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UNIT 16 FINANCIAL APPRAISALStructureObjectives Introduction When to Undertake a Financial Analysis? How to Value Project Benefits and Costs in a Financial Analysis? The Cash Flow in the Financial Analysis Discounting in Project Analysis Let Us Sum Up Key Words References Answers to Check your Progress Exercises
16.0 OBJECTIVESAfter reading this unit, you should be able to: understand the meaning of financial appraisal; highlight the need for a financial analysis; and explain the methodology of financial analysis.
16.1 INTRODUCTIONFinancial appraisal is a method used to evaluate the viability of a proposed project by assessing the value of net cash flows that result from its implementation. Financial appraisals differ from economic appraisals in the scope of their investigation, the range of impacts analysed and the methodology used. A financial appraisal essentially views investment decisions from the perspective of the organization undertaking the investment. It therefore measures only the direct effects on the cash flow of the organisation of an investment ,decision. By contrast, an economic appraisal considers not only the impact of a project on the organisation sponsoring the project, but also considers the external benefits and costs of the project for other government agencies, private sector enterprises and individuals-regardless of whether or not such impacts are matched by monetary payments. Financial appraisals also differ from economic appraisals in that: market prices and valuations are used in.assessing benefits and costs, instead of measures such as willingness to pay and opportunity cost; the discount rate used represents the weighted average cost of debt and equity capital, rather than the estimated social opportunity cost of capital; and The discount rate and the cash flows to which it is applied are usually specified on a nominal basis as the cost of debt and cost of equity are observed only in nominal terms. A financial analysis of a project is undertaken to assess whether it will be commercially profitable for the enterprise implementing it. A private firm will undertake a financial analysis of a potential investment in order to determine its impact on the firm's balance sheet. Governments and international agencies will also routinely undertake a financial analysis, as well as an economic analysis, of any project in which the output will be sold and a financial analysis will therefore
Investment of Pubnc Funds
have some meaning. In this unit we will be discussing the meaning, the need and methodology of financial appraisals.
16.2 WHEN TO UNDERTAKE A FINANCIAL ANALYSIS?A financial analysis must be undertaken if it is necessary to determine the financial profitability of a project to the project implementer. Normally it will only be worthwhile carrying out a financial analysis if the output of the project can be sold in the market, or otherwise valued in market prices. This will almost always be the case for a privately sponsored project, but will also apply to some government business undertakings. A private firm will primarily be interested in undertaking a financial analysis of any project it is considering, and only in some special circumstances will it wish to undertake an economic analysis. . Commercially oriented government authorities that are selling output, such as railway, electricity, telecommunications, or freeway authorities, will usually undertake a financial as well as an economic analysis of any new project they are considering. They need to assess the project's potential impact on their budget, as well as its impact on the country's welfare. For example, the Department of Telecommunication offers provision of telephone services at a reduced rate, it needs to examine the impact of the decision on their budget and overall public good. Another situation where a government will be interested in undertaking a financial analysis of a project is when the project is financially viable without the subsidy or other forms of assistance. In practice, governments and international agencies routinely undertake a financial as well as an economic analysis of any project where a financial analysis will have some meaning- essentially, if the output will be sold. It can then compare the results of the financial and economic evaluation, to determine the project's budgetary impact on the government, as the implementer, as well as its contribution to national welfare. Even non-commercial government institutions may sometimes wish to choose between alternative facilities on the basis of essentially financial objectives. For example, in the case of a hospital service, the management of hospital could well be required to select the cheapest method of providing a given standard of accommodation or care. A national defence force will often choose between available alternative methods of achieving a physical goal, such as airborne troop management capacity, on the basis of the, cheapest financial option. This procedure is called cost minimization or cost effectiveness. It differs from a full financial analysis in that only the cost of a project is estimated in market or conceivably in economic prices. The benefits are specified in terms of some quantitative target, such as the number of patient beds to be provided or number of troops that can be moved.
16.3 HOW TO VALUE PROJECT BENEFITS AND COSTS IN A FINANCIAL ANALYSIS?The financial benefits of a project are just the revenues received and the financial costs are expenditures that are actually incurred by the implementing agency as a resulpof the project. If a project is producing some good or service for sale, the revenue that the project irnplementers expect to receive each year from these sales will be the benefits of the project. The costs incurred are the expenditures made to establish and operate the project. These include capital costs, the cost of purchasing land, equipment, factory building, vehicles and office machines, and working capital, as well as its ongoing operating costs, for labour, raw materials, fuel and utilities.
In a financial analysis, all these receipts and expenditures are' valued as theyappear in the financial balance sheet of the project, and are therefope measured in market prices. Market prices are just the prices in the local economt, and include all applicable taxes, tariffs, trade mark-ups and commissions. Since the project's implementers will have to pay market prices for inputs they use and will receive market prices of the output they produce, the financial costs and benefits of the project are measured in these market prices.P
Real or Nominal Prices
It is obviously very important to know whether the input and output projections given by the proposing firm or agency are valued in current prices (normal) or constant prices (real). This is necessary to ensure that the analysis is carried out in a consistent set of prices, so that the total net value of the project ultimately calculated is a real figure. Often, constant (say 1990) prices, rather thin current prices, are used in a project's cash flow. A project's cash flow is merely the costs and benefits paid and produced by the project over its lifetime in the years that they occur. The use of constant prices simplifies the analysis, as it relieves the analyst of the need to make projections about the anticipated inflation rate in the country over the life of the project. This procedure is quite appropriate if input and output prices in domestic currency are expected to increase at approximately the same rate over the life of the project. However, there are several situations where the use of constant prices may not be appropriate. The first is when the analyst is drawing up project financing plans. In this situation, the analyst will need to estimate expenditures in nominal terms to ensure that planned sources of finance will be sufficient to cover all project costs. The second is a situation where the investment is privately operated and will pay company tax. The financial analysis will need to be carried out in both nominal and real terms because the rate of inflation will affect the interest payments, depreciation allowance and the cost of holding stocks. All these will influence the firm's tax liability. Working capital requirements will also be affected by the level of inflation. Finally, if input prices are expected to rise at different rates over the life of the project, and vary from year to year, it will usually be simpler to include all prices in current terms.
Internal Transport and Handling Costs
It is important to be clear about where inputs and outputs should be priced in a project appraisal. In the case of a project's output, it could be valued at the project gate or in the market for the project's output. In a case of project inputs, they could be valued at the project gate, at the gate of the input supplier's factory or mine or at the port of entry into the country. In order to determine which the appropriate price is, it is necessary to remember that in a 'financial appraisal it is the net incremental benefit of the project to the implementing agent that is of interest., In the case of project outputs, they should therefore be valued at the market price
received for them at the project gate. Transport costs from the project to market should be subtracted from the wholesale price received in the market. Project inputs should also be valued at their market cost at the project gate. This price will include the transport and handling cost of getting them there.
Local and Foreign Costs
Many a times project appraisals split costs (and sometimes benefits) between locally incurred and foreign exchange costs and benefits. This is use