CHAPTER FIVE: FINANCIAL EVALUATION

5.1. INTRODUCTION

Project is evaluated (or analyzed) from financial point of view and economic point of view. Financial
analysis of the project is concerned with the analysis of the profitability of the project based on
monetary costs and benefits. On the other hand, economic analysis of the project deals with project
analysis based on social costs and benefits. Economic analysis of the project will be dealt with in unit
six. This unit deals with financial analysis of the project. Financial analysis requires the determination of
project costs, the estimation of cost of production and other expenses, the estimation of project net
cash flows, and the evaluation of the desirability of the project using various criteria.

5.2. COST OF PROJECT

Conceptually, the cost of project represents the total of all items of outlay associated with a project
which are supported by long-term funds. It is the sum of the outlays on the following: Land and site
development, Building and civil works, Plant and machinery, Technical know-how and engineering fees,
Expenses on foreign technicians and training local technicians abroad, Miscellaneous fixed assets, Pre-
operative expenses, Margin money for working capital and Initial cash losses.
5.2.1. Land and Site Development
The cost of land and site development is the sum of the following:
 Basic cost of land including conveyance and other allied charges
 Premium payable on leasehold and conveyance charges
 Cost of leveling and development
 Cost of laying approach roads and internal roads
 Cost of gates
 Cost of tube wells

The cost of land varies considerably from one location to another. While it is very high in urban and
even semi-urban locations, it is relatively low in rural locations. The expenditure on site development,
too, varies widely depending on the location and topography of the land.

5.2.2. Buildings and Civil Works

Buildings and civil works cover the following:
 Buildings for the main plant and equipment
 Buildings for auxiliary services like steam supply, workshops, laboratory, water supply, etc.
 Good owns, warehouses, and open yard facilities
 Non-factory buildings like canteen, guesthouses, time office, excise house, etc.
 Quarters for essential staff
 Silos, tanks, wells, chests, basins, cisterns, hoopers, bins, and other structures necessary for
installation of the plant and equipment
 Garages

1
  Sewers, drainage, etc.
 Other civil engineering works.

The cost of the buildings and civil works depends on the kinds of structures required which, in turn,
are dictated largely by the requirements of the manufacturing process. Once the kinds of structures
required are specified, cost estimates are based on the plinth area and the rates for various types of
structures. These rates, of course, vary with the location to some extent.
5.2.3. Plant and Machinery
The cost of the plant and machinery, typically the most significant component of the project cost,
consists of the following:
 Cost of imported machinery: This is the sum of (i) FOB (free on board) value, (ii) shipping,
freight, and insurance cost, (iii) import duty, and (iv) clearing, loading, unloading, and
transportation charges.
 Cost of indigenous machinery: This consists of (i) FOR (free on rail) cost, (ii) taxes, if any, and
(iii) railway freight and transport charges to the site.
 Cost of stores and spares
 Foundation and installation charges
The cost of plant and machinery is based on the latest available quotation adjusted for possible
escalation. Generally, the provision for escalation is equal to the following product: (latest rate of
annual inflation applicable to the plant and machinery) x (length of the delivery period).
5.2.4. Technical Know-how and Engineering Fees
Often it is necessary to engage technical consultants of collaborators from local and /or abroad for
advice and help in various technical matters like preparation of the project report, choice of technology,
selection of the plant and machinery, detailed engineering, and so on. While the amount payable for
setting up the project is a component of the project cost, the royalty payable annually, which is typically
a percentage of sales, is an operating expense taken into account in the preparation of the projected
profitability statements.
5.2.5. Expenses on Foreign Technicians and Training of Local Technicians Abroad
Services of foreign technicians may be required for setting up the project and supervising the trial runs.
Expenses on their travel, boarding, and lodging along with their salaries and allowances must be shown
here. Likewise, expenses on local technicians who require training abroad must also be included here.
5.2.6. Miscellaneous Fixed Assets
Fixed assets and machinery which are not part of the direct manufacturing process may be referred to
as miscellaneous fixed assets. They include items like furniture, office machinery and equipment, tools,
vehicles, railway siding, diesel generating sets, transformers, boilers, piping systems, laboratory
equipment, workshop equipment, effluent treatment plants, fire -fighting equipment, and so on.
Expenses incurred for the procurement or use of patents, licenses, trademarks, copyrights, etc. and
deposits made with the electricity authority may also be included here.
5.2.7. Preliminary and Capital Issue Expenses
Expenses incurred for identifying the project, conducting the market survey, preparing the feasibility
report, drafting the memorandum and articles of association and incorporating the company are
referred to as preliminary expenses.

2
Expenses borne in connection with the raising of capital from the public are referred to as capital issue
expenses. The major components of capital issue expenses are underwriting commission, brokerage,
fees to managers and registrars, printing and postage expenses, advertising and publicity expenses,
listing fees, and stamp duty.

5.2.8. Pre-operative Expenses

Expenses of the following types incurred till the commencement of commercial production are referred
to as pre-operative expenses these include (i) establishment expenses, (ii) rent, and taxes, (iii) traveling
expenses, (iv) interest and commitment charges on borrowings, (v) insurance charges, (vi) mortgage
expenses, (vii) interest on deferred payments, (viii) start-up expenses, and (ix) miscellaneous expenses.
Pre-operative expenses are directly related to the project implementation schedule. So, delays in project
implementation, which are fairly common, tend to push up these expenses. Pre-operative expenses
incurred up to the point of time the plant and machinery are set up may be capitalized by apportioning
them to fixed assets on some acceptable basis. Pre-operative expenses incurred from the point of time
the plant and machinery are set up are treated as revenue expenditure. The firm may, however, treat
them as deferred revenue expenditure and write them off over a period of time.
5.2.9. Provision for Contingencies
A provision for contingencies is made to provide for certain unforeseen expenses and price increase
over and above the normal inflation rate which is already incorporated in the cost estimates.
To estimate the provision for contingencies, the following procedure may be followed:
(i) Divide the project cost items into two categories, viz, ‘firm’ cost items and ‘non-firm’ cost items
(firm cost items are those which have already been acquired or for which definite arrangements have
been made). (ii) Set the provision for contingencies at 5 to 10 percent of the estimated cost of non-firm
cost items. Alternatively, make a provision of 10 percent for all items (including the margin money for
working capital) if the implementation period is one year or less. For every additional one-year, make an
additional provision of 5 percent.

