Economic feasibility study

Chapter 7
Feasibility Study
Econ 4315

prepared by: Abd ElRahman J. AlFar

Balance sheet
• A balance sheet is a financial statement that summarizes a company's
assets, liabilities and shareholders' equity at a specific point in time.
These three balance sheet segments give investors an idea as to what
the company owns and owes, as well as the amount invested by
shareholders.

The balance sheet adheres to the following formula:

• Assets = Liabilities + Shareholders' Equity
BREAKING DOWN 'Balance Sheet'
The balance sheets gets its name from the fact that the two sides of the
equation above – assets on the one side and liabilities plus shareholders'
equity on the other – must balance out. This is intuitive: a company has to
pay for all the things it owns (assets) by either borrowing money (taking on
liabilities) or taking it from investors (issuing shareholders' equity).
For example, if a company takes out a five-year, $4,000 loan from a bank, its
assets – specifically the cash account – will increase by $4,000; its liabilities –
specifically the long-term debt account – will also increase by $4,000,
balancing the two sides of the equation. If the company takes $8,000 from
investors, its assets will increase by that amount, as will its shareholders'
equity.
Assets
• Within the assets segment, accounts are listed from top to bottom in
order of their liquidity, that is, the ease with which they can be
converted into cash. They are divided into current assets, those which
can be converted to cash in one year or less; and non-current or long-
term assets, which cannot.
current assets:
• Cash and cash equivalents: the most liquid assets, these can include
Treasury bills and short-term certificates of deposit, as well as hard
currency
• Marketable securities: equity and debt securities for which there is a liquid
market
• Accounts receivable: money which customers owe the company, perhaps
including an allowance for doubtful accounts (an example of a contra
account), since a certain proportion of customers can be expected not to
pay
• Inventory: goods available for sale, valued at the lower of the cost or
market price
• Prepaid expenses: representing value that has already been paid for, such
as insurance, advertising contracts or rent
Long-term assets
• Long-term investments: securities that will not or cannot be
liquidated in the next year
• Fixed assets: these include land, machinery, equipment, buildings and
other durable, generally capital-intensive assets
• Intangible assets: these include non-physical, but still valuable, assets
such as intellectual property and goodwill; in general, intangible
assets are only listed on the balance sheet if they are acquired, rather
than developed in-house; their value may therefore be wildly
understated—by not including a globally recognized logo, for
example—or just as wildly overstated
Liabilities
• Liabilities are the money that a company owes to outside parties,
from bills it has to pay to suppliers to interest on bonds it has issued
to creditors to rent, utilities and salaries. Current liabilities are those
that are due within one year and are listed in order of their due date.
Long-term liabilities are due at any point after one year.
Current liabilities
• Short term debts
• Interest payable
• Wages payable
• Customer prepayments
• Dividends payable and others
Long-term liabilities
• Long-term debt: interest and principle on bonds issued
• Pension fund liability: the money a company is required to pay into its
employees' retirement accounts
Shareholders' equity
• Shareholders' equity is the money attributable to a business' owners,
meaning its shareholders. It is also known as "net assets," since it is
equivalent to the total assets of a company minus its liabilities, that is,
the debt it owes to non-shareholders.
• Retained earnings: are the net earnings a company either reinvests in
the business or uses to pay off debt; the rest is distributed to
shareholders in the form of dividends.
• Common stocks and preferred stocks
What is an 'Income Statement'
• An income statement is a financial statement that reports a
company's financial performance over a specific accounting period.
Financial performance is assessed by giving a summary of how the
business incurs its revenues and expenses through both operating
and non-operating activities. It also shows the net profit or loss
incurred over a specific accounting period.

• Unlike the balance sheet, which covers one moment in time, the
income statement provides performance information about a time
period. It begins with sales and works down to net income and
earnings per share (EPS).
• The income statement is divided into two parts: operating and non-
operating. The operating portion of the income statement discloses
information about revenues and expenses that are a direct result of
regular business operations. For example, if a business creates sports
equipment, it should make money through the sale and/or
production of sports equipment. The non-operating section discloses
revenue and expense information about activities that are not directly
tied to a company's regular operations. Continuing with the same
example, if the sports company sells real estate and investment
securities, the gain from the sale is listed in the non-operating items
section.
Cash flow statement
• A cash flow statement is a financial report. The document provides
aggregate data regarding all cash inflows a company receives from its
ongoing operations and external investment sources, as well as all
cash outflows that pay for business activities and investments during
a given quarter.

