt and need only be made when project funds are available.

When they are not available, mezzanine financing is treated like equity and no payments are made hence, mezzanine financing provides projects with an additional equity cushion.

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.

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 personnelThe completion and technical targets of the project’s budget, as any slippage will have an adverse effect on the economic viability of the projectThe 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 basedThe 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. African Development Bank (AfDB)

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.

investment from income annual Netinvestment Net

period Pay back

=

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

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.

Year 0 1 2 3 4

Machine ACash flow (Birr) -35,000 +20,000 +15,000 +10,000 +10,000

Machine BCash flow (Birr) -35,000 +10,000 +10,000 +15,000 +20,000

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:

Number of years (Total gains)-(Total outlay)

Average Annual Profit

=

Original Investment Average Annual Profit

Return on Investment = X 100%

Using the machine selection project

Profit (A & B) = $55,000 - $35,000 = $5,000 per year (same for both machines)4

20,000 Annual Profit =

35,000 5,000

Return on Investment = X 100%= 14%

Year Cash-Flow Machine A Cash-Flow Machine B

0 ($ 35,000) ($ 35,000)

1 $20,000 $10,000

2 $15,000 $10,000

3 $10,000 $15,000

4 $10,000 $20,000

Total Gains $55,000 $55,000

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

• CompoundingS = P (1 + r ) n where,

100S = the sum owing at time tP = principal (sum invested at time 0)N = number of time periods, usually yearsR = the percentage interest rate per time period

• DiscountingP = S (1 + r) n

100

E.g. A company receives USD 136,000 in 3 yrs. attaching a 13% per annum time value of money. What amount would the company receive today?

Present Value (PV) = discounted value = 136,000 (1 + 13)3 100

= 136,000 x 0.693

= USD 94,250

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 ValueIf 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).

Year Project Cash-Flow Discount Factor Present Value

0      

1      

2      

3      

4      

Total     NPV

Net Present ValueNPV = 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 ValueThe 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) Is the discount rate at which the net present

value of costs (negative cash flows) of the investment equals the net present value of the benefits (positive cash flows) of the investment.

It is commonly used to evaluate the desirability of investments or projects. The higher a project's internal rate of return, the more desirable it is to undertake the project.

Assuming all projects require the same amount of up-front investment, the project with the highest IRR would be considered the best and undertaken first.

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