5.2.10 Margin Money for Working Capital

The principal support for working capital is provided by commercial banks and trade creditors.
However, a certain part of the working capital requirement has to come from long-term sources of
finance. Referred to as the ‘margin money for working capital’ this is an important element of the
project cost.

The margin money for working capital is sometimes utilized for meeting over-runs in capital cost. This
leads to a working capital problem (and sometimes a crisis) when the project is commissioned. To
mitigate this problem, financial institutions stipulate that a portion of the loan amount, equal to the
margin money for working capital, be blocked initially so that it can be released when the project is
completed.
5.2.11. Initial Cash Losses
Most of the projects incur cash losses in the initial years. Yet, promoters typically do not disclose the
initial cash losses because they want the project to appear attractive to the financial institutions and the
investing public. Failure to make a provision for such cash losses in the project cost generally effects the
liquidity position and impairs the operations. Hence prudence calls for making a provision, overt or
covert, for the estimated initial cash losses.

3
5.3 MEANS OF FINANCE

To meet the cost of the project, the means of finance that are available include Share capital, Term
loans, Bonds, Deferred credit, Incentive sources, and Miscellaneous sources.

1. Share Capital: There are two types of share capital; namely, equity capital (through the issuance of
common stock) and preference capital (through the issuance of preferred stock). Equity capital
represents the contribution made by the owners of the business, the equity shareholders, who enjoy the
rewards and bear the risks of ownership. Equity capital being a risk capital carries no fixed rate of
dividend. Preference capital represents the contribution made by preference shareholders and the
dividend paid on it is generally fixed.
2. Term Loans: They are provided by financial institutions and commercial banks. Term loans
represent secured borrowings which are a very important source (and often the major source) for
financing new projects as well as for the expansion, modernization, and renovation schemes of existing
firms.
3. Bond capital: Bonds are instruments for raising debt capital. The typical example of bonds is
debentures. There are two broad types of debentures; namely, non-convertible debentures and
convertible debentures. Non-convertible debentures are straight debt instruments. Typically they carry
a fixed rate of interest. Convertible debentures, as the name implies, are debentures, which are
convertible, wholly or partly, into equity shares. The conversion period and price are announced in
advance.
4. Deferred Credit. Many a time the suppliers of the plant and machinery offer a deferred credit facility
under which payment for the purchase of the plant and machinery can be made over a period of time.
5. Incentive Sources. The government and its agencies may provide financial support as an incentive to
certain types of promoters or for setting up industrial units in certain locations. These incentives may
take the form of seed capital assistance (provided at a nominal rate of interest to enable the promoter
to meet his contribution to the project), or capital subsidy (to attract industries to certain locations), or
tax deferment or exemption for a certain period.
6. Miscellaneous Sources. A small portion of the project finance may come from miscellaneous sources
like unsecured loans, public deposits, and leasing and hire purchase finance. Unsecured loans are
typically provided by the promoters to bridge the gap between the promoters’ contribution (as
required by the financial institutions) and the equity capital the promoters can subscribe to. Public
deposits represent unsecured borrowings from the public at large. Leasing and hire purchase finance
represent a form of borrowing different from the conventional term loans and debenture capital.

Planning the Means of Finance

The various means of finance that can be tapped for a project have been descried above. How should
you go about determining the specific means of finance for a given project? The guidelines and
considerations that should be borne in mind for this purpose are as follows:
1. Norms of Regulatory Bodies and Financial Institutions. In some countries, the proposed means of
finance for a project must either be approved by a regulatory agency or conform to certain norms laid
down by the government or financial institutions in this regard. The primary purpose of such
regulations is to impart prudence to project financing decisions and provide a measure of protection to

4
investors. In addition, the norms of financial institutions, which often provide substantial assistance to
projects significantly shape and circumscribe project financing decisions.

2. Key Business Considerations. The key business considerations which are relevant for the project
financing decision are cost, risk, control, and flexibility.

a. Cost.: In general, the cost of debt funds is lower than the cost of equity funds. Why? The primary
reason is that the interest payable on debt capital is a tax-deductible expense whereas the dividend
payable on equity capital is not.

b. Risk: The two main sources of risk for a firm (or project) are business risk and financial risk.
Business risk refers to the variability of earnings before interest and taxes and arises mainly from
fluctuations in demand and variability of prices and costs. Financial risk represents the risk arising from
financial leverage. It must be emphasized that while debt capital is cheap it is also risky because of the
fixed financial burden associated with it.

Generally, the affairs of the firm are, or should be, managed in such a way that the total risk borne by
equity shareholders, which consists of business risk and financial risk, is not unduly high. This implies
that if the firm is exposed to a high degree of business risk, its financial risk should be kept low. On the
other hand, if the firm has a low business risk profile, it can assume a high degree of financial risk.

c. Control: From the point of view of the promoters of the project, the issue of control is important.
They would ordinarily prefer a scheme of financing which enables them to maximize their control,
current as well as potential, over the affairs of the firm, given their commitment of funds to the project.
d. Flexibility. This refers to the ability of a firm (or project) to raise further capital from any source it
wishes to tap to meet the future financing needs. This provides maneuverability to the firm. In most
practical situations, flexibility means that the firm does not fully exhaust its debt capacity. Put
differently, it maintains reserve-borrowing powers to enable it to raise debt capital to meet largely
unforeseen future needs.