• Cash flow from operations

• Cash flow from investment
• Cash flow from financing
Cash flow from operations
• The first set of cash flow transactions is from operational business
activities. Cash flows from operations starts with net income and then
reconciles all noncash items to cash items within business operations.
For example, accounts receivable is a noncash account. If accounts
receivables go up, it means sales are up, but no cash was received at
the time of sale. The cash flow statement deducts receivables from
net income because it is not cash. Also included in cash flows from
operations are accounts payable, depreciation, amortization and
numerous prepaid items booked as revenue or expenses but with no
associated cash flow.
Cash Flows From Investing

• Cash flows from investing activities includes cash spent on property,

plant and equipment. This is where analysts look to find changes in
capital expenditures (CAPEX). While positive cash flows from investing
activities is a good thing, investors prefer companies that generate
cash flows primarily from business operations, not investing and
financing activities.
Cash Flows From Financing
• Cash flows from financing is the last business activity detailed on the
cash flow statement. The section provides an overview of cash used
in business financing. Analysts use the cash flows from financing
section to find the amount paid out in dividends or share buybacks.
Cash obtained or paid back from capital fundraising efforts, such as
equity or debt, is also listed.
Depreciation value
The annual rate deducted from the parent value of the asset

Depreciation value = asset value - junk value

Life time

• Noting that:
The current assets have no depreciation value because it must be
returned at the end productive operation, which length depends on the
nature of the commodity itself.
 profits and commercial Evaluation measures

accounting based profitability measures

economic based
profitability measures
time based profitability
measures
1. Time based profitability measures:
• Pay-back period (pp): It’s simply the time (period) which investment
cost is recovered.

1. If the average cash flow constant for every years of the project life.
2. If the cash flow (unequal) over the years.
If the average cash flow constant for every
years of the project life.
Example:
Project with five-year span and with the total investment costs of 760.000
NIS, having annual cash flow 200,000 NIS. What would be recovery period
for this project? Or (what is the time needed for this project to recover its
initial investment costs)?
Answer:
= initial investments
Annual cash flow
760.000 = 3.8 year
200.000
If the cash flow (unequal) over the years.
Project with six -year span and with the total investment costs of
760.000 NIS, having annual as shown in the following table.
Life Annual Cash flow
time
1 200.000
2 230.000
3 200.000
4 180.000
5 190.000
6 140.000

What would be recovery period for this project?

To answer this example we must follow the following steps:
• For the first year: Initial investments - cash flow = 760.000 - 200.00 =
560.000 remaining from the Initial investments
• For the second year: remaining Initial investments from the pervious year-
Cash flow for the new year = 560.000- 230.000 = 330.000
• For the third year: remaining Initial investments from the pervious year-
Cash flow for the new year = 330.000 - 200.000 = 130.000.
• For the fourth year: remaining Initial investments from the pervious year-
Cash flow for the new year = 130.000 - 180.000 = (-50.000) surplus over
the Initial investments

Recovery period for this project is 3.86 months

Disadvantages of payback period
1. Ignoring the time value of money:
Payback period dealing with money recovered in the first year and last
year of the project with equal value. This treatment is not viable
economically because the real value of the cash flows at the beginning
of the project lifetime are usually larger than the actual value of the
cash flows at the end of six years in our last example.
Disadvantages of payback period (cont.)
2. ignoring the cash flows tacks place after the return of initial invested
capital:
in our 2nd example when the project recovered its initial investment in
three years and 8.6 month this criterion do not inform us what to do
with the cash flow take place after recovery period which almost 1/3 of
the initial investment.
Disadvantages of payback period (cont.)
3. Suitable only with short-term projects that do not seek for the
consolidation of its relationship to society and continuity.
In spite of the disadvantages of this measure, it cannot be ignored as
gives an idea to the entrepreneur on the time required to restore the
initial investment is also appropriate for investor who wants to invest in
businesses with quick and short-term return.
2. Accounting based profitability measures:
1. Return on capital: is a profitability ratio. It measures the return that
an investment generates for capital contributors, i.e. bondholders and
stockholders. Return on capital indicates how effective a company is at
turning capital into profits.

Net operating profit is the EBIT

2. Return on equity (ROE) is a measure of the profitability of a business
in relation to the book value of shareholder equity, also known as net
assets or assets minus liabilities. ROE is a measure of how well a
company uses investments to generate earnings growth.

ROE = [Net income / shareholders equity] * 100%

3. economic based profitability measures:
• Net present value(NPV).
• Profit index
• Rate of Return/cost .
• Internal Rate of Return(IRR).
Net present value(NPV).
• It indicates the difference between the current value of the in cash
flows for the project and current value of the out cash flow. A
decision-making using this criteria is based on:
• If we have (+)result i.e. cash inflows larger than cash outflows then
project is profitable
• If we have (-)result i.e. cash outflows larger than cash inflows then th
project unattractive .
• if result is (0) i.e. cash outflows equal cash inflows then the project
does not make any loss or profit for this type of project we have to
consider other considerations such as the strategic importance of the
project within national economic and development plan.
NPV EQUATION
This Data were obtained for three investment
project proposals, as shown in the following table:
ti Cash in Cash in Cash in
m flow for flow for flow for
e project (a) project (b) project (c)
1 (400) (600) (800)
2 150 250 200
3 140 150 150
4 100 200 200
5 0 180 180
6 0 0 0

If the interest rate 10%, use NPV to decide which project is the best alternative
Time Cash-in flow for Cash-in flow for project Cash-in flow for Present value at
project (a) (b) project (c) 10%
1 ( 400 ) ( 600) ( 800 ) 1
2 150* .909 = 136.4 250 * .909 =227.25 200 * .909 =181.8 .909

3 140 * .826 = 115.64 150 * .826 =123.9 150 * .826=123.9 .826

4 100 * .751 = 75.1 200 * .751=150.2 200 * .751=150.2 .751

5 0 * .683 = 0 180 * .683 =122.94 150 * .683 =02.45 .683

6 0 * .821 = 0 0 * .821 = 0 150 * .821= 123.15 .621

total 327.14 624.29 681.5

Indebted capital ( 400 ) ( 600 ) ( 800 )

Net flow ( 72.86 ) 24.29 ( 118.5 )

decision rejected Accepted rejected
Profit index
• It's the ration of present value of future cash flows to the invested
capital in the project.
• The higher the cost benefit ratio the better is the project profitability
and vice versa.
• If the cost benefit ratio less than one (1) i.e. the in cash flows is less
than out cash flow so the project unattractive and vice versa.
Profit index (PI) = The total present value of cash inflows
Investment cost
PI example
Project 1 Project 2 Project 3
NPV out cash flow ( 400 ) ( 600) ( 800 )
NPV in cash flow 327.14 624.29 681.5

By using the above information, you are required to determine the profitability index for the three project proposals?
Recall that
Profit index (PI) = The total present value of cash inflows
Investment cost

PI for project 1= 327.5/400 = .871 note its less than one its rejected
PI for project 2= 624.29/600 = 1.04 note its greater than one its accepted
PI for project 3= 681.5/800 = .85 note its less than one its rejected
Return on cost ratio
• This standard refers to the relationship between the current value of
expected return from the investment in the project and the current
value of the projected costs of investment throughout the life time of
the project. It can be determined by:
𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛
• 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑐𝑜𝑠𝑡 𝑟𝑎𝑡𝑖𝑜 = −1
𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑜𝑠𝑡
• If the return for cost ratio is ZERO or more then the project is
accepted and economically feasible project. Other-wise the project
not economically feasible and should be rejected.
Example
• The following data from a project's feasibility studies and you are
required: calculate the return cost ratio, if the discount rate for the
cost of capital = 15%?
year cost Return
0 120 -
1 75 115
2 80 120
3 85 125
4 95 135
5 100 140
year Cost present value Return present value
0 120 * 1 = 120 ZERO
1 75 * .926 = 69.45 115 * 926.0 = 106.49
2 80 * 0.857 =68.56 120 * 0.857 = 102.84
3 85 * .794 = 67.49 125 * 0.794 = 99.25
4 95* .73 =69.83 135 * 0.735 = 99.225
5 100 * .681 = 68.10 140 * 0.681 = 95.34
total 463.43 503.15

𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑐𝑜𝑠𝑡 𝑟𝑎𝑡𝑖𝑜 = −1
𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑜𝑠𝑡

503.15
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑐𝑜𝑠𝑡 𝑟𝑎𝑡𝑖𝑜 = − 1= .08 OR 8%
463.43

because the rate of return on cost is greater than ZREO the project is acceptable.
Internal rate of retune (IRR):
• Internal rate of return is a discount rate that makes the net present
value (NPV) of all cash flows from a particular project equal to zero.

• The formula for IRR is

0 = P0 + P1/(1+IRR) + P2/(1+IRR)^2 + P3/(1+IRR)^3 + . . . +Pn/(1+IRR)^n
where P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . . n,
respectively; and IRR equals the project's internal rate of return
Example
• Assume Company XYZ must decide whether to purchase a piece of
factory equipment for $300,000. The equipment would only last three
years, but it is expected to generate $150,000 of additional annual
profit during those years. Company XYZ also thinks it can sell the
equipment for scrap afterward for about $10,000. Using IRR,
Company XYZ can determine whether the equipment purchase is a
better use of its cash than its other investment options, which should
return about 10%.
• Here is how the IRR equation looks in this scenario:
• 0 = -$300,000 + ($150,000)/(1+.2431) + ($150,000)/(1+.2431)2 +
($150,000)/(1+.2431)3 + $10,000/(1+.2431)4
• The investment's IRR is 24.31%, which is the rate that makes the
present value of the investment's cash flows equal to zero. From a
purely financial standpoint, Company XYZ should purchase the
equipment since this generates a 24.31% return for the Company --
much higher than the 10% return available from other investments.