International Project Management prof.dr MILOŠ D. MILOVANČEVIĆ
Project Evaluation and Analysis Project Financial Analysis
Project Evaluation and Analysis The important aspects of project analysis are: Market analysis Technical analysis Financial analysis Economic analysis Environmental Analysis
Market analysis is concerned primarily with the answers to the following questions: Consumption trends in the past and the present consumption level Past and present supply position Production possibilities and constraints Structure of competition Cost structure Elasticity of demand Consumer behavior, intentions, motivations, attitudes, preferences, and requirements Distribution channels and marketing policies in use
Technical analysis seeks to determine whether the prerequisites for the successful commissioning of the project have been considered and reasonably good choices have been made with respect to location, size, process, etc. The important questions raised in project technical analysis are: Whether the preliminary tests and studies have been done or provided for? Whether the availability of human resources, power, and other inputs have been established? Whether the selected scale of operation is optimal? Whether the production process chosen is suitable? Whether the equipment and machines chosen are appropriate? Whether the auxiliary equipments and supplementary engineering works have been provided for?
In recent years, environmental concerns have assumed a great deal of significance. Among the question to be asked, environmental analysis includes: What is the likely damage caused by the project to the environment? E.g. how installation of transmission stalls affect the environment? What is the cost of restoration measures required to ensure that the damage in the environment is contained within acceptable limits?
Economic analysis, also referred to as social cost benefit analysis, is concerned with judging a project from the larger social point of view. The questions ought to be answered in social cost benefit analysis are: What are the direct economic benefits and costs of the project? What would be the impact of the project on the distribution of income in the society? What would be the contribution of the project towards the fulfillment of certain merit wants like self-sufficiency, employment, and social order?
Financial analysis Financial analysis seeks to ascertain whether the proposed project will be financially viable in the sense of being able to meet the burden of servicing debt, and whether the proposed project will satisfy the return expectations of those the shareholders (owners of the firms).
The aspects which have to be looked into while conducting financial evaluation of a project are: Investment outlay and cost of project Means of financing Cost of Capital Projected profitability Break-even point Cash flows of the project Projected financial position Level of risk
Financial analysis is complex Project financial analysis needs special attention for two reasons: Firstly, it is often regarded as the most complex part of the project evaluation process and secondly, financial efficiency and effectiveness are very powerful strategic goals
Financial evaluation & objectives Important concepts: Capital rationing Return on investment (ROI) Return on equity (RoE) Economic value added (EVA) Cost of funds Evaluation in the public sector: Cost / benefit analysis Non-financial techniques Complexities in measurement Importance of clarity about objectives
Financial Evaluation Profit and lossbased (accountant, traditional approach) Raise complicated accounting issues Ignore opportunity cost Problem of costs allocation So we will ignore Cash-based (contemporary approcah) Capital budgeting process Evaluation basis: incremental cash flow Two important cash based methods: Statical methods Discounted methods (money has a time value )
Identifying incremental cash flows Incremental cash flow is cash flow that results directly from the decision to accept the project (represent the changes in the firms total cash flows that occurs as a direct result of accepting the project) Project s incremental cash flow can be classified into three parts: Cash flow that occur only at the start of the project s life, time 0 (initial investment outlay) Cash flow that continuously throughout the projects life, time period 1 through n (Incremental operating cash flow)
Initial investment outlay Refer to the increment cash flow that occur only at the start of a projects life. The initial investment includes such cash flows as the purchase price of the new project, and the shipping and the installation costs. In replacement decision, the initial investment also must take into account the cash flows associated with the disposal of the old or replaced asset and any tax effects associated with the disposal. Also, the changes in the net working capital that results from the acceptance of a project is an
Incremental operating cash flow Capital project also affects the day-to-day cash flow generated by the firm. The cost reduction would result because the technological advancement of the new machine would allow either the use of less electricity or fewer raw materials in the manufacturing process. These cost savings, as well as any changes in depreciation will affect the taxes paid by the firm. Generally the changes in day to day cash flows that results from purchase of a capital project and will continue until the firm disposes of the assets.
