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 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 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.
 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
personnel
The completion and technical targets of the
projects 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 projects 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
countrys exports and the grants are usually tied
to the purchase of equipment from the ECAs
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 ones 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 projects 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
(1 + 13)3
100
= 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