5.4. PRODUCTION COSTS

There are three major categories of manufacturing costs. These are

1. Direct materials cost: - The acquisition costs of all materials that are identified as part of the cost
object and that may be traced to the cost object in an economically feasible way. Acquisition costs
of direct materials include inward delivery charges, tax, and custom duties. Direct material often
does not include minor items such as glue or tacks. Why? because the cost of tracing insignificant
items do not seem worth the possible benefits of having more accurate product costs. Such items
are called supplies or indirect materials and are classified as part of the indirect manufacturing
costs.
2. Direct labor. The compensation of all labor that can be identified in an economically feasible way
with a cost object. Examples are the labor of machine operators and assembler. Indirect labor costs
are all factory labor compensation other than direct labor compensation. These are labor costs that

5
 are impossible or impractical to trace to a specific product. They are classified as part of the
indirect manufacturing cost. Examples include wages of janitors, and plant guards.
3. Indirect manufacturing costs (manufacturing overhead). All manufacturing costs that cannot be
identified specifically with or traced to the cost object in an economically feasible way. Other terms
used are factory overhead, factory burden, manufacturing overhead, and manufacturing expenses.
Examples of factory overhead (when products are cost object) include power, supplies, indirect
labour, factory rent, insurance, property taxes, and depreciation.
5.5. ESTIMATES OF SALES AND PRODUCTION

5.5.1. Estimating Sales

The sales forecast is the starting point for the projections of profitability. In estimating sales revenues,
the following should be taken into account:
1. Economic level (activities)
2. The project’s probable market share in each distribution territory
3. Competitor’s and their capacities
4. Pricing strategies
5. The effect of inflation on prices
6. Advertising campaigns, promotional discounts, and credit terms.
5.5.2. Estimating Production
Once sales projections are made, the next step is production estimates. Production may be estimated as
follows:
Production = sales + Desired ending Inventory – Beginning finished goods inventory
For the first year of operation, there is no beginning inventory. To illustrate, assume that the sales are
projected to be 100,000 units in the first year although the capacity is 180,000 units. It is estimated that
there should be finished goods inventory of 5000 units on hand at the end of the first year. Estimated
production would be:
Production = 100,000 + 5000 – 0 = 105,000 units
Similar approach can be followed for a period of more than one year. Production can also be estimated
in another way. To illustrate, assume that Addis Company has set the policy of maintaining finished
goods inventory of 10,000 units at the end of each year. The installed plant capacity is estimated to be
300,000 per year. It is estimated that the project will operate at 50% and 60% in year 1 and year 2 and
full capacity from year 3 to year 5.
Annual production is computed as follows:
Year 1 Year 2 Year 3 Year 5 Year 6
Installed capacity 300,000 300,000 300,000 300,000 300,000
Capacity utilization 50% 60% 100% 100% 100%
Production 150,000 180,000 300,000 300,000 300,000
Based on production estimates and ending finished goods inventory policy, sales revenue projections
can be that a unit of output is expected to be gold at Br. 160. Revenue budget is prepared as follows:

Table 5-1 Estimation of total Revenue

Year
1 2 3 4 5
Production 150,000 180,000 300,000 300,00 300,000

6
Desired ending inventory 10,000 10,000 10,000 10,000 10,000
Sold 140,000 170,000 290,000 290,00 290,000
Expected selling price/unit 160 160 160 160 160
Total sales revenue 22,400,000 27,200,000 46,400,000 46,400,000 46,400,000

5.6 ESTIMATION OF MATERIAL COSTS

The costs of materials include the cost of raw materials, chemicals, components, and consumable stores
required for production. The following should be considered in estimating the cost of materials:
1. The requirements of various material inputs per unit of output.
When materials inputs requirements are established, it is necessary to consider:
- Theoretical consumption norms
- Experience of the industry
- Performance guarantees
- Specification of machinery suppliers
2. The total requirements of various inputs
Total requirements = Requirements per unit X Expected Production
3. The prices of material inputs
The prices of material inputs are defined in cost, insurance, and freight (CIF)
4. The present costs of various material inputs
5. The seasonal fluctuations in prices

To exemplify, refer to the above example, suppose that each unit of output requires two types of
materials: three units of input x and 2 units of material y. The estimated costs of one unit of material x
and one unit of material y are Br. 5 and Br. 10 respectively. To adjust for estimation error the company
allows a 2% contingency on the costs of materials. The total requirement of each material type is
computed as follows:

Table 5-2 Estimated cost of Material x

Year
1 2 3 4 5
Production 150,000 180,000 300,000 300,000 300,000
Material x /unit of output 3 3 3 3 3
Total requirements 450,000 540,000 900,000 900,000 900,000
Unit cost 5 5 5 5 5
Total cost of material x 2,250,000 2,700,000 4,500,000 4,500,000 4,500,000
before contingency
Contingency (2%) 45,000 54,000 90,000 90,000 90,000
Total cost of material x 2,295,000 2,754,000 4,590,000 4,590,000 4,590,000

Table 5- 3 estimated cost of material Y

Year

7
 1 2 3 4 5
Production 150,000 180,000 300,000 300,000 300,000
Material y/unit of output 2 2 2 2 2
Total requirements 300,000 360,000 600,000 600,000 600,000
Unit cost 10 10 10 10 10
Cost before contingency 3,000,000 3,600,000 6,000,000 6,000,000 6,600,000
Contingency (2%) 60,000 72,000 120,000 120,000 120,000
Total cost of material y 3,060,000 3,672,000 6,120,000 6,120,000 6,120,000
Total material costs are summarized below:
Year Material X Material Y Total
1 2,295,000 3,060,000 5,355,000
2 2,754,000 3,672,000 6,426,000
3 4,590,000 6,120,000 10,710,000
4 4,590,000 6,120,000 10,710,000
5 4,590,000 6,120,000 10,710,000

