Chapter 3: Feasibility Study Calculation

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Economic Feasibility Analysis(EFA)
Techniques of Economic Feasibility Analysis:
i) Calculate Operating Return onInvestment:
• Allows comparison of Operating income of alternative solutions.
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒
ROI= *100% E.G. Let a firm‘s Operating Income =100,000 Br & Total
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠/𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
asset/Investment = 920,000 Br then find ROI?
N.B: 1.Operating Income is found from income statement & total asset from balance sheet
2.Disadvantage: it depends on income not on cash
Solution:10.87% .if the average industry ROI=13.2%.It is evident that the firm‘s return on total invested
capital is less than the average rate of return for the industry. This implies the firm is generating less income
on each birr of the assets than are its competitors.
Decision : the firm should know why the return is below the average. Maybe the assets are not used
efficiently.

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In other way ROI formula is:
Net Profit / Total Investment * 100 = ROI.
Let's apply the formula with the help of an example.
You are a house flipper. You purchased a house at the courthouse auction for
$75,000 and spent $35,000 in renovations. After sales, expenses, and
commission, you netted $160,000 on the sale of the renovated house. What is the
ROI?
Your net profit is going to be what you netted ($160,000) minus what you spent
($75,000 + $35,000), so it is $50,000. Your total investment is also what you
spent ($75,000 + $35,000), which is $110,000.
ROI = Net Profit / Total Investment * 100
ROI = 50,000 / 110,000 * 100
ROI = .45 * 100
ROI = 45%
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• The fundamental accounting equation

Profit = Revenues - Costs

Revenue = SP*units sold ,SP = selling price
Costs = FC + VC(units manufactured)
FC = fixed cost
VC = unit variable costs.
• We are assuming that units manufactured equal
units sold

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 What if we want to know how much product we
must sell to break even?
•The breakeven point is the point where profit is zero,
so Profit /Loss = 0 = Revenue - Cost
= SP*units sold - FC - VC*units sold
= (SP - VC)*units sold - FC

units sold = FC/(SP - VC)

•We will call units sold at Profit /Loss = 0: BE units

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 Cont…
ii) Calculate Break-Even point
𝐹𝐶
BP=
𝑈𝑆𝑃−𝑈𝑉𝐶

e.g. let the fixed costs(rent, land, interest loan, insurance, equipment,
advertising expenses ,property, etc.) be $50,000; USP= $ 20 and UVC of
direct material, labor, energy be $10. Determine the BP.

F𝐶
Solution: BP(Q)= = 50,000 = 5,000 Units
𝑈𝑆𝑃−𝑈𝑉𝐶 20−10

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 EXERCISE
John sells a product for $10 and it cost $5 to produce (UVC)
and has fixed cost (FC) of $25,000.

a) How much will he need to sell to break-even?

b) How much will he need to sell to make a target profit of

$1000?

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Solution
a) Revenues – Variable cost – Fixed cost = profit
(USP x Q) – (UVC x Q) – FC = profit
$10Q - $5Q – $25,000 = $ 0.00
$5Q = $25,000
Q = 5,000 units
b) What quantity demand will earn $1,000?
$10Q - $5Q - $25,000 = $ 1,000
$5Q = $26,000
Q = 5,200 units

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The break-even point can be calculated in terms of:
 Volume of production at break even point
 Sales revenue at break even point
 Factory Capacity; and
 Sales Price

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Example 1
ABC company is working in the following business environment
Maximum Capacity= 25,000 units per year
Total Fixed Cost = ETB 30,000
Sales Price =ETB 10
Variable Cost = ETB 7
Calculate the break even point in
a) Volume of Production at break-even point
b) Sale revenue at break-even point
c) Capacity utilization
d) Using the same data give above, ABC plans to produce and
sell 15,000 units and wishes to know the minimum price below
which it should not sell his product. 10
 a) Volume of
Production

BEP =

= = 10,000 units

You need to sell 10,000 units to break even points

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b) sales revenue

sales revenue = Production units X Sales price

= 10,000 units X 10 ETB= 100,000 ETB

OR = X unit price = X 10 = 100,000 ETB

The result can also be calculated based on the equation that at

break even sales revenue and all costs (fixed and variable) are the
same, i.e.
Sales revenue = total fixed cost + total variable costs
= 30,000 ETB + (10,000 X 7) = 100,000 ETB
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 C) Capacity
Utilization

Capacity Utilization=

= = 40 %

This is the most popular method of expressing break-even.

In this example, if you are able to make use of at least 40% of
your theoretical production capacities ( and sell the products),
then you are break even.
If you produce more, you make a profit. It is a quick indicator
for steering your business.

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D) Minimum acceptable price

The break-even analysis can also be utilized for guiding the

minimum acceptable price to a business at a particular level of
production.

It can be calculated as follows:

Price = =

= = 9.00 ETB

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 Con’t…..