Terminal Cash flow This is the net cash flow that occurs at the end of the life of a project, including the cash flows associated with, the final disposal of the project and returning the firm s operations to where they were before the project was accepted. It includes the salvage value, with could either be positive (selling the asset) or negative (paying for removal) and the tax impact of the disposition of the project. Any working capital account changes that occurred at the beginning of the project s life will be reversed at the end of its life.
Statical financial evaluation methods Do not take into account the time value of money Payback period Return on investments (ROI)
Payback period Widely used due to its simplicity The payback period (t p ) is the length of time before cumulative cash flow becomes positive Or, the amount of time required for the benefits to pay back the cost of the project. Simple example: The payback period is three years; the project is financially valid for realization since
Payback - Graphically
Payback period Payback can be used for comparing projects Simple example:
Disadvantages of the payback techique Doesn t necessarily give best overall result Doesn t take into account the profitability of the project (just the risk of paying back the invested capital) Doesn t take into account the time value of money
Return on Investment (ROI) A measure of the net income a project is able to earn with the total assets employed. Return on investment (or rate of return) is calculated by dividing net profits after taxes by total investments (investments in fixed and current asset) ROI measures how effectively the firm uses its capital to generate profit; the higher the ROI, the better. ROI does not indicate how long an investment
ROI is a widely used technique that assumes: Money invested in project Profits realized in future ROI is a comparison of the profit generated by the investment with the cost of the investment Average annual return or annual profit ARR = ----------------------------------------------------------------------- Initial cost of investment
An example An investment project is expected to yield cash flows of 10,000 annually for the next 5 years The initial cost of the investment is 20,000 Total profit therefore is: 30,000 Annual profit = 30,000 / 5 = 6,000 ROI = 6,000/20,000 x 100 = 30%
COST OF CAPITAL DEFINED "Cost Of Capital" (also called "hurdle rate") is more appropriately thought of as an opportunity cost of capital. The investment hurdle rate calculation used by industry is: The prime lending rate (the rate for rented money), plus a premium for general economic risk (inflation), plus a premium for economic risk faced in this industry, plus a premium for risk faced in dealing with assets of this type (with the concrete project)
Time Value of Money It is necessary to modify the streams of benefits and costs so that they can be compared at a single point in time. The comparison is termed "Discounted Cash Flow". The objective is to compare cash streams at a single point in time with reference to the established hurdle rate.
Present value Future Value PV = ---------------------------------- (1 + i) n Where i = interest rate n = number of years The PV of 1 @ 10% in 1 years time is 0.9090 If you invested 0.9090p today and the interest rate was 10% you would have 1 in a year s time Process referred to as: Discounting Cash Flow
Discounted financial evaluation methods Takes into account the fact that money values change with time Net present value Internal rate of return Discounted payback period
Net Present Value (NPV) The Net Present Value of an investment is determined by subtracting the sum of the discounted inflows from the discounted outflows, e.i. this is a sum of discounted net cash flows. In formula terms: Net Present Value = Sum of Discounted Inflows - Sum of Discounted Outflows
The rule NPV> 0 NPV< 0 NPV= 0 the investment would add value to the firm the investment would subtract value from the firm the investment would neither gain nor lose value for the firm The project may be accepted The project should be rejected This project adds no monetary value. Decision should be based on other criteria, e.g. strategic positioning or other
Net present value an example An example: A firm is deciding on investing in an energy efficiency system. Two possible systems are under investigation One yields quicker results in terms of energy savings than the other but the second may be more efficient later Which should the firm invest in?
Discounted Cash Flow System A Year Cash Flow ( ) Discount Factor (4.75%) Present Value ( ) (CF x DF) 0-600,000 1.00-600,000 1 +75,000 0.9546539 71,599.04 2 +100,000 0.9113641 91,136.41 3 +150,000 0.8700374 130,505.61 4 +200,000 0.8305846 166,116.92 5 +210,000 0.7929209 166,513.39 6 +150,000 0.7569650 113,544.75 Total 285,000 NPV
Discounted Cash Flow System B Year Cash Flow ( ) Discount Factor (4.75%) Present Value ( ) (CF x DF) 0-600,000 1.00-600,000 1 +25,000 0.9546539 23,866.35 2 +75,000 0.9113641 68,352.31 3 +85,000 0.8700374 73,953.18 4 +100,000 0.8305846 83,058.46 5 +150,000 0.7929209 118,938.10 6 +450,000 0.7569650 340,634.30 Total 285,000 NPV =108,802.70
NPV Project A represents better investment Project B yields the same return after six years but the returns of System A occur faster and are worth more to the firm than returns occurring in future years even though those returns are greater
Internal Rate of Return Allows the risk associated with an investment project to be assessed The IRR is the rate of interest (or discount rate) that makes the net present value = to zero Helps measure the worth of an investment Allows the firm to assess whether an investment in the machine, etc. would yield a better return based on internal standards of return
In the case of cash flows at whole numbers of years, to find the internal rate of return, find the value (s) of r that satisfies the following equation:
The rule IRR>WAC C IRR<WAC C IRR=WAC C (weighted average cost of capital) the investment would add value to the firm the investment would subtract value from the firm the investment would neither gain nor lose value for the firm The project may be accepted The project should be rejected This project adds no monetary value. Decision should be based on other criteria, e.g. strategic positioning or other
IRR- an example Calculate the internal rate of return for an investment of 100 value in the first year followed by returns over the following 4 years, as shown in the table: Solution: We use an iterative solver to determine the value of r. The result from the numerical iteration is IRR=28,09%. Year Cash flow 0-100 1 40 2 59 3 55 4 20
Benefit/Cost Ratio The ratio between the sum of the discounted benefits and the sum of the discounted costs. If the Benefit/Cost ratio is greater than 1, then the project is viable from the financial point of view. This simple variation of Net Present Value assists in ranking a series of investment projects that are being reviewed.
Comparing Alternatives All three of the discounted cash flow methods may be used to rank alternatives. However, the user of a financial evaluation must be aware of what the methods indicate.
Comparing Alternatives Net present value is the conceptually superior method. Cash payback illustrates the amount of time that you are at risk. The internal rate of return lets you test the integrity of the discount rate.
ISSUES IN INTERNATIONAL PROJECTS FINANCIAL ANALYSIS 1. Parent v. Project Cash Flow The cash flows from the project may differ from those remitted to the parent; Relevant cash flows become quite important 2. Three Stage Approach to simplify project evaluation a. compute subsidiary s project cash flows b. calculate the cost of funds and evaluate the project to the parent
ISSUES IN INTERNATIONAL PROJECTS FINANCIAL ANALYSIS What increase in incremental demand for products (services) of the company will result from the FI? At what price, in terms of foreign currency, can the goods be sold in the foreign market? What is the price elasticity? What is the full cost of FI? How much of this cost can be recovered if the project falls? What proportion of the cost of FI can be bought in foreign country and how much needs to be imported? What grants and tax concessions can be negotiated with the government in the foreign country? What are the working capital requirements for the foreign project (do they differ from the same requirements in the
What is the cost of funds in the foreign country? What proportion of these funds can be raised locally? Is this project likely to be a permanent project or a capital venture with a fixed life? If the lifetime is short what is the likely terminal value of the project? What are the rules regarding repatriation of profits from the foreign country? How stable is exchange rate between the foreign and home currency? Are devices such as forward, options and futures available in the foreign country? How stable is the government of the country in which the investment is to be made? What is political risk index
ISSUES IN INTERNATIONAL PROJECTS FINANCIAL ANALYSIS How to adjust for increased economic and political risk of project? Three Methods of Economic and Political Risk adjustments: a. Shortening minimum payback period b. Raising required rate of return c. Adjusting cash flows
Literature: Levy H., Sarnat M. (1999) Capital Investment and Financial Decisions, Prentice Hall McRae T. (2000), International business finance, Wiley & Sons Ltd.