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PROJECT FINANCE

Unit – III: Financial Analysis

As earning is the prime motive of any business, therefore, market & demand forecasting and
technical analysis is the side studies of detailed feasibility analysis. Main motive of detailed
feasibility study is to assess the profitability of the project (especially for a private project).
Therefore, financial analysis or financial appraisal is done with regards to have surety about the
profitability of project idea, although it is done on the basis of market & demand and technical
analysis. Apart from checking the profitability of project idea, there are few other activities involved
in financial analysis.

Activities Involved in Financial Analysis:

Along with checking the profitability of the project there are some other activities involved in
financial analysis related to cost of project and fund collection for it. All the activities under financial
analysis can be list out as follows:

Main Activity
1. Financial Evaluation of Project
Other Activities
2. Cost of Project
3. Decision about Sources of Finance
o Cost of Capital
o Capital Structure
4. Working Capital Requirement

1. FINANCIAL EVALUATION OF A PROJECT:

“Financial evaluation is a planning process used to determine whether a firm’s long term
investment in project is financially feasible or not, on the basis of expected cash inflows and
outflows in future”.

Inflows are provided by market & demand analysis by calculating forecasted demand and price.
Outflows are provided by Technical analysis (Operational Cost) and Financial Analysis (Financial
Cost). On the basis of cash inflows and cash outflows, net cash inflows are calculated. Finally,
project is evaluated by applying various techniques of capital budgeting on net cash inflows.
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Objective of Financial Analysis:

Basic object of financial analysis is to check the feasibility of project from the point of view of
profitability. As it is the objective of whole feasibility study, this study is having prime importance in
whole feasibility study. There can be other objectives like avoiding the risky project.

Methods of Techniques of Financial Evaluation:

There are various methods available for financial evaluation of a project (i.e. to see whether project
will be profitable as per our expectations or not). These methods can be categorized under two
categories:
Non-Discounting or Traditional Techniques: (Methods which do not use time value of money)
1. Average Rate of Return (ARR)
2. Pay Back Period Method (PBP)

Discounting or Modern Techniques: (Methods which use time value of money)

3. Net Present Value (NPV) Method
4. Profitability Index (PI) or Benefit-Cost Ratio (BCR)
5. Internal Rate of Return (IRR)

The difference in two methods is of ‘Time Value of Money’. +TMV means that the value of a unit
of money is different in different time pe4riods. “Rs.100 not today is having more worth than Rs.
100 note tomorrow”. Conversely, the sum of money received in future is less valuable than it is
today. The main reason for time value of money is to be found in the reinvestment opportunities for
funds which are received early. The funds so invested will earn a rate of return; this would not be
possible if the funds are received at a later time. The time value of money is therefore, expressed
generally in terms of a rate of return or discounting rate.

NON-DISCOUNTING TECHNIQUES

1. Average or Accounting Rate of Return:

It can be termed as average annual profit earned by a project on investment made in the
project expressed in terms of percentage. The Accounting Rate of Return uses the accounting
information as revealed by financial statements, to measure the profitability of an investment.
The accounting rate of return is the ratio of average after tax profit divided by average
investment. Here average income is adjusted for interest.

The average profit after taxes are determined by adding up the after-tax profits expected for each
year of project’s life and dividing the result by the number of years. The initial investment is the
total investment in the business at the time of starting it. Some experts suggest to take average
investment instead of initial investment, as charging of depreciation against profit is regularly
reducing the investment is business. Such average investment will be calculated by dividing the
total investment by two (assuming scrap value as zero)
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Accept-Reject Criteria: The actual ARR would be compared with a predetermined or a

minimum required rate of return or cut-off rate. A project would qualify to be accepted if the
actual ARR is higher than minimum desired ARR. Otherwise; it is liable to be rejected. In case of
alternative projects, the ranking method can be used to select or reject proposals. Thus, the
alternative proposals under consideration may be arranged in the descending order of ARR.
Projects having higher ARR would be preferred.

Merits:
1. It is very easy to understand and to calculate
2. It uses readily available accounting information.

Demerits:
1. It ignores the time value of money. Yearly inflows of (Rs.10000, 20000 & 30000) and
(Rs.3000, Rs.20000 and Rs.10000) will be treated as same.
2. It uses accounting profits, which takes into account the non-cash expenditures.

2. Pay Back Period Method:

The pay back period method is the second traditional method of project evaluation. It is the
simplest and, perhaps, the most widely employed, quantitative method for appraising capital
expenditure decisions. Pay Back Period it that time period in which firm will recover its
initial investment in project in form of annual cash inflows. Cash inflows here mean the
profit excluding non-cash expenditures i.e. profit before depreciation but after tax.

Initial Investment
PBP (in years ) 
Annual Cash Inflow

 Balance R emaining 
PBP  CompleteYears   12
 Cash Inflow for the year  months
First formula is used in case of annuity of cash inflows and second one is used when cash
flows are not uniform (mixed stream).

Accept Reject Criterion: The actual pay back is compared with predetermined or desired
pay back, that is, the pay back set up by the management in terms of the maximum period
during which the initial investment must be recovered. If the actual pay back period is less
than the predetermined pay back, the project would be accepted; if not, it would be rejected.
When there are alternative projects, they may be ranked according to the length of the pay
back period. Thus, the project with shorter pay back period will be selected.

Merits:
1. It is easy to calculate and simple to understand.
2. It is based on cash inflows and not on accounting profit.
3. It favors the project with larger cash inflows in earlier years (although do not consider
time value of money).

Demerits:
1. It ignores the time value of money
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2. It do not consider the cash flows beyond the pay-back period. Project A – Rs.5000,
Rs.6000 and Project B – Rs.5000, Rs.6000, Rs.8000, Rs.10000 with initial investment
of Rs.10000 are same for this method.

DISCOUNTING TECHNIQUES
The discounting techniques take into consideration the time value of money while evaluating the
costs and benefits of a project. These methods require cash flows to be discounted at a certain rate.
Frequently used discounting techniques of project evaluation are:

3. Net Present Value (NPV) Method:

NPV may be described as the summation of the present values of cash inflows in each year
minus the summation of present values of the cash outflows in each year. It can be denoted by
following formula:

NPV  PV of all CI  PV of all CO

This method is based on the concept of ‘Time Value of Money’ which says that – cash flow
streams at different time periods differ in value and can be compared only when they are
expressed in terms of a common denominator, that is, present values. In this method, all cash
flows are expressed in terms of their present values using a discounting rate by using following
formula:

 FV 
PV   t 
 (1  r ) 
Where: PV = Present Value of Cash Flow
FV = Future Value of Cash Flow
r = Rate of Discounting (can be the cost of capital, or desired rate of return)
t = Time i.e. year of the cash flow to be discounted

Let us see with the help of illustration:

If future Cash Inflows are given as - CI1, CI2, CI3, ……………, CIn and Initial Cash Outflows
(investment) is given as: - CO0,Than NPV can be Calculated as:

 CI1   CI 2   CI 3   CI n 
NPV   1 
 2 
 3 
 .............   (1  r ) n   COo
 (1  r )   (1  r )   (1  r )   

Accept-Reject Criteria: If the NPV is positive, the project should be selected and if it is
negative, project should be rejected. Zero NPV implies that the firm is indifferent to accepting or
rejecting the project. In case of many alternative projects, the various projects would be ranked in
order of the NPV. The project with the highest NPV would be assigned the first rank, followed
by others in the descending order.

Merits:
1. It considers the Time Value of Money
2. It also considers the all cash flows while evaluating the project
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Demerits:
1. It is difficult to calculate in comparison to non-discounting techniques.
2. May not give correct result when initial investments are different in two projects, as it is an
ABSOLUTE MEASURE only.
3. Deciding about the appropriate discounting rate is very difficult, it can be different for
different persons.

4. Profitability Index (PI) or Benefit-Cost Ratio (B/C Ratio)

It is similar to the NPV approach. The profitability index approach measures the present value of
returns per rupee invested, while the NPV is based on the difference between the present value of
future cash inflows and present value of cash outflows. But NPV is an absolute measure;
therefore, it is not reliable method to evaluate project requiring different initial investment. The
PI method provides a solution to this kind of problem. It is, in other words, a relative measure. It
may be defined as the ratio which is obtained by dividing the present value of future cash inflows
by the present value of cash outflows. Symbolically,

PV of all CI
PI or BCR 
PV of all CO
Let us see with the help of illustration:
If future Cash Inflows are given as - CI1, CI2, CI3, ……………, CIn and Initial Cash Outflows
(investment) is given as: - CO0,Than PI can be Calculated as:

 CI1   CI 2   CI 3   CI n 
 
 (1  r )1   (1  r )2   (1  r )3   .............   (1  r ) n 
PI         
COo

Accept-Reject Criteria: A project will qualify for acceptance if its PI exceeds one and rejected if
it is less than one. When PI equals 1, the firm remains indifferent to the project. When PI is
greater than, equal to or less than 1, the net present value is greater than, equal to or less than
zero respectively. Selection of projects with PI method can be done on the basis of ranking. The
highest rank will be given to the project with the highest PI, followed by others in the same order.

Merits:
1. It considers the Time Value of Money
2. It considers all the inflows from the project
3. It is a Relative Measure, can be used in all cases

Demerits
1. This method is difficult to use in comparison to traditional methods
2. Deciding about the appropriate discounting rate is very difficult, it can be different for
different persons.

4. Internal Rate of Return (IRR):

This technique is also known as yield on investment, marginal efficiency of capital, rate of
return, time-adjusted rate of return and so on. Like the present value method, the IRR method
also considers the time value of money by discounting the cash stream. The internal rate of
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return is usually the rate of return that a project earns. It is defined as the discount rate ® which
equates the aggregate present value of the net cash inflows with the aggregate present value of
cash outflows of a project. In other words, it is that rate which gives the project NPV as zero.
Symbolically, it can be shown as follows:

 CI1   CI 2   CI 3   CI n 
 (1  r )1    (1  r )2    (1  r )3   .............   (1  r ) n   COo  0
       

Unlike the NPV method of calculating the value of IRR is more difficult. The procedure is
based on ‘hit & trial’. We try different rates for discounting the cash flows and find out the
NPV and try the same till we get a discounting rate at which NPV becomes zero. That
discounting rate is the IRR for the project. We can also use following steps and formula to have
some approximation regarding the zero NPV discounting rate i.e. IRR.
 Find fake PBP (as discounting factor)
 Search nearby value (rates) from the table
 Put the value in formula to make NPV zero
 If not getting zero, try some other nearby rate
 Get two rates - one negative and one positive NPV
 Put the Figures in formula to get IRR

PV of CI rL  PV of COrL
IRR  rL   r
PV of CI rL  PV of CI rH

Accept-Reject Criteria: The project would qualify to be accepted if the IRR exceeds the cut-off
rate or desired rate. If the IRR is less than the required rate it would be rejected. Ranking
method can also be used in case of multiple projects. Ranking is done in descending order from
high IRR project to low IRR project and select from top.

Merits:
1. It considers the Time Value of Money
2. It considers all the inflows from the project
3. It do not require any discounting rate
4. It indicates the real profitability of the business

Demerits:
1. It is very difficult to calculate (Hit & Trial)

OTHER ACTIVITIES:
Apart from project evaluation there are some other activities which comes under financial analysis:
 Estimating the Cost of Project
 Decision about Sources of Finance
 Working Capital Requirement
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1. Estimating the Cost of Project:

Estimating the total cost of project is also an important activity under financial analysis, as
without it financial costs of the firm can not be calculated. Total cost of project is comprises of
cost of all individual activities of the project. These activities are as follows:
 Land & Site Development
 Building & Civil Work
 Plant & Machinery (& Other Fixed Assets)
 Expenses on Services of Professionals
 Margin Money for Working Capital
 Provision for Contingencies
 Pre-Operative Expenses

2. Decision about Sources of Finance:

After estimating the cost of project next step is to look for the sources of the funds, form which
this amount will be arranged. Following are the different sources of funds:
 Equity Share Capital
 Preference Share Capital
 Debentures
 Term Loans
 Lease Financing
 Deferred Credit
 Other Miscellaneous Sources

All above sources are having some merits as well as some demerits; therefore, a proper
combination out of above sources has to be formed keeping following factors in mind:
 Cost of Capital
 Risk Bearing Capacity
 Duration
 Willingness to loose control over business
 Trading on Equity etc.

3. Working Capital Requirement:

Funds which are required to finance the current assets of the project are known as working
capital. It is also equally important to estimate the requirement of working capital in starting as
well as during the tenure of the project. It will help in estimating the total funds required for the
project and financial cost. Different assets to be financed through working capital are:
 Raw-Material and Components
 Work-In-Progress
 Stock of Finished Goods
 Debtors
 Cash and Bank Requirements (for Expenses)
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A NOTE ON ‘TRADING ON EQUITY’

As we know that debt capital is a cheaper source of finance, but it is risky because of its fixed legal
obligation of paying interest and capital repayment. Therefore, while deciding about the capital
structure proper use of debt capital should be made to minimize the cost of capital but at the same
time risk should be checked.

Trading on Equity can be defined as using more and more debt capital in capital structure of a firm
for increasing the value of shareholders.

This increase of value is because of two reasons, which are:

1. Interest is a tax deductible item, therefore, firm gets this benefit which it does not get in case
of dividend to shareholders.
2. Generally, rate of return in business is greater than the rate of interest on debt capital, which
means you can earn more and pay a part to debt provider, rest is balance for shareholders.

Let us see this with an illustration:

Suppose a firm has to invest Rs.10 lacs in a business, which will give return @20% P.A. Now there
are two options for this firm.
1. Option A: Whole capital should be subscribed from shareholders i.e. 100000 shares of
Rs.10/-
2. Option B: Rs.500000 should be subscribe from shareholders i.e. 50000 shares of Rs.10/- and
Rs.500000 from bank term loan @12%

Investment 10,00,000
ROI 20%
Tax Rate 50%
Items Option A Option B
Sources of Finance
No. of Equity Shares of Rs.10 100000 50000
Equity Capital / Funding 1000000 500000
Term Loan @12% Interest 0 500000
Total Capital Employed 1000000 1000000

PBIT @20% of Investment 200000 200000

Interest 0 60000
PBT 200000 140000
Tax @ 50% 100000 70000
PAT 100000 70000
EPS (PAT/No. of Shares) 1 1.4

It is clear from the above illustration that under option A (100% equity financing) earning per
share is Re.1 where as by using 50% debt of 12% rate of interest it has increased to Rs.1.4. It is
because of ‘trading on equity’.
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But trading on equity is a two edge sword. The way it is providing benefit to the shareholder can
reverse also i.e. it can give loss also to shareholders, if rate of return from the business becomes
less than the rate of interest on the loan. Again changing the above example we can see this:

Investment 10,00,000
ROI 10%
Tax Rate 50%
Items Option A Option B
Sources of Finance
No. of Equity Shares of Rs.10 100000 50000
Equity Capital / Funding 1000000 500000
Term Loan @12% Interest 0 500000
Total Capital Employed 1000000 1000000

PBIT @10% of Investment 100000 100000

Interest 0 60000
PBT 100000 40000
Tax @ 50% 50000 20000
PAT 50000 20000
EPS (PAT/No. of Shares) 0.5 0.4

We can see that when rate of return is less than rate of interest on debt using more debt in capital
structure is harmful for shareholders. Therefore:
 More of Debt Capital is used when Expected ROI > Interest on Debt
 Less of Debt Capital is used when Expected ROI < Interest on Debt