5.7. ESTIMATING LABOR COSTS

Labor cost includes the cost of all the manpower employed in the factory. Labor cost is a function of
the number of employees and the rate of payment. Refer to Addis Company’s example; assume that 3
hours of direct labor are required to produce one unit of output. It is estimated that direct labor cost
per hour is Br. 20 and is expected to increase at the rate of 5% every year. Accordingly, direct labor cost
is estimated as follows:
Table 5- 4 Estimated direct labor cost
Year
1 2 3 4 5
Production 150,000 180,000 300,000 300,000 300,000
Labor hour/unit of output 3 3 3 3 3
Total labor hours required 450,000 540,000 900,000 900,000 900,000
Labor rate/hour 20 21 22.05 23.15 24.31
Total cost of labor 9,000,000 11,340,000 19,845,000 20,835,000 21,879,000
Note that direct labor rate increases at 5% per year.

5.8. ESTIMATING OVERHEAD COSTS

Overhead costs are costs other than direct material costs and direct labor costs. Certain bases should
be used to estimate overhead costs. Some of the bases could be direct labor hours, direct labor costs,
material costs etc. To illustrate, suppose that (refer to Addis Company’s example) factory overhead
costs are estimated to be 60% of direct labor costs. Then factory overhead costs are estimated as
follows:
Table 5- 5Estimates of Factory overhead
Year
1 2 3 4 5

8
Estimated labor costs 9,000,00 11,340,000 19,845,000 20,835,000 21,879,000
0
Overhead rate 60% 60% 60% 60% 60%
Estimated Factory Overhead 5,400,000 6,804,000 11,907,000 12,501,000 13,127,400

5.9. COMPUTATION OF UNIT COSTS

The computation of unit cost is based on manufacturing costs which is composed of Direct materials,
direct labor, and overhead costs

Unit Cost = Manufacturing costs

Units produced
The unit cost is computed for each of the five years as shows below:

Table 5- 6 Computation of unit cost

Direct Material Direct labor Factory
Year Costs cost overhead Total Production Unit cost
costs
1 5,355,000 9,000,000 5,400,000 19,755,000 150,000 131.70
2 6,426,000 11,340,000 6,804,000 24,570,000 180,000 136.50
3 10,710,000 19,845,000 11,907,000 42,462,000 300,000 141.54
4 10,710,000 20,835,000 12,501,000 44,046,000 300,000 146.82
5 10,710,000 21,879,000 13,127,400 45,716,400 300,000 152.39

Once unit cost is determined, the cost of ending inventory and cost of goods sold can be computed.
The following table shows the cost of ending finished goods inventory assuming that FIFO method is
used:

Table 5- 7 estimated cost of ending inventory

Year
1 2 3 4 5
Desired ending inventory 10,000 10,000 10,000 10,000 10,000
Unit cost 131.70 136.50 141.54 146.82 152.39
Cost of ending Inventory 1,317,000 1,365,000 1,415,400 1,468,200 1,523,900

Cost of ending inventory = Desired ending inventory X Unit cost

Based on the above data, the cost of goods sold can also be computed as follows:

9
Table 5- 8 Estimated cost of goods sold
Year
1 2 3 4 5
Cost of production 19,755,000 24,570,000 42,462,000 44,046,000 45,716,400
Add: Beg. Finished - 1,317,000 1,365,000 1,415,400 1,468,200
Goods inventory
Available for sale 19,755,000 25,887,000 43,827,000 45,461,400 47,184,400
Ded: Ending Finished 1,317,000 1,365,000 1,415,400 1,468,200 1,523,900
Goods inventory
Cost of goods sold 18,438,000 24,522,000 42,411,600 43,993,200 45,660,500

5.10. ESTIMATING ADMINISTRATIVE, SELLING, AND OTHER COSTS

Administrative, general, selling and other costs should be estimated in order to prepare projected
income statements. To prepare the projected income statement, based on the foregoing illustration,
assume the following additional data:
a) Administrative and general expenses, including depreciation of Br. 100,000 per year are
estimated at Br. 500,000 in year 1 and expected to increase by Br. 10,000 thereafter.
b) Selling expenses, including depreciation of Br. 60,000 per year are estimated at Br. 400,000 in
year 1 and year 2 and are expected to be Br. 420,000 thereafter.
c) The project will be financed fully by equity.
d) Income tax rate is 30% after two years

Accordingly, the projected income statement is prepared as follows:

Addis Company
Projected Income Statement
For the year ended Dec. 31, years 1 – 5
Year
1 2 3 4 5
Sales 22,400,000 27,200,000 46,400,000 46,400,000 46,400,000
Cost of goods sold 18,438,000 24,522,000 42,411,600 43,993,200 45,660,500
Gross profit 3,962,000 2,678,000 3,988,400 2,406,800 739,500
Expenses:
Administrative & General 500,000 510,000 520,000 530,000 540,000
Selling 400,000 400,000 420,000 420,000 420,000
Total expenses 900,000 910,000 940,000 950,000 960,000
Earnings before taxes 3,062,000 1,768,000 3,048,400 1,456,800 (220,500)
Taxes (30%) - - 914,520 437,040 -
Net income 3062,000 1,768,000 2,133,880 1,019,760 (220,500)

It is also possible to prepare balance sheet and statement of cash flows, had the information is
complete.

10
5.11. ESTIMATIING PROJECT CASH FLOWS FOR REVENUE EXPANSION

The estimation of project cash flows is a key element in investment evaluation but also the most
difficult step in capital budgeting. Forecasting project cash flows involves numerous variables and many
parties participate in this exercise.
These parties include:
1. Engineers – estimate capital outlays
2. Marketing group – projects revenues
3. Production people – forecast operating costs.
The forecasting of operating costs also involves cost accountants, purchase managers, personnel
executives, tax experts, and so on.

What is the role of finance manager in forecasting project cash flows? The role of finance manager is to
coordinate the efforts of various departments and obtain information from them, ensure that the
forecasts are based on a set of consistent economic assumptions, keep the exercise focused on relevant
variables, and minimize the biases inherent in cash flow forecasting.

The Elements of Project Cash flows

Project cash flows comprises of three basic components.
These are:
1. Initial investment. The initial investment, also called net investment, is the cash outlay on
capital expenditures. In revenue expansion projects, initial investments include the purchase
price, installation costs, taxes, transportation costs, increase in networking capital etc.
2. The operating cash flows. These include the after-tax cash flows resulting from the operations
of the project during its economic life.
3. Terminal cash flow. These are cash flows that occur at the end of the life of the project.
Terminal cash flows involve mainly salvage value (net of tax) and recovery in networking
capital.

1. Initial Investment
The components of the initial investment are:
a) Gross investment. The gross investment of a project or asset is its purchase price and
other incidental costs. Gross investment the base for depreciation of the entire project
alternatives.

b) Investment tax Credit. It is the specified percentage of the Birr amount of new investments
in each of certain categories of assets which business firms deduct as a credit against their
income taxes. This percentage is applied to the gross investment amount. The purpose of
such tax credit is to provide an incentive for new investment projects. For instance,
assume that a firm is considering a project that entails the purchase of new equipment for
500,000 Birr with an expected duration of 10 years. If the asset acquisition qualifies for tax
credit of 10- percent, the investment tax credit is 50,000 Birr (i.e. 500,000 x 10% = 50,000
birr). Although the practice varies from country to country, it is assumed that the tax
authorities force the firm to reduce the value of the asset by the amount of investment tax

11
 credit for depreciation purpose. This is to avoid double benefits. The investment tax credit
is the direct reduction of taxes. Suppose that a firm estimates that its taxable income next
year will be 80,000 birr and that its profit tax is 40 percent. The company expects to
acquire an equipment costing 60,000 birr. If the investment tax credit is 10 percent, the
amount of income tax to be paid to the taxing authority is only 26,000 birr i.e. (80,000)
(0.40) - (60,000) (0.10) = 26,000.

c) Net Working Capital Increases

Net working capital is the difference between the total current assets and total current
liabilities. Investment in new long-term asset may increase the amount of net working
capital if the project is the revenue expansion investment. Cost reduction investment will
not affect the amount of net working capital required. Increase in the amount of net
working capital is added to the gross investment while determining the amount of initial
investment.

d) Opportunity Costs:
Opportunity cost is the highest return that will not be earned if the funds are invested in a
particular project type. In other words, opportunity cost is the income generated by the
alternative use of an asset that is forgone when a new project is adopted. The relevant
opportunity costs associated with an investment proposal should be included in the initial
investment.
e) Tax Increase or Shield
The tax both ordinary income tax and capital gain tax will be added to the original costs of
long-term assets in order to determine the initial investment. In the case of replacement
projects, if the old assets (i.e. assets to be replaced) are sold at amounts less than their
book values, there will be losses on sales of these assets. The ordinary income tax rate is
applied to these loss amounts to determine the amount of tax shield which will be
deducted from the original cost of new fixed assets to determine the amount of the initial
investment.
To illustrate how project cash flows are forecasted, suppose that the project requires gross investment
of Br. 900,000. Besides, it is forecasted that additional costs will be incurred at the beginning of the life
of the project.
Transportation costs 60,000
Assembling & installation costs 20,000
Increase in networking capital 200,000
Based on the above data, initial investment can be computed as follows:
Gross investment 900,000
Transportation costs 50,000
Assembly and installation costs 20,000
Increase in networking capital 200,000
Initial Investment 1,170,000

2. The operating cash flows.

For revenue expansion long-term investment projects, operation cash flows represent the net cash flows
after tax.

12
Let’s use Addis Company’s project to illustrate how operating cash flows are forecasted. Project after-
tax cash flows (or net cash flows) can be determined using the following formula:
After tax cash = Net income + Non-cash expenses + Interest (1-tax rate)
In Addis Company’s project, depreciation is considered the only non-cash expense. Assuming that the
project required increase in networking capital of Br. 100,000 at the beginning of year 1 and is expected
to be recovered at the end of year 5. Besides, the project has salvage value of Br. 80,000 at the end of
year 5. Straight-line method of depreciation will be used.
After-tax cash flows of Addis Company are computed below:

Table 5- 9 Determination of project net cash flows

Year
Items 1 2 3 4 5
Net income 3,062,000 1,768,000 2,133,880 1,019,760 (220,500)
Add: Depreciation 160,000a 160,000 160,000 160,000 160,000
Salvage proceeds - - - - 80,000
Recovery in NWCb - - - - 100,000
After tax cash flows 3,220,000 1,928,000 2,293,880 1,179,760 119,500

a Obtained by adding Depreciation related to administrative and general expense (Br. 100,000) and
selling expense (Br. 60,000)
b Net working capital

5.12. ESTIMATING PROJECT CASH FLOWS FOR REPLACEMENT PROJECTS

In replacement projects, old asset is replaced by new one. The old asset is sold. As a result, the initial
investment can be determined using the following components:
1. Purchase price of new asset
2. Salvage proceed (net of tax) of old asset
The primary benefits from replacement projects are cost saving. Similarly, the manner in which net
cash flows for replacement projects is different from that of revenue expansion projects.