The minimum price will be lower if production is more, say

20,000 units

i.e. = 8.50 ETB

The reason for reduction in the break-even price is that the
fixed costs are spread over a large number of units; hence the
cost per unit goes down.
Thus, the higher the safety margin, sales price being the
same, the higher will be the scope of profit.
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Example 2:
A small street side café offers fresh traditional coffee to the
general public. Total variable cost per coffee (including coffee
beans, water, fire wood and sugar) amount to be ETB 1.60 per
cup. The selling price is ETB 4.00. The café has fixed costs per
week of ETB 360.00, being the rental of the place.
Capacity = 300 units
Calculate:-
1) Volume of production at break-even point
2) Sales at break-even point
3) Capacity Utilization (%)
4) What is the minimum acceptable price, if the café
plans to produce 250 cups.
5) diagrammatic presentation of the break – even
analysis
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 Techniques…
iii)Payback period

1st method: Payback period= Amount invested

Expected annual net cash inflow

Example 1: Amount Invested =15,000 Br & Expected Net Annual

Cash Inflow=4500 Br.
Payback period= 15,000 = 3.33years
45,000

OR, pay back period = Total outflow

Inflow every year
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PAYBACK CONT…
What Is Net Cash Flow?
 Net cash flow is the difference between a company’s cash inflows and
outflows within a given time period.
 After paying for all operating costs and debt payments, a company has
a positive cash flow when it has excess cash. If a company is paying
more for expenses than it earns, it has a negative cash flow.

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PAYBACK CONT…

Payback period for uneven cash flow = Year before full recovery +
unrecovered cost at beginning of the year
Cash flow during the year

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PAYBACK CONT…
2nd method: trial & error: it is better than the 1st one
N.B: Net Cash is found from investment cash flow statement.

The initial investment is 15000 br

At the end of 3rd year,12000 br will have been paid. The additional 3000
br can be paid before 4th year, when 6000 is expected. Thus it will
take(3+3000/6000)=3.5 years to pay the original investment.
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 Techniques cont… Net Present Value (NPV) is the value of all
future cash flow (positive and negative) over the
entire life of an investment discounted to the
iv) Net Present Value present.
NPV= Total Present value - Initial Cost
E.g. Assume a company invest $ 9000 in a project today and the project is
expected to have a life of 4 years. The expected cash inflows at the end of
each of the next four years are $2000,$3000,$3000 and $4000.
Cash Flow Diagram

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NPV cont…
PV formula: Determine the NPV

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Conclusion

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CASH FLOW

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CASH FLOW
A lack of cash can arise for a number of reasons, including:
 unplanned payments, which are to be made (e.g.
maintenance);
 poor profit margins (e.g. large overhead cost structure);
 over-trading / growing too fast;
 ineffective debt collection;
 carrying too much raw materials / work in progress /
finished goods stock.

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HOW DOES MONEY FLOW THROUGH A
BUSINESS?

 Cash introduced by the owners:- Owners Capital or

Equity
 Cash borrowed from other people:- Third-party loan
 Cash generated from sales:- Sales revenue

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 How does cash flow out of your business?
 Cash is spent buying things to keep running the
businesses. E.g. buying fixed assets
 Cash is spent making things to sell.
E.g. buying raw materials, payment for workers
 Cash is spent on covering business expenses
E.g. rent, interest, utility, etc.
 Drawings by the owner of the business:
E.g. pay school fees, feed your family, maintain your
lifestyle, etc
 Cash is spent paying taxes 27
Suppose you are the owner of hollow blocks manufacturing
enterprise. Hollow blocks are sold for ETB 850 per 100 blocks.
The monthly cost structure of your enterprise looks the following
Salaries ETB 3,000 per month
Production Labor ETB 50 per 100 blocks
Rent ETB 3,000 per month
Cement, sand and stone ETB 500 per 100 blocks
Machine credit payment ETB 1,000 per month
Delivery costs ETB 50 per 100 blocks
Telephone / Communication ETB 500 per month

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 Con’t…..
The enterprise fix budget to produce and sell the following

quantities of blocks:

September October November

Blocks 5,000 6,500 7,000

There is lower production in September due to weather

conditions and lower demand.

Prepare a Cash flow forecasts and profit forecasts for this

Hollow concrete enterprise

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 Illustrating Profit Before Tax (PBT)
The concept of profit before tax is demonstrated in the example
below:
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What is the Balance Sheet?
 The balance sheet is one of the three fundamental financial
statements and is key to both financial modeling and accounting.
 The balance sheet displays the company’s total assets, and how these
assets are financed, through either debt or equity.
 It can also be referred to as a statement of net worth, or a statement of
financial position.
 The balance sheet is based on the fundamental equation:
Assets = Liabilities + Equity.
A simple balance sheet
Types of asset
Types of asset
 Different Types of Liabilities
Liabilities are primarily categorized based on how early an organization is
liable to settle them. These types are –

Working capital = Current assets – Current liabilities

Equity

accounts: