Chapter Two: Financial Analysis

2.1. Scope and rational for 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 who provide the equity capital. Here the project
analysts is concerned with the financial effects of the proposed project on each of its various
participants (firms, framers/workers, government etc.). This analysis will seek to assess the
financial effects on participants as well as on the public sector, which will be involved in
investing and operating the project.
Why financial analysis is undertaken? It is because:
 There is a need for investment by the private sector
 There is a need for investment by the public sector
 Public investment for large scale projects (railway, electricity generation)
 It is the basis for economic analysis
Objectives of financial analysis:
 To ensure that there is adequate incentive for the project participants
 To assess the current and potential financial impacts of the project
 To judge efficient resource usage in the project
 To come up with sound financial plan
 To assess financial management competencies
When to undertake financial analysis?
Planners should conducted financial analysis when there is a need to determine the liquidity and
financial viability of a project.
Liquidity relates to the continued availability of funds in order to finance activities throughout
the implementation and operation of the project. The liquidity of a project can be determined by
analyzing the cash flow statement.
Financial viability is related to liquidity in that it is another way of saying that project meets the
basic feasibility criteria for financial analysis. Financial viability can therefore be defined as a
situation where:
 Cash flow is always positive and sufficient to meet all financial commitments
 All stakeholders have sufficient financial incentive to participate in project
2.2 Identification and Analysis of the Estimates of Costs and Benefits
In project analysis, the identification of costs and benefits is the first step. This involves the
specification of the costs and benefit variables for which data should be collected, identification
of the sources of information, collection of the same and then assessment of the quality and
reliability of the collected information. The costs and benefits of a project depend on the
objectives the project wants to achieve. So, the objectives of the analysis provide the standard

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against which cost and benefits are defined. A cost is anything that reduces an objective, and a
benefit is anything that contributes to an objective. However, each participant in a project has
many and different objectives.
 For a farmer, a major objective of participating may be to maximize family income.
 For a private business firm or government corporations a major objective is to maximize
net income
 A society as a whole will have as a major objective increased national income, but it
clearly will have many significant, additional objectives.
2.3 Classification of Costs and Benefits

Project cost and benefit

Tangible cost and benefit Intangible cost and benefit

2.3.1 Tangible costs and benefits of a project

The first question that the analyst needs to know is whether it is one project that is to be
evaluated or several alternatives? Determining the relevant alternative project based perhaps on
technology, size, or length of time required for the phasing out of the project etc. is a critical
problem.
2.3.1.1 Tangible costs of a project: In almost all project analyses costs are easier to identify
(and value) than benefits. In examining costs the basic question is whether the item reduces the
net benefit of a farm or the net income of a firm. The prices that the project actually pays for
inputs are the appropriate prices to use to estimate the project’s financial costs. These prices may
include taxes, tariffs, monopoly or monopsony (seller monopoly) rents, or be net of subsidies.
Some of the project costs are tangible and quantifiable while many more are intangible and non-
quantifiable. The costs of a project depend on the exact project formulation, location resource
availability, or objective of the project. Tangible costs refer to costs incurred by the company in
the project from project idea identification throughout the implementation and operation phases
and that can be quantified directly and easily in monetary value. In general, the cost of a project
would be the sum of the total outlays on the following items.
The cost of land and site development
 Land charges
 Payment for lease
 Cost of leveling and development

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  Cost of laying approach roads and internal roads
 Cost of gates
 Cost of tubes wells
The cost of buildings and civil works
 Buildings for the main plant and equipment’s
 Buildings for auxiliary services (steam supply, workshops, laboratory, water
supply, etc.)
 Warehouses and show rooms
 Non factory buildings like guest house, canteens, residential quarters, staff rooms
 Silos, tanks, wells, basins, etc.
 Garages and workshops
 Other civil engineering works
Plant and machinery
 Cost of imported machinery which might include the FOB value, shipping freight and
insurance costs, import duty, clearing, loading, unloading, and transportation costs
 Cost of local or indigenous machinery
 Cost of stores and spares
 Foundation and installation charges
Technical know-how and engineering fees
 Consultants (local or external)
Miscellaneous fixed assets
 Expenses related to fixed assets such as furniture, office machines, tools, equipment’s,
vehicles, laboratory equipment’s, workshop equipment’s
Pre-operative expenses
 Establishment expenses,
 Rents, taxes, and rates
 Traveling expenses interest and commitment charges on borrowings
 Insurance charges
 Mortgage expenses interest on differed payments,
 Miscellaneous expenses
Provision for contingencies
The cost of production