Net cash flows = After-tax cost saving + Tax saving on incremental depreciation
To illustrate the determination of initial investment for replacement projects, suppose that the firm is
contemplating to replace old equipment with new equipment, which has a cost of Br. 900,000. The
original cost and accumulated depreciation of old equipment are Br. 400,000 and Br. 280,000
respectively. Income tax rate and capital gain tax rate are 40% & 20% respectively. Old equipment is
sold for Br. 150,000.

In replacement project, gain or loss on disposal of old equipment should be computed before initial
investment is determined. This is due to the fact that any gain or loss on disposal has tax implication.

13
Gain results in additional tax payment to taxing authority and loss results in tax saving (shield). Thus,
gain or loss on disposal is computed as:
Gain/loss = Selling price of old equipment – Book value of old equipment
Book value = Original cost – Accumulated depreciation
= 400,000 – 280,000
= 120,000
Gain = 150,000 – 120,000
= 30,000
Tax increase = Gain X Income tax rate
= 30,000 X 40% = 12,000
Then initial investment is determined as follows:
Original cost of new equipment 900,000
Tax increase (12,000)
Selling price of old equipment (30,000)
Initial investment 882,000
Let’s modify the assumption in that the selling price of old equipment is Br. 100,000. Book value of old
equipment is Br. 120,000
Loss on disposal is Br. 20,000 (i.e., 120,000 – 100,000 = 20,000).
Tax saving on loss is Br. 8,000 (i.e. 20,000 x 40% = 8,000). Then initial investment is computed below:
Original cost of new equipment 900,000
Proceed from sales of old equipment (100,000)
Tax selling (8,000)
Initial investment 792,000
Old equipment may be sold above its original cost. In the illustration under consideration, let’s assume
that the old equipment is sold for Br. 480,000. When old asset is sold above its original cost, two types
of gains result.
i. Ordinary gain = Original cost – Book value
= 400,000 – 120,000
= 280,000
ii. Capital gain = Selling price – Original cost
= 480,000 – 400,000
= 80,000
Ordinary gain is taxed at normal income tax rate.
Tax on ordinary gain = ordinary gain X normal income tax rate
= 280,000 X 40%
= 112,000
Similarly, tax is also paid on capital gain
Tax on capital gain = Capital gain X Capital gain tax rate
= 80,000 x 20% =16,000
Total tax increase = Ordinary tax + Capital gain tax
= 112,000 + 16,000 = 128,000
Then, initial investment is computed as follows:
Original cost of new equipment 900,000
Proceed from sale of old equipment (480,000)
Tax increase 128,000

14
 Initial investment 548,000
The evaluation of replacement project also requires the determination of net cash flows. To illustrate
the estimation of net cash flows, assume that the company is planning to replace old equipment by new
one. The old equipment had original cost of Br. 100,000, salvage value of Br. 5000 and useful life of ten
years, but remaining life of five years. The new equipment has original cost, salvage value and useful life
of Br. 150,000, Br. 10,000 and five years respectively. The company uses straight-line method. If old
equipment is replaced, the company can have cost saving (before tax) of Br. 30,000 per year over five
years. Income tax rate is 30%.
Net cash flow for replacement project is computed as follows:
Net cash flows = After-tax cost saving + tax saving on incremental depreciation
Depreciation on:
Old equipment = 100,000 – 5000 = 9500
10
New equipment = 150,000 – 10,000 = 28,000
5
Incremental depreciation = 28000 – 9500 = 18500
Net cash flows (year 1 – year 4) = 30,000 (1 – 0.30) + 18500(0.30)
= 21,000 + 5550
= 26,550
Net cash flows (year 5) = Operating cash flows + Terminal cash flows
Terminal cash flows = Salvage value of new equipment
Net cash flows (year 5) = 26,550 + 10,000 = 36,550
5.13. PROJECT EVALUATION TECHNIQUES/CRITERIA
The key steps involved in determining whether a project is worthwhile or not are:
- Estimate the cost and benefits (revenues) of the project
- Calculate the cost of capital,( also called the Required Rate of Return)
- Compute the criterion of merit and judge whether the project is good or bad.

The estimation of the costs and revenues was the concern of the preceding sections. The cost of capital
is dealt with in your financial management courses. Similarly, risk assessment was discussed at the end
of unit three and you can also refer to your earlier accounting courses (financial management) and
management courses.

This section is concerned with the project’s evaluation techniques, (also called capital budgeting
techniques). There are several project evaluation criteria that have been suggested by economists,
accountants, and others to judge the worthwhileness of capital projects. However, only few of them and
the most common ones are presented in this section. They are classified into two categories. These are:
1. Non-discounting (traditional) criteria
a) Payback Period (PBP)
b) Accounting Rate of Return (ARR)
2. Discounted Cash Flows (DCF) criteria
a) Net Present Value (NPV)
b) Internal Rate of Return (IRR)
c) Profitability Index (Benefit-cost ratio)

