31/03/2024

PROJECT APPRAISAL

Chapter 6
FINANCIAL ANALYSIS OF THE PROJECT

Assoc. Prof. Dr. Tien Dung Khong

E: [email protected]
P: 0939 006 222

Recall
• Organizing the drafting of the investment project
• Organizing the appraisal of the investment project
• Market analysis of the project
• Technical analysis of the project
• Organizing management and personnel
• Financial analysis of the project

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Contents
• The basic parameters of the project
• Financial analysis of the project
• Breakeven point and Payback period
• Selection of the discount rate for the project
• Net present value (NPV)
• Benefit-cost ratio (BCR)
• Internal rate of return (IRR)

Purpose of financial analysis

• Examining of needs and security of financial resources (scale of

investment, the structure of capital types, funding sources)
• Estimation of the costs, benefits, and operational efficiency of the
project
• Assessment of financial safety
Source of mobilized capital
The ability to pay short-term obligations and repay debts
Examining the certainty of financial performance indicators.

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Some Issues To Consider

• Time value of cash flow

• Determination of the rate “r”
The minimum rate of return required by the financier
If borrowing money to invest, then r = interest rate
If borrowing from multiple sources, then r is the average interest
rate
I k .rk I k - Loan amount from source k
r= k=1
rk - Loan interest rate from source k
I k
k =1 n - Number of loan source

BASIC PARAMETERS OF THE PROJECT

 Estimation of total investment capital

 Making a budget plan

 Estimation of annual revenue

 Estimation of annual costs

 Other parameters

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 Estimation of total investment capital

• Fixed capital:
– Initial investment cost: Making a feasible project, recruiting, training, surveying,
designing, ...
– Costs of investing in fixed assets: Buying machines and equipment, transferring
technology, constructing infrastructure, ...
• Working capital:
– Inventory of raw materials; finished products (I)
– Receivable (R)
– Payable (P)
– Cash in hand (C)
 Working capital: WC= C+ R – P + I

Estimation of working capital needs

Items Year 1 Year 2 Year… Year n
Receivable (R)

Payable (P)

Cash in hand (C)

Inventory (I)

WC= C + R – P + I

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 Making a budget plan

• Owner’s equity
– Equity capital
– Share capital
– Undistributed earnings
• Borrowed capital
– Borrowed directly to the bank
– Hire purchase (Lease purchase)
– Finance lease

 Estimation of annual revenue

• Estimation of annual mobilization capacity

• Annual inventory quantity

• The selling price of the product

Revenue = Sold quantity * Unit price/product

Sold quantity = Opening inventory + Produced quantity

– Closing inventory

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 Estimation of annual costs

⧫ Direct costs
❑ Direct raw material cost
❑ Direct labor cost
❑ General production cost ...
⧫ Administrative costs
❑ Salary and allowances for managers
❑ Depreciation of project office equipment
❑ Other administrative costs
⧫ Selling expenses
❑ Salary and allowances for salespeople
❑ Marketing and advertising cost
❑ Packaging cost ...

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 Other parameters
• These parameters affect the effectiveness of the project:
– Taxes
– Inflation
– Exchange rate
• The systematic presentation of a project's financial parameters helps
investors to
– Figure the context of the project;
– Identify risks of the project;
– Determine which vital information to collect and review;
– Make the right investment decision.

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Example: An investment project with basic financial parameters:

1. Investment capital (Year 0)
• Land 1.000 Million VNĐ
• Machinery 3.200 Million VNĐ
• The life of machinery 4 years
2. Financing
• Borrowed capital 40% Invested cost
• Interest rate 12%/year
• The number of principal repayments 3 Years
3. Revenue
• Production capacity 15.000 products/year
Year 1 Year 2 Year 3
• Exploited capacity 80% 90% 100%
• Price 0,3 Million VNĐ/product
4. Cost (excluding depreciation) 50% Revenue
5. Other parameters
• Income tax 25%
• Discount rate 12%
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Financial analysis of the project

• Table of the investment plan
• Depreciation plan
• Repayment plan
• Table of revenue estimation
• Table of cost estimation
• Table of profit and loss plan

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Table of the investment plan

Investment item Year 0 Year 1 Year 2 Year 3 Year 4

Land 1.000

Factory

Machinery 3.200

Cost before operation

Total 4.200

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Table of depreciation plan

Item Year 0 Year 1 Year 2 Year 3 Year 4

Machinery cost 3.200 3.200 3.200 3.200 3.200

Annual depreciation 800 800 800 800

Accumulated depreciation 800 1600 2400 3200

New investments 3.200

Closing residual value 3.200 2.400 1.600 800 0

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Repayment plan
Item Year 0 Year 1 Year 2 Year 3

Opening balance 1.680 1.120 560

Interest expense 202 134 67

Total repayment 762 694 627

- Principal repayment 560 560 560

- Interest repayment 202 134 67

Closing balance 1.680 1.120 560 0

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Table of revenue estimation

Item Year 0 Year 1 Year 2 Year 3 Year 4

Exploited capacity 80% 90% 100% 100%

No. of consumed products 12.000 13.500 15.000 15.000

Sales Price 0,3 0,3 0,3 0,3

REVENUE 3.600 4.050 4.500 4.500

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Table of cost estimation

Item Year 1 Year 2 Year 3 Year 4
Variable cost 1.800 2.025 2.250 2.250
- Raw material cost
- Direct labor cost
- Fuel cost
- Repair and maintenance cost
….
Fixed cost 800 800 800 800
TOTAL COST 2.600 2.825 3.050 3.050

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Table of profit and loss plan

Item Year 1 Year 2 Year 3 Year 4
1. Revenue 3.600 4.050 4.500 4.500
2. Total cost 2.600 2.825 3.050 3.050
3. Income before tax and interest (1-2) 1.000 1.225 1.450 1.450
4. Interest expense 202 134 67 0
5. Income before tax (3-4) 798 1.091 1.383 1.450
6. Income tax1 200 273 346 363
7. Profit after tax (5-6) 599 818 1.037 1.088
4. Interest expense (Not borrowing) 0 0 0 0

5. Income before tax (3-4) 1.000 1.225 1.450 1.450

6. Income tax2 250 306 363 363

7. Profit after tax (5-6) 750 919 1.088 1.088

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BASIC CRITERIA FOR FINANCIAL ANALYSIS

Break Even Point Analysis

F: Total fixed costs R: Total sales revenue

V: Total variable costs D: Depreciation

LD: current portion of long-term principal debt
T: Income tax

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BASIC CRITERIA FOR FINANCIAL ANALYSIS

Break Even Point Analysis

p: Sales price per unit

v: Variable cost per unit

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BASIC CRITERIA FOR FINANCIAL ANALYSIS

Break Even Point Analysis

Q: Expected quantity (full capacity)

R: Total sales revenue
p: Sales price per unit

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BASIC CRITERIA FOR FINANCIAL ANALYSIS

Break Even Point Analysis

Cost, Total revenue

Revenue

Total costs

Breakeven point Variable costs

Fixed costs

Units sold

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Break Even Point Analysis

Example:
A project has the following figures (Unit: 1.000 VND)
Fixed cost 200.000; Variable cost 600.000;
Depreciation 20.000; current portion of long-term principal debt 30.000;
Expected output when operating at full capacity is 20.000 tons,
corresponding to the revenue of 1.000.000;
Income tax: 10.000.
Calculate the types of break-even points?

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Payback Period
• Payback period is the number of years it takes to recover all the
capital invested.
• The payback rule states that a project should be accepted if its
payback period is less than some specified cutoff period.

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• Example 1: Both investment projects are 140 million with a

construction time of one year. The expected incomes from Profit +
Depreciation are shown in the following table.
• Undiscounted payback period?
Year Net income
Project I Project II
1 60 20
2 50 40
3 40 50
4 40 50
5 20 60

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Undiscounted Payback Period

Advantages
• Easy to understand and apply;
• It can be used as a measure of liquidity;
• It is easier to predict short term flows than long term flows.
Drawbacks
• The time value of cash flow is not taken into account;
• Cash flow after the payback period is not considered;
• The maximum payback period is subjective.

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Future Value
0 1 2 n

P F1
F2

F1 = P + P.r = P( 1 + r ) Fn

F2 = F1 + F1 .r = P( 1 + r ) + P( 1 + r ).r = P( 1 + r )2
Fn = P( 1 + r )n
Present Value
Fn
Fn = P( 1 + r )n P=
( 1 + r )n

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(NPV - Net Present Value)

(NPV > 0  A project is financially feasible)

n
Bi n
Ci
NPV =  PV −  PC =  − 
i =0 ( 1 + r ) I =0 ( 1 + r )
i i

Advantages
•Assume that the cash flow is reinvested following the rate of return;
•Taking into account the time value of cash flow;
•Examining the entire cash flow.
Drawbacks
• Depending on the discount rate (the opportunity cost of capital)

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Net Present Value

Year 0 1 2 3 4
1. Inflow 200 220 280 230
2. Outflow 400 100 100 100 100
3. Net cash flow (1-2) -400 100 120 180 130
4. Discount factor
(r=10%) 1,000 0,909 0,826 0,751 0,683

5. PV (3*4) -400 90,9 99,2 135,2 88,8

NPV 14,1

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Selection of project discount rate

Opportunity cost of capital
Suppose that there are 100 million, invest in 2 projects:
Probability 30% 40% 30%
Income of project A 70 110 130
Income of project B 80 140 90

Expectation A (70*30%)+(110*40%)+(130*30)=104 rA=4,0%

Expectation B (80*30%)+(140*40%)+(90*30)=107 rB=7,0%

Thus, using a discount rate of 7%,

and NPVA= -100 + 104/(1+7%) = -100 + 97,2 = -2,8 million

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Selection of project discount rate

Weighted average cost of capital
Source of capital Proportion Interest r =12%
Borrowed capital WB=60% rB=10% 60%*10%
Equity capital WE=40% rE=15% 40%*15%
r = (WB*rB) + (WE*rE)
• Add the percentage of risk to the discount rate (R=5%)
rR = r + R = 12%+5%=17%
• Add the percentage of inflation to a discount rate (I=6%)
rI = r + I + r.I = r + (1 + r)*I = 12%+6%+12%*6%=18,72%
• The case includes both risk and inflation
rRI = r + R + (1 + r + R)*I = 12%+5%+(1+12%+5%)*6%=24,02%
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BCR-Benefit Cost Ratio

n
Bi
 PV (1+ r ) i
BCR = = i=1

 PC  C
n
i

Advantages (1+ r ) i=1

i

• Same with NPV;

• Allowing comparison of projects of different scales.
Drawbacks
• Same with NPV;
• Only indicates relative profitability;
• There is a potential issue in the ranking of the project.

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BCR-Benefit Cost Ratio

Table of project parameters

Project PV PC BCR NPV

A 15 11 1,36 4
B 12 10 1,20 2
C 96 70 1,37 26
D 22 14 1,57 8

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• Example 2: The two projects have the same investment capital of 250
million VND, and the construction period of these two projects is one
year, with r = 10%/year and net income as follows. Calculate
• Discounted Payback Period?

Year Project I Project II

1 100 10
2 120 50
3 100 80
4 50 120
5 40 180
Total 410 440

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IRR–Internal Rate of Return

NPV

Feasible project

NPV1 Find r1 < IRR = r < r2 such that NPV = 0

IRR NPV1
IRR = r1 + *(r2 − r1 )
r2
NPV1 + NPV2
r1

Unfeasible project
NPV2

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IRR–Internal Rate of Return

Advantages
• Taking into account the time value of the cash flow
• Considering all cash flows
• Less subjective
Drawbacks
• Assuming the entire cashflow is reinvested with the IRR
• Difficulty with project ranking and case with multiple IRRs

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Example 3: Information of the two projects is as follows, r=12%. Based on the criteria
of the payback period, NPV, BCR, IRR to evaluate? Assuming that the risk is 5% and
10%.
Investment capital Net income
Year A B A B
-1 2.000 1.500
0 3.000 1.000
1 1.500 300 1.750 1.000
2 1.800 1.200
3 1.850 1.300
4 2.000 1.050
5 2.100 950
6 2.500 850
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Project evaluation criteria

• Payback Period (Tpp< TE)
• Net Present Value (NPV > 0)
• Internal rate of return (IRR > IRRE)
• Benefit Cost Ratio (BCR >1)

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Potential problems in mutually exclusive

projects
• Investment scale
• The appearance type of cash flow
• The life cycle of the project

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Potential problems in mutually exclusive projects

Comparing the differences in scale
Ex4: Suppose there are net cash flows of the following 2 projects:

Year 0 1 2
Small Project -100 0 400
Big Project -100.000 0 156.250
Calculate Tpp, IRR, NPV, BCR (12%)? Which project is more preferred?

Year Tpp IRR NPV BCR

Small Project 3m,24d 100,0% 219 3,19
Big Project 9m18d 25,0% 24.562 1,25

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Potential problems in mutually

exclusive projects
The appearance type of cash flow
Ex5: Suppose there are net cash flows of the following 2 projects:

Year 0 1 2 3
Project A -900 1.000 500 100
Project B -900 114 600 1.100
Calculate Tpp, IRR, NPV, BCR (12%)? Which project is more preferred?

Year Tpp IRR NPV BCR

Project A 1y0m,6d 52,4% 463 1,51
Project B 2y4m27d 32,5% 463 1,51

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Potential problems in mutually exclusive projects

Determination of NPV

Draw the NPV for each project

Net present value ($)

with different discount rates

600

NPV
IRR
400
200

0 5 12 32,5 52,4
Discount rate (%)

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Potential problems in mutually exclusive projects

The intersection of discount rate

With r<12%, Project B

is the best!
Net present value ($)

The intersection of discount rate

600

NPV
With r>12%, Project A
400

is the best!
200

0 5 12 32,5 52,4
Discount rate (%)

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Allocation of investment capital

The allocation of investment capital when the total source of capital
is limited in a certain period, knowing the total source is $ 32,500
Project Investment IRR NPV BCR
A 500 18% 50 1,10
B 5.000 25% 6.500 2,30
C 5.000 37% 5.500 2,10
D 7.500 20% 5.000 1,67
E 12.500 26% 500 1,04
F 15.000 28% 21.000 2,40
G 17.500 19% 7.500 1,43
H 25.000 15% 6.000 1,24

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The selection according to IRR

Project Investment IRR NPV BCR

C 5.000 37% 5.500 2,10
E 12.500 26% 500 1,04
F 15.000 28% 21.000 2,40
Total 32.500 27.000

Projects C, F, and E have the three largest IRR.

These three projects increase the wealth by $27.000
With an initial investment of $32,500.

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The selection according to NPV

Project Investment IRR NPV BCR

F 15.000 28% 21.000 2,40
G 17.500 19% 7.500 1,43
Total 32.500 28.500

Projects F and G have two largest NPV.

These two projects increase the wealth by $28.500.
With an initial investment of $32,500.

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The selection according to BCR

Project Investment IRR NPV BCR

F 15.000 28% 21.000 2,40
B 5.000 25% 6.500 2,30
C 5.000 37% 5.500 2,10
D 7.500 20% 5.000 1,67
Total 32.500 38.000

Projects F, B, C, and D have four largest BCR.

These four projects increase the wealth by $38.000
With an initial investment of $32,500.

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Summary of comparison results

Method Accepted project Added value

BCR F, B, C, D $38.000
NPV F, G $28.500
IRR C, F, E $27.000

BCR makes the most increase in wealth when we have

only a limited amount of capital at a certain period.

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