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Once the project idea has been accepted and the project is being implemented the cost of
production may be worked out: For instance, for an agricultural project the following may be
necessary:
 Material cost which comprises the cost of raw materials, chemicals, components,
fertilizer and pesticides for increasing agricultural production, concrete for irrigation
canal construction, material for the construction of homes etc and consumable stores
required for production. It is not the identification that is difficult in this case but the
problem of finding out how much is needed from each.
 Utilities consisting of power, water, and fuel are also important cost components.
 Labor: this is the cost of all manpower employed in the enterprise. It will not be difficult
to identify and quantify the labor required for the production process. From the highly
skilled manager to the unskilled factory worker the labor input can easily be identified.
Problems in the case of valuing unskilled labor and family labor might arise in the
economic analysis of projects.
 Factory Overhead: the expense on repairs and maintenance, rent, taxes, insurance on
factory assets, etc. are collectively referred to as factory overheads.
 Land to be used for the project can also be easily identified and quantified. It will not be
difficult to know who much land is need and about the location. Yet problems might arise
in valuing land because of the special kind of market conditions that exist when land is
transferred from one owner to another.
 Contingency allowances are usually included as a regular part of the project cost. In
general project costs estimates are assume that there will be no relative changes in
domestic or international prices and no inflation during the investment period or there
will not be any modification in design, no exceptional conditions such as unanticipated
environmental conditions (flood, landslides, or bad weather). It would be unrealistic to
base project cost estimates only on these assumptions of perfect knowledge and complete
price stability. Sound project planning requires that provision be made in advance for
possible adverse changes in physical conditions or prices that would add to the baseline
cost. Contingency allowances may be divided into those that provide for physical
contingencies and those for price contingencies. In turn price contingencies comprises
two categories, those for relative cages in price and those for general inflation. Physical
contingency allowances and price contingency allowances for relative changes in price
are expected and form part of the cost base when measures of project worth are
calculated. To avoid the problem of inflation on the other hand it is advisable to work
with constant prices instead of current prices. This approach assumes that all prices will
be affected equally by any rise in the general price level. So contingency allowances for
inflation will not be included among the costs in project accounts other than the financing
plan.

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  Taxes: payment of taxes including tariffs and duties is treated as a cost to the project
implementer in financial analysis. But they are considered as transfer payments in
economic analysis.
 Debt service: the same approach applies to debt service - the payment of interest and the
repayment of capital. Both are treated as an outflow in financial analysis. In economic
analysis debt service is treated as a transfer payment within the economy even if the
project will actually be financed by a foreign loan and debt service will be paid abroad.
 Sunk costs: sunk costs are those incurred in the past and upon which the proposed new
investment will be based. Such costs cannot be avoided however, poorly advised they
may have been. When we analyze a proposed investment, we consider only future returns
to future costs; expenditures in the past, or sunk costs do not appear in our account.
2.3.1.2 Tangible Benefits
Tangible benefits can arise either from increased production or from reduced costs. The specific
forms, in which tangible benefits appear, however, are not always obvious and valuing them
might be difficult. Tangible Benefits on the other hand are the return of the project, which are
expressed in the cash flow statement as cash inflow. In general the following benefits can be
expected
 Increased production
 Quality improvement
 Changes in time of sale changes in location of sale
 Changes in product form (grading and processing)
 Cost reduction through technological advancement
 Reduced transport costs
 Loses avoided
 Other kinds of tangible benefits
2.3.1 Intangible costs and benefits
There may be benefits that are intangible like: negative felling among people belonging to
different department may lead to the disruption of implementation and failure of otherwise
promising projects. Biasness due to internal policies or any other reasons may damage industrial
relation among workers. Negative externalities (spillover effects) such as noise, pollution. Such
intangible benefits, however, do not readily lend themselves to valuation. Under such
circumstances one may have to resort to the least cost approach instead of the normal benefit cost
analysis.
Although the benefits may be intangible most of the costs are tangible. However, it may improve
the attractiveness of the product or service; it may give the organization a sense of pride; it may
make the working environment of the organization more pleasing; it may strengthen the
technological capability of the organization; it may enhance the moral of employees in the

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organization; etc. These benefits referred to generally as intangibles these benefits cannot be
translated into monetary terms.
2.4. The valuation of financial costs and benefits
This is an issue of pricing/valuing/ of the project’s inputs and outputs. The inputs and outputs of
a project appear in physical form and prices are used to express them in value terms in order to
obtain common denominator. Market prices are just the prices in the local economy, and include
all applicable taxes, tariffs, trade mark-ups and commissions.

 Since the project implementers will have to pay market prices for the inputs and will
receive market prices for the outputs they produce, the financial costs and benefits of the
project are measured in these market prices.
Prices may be defined in various ways, depending on whether they are:
 Market / Shadow prices:
Market or explicit prices are those present in the market, no matter whether they are determined
by supply and demand or by the government. They are the prices at which the firm will buy the
inputs and sell the outputs. In financial analysis market prices are applied.
 Absolute / relative prices:
Absolute prices reflect the value of a single product in an absolute amount of money, while
relative prices express the value of one product in terms of another.
 Constant / Current prices
Current and constant prices differ over time due to inflation, which is understood as a general
rise of price levels in an economy. If inflation can have a significant impact on project inputs and
output prices, such an impact must be dealt with in the financial analysis. Wherever relative
input and output prices remain stable, it is sufficiently accurate to compute the profitability or
yield of an investment at constant prices.
Treatment of transfer payments in financial analysis
Transfer payments represent the transfer of claims to real resources from one person to another.
The most common transfer payments include taxes, duties, subsidies, loan receipt, interest and
repayment of principals. In financial analysis, taxes and duties are treated as costs while
subsidies are treated as benefits. Loan receipt is considered as benefit but payment of interest and
principal as cost.
2.5 Cash flows in financial analysis
Cash flow analysis is simply the process of identifying and categories of cash flows associated
with a project or proposed course of action, and making estimates of their values. The movement

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of cash refers to cash inflow and cash outflow. The sources of cash inflow are equity capital,
loan, and sales while cash outflow include expenditures like investment, incremental working
capital, operating costs, interest on loan, loan repayment, and tax.
The key point to remember when assessing the liquidity of a project is that the cumulative cash
flow must remain positive. A negative figure indicates the project lacks sufficient fund to cover
its expenditure and as a result the project should be ceased.
Basic principles of measuring project cash flows
The following principles should be followed while estimating the cash flows of a project:
i) Separation principle: There are two sides of a project; the investment (or asset) side and
financing side and the cash flow associated with these sides should be separated.
ii) Incremental principle: The cash flow of a project must be measured in incremental term. To
ascertain a project’s incremental cash flows you have to look at what happens to the cash flow of
the firm with the project and without the project. The difference between the two reflects the
incremental cash flows attributable in the project. That is:

iii) Post-tax principle: Cash flow should be measured on an after-tax basis. Some firms may
ignore tax payments and try to compensate this mistake by discounting the pre-tax cash flows at
a rate higher than the cost of capital of the firm. Since there is no reliable way of adjusting the
discount rate, you should always use the after-tax cash flow along with after-tax discount rate to
assess the impact of taxes.
Components of the Cash Flow Stream
The cash flow stream associated with a project may be divided into three basic components:
(i) An initial investment: represents the relevant cash flow when the project is set up like:-
 Infrastructures, building construction, machines and equipment, auxiliary items, etc.
 Fixed investment:
 Pre-production expenditure: surveys, office setting, studies, etc.
 Working capital: to ensure for smooth operation of the project.
 Office materials and equipment’s,
(ii) Operating cash inflows, the cash inflows that arise from the operation of the project during its
economic life like: wages and salaries, tax, debt services, Project management, Fuel,
Maintenance and etc.
(iii) A terminal cash flow: relevant cash flow occurring at the end of the project life on account
of liquidation of the project.
CASH FLOW ILLUSTRATION
Example 1
A project involves an immediate outlay of $25,000, with annual expenditures in each of the four
years as 2000, 4000, 4000and 2000 and generates revenue in each of three years of $15,000.

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These cash flows data may be set out, and annual net cash flows derived, as in the table below.

Example 2
Consider a hypothetical fertilizer plant having an operating life of 10 years and requiring an
initial capital investment of 20 million Birr. It is assumed that the plant will take one year to
begin its operation (year zero) and commence full capacity operation at the beginning of year
one. Operation will be ceased and equipment scrapped with no salvage value at the end of year
10. The price of fertilizer is Birr 1400 per ton and the capacity of the plant is 10,000 tons per
annum. Fixed operating expenses amount to Birr 1 million per year while unit costs of
manufacture are Birr 900 per ton. Prepare the cash flow of the project.
Solution:
Investment Cost = 20 million Birr; Total Operating Costs starting year one is Birr 10 million per
annum [(Birr 1 million) + (Birr 900 x 10000 tons)]; Total sales Revenue starting year one is Birr
14 million (1400 Birr/ton x 10000 tones). Therefore, the total cost stream is subtracted from the
total revenue steam to obtain the net financial cash flow as shown in the following table:

From the above cash flow table we can easily observe that the project will have a net cash flow
balance of 20 million Birr when it phased out or liquidate.
Biases in Cash flow estimation
As cash flows have to forecast far in to future, errors in estimation are bound to occur.
Overstatement of Profitability
Either the initial investment is underestimated and/or the operating cash inflows are exaggerated.
The principal reasons for such optimistic bias appear to be as follows:
♦ Intentional Overstatement / Capital rationing: In a bid to present their projects in a favorable
light, project sponsors may intentionally over-estimate the benefits and under-estimate the costs.
♦ Lack of Experience: Inadequate experience on the part of project sponsors generally leads to
over-optimistic estimates. Experience often induces conservatism that checks overoptimistic
tendencies. On the other hand, inexperience may lead to wishful thinking.
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Understatement of Profitability
There can also be an opposite kind of bias relating to the terminal benefit that may depress a
project’s true profitability. The understatement of profitability might arise due to the following
reasons: Underestimation of salvage value of machineries: In real life situation the rate of
physical wear and tear is usually much less than the rate of depreciation estimated for tax or
accounting purposes.
2.6 Investment profitability analysis
Once costs and benefits have been identified, priced and valued, the project analyst should work
out to determine on which project to invest. To this effect, the project analyst should have ways
and means/methods, tools, approaches/ to select more profitable from less profitable or
unprofitable projects. A wide range of criteria have been suggested for choosing investment
proposals, which are suitable for both financial and economic analysis. These criteria may be
classified into two categories:
a. Non-discounting criteria including:
b. Discounting criteria
Non-Discounted Measures of Project Worth
In order to appraise a project idea we need operational criteria applicable in evaluating
alternatives. Technical criteria are used to compare the merits of alternative technical solutions.
It should be noted that there might be no one best technique for estimating project worth non-
quantifiable and non-economic criteria for making project decisions. The tools are only used to
improve the decision making process. Before we discuss the discounted measure of project worth
we need to consider some common undiscounted measures and show their limitations and hence
require discounting.
1. Ranking by Inspection
It is possible, in certain cases, to determine by mere inspection which of two or more investment
projects is more desirable. There are two cases under which this might be true.
(i) Two investments have identical cash flows each year up to the final year of the short-lived
investment, but one continues to earn cash proceeds (financial results or profits) in subsequent
years. The investment with the longer life would be more desirable.
Example: consider the following hypothetical irrigation project
Investment (project) initial cost net cash proceeds per year
Year I year II total proceeds
A 10,000 10,000 ------- 10,000
B 10,000 10,000 1,100 11,100
C 10,000 3,762 7,762 11,524
D 10,000 5,762 5,762 11,524

Accordingly project B is better than investment A, since all things are equal except that B
continues to earn proceeds after A has been retired. More analysis is required to decide between
C and D.

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(ii) Two investments have the same initial outlay (the total net value of incremental production
may be the same), the same earning life and earn the same total proceeds (profits), but one
project has more of the flow earlier in the time sequence, we choose the one for which the total
proceeds is greater than the total proceeds for the other investment earlier. Thus investment D is
more profitable than investment C, since D earns 2000 more in year 1 than investment C, which
does not make up the difference until year 2.
2. Urgency
According to this criterion projects which are deemed to be more urgent get priority over
projects which are regarded as less urgent.
The problem with this criterion is: how can the degree of urgency be determined? In certain
situations it may not be practically difficult to determine the urgency of a certain project
proposal. For instance the project could be bottleneck alleviation bottleneck of an ongoing
operation/firm/ etc. Since it is not a systematic decision, this is not something that can be
encouraged. Rather it is a practice that should be discouraged.
3. The Payback Period
The payback period also called the payoff period is one of the simplest and apparently one of
the most frequently used methods of measuring the economic value of an investment. Since it
addresses the prime concern of an investor in terms of reclaiming/recovering the initial outlay, it
is frequently used method of project evaluation. The recovered money can be reinvested in
something else. If the investor recovers its initial outlay, then in a way it is minimizing the risk it
faces in the subsequent operation of the project.
The payback period is defined as the length of time required for the stream of cash proceeds
produced by the investment (project) to be equal to the original cash outlay required by the
investment (capital investment). It is defined as the number of years it is expected to take from
the beginning of the project until the sum of its net earnings (receipts minus operating costs)
equals the cost of the projects initial capital investment. It is the period of time that the investor
recovers its initial total outlay. This criterion is most often used in the business enterprises.
However, its use in agricultural projects is limited.
Example: if a project requires an original outlay of Birr 300 and is expected to produce a stream
of cash proceeds of Birr 100 per year for 5 years, the payback period would be
300/100 = 3 years.
Note: if the expected proceeds are not constant from year to year, then the payback period must
be calculated by adding up the proceeds expected in successive years until the total is equal to
the original outlay.

Example:
Investment (project) initial cost net cash proceeds per year
Year I year II total proceeds
A 10,000 10,000 ------- 10,000

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B 10,000 10,000 1,100 11,100
C 10,000 3,762 7,762 11,524
D 10,000 5,762 5,762 11,524

Consider project C. 10,000 - 3762 = 6238. Then 6238/7762 = 0.8 So the payback period is 1.80
years. Consider project D. 10,000 - 5762 =4238. Then 4238 /5762 = 0.7 so the payback period is
1.70 years.
Investmen payback (period in years) ranking of projects using the payback period criteria
t
A 1 1
B 1 1
C 1.8 4
D 1.7 3
Investment A and B are both ranked as 1, since they both have shorter payback periods than any
of the other investments, namely 1 year. But investment B which has the same rank as A will not
only earn 10,000 Birr in the first year but also 1,100 Birr a year later. Thus investment B is
superior to A. But a ranking procedure such as the payback period fails to disclose this fact. Thus
it has two important limitations:
(i) It fails to give any considerations to cash proceeds earned after the payback date. It simply
emphasizes quick financial returns, ignoring the performance of the project over its economic
life.
(ii) It fails to take into account differences in the timing of receipts and earned proceeds prior to
the payback date. For instance, if we have two projects with the same capital cost and if they
have the same payback period then they are equally ranked. Yet we know by the inspection
method the project with earlier benefits should be desirable and should be preferred since the
earlier a benefit is received the earlier it can be reinvested or consumed.
4. Proceeds per Unit of Outlay
Under this method, investments are ranked according to their total proceeds divided by the
amount of the corresponding investments. In other words the total net value of incremental
production divided by the total amount of the investment gives us the proceeds per unit of outlay.
Example: consider the following hypothetical example:
Investment total proceeds Investment proceeds per unit of outlay Ranking
A 10,000 10,000 1 4
B 11,100 10,000 1.11 3
C 11,524 10,000 1.15 1
D 11,524 10,000 1.15 1

Accordingly project C and D must be implemented. However, both projects are given the same
rank. Although we know by inspection that project D is superior because D generates Birr 2000
of proceeds in year 1. This method is again deficient because it still fails to consider the timing
of proceeds. In other words, the method considers that 1 Birr of proceeds received in year 2 is

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equal to 1 Birr received in year 1. This is inconsistent with the generally accepted economic
principle that 1 Birr today is more valuable than 1 Birr at some future date.
5. The average annual proceeds per unit of outlay
This is similar to the proceeds per unit of outlay except that the average proceeds per year is
expressed as a ratio of the original investment. The total proceeds are first divided by the number
of years during which they are received, and this figure (the average proceeds per year) is then
expressed as a ratio of the original outlay. This method fails to take properly into considerations
the timing of proceeds and exhibits a built in bias for short-lived investment with high cash
proceeds.
Example:

We know that project D is superior to c although this method gives them equal ranks. Investment
A and B are also incorrectly ranked by ranking A above B in spite of the fact that the latter is
obviously superior. No weight is given to the time distribution. For instance, a project that earns
10000 Birr for 10 years would also have an average proceed of 10000 per year and it would be
given the same rank as project A.
In general, non-discounted measures of project worth can be regarded as simplified short cuts
that can be used for rough approximations and making decisions on small investments. They are
not as such recommended for making decisions associated with development projects and larger
investments.
DISCOUNTED PROJECT ASSESSMENT CRITERIA IN PROJECT ANALYSIS
The saying goes, a bird at hand is better than two birds in the bush!!!
The undiscounted measures discussed so far share a common weakness. They fail to take into
account adequately the timing of benefits and costs. If the costs and benefits of a project occur
over a number of years, they will not be directly comparable. It is not possible to just add all the
benefits of the project and to subtract all the costs, irrespective of when they occur. It is
therefore, necessary to find some method of standardizing the value of the benefits and the costs
that occur in different periods over the project’s life, so that they can be compared and added
together. For the reasons outlined above, income available now is more valuable than future
income even if there is no inflation. The accepted method for this adjustment amounts to
bringing them to a common time denominator. This principle is called discounting.
The Discounting Process
Discounting is a technique or a process by which one can reduce future benefits and costs to their
present worth or present value. This is the method used to revalue future cost and benefit flows
from project into present day values so that they are comparable and can be added together.
Costs and benefits are discounted by a factor that reflects the rate at which today’s value of a

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monetary unit decreases with the passage of every time unit. Any costs and benefits of a project
that are received in future periods are discounted, or deflated by some factor, r, to reflect their
lower value to the individual (society) than currently available income. The factor used to
discount future costs and benefits is called the discount rate and is usually expressed as a
percentage. Hence, discounting is very important for project analysis. The discount rate is
usually determined by the central authorities (national Bank). In order to clearly understand the
principles of discounting it will be helpful to have a clear understanding of the principle of
compounding. Compounding is the technique of calculating the future worth (F) of a present
amount (P) at the end of some period T at a given interest rate. On the other hand finding the
present worth of a future stream of value is called discounting. Consider that bank loans or in
general debts involve two obligations:
a. Payment of the principal,
b. Payment of the interest expense/earning;
Hence, if there is an initial amount P at present, then if this investment was borrowed from the
bank at an interest rate of r Birr then after one period it becomes:
P + Pr = P(1+r)
After two periods the amount becomes:
P+Pr+(P+Pr)r
In general, the amount accumulated after t periods would be
A = P(1+r)t
Observe that A constitutes the future value of initial loan to the lender (the bank) and‘t’ stands
for the loan period, a year in which the loan agreement stipulates for the final settlement of the
debt obligation. The term (1+r) t is referred to as compounding factor, a factor used to estimate
the future value of given initial sum/loan/ (present value). The ‘r’ in this term is referred to as
compounding rate, which is the rate of interest, which the banks charge their client borrowers.
Now, given that future value accumulated after t periods as above, if we want to know the
present value of this amount we would be talking about discounting. Hence the present value
would be:

The term (1+r) t in the denominator or (1+r)-t in the numerator is referred to as discounting
factor, a factor used to estimate the present value of a stream of future values. The ‘r’ in this
term is referred to as discounting rate. So the discount factor tells us how much Br 1 at a
future date is worth today at a certain discount rate.
Writing P0 for the present value and P1, P2 ....,Pt for the stream of payments accruing for years 1
to t, and the relevant discount rate is denoted by r, then the general formula for discounting
becomes,
P0 =P1 /(1+r)1+P2 /(1+r)2+...+Pt/(1+r)t

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 A. Net Present Value (NPV)
The NPV is defined as the difference between the present values of the future benefits and costs.
It is the simplest of all the four methods and is essentially a measure of the present value of
aggregate surplus generated by the project over its expected operating life. It is calculated by
subtracting the present values of costs (PVC)1 from the present values of benefits (PVB). This
implies that NPV represents the net benefit over and above the compensation for time and risk.
This involves two steps of calculations as expressed by the formula.
n n
NPV =∑ PVB−∑ PVC
t =1 t=1 ---------------------------------------------------------- (6.2a)
Or
n n
Bt Ct
NPV =∑ t ∑
− t
t=1 ( 1+ r ) t=1 ( 1+r ) --------------------------------------------------- (6.2b)
Where, n is the life of the project.
Example: Assume that a textile plant is to be established at a costs of 20 million Birr. It is
expected that the annual total cost is 10 million Birr and the sales revenue is expected to be 14
million Birr annually. The operating life of the project is 10 years. If loan is available for the
financing of the project at 10 percent rate.
Undiscounted Discounted
1 2 3 4 5
Year(t Cos Benefit Net benefits Discount factors Discounted net
t
) ts (Cash flow) (10%)= 1/(1+0.10) benefits (cash flow)
(2) – (1) (3)*(4)
0 20 0 -20 1/(1+0.10)0 = 1.000 -20(1.000) = -20.00
1 10 14 4 1/(1+0.10)1 = 0.909 4(0.909) = 3.64
2 10 14 4 1/(1+ 0.10)2 = 0.826 4(0.826) = 3.30
3 10 14 4 1/(1+0.10)3 = 0.751 4(0.751) = 3.00
4 10 14 4 1/(1+0.10)4 = 0.683 2.73
5 10 14 4 … 2.48
6 10 14 4 … 2.26
7 10 14 4 … 2.05
8 10 14 4 … 1.87

1
Total cost is the sum of investment costs, incremental working capital (incremental stocks plus net incremental
receivables, account receivable less account payable), and operating cost. Note also that incremental stocks and
net incremental receivable figure are the difference in values between the total stocks and net receivables in
certain year minus total stocks and net receivables in the preceding year.

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 9 10 14 4 …. 1.70
10 10 14 4 1/(1+0.10)10 = 0.386 4(0.386) = 1.54
Total 120 140 20.00 1/(1+0.10)t = 6.144 NPV = 4.57
The project’s net present value can then be estimated by just adding up these discounted net
benefits. Column 1, 2 and 3 show the non-discounted cost, benefits and net benefits (benefits -
costs). Thus 4 million Birr in year 10 is only 3.64 Birr in year 1. The present value of the stream
of payments (future income) realized over 10 years is 24.57 million Birr. The sum is what we
call NPV. In other words, the present worth of 4 million received yearly for 10 years at a
discount rate of 10 percent is 24.57 million Birr. The present worth is the sum of all the present
values for all the years together.
Note: the figure -20 million Birr represent the investment outlay of the project. It is negative
because it has been subtracted from zero revenue in the first (base) year of the project.
Working out the present worth of a future income stream or a given sum of money is this manner
is time consuming and laborious. Thu, discounting tables are normally used. We can use
compounding and discounting tables for project evaluation prepared for the purpose. In this table
the column entitled discount factor shows how much 1 Birr at a future date is worth today at a
certain discount rate (interest rate).
Example Let us use this formula to calculate the NPV for the hypothetical XYZ project we
considered earlier to show how cash flows are determined.
Table 6.1: Cost and benefit streams discounted at 10% separately (Method 1) (all figures in
million)
Year 1.Total 2.Discount 3.Present value 4.Total 5.Discount 6.Present value of
cost factor at 10% of costs (1*2) Revenues/Benefit factor at 10% Benefits (4*5)
s
1 140 0.9091 127.3 0.0 0.9091 0.0
2 65 0.8264 53.7 100 0.8264 82.6
3 95 0.7513 71.4 150 0.7513 112.7
4 95 0.6830 64.9 200 0.6830 136.6
5 75 0.6209 46.6 150 0.6209 93.1
6 55 0.5645 31.1 100 0.5645 56.5
PVC=395 PVB=481.5

For this project the NPV =481 .5−395=86. 5

The alternative method (method 2) of calculating NPV is that the difference between benefits
(revenues of cash inflows) and costs (cash outflows) may be taken separately and then the single
stream of net cash flows could be discounted to arrive at the NPV. For it reduces the number of
discounting calculations, the second method is usually adopted. The formula is expressed as:

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 n
NPV =∑ PV (B−C )
t=1 ------------------------------------------------------------ (6.3a)
Or
n
( Bt −C t )
NPV =∑
t =1
[ (1+ r )t ]
----------------------------------------------------------- (6.3b)
Table 6.2: Cost and benefit streams discounted at 10% (Method 2) (all figures in million)
Yea 1.Total 2.Total 3.Net benefit/cash 4. Discount factor at 5.Present value of
r cost Revenues/Benefits flow (2 – 1) 10% Benefits (3*4)
1 140 0.0 -140 0.9091 -127.3
2 65 100 35 0.8264 28.9
3 95 150 55 0.7513 41.3
4 95 200 105 0.6830 71.7
5 75 150 75 0.6209 46.6
6 55 100 45 0.5645 25.4
NPV=86.62

2
Note that there may be slight difference in NPV computed using the two methods due to rounding all the
numbers to one decimal place. In our example for instance the second method is greater than the NPV of first
method by Birr 100. Such a difference is insignificant and is well within the margin of error of the cost and benefit
estimates.

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