15
Each of the above methods is discussed in the following sections:
5.13.1. Payback Period (PBP)
Payback period refers to the length of time it takes to recover initial investment of the project.
Depending on the nature of net cash flows, payback period may be computed in two ways.
a) When cash flow is in annuity form. Annuity refers to equal amount of cash flows that occur every
period over the life of the project
Initial Investment
PBP = Annual Net Cash Flows
To illustrate the computation of payback period, assume that a project requires an initial investment of
Br. 24,000 and annual after tax cash flows of Br. 6000 for five years. How long it takes the company to
recover its initial investment?
24 ,000
PBP = 6000 = 4 years
It is expected to take the company four years to recover the project’s initial investment of Br. 24,000
b) When cash flows are not in annuity form
When net cash flows are not annuity, payback period is obtained by adding net cash flows for
successful years until the total is equal to initial investment. To exemplify, assume that a project
requires an initial investment of Br. 60,000. The after tax cash flows (or net cash flows) are as follows:
Year 1 = 8000 Year 4 = 20,000
Year 2 = 15,000 Year 5 = 20,000
Year 3 = 22,000
The payback period is computed as follows:
15 , 000
PBP = 3 years + 20 , 000 = 3.75 years
In the above example, if the 1 st three years’ net cash flows are added, the sum is equal to Br. 45,000. But
the initial investment is Br. 60,000. If the fourth year net cash flows (Br. 20,000) is added to Br. 45,000,
the sum is Br. 65,000 which is greater than the initial investment. Thus, the payback period is between
year 3 and year 4. To find the exact payback period, we take the three years and divide the remaining
cash flows by the fourth year net cash flows. If the exact payback period is needed in months the
fraction can be computed as follows:
15 , 000
(12 months)
PBP = 3 years + 20 , 000
= 3 years and 9 months

Decision Rule for Payback Period

i. Accept the project if it’s payback period is less than or equal to the required payback period
(standard)
ii. Reject the project if it’s payback period exceeds the required payback period. The shorter the
payback period, the more desirable the project.
Advantages of Payback Period
1. It is simple both in concept and application
2. It is a rough and ready made method for dealing with risk

16
 3. It may be a sensible criterion when the firm is pressed with problems of
liquidity
Disadvantages of Payback Period
1. It fails to consider time value of money
2. It ignores cash flows beyond the payback period
3. It is a measure of the project’s capital recovery, not profitability.
4. It does not indicate the liquidity position of the firm as a whole.
5.13.2. Accounting Rate of Return (ARR)
Also called the average rate of return on investment, the accounting rate of return is a measure of
profitability which relates net income to investment. Both net income and investment are measured in
accounting terms. Although there are several methods of computing ARR, the most common method is
shown below:
Average annual net income
ARR = Average investment
Original costs + salvage value
Average Investment = 2
To illustrate, assume that a project has original investment of Br. 70,000, life of 4 years, and salvage
value of Br. 6000. Straight-line method of depreciation is used. Income before depreciation and taxes
for each of the four years are as follows: year1, Br. 40,000; year 2, Br. 42,000; year 3, Br. 36,000; and
year 4, Br. 50,000. Income tax rate is 40%.
Depreciation = 70,000 – 6000 = 16,000
4
Before ARR is determined, it is necessary to compute net income for each of the four years as follows:
Year 1 Year 2 Year 3 Year 4
Income before depreciation tax 40,000 42,000 36,000 50,000
Less: Depreciation 16,000 16,000 16,000 16,000
Income before taxes 24,000 26,000 20,000 34,000
Less: Taxes (40%) 9600 10,400 8000 13,600
Net income 14,400 15,600 12,000 20,400
14 , 400+15 ,600 +12 ,000+20 , 400
=15 ,600
Average Net income = 4
70 , 000+6000
=38 , 000
Average Investment = 2
Average Annual Net Income
ARR = Average Investment
15600
=41 %
= 38000
Decision Rule for Accounting Rate of Return
i. Accept the project if ARR exceeds the required rate of return.
ii. Reject the project if ARR is less than the required rate of return.
Advantages of ARR
1. It is simple to calculate

17
 2. It is based on accounting information, which is readily available and familiar to businessmen.
3. It considers benefits over the entire life of the project.
4. It facilitates post-auditing of capital expenditures.

Limitations of ARR
1. It is based upon accounting profit, not cash flow.
2. It does not take into account the time value of money.
3. Since there are numerous measures of accounting rate of return, this may create controversy,
confusion, and problems in interpretation.
4. Accounting income is not uniquely defined because it is influenced by various methods, such as
depreciation methods, inventory costing method etc.
5.13.3. Net Present Value Method
The net present value of project is the difference between the present value of net cash inflows and
present value of initial investment. In formula,
n Ct
∑ t
−I 0
NPV = i=1 ( 1+r )
Where:
NPV = Net present value
Ct = Net cash flows at the end of year t
n = Life of the project
r = Discount rate
I0 = Initial investment
Net present value can also be determined as follows:
NPV = PV of NCF – I0
Where: PV = Present value
NCF = Net cash flows
To illustrate, assume that a project is expected to have initial investment and life of Br. 40,000 and five
years respectively. The annual after tax net cash flow is estimated at Br. 12,000 for each of the five years.
The required rate of return is 10%. Net present value is determined as follows:
NPV = PV of NCF – I0

( )
1
1−
( 1+0.10 )5
− 40,000
= 12,000
0.10
= 12,000 (3.791) – 40,000
= 45,492 – 40,000
= 5492
1
1−
( 1+ 0. 10 )5
In the above formula, 0 . 10 represents the discount factor and its value is equal to 3.791. This
discount factor can be taken from the present value of annuity of 1 table from the intersection of i =
10% and n = 5. It can also be determined using your calculator.

18
In the above example, net cash flows are annuity. The same procedure can be followed if net cash flows
are not in annuity form. To illustrate the computation of NPV when net cash flows are not annuity,
suppose the project has initial investment and useful life of Br. 30,000 and four years respectively. Its
annual cash flows are as follows: Year 1, Br. 10000; Year 2, Br. 8000; year 3, Br. 15000; and year 4, Br.
12,000. If the required rate of return is 10%, NPV is determined as follows:

Year Net cash flows Discount factor (10%) Present value

1 10,000 0.909 9090
2 8000 0.826 6608
3 15,000 0.751 11,265
4 12,000 0.683 8196
Present value of NCF 35,159
Less: Initial investment 30,000
NPV + 5159

What does NPV represent? NPV represents the amount by which the value of (wealth of) the firm will
increase if the project is accepted.
Decision Rule for NPV
1. If NPV is greater than zero (NPV > 0), the project is considered desirable.
2. If NPV is less than 0, the project is considered undesirable.
5.13.4. Internal Rate of Return (IRR)
Internal Rate of Return is the discount rate which equates the project NPV equal to zero. It is the
discount rate at which the present value of Net cash flows is equal to the present value of initial
investment. In other words, IRR is the rate of return on investments in the project. The determination
of IRR is purely based on project cash flows. Mathematically, at IRR,
n Ct
∑ ( 1+ r )t = Initial investment
i=1

IRR is determined using trial and error: the complexity of determining IRR is greater if net cash flows
are not in annuity form. This section illustrates the determination of net cash flows when cash flows are
annuity as well as non-annuity.

a) Determination IRR when NCFs are annuity.

Assume that the project has initial investment of Br. 40,000, and useful life of five years. the annual net
cash flows is estimated at Br. 12000 for five years. The required rate of return is 10%. The following
steps can be followed to determine IRR.

Step1: Compute the leading discount factor (payback period)

Initial Investment 40 , 000
=
PBP = Annual net cash flows 12, 000 = 3.333

19
Step 2. From the present value of annuity table, find two discount factors and their corresponding
interest rates closest to the computed leading discount factor. If we look in the PV of annuity table on n
= 5 years row (horizontally), the leading discount factor (3.333) is found between 15% and 16%.
Interest rate 15% 16%
Discount factor 3.352 3.274

Step 3: Compute the actual IRR using the following formula

Initial Investment 40 , 000
=
IRR = r – Annual net cash flows 12, 000
Where:
r = Either of the two interest rates (15% or 16%)
DFr = Discount factor for the taken interest rate
DFrL = Discount factor for the lower interest rate
DFrH = Discount factor for the higher interest rate
Let's take r = 15%, IRR is determined as follows:

( 3 .333−3 .352
IRR = 15% - 3 .352−3. 274
)
= 15% - (-0.24)
= 15.24%
If we take r = 16%, the computation of IRR looks like the following:

( 3 .333−3 .274
IRR = 16% - 3 .352−3 .274
)
= 15.24%
b) Determination of IRR when net cash flows are non-annuity
The steps followed in the preceding section are equally applicable for non-annuity cash flows. However,
one step is added at the beginning to determine the weighted average net cash flow, which will be used
to determine the leading discount factor. To illustrate, assume that a project has initial investment of
Br. 40,000 and the following net cash flows: year 1, Br. 15,000; year 2, Br. 10,000; year 3, Br. 10,000; year
4, Br. 15000; and year 5, Br. 15,000. The discount rate is 15%. The following steps can be used to
compute IRR:

Step 1. Compute the weighted average net cash flows.

Year Net cash flows Weight NCF X weight
1 15,000 5 25,000
2 10,000 4 40,000
3 10,000 3 30,000
4 15,000 2 30,000
5 15,000 1 15,000
Total 15 190,000
Note that the weight is assigned in the reverse order of the project's useful life.
190 , 000
Weighted average NCF = 15

20
 = 12,667
Step 2: Compute the leading discount factor (PBP)
Initial Investment
PBP = Weighted average NCF
40 ,000
= 12 , 667
= 3.158
Step 3: From the present value of annuity table, find the starting rate (a good first guess) by looking for
the closest interest rate and discount factor. In this case, the nearest rate is 18% (i.e., first guess = 18%)

Step 4: Compute NPV at the 1st guess (18%)

NPV (18%)
Year NCF Discount factor (18%) Present value
1 15,000 0.847 12,705
2 10,000 0.718 7180
3 10,000 0.609 6090
4 15,000 0.516 7740
5 15,000 0.437 6555
Present value of net cash flows 40,270
Less: Initial Investment 40,000
NPV + 270
Since, at IRR, NPV is equal to zero, 18% is not the exact IRR. Thus, another rate should be tried. Which
rate should be tried next? Generally as we go down (in rate decreasing direction), discount factor
increases. Now we need to find a rate at which NPV = 0. Thus, we should try a higher rate. The next
(2nd) guess could be 19%. Then NPV should be computed at 19% using the above procedure.

NPV at 19%:
Year NCF Discount factor (19%) Present value
1 15,000 0.840 12,600
2 10,000 0.706 7060
3 10,000 0.593 5930
4 15,000 0.499 7485
5 15,000 0.419 6285
Present value of net cash flows 39,360
Less: Initial investment 40,000
NPV -640
At 19% NPV is negative; this implies that IRR lies between 18% and 19%. Thus, such iteration process
ends when two neighboring rates, at lower rate NPV is positive and at higher rate is negative. To find
the exact IRR, steps 4 and 5 will be followed:

Step 4: Obtain the absolute sum of the two present values

Sum = |+270| + |-640|
= 270 + 640

21
 = 910
Step 5: Divided the NPV of the smaller rate by the absolute sum and add to the smaller rate
270
IRR = 18% + 910
= 18.30%
Decision Rule for IRR
Accept: If the IRR is greater than the discount rate
Reject: If the IRR is less than the discount rate
5.13.5. Profitability Index (PI)
The profitability index, also called benefit - cost ratio, is the ratio of the present value of net cash flows
and initial investment.
Pr esent value of NCF
PI = Initial investment
To illustrate, assume that a project is expected to have initial investment and useful life of Br. 90,000
and four years respectively. Annual net cash flows amounted to Br. 40,000. The discount rate is 10%.
Profitability index can be computed as follow:
Pr esent value of NCF
PI = Initial investment
40 ,000 (3. 170 ) 126,800
= 90, 000 = 90,000 = 1.41
Decision rule for profitability Index
i. Accept if the project's profitability index is greater than 1
ii. Reject if the project's profitability index is less than 1

22