Chapter Two: Project

Identification and
Preparation
 2.1 Project Identification
• The first stage in the project cycle is project identification phase
which aims at identifying an issue that a project could address.
• This usually involves a ‘needs assessment’ which finds out what
community needs are and whom they affect.
• The needs assessment is followed by a ‘capacity assessment’ to see
what strengths the community has which it can use to address its
problems.
• In the unit there are tools that can be used or adapted to help
community members identify their vision supporting. The project
can then aim to help the community achieve part of its vision.
2
 2.1 Project Identification
 The first stage in the project cycle is the identification of projects.
 Within this initiation phase, the business problem or opportunity is
identified, a solution is defined, a project is formed and a project
team is appointed to build and deliver the solution to the customer.
 There are four key phases of project identification. These are:
 Actual Project Identification: The generation of project ideas
by formal and informal institutions and individuals.

3
 2.1 Project Identification
 Description of Project Idea: An actual written description of
the project idea or concept, summarizing the main elements of
the proposed project to use in the screening raking and
prioritization of project ideas.
 Screening: An initial review of project ideas and concepts to see
if they should be advanced or abandoned at an early stage.
 Prioritization: The ranking and selection of projects against a
set of criteria to identify the “best projects to move actively into
the designed stage and development.

4
 2.1 Project Identification
 How to come up with a project before grasping to project preparation?
Usually there are two major levels where project ideas are originate:
o Macro level, Project ideas emanate from, among others:
National, sector or regional plans,
Unusual events such as droughts, floods, earthquakes, etc
Multilateral or bilateral development agencies,
Regional or international agreements in which a country
participates, etc
o Micro level project ideas can emerge from:
 Existence of unused or underutilized natural and human resources and
perception of opportunities for their efficient use.
5
 2.1 Project Identification
 Identification of unsatisfied demand or needs
 Need to remove shortage in essential materials, services, or facilities
that constrain the development effort etc
 During identification analyst should eliminate project proposals that:
 Are technically unsound and risky
 Have no market for the output
 Have inadequate supply of inputs
 Are very costly in relation to benefits
 Assume over ambitious sales and profitability, etc
 As a result, some of the project alternatives will be rejected and those
promising will be advanced to the next stage called project preparation.
6
 Sources of Project Ideas
 The search for promising project ideas is the first
step towards establishing a successful venture.
 In the case of development projects, national and sub
national plans serve as a frame of reference.
 In addition to the aforesaid sources, there are several
sources of project ideas but most can be traced to
constraints in the development efforts.
 For example, if one of the major problem for
development in Ethiopia is lack of skilled labour. This
can be sources of project ideas. What to do to eliminate
the problem?
7
 Opportunity Studies
 Tell us what is possible in the region, or particular area.

a) General opportunity studies:

 Geological structure (ex. Soil type, exploitable minerals, and other
natural resources...)
 Climat variables (ex. Soler energy, température variations, e.t.c.)

 Land use patterns

 Human resources and socio-economic data (ex. Population and

population trends by sex, age etc., migration patterns, health and
nutrition, housing)
 Future demand for certain consumer goods that have growth
potential as a result of increased population or purchasing power of
8
for newly developed goods, etc
 Opportunity Studies
b) Specific opportunities study:
 A specific project opportunity study must include certain basic information; the mere
listing of products that may have potential for domestic manufacture is not sufficient.
 Potential investor, either domestic or foreign, can consider whether the
possibilities are attractive enough to proceed to the next stage of project preparation.
 Information on basic policies and procedures that may be relevant to the production
of the particular product
 Project ideas may be:
 Resource based: Stem from the opportunity to make profitable use of available
resource
 Market based: Arise from an identified demand in home or overseas market.
 Need based: To make available to all people in an area where minimal amounts of
certain basic material requirements and services exist.

9
 Who Identifies Projects
 The parties or agents may identify different project ideas as per their
intention.
 As well these parties have different criteria as per their context to identify
the project ideas.
o Investment promotion agency: Development goals of the country or
the region which may be related to issues of security, economic
growth, political stability may be a cause for prioritizing projects.
o Investor: Projected profitability - higher return is better; short
Payback period, expanding market and general economic prosperity
and tolerance to risk
o Lender: Banks and other financial institutions sometimes do opportunity
studies and screen the resulting investment ideas to assess the structure of
their loan portfolios. 10
 Project Concepts and Profiles
o Once a project idea has been conceived, the next stage is to
describe the idea so that it can be prioritized and move on to the
next stage in the process.
o This may involve the preparation of a project identification report
or project concept or profile.
o Questions and Project Profile or Concept:
 Justification and Purpose:
 What is the purpose of the project, what does it intend to
achieve?
 What problem is the project addressing?
 What is the justification of the project?
 What demands, needs or opportunities is the project
addressing?

11
 Project Concepts and Profiles
 Beneficiaries and Stakeholders Best regards:
 What will benefit from the project?
 Who has a share or stake in the project?
 How have project beneficiaries and other stakeholders
participated in the identification of the project?
 Resource and Institutions:
 What potential resources may be available for implementing the
project?
 Which organizations are to be involved in project planning and
implementations?
 Policies and Plans:
 How does the project proposal fit into any sector or regional
plans?
 Does the project fit into current policies?
12
 Project Concepts and Profiles
 Impacts:
 What are the likely major positive and negative social impacts
of the project?
 What are the likely positive and negative environmental impacts
of the project?
 Support:
 What is the level of political and administrative support for the
project?
 Does the project have the support of beneficiaries and/or local
communities?
 Risks:
 What are the chances of the project achieving its objective?
 What are the main risks associated with the project?

13
 Project Prioritization and Ranking
 The limited resources available mean that effective project identification and
selection at various levels will be essential.
 Hence, we need criteria for prioritizing and ranking projects. The following are
considered as a tool for achieving this purpose.
 Compatibility with the Promoter/project:
 Idea must be compatible with the personality, interest, and resource of the
entrepreneur.
 Consistency with the Government Priorities:
 Projects would only be feasible when consistent with the national goals and
government regulations
 Availability of Inputs:
 The resources and inputs required for the project must be reasonably assured.
14
 Project Prioritization and Ranking
 Adequacy of Market:
 The size of the present market must offer the prospects of adequate sales
volume, potential growth and return on investment. To judge this, the following
factors need to be examined: Total present domestic market, Competitors and
their market share, Sales and distribution system, etc.

 Reasonableness of cost:
 The cost structure of the project must be reasonable to ensure profitability. The
following factors need to be analyzed:-Cost of material inputs, Labour costs,
Selling and distribution cost, etc.

 Acceptability of risk level:

 The desirability of a project is critically dependent on the its risk characteristics
like Technological Changes, Competition from Substitutes, Governmental
15
Control Over Price and Distribution, etc.
 Project Prioritization and Ranking
o After we made a preliminary screening, those project ideas should be
rated by project rating index. It is a tool for screening large number of
project ideas.
o There are five steps that to be followed to rate those projects ideas.
These Steps are;-
 Identify factors relevant for project rating

 Assign weights to each factor

 Rate the project proposal on various factors using an appropriate

rating scale
 Multiply the factor rating with the factor weight

 Add all the factor scores to get the overall project rating index 16
Project Prioritization and Ranking

17
 Project Selection
 Projects meeting screening criteria are selected for further study.

Unless they may face one of the following options;-

o Reject: Some of the projects which not acceptable at the present

time would be rejected as worthless.

o Rework: Projects that need some refining of major features

before serious consideration.

o Consider later: Projects that are not currently timely accepted

but, latter it may be considered.

18
 Identification of Commercial Project Ideas
 The following are undertaken when ideas are identified for
commercial or industrial projects:
1. Generation of Ideas
o SWOT Analysis: This represents a conscious, deliberate, and
systematic effort by an organization to identify opportunities
that can be profitability exploited by it. Periodic SWOT
analysis facilitates the generation of ideas.
2. Monitoring the Environment:
o Basically a promising investment idea enables a firm (or
entrepreneur) to exploit opportunities in the environment by
drawing on its competitive strengths.
o Hence, the firm must systematically monitor of environment and
assesses its competitive abilities.

19
 Identification of Commercial Project Ideas

3. Corporate Appraisal:
o A realistic appraisal of corporate strengths and weaknesses is
essential for identifying investment opportunities which can be
profitably exploited.
4. Seeking for Project Ideas:
o Good project ideas – the key to success are elusive so a wide
variety of sources should tap to identify them by Analyze the
Performance of existing Industries, examine Inputs and Output
of Various Industries, Investigate availability of Local materials
& Resources, etc.
20
 Identification of Commercial Project Ideas
5. Preliminary Screening:
 By using the suggestions made in previous sections, it is possible to develop
a long list of project ideas.
 Some kind of preliminary screening is required to eliminate ideas which
prima facie are not promising.
 For this purpose, the following aspects may be looked into: compatibility
with the promoter, consistency with government proprieties, availability of
inputs, adequacy of the market, reasonableness of costs and acceptability of
risk level.
6. Project Rating Index:
 A preliminary evaluation may be translated into a project rating index.
 The steps involved in determining the project rating index are discussed
21
previously
 2.2 Project Preparation and Analysis
• Feasibility study provides a comprehensive review of all aspects of the project and
lays the foundation for implementing the project and evaluating it when completed.
• The focus of this phase of capital budgeting is on gathering, preparing, and
summarizing relevant information about various project aspects, which are being
considered for inclusion in the capital investment.
• Based on the information developed in this analysis, the stream of costs and benefits
associated with the project can be defined.
• The major difference between the pre-feasibility and feasibility studies is the
amount of work required in order to determine whether a project is likely to be
viable or not.
• If the preliminary screening suggests that the project is prima facie worthwhile, a
detailed analysis of the marketing, technical, financial, economic, and ecological
aspects is undertaken.
 2.2 Project Preparation and Analysis
• At this stage a team of specialists (Scientists, engineers, economists, sociologists)
will need to work together.
• At this stage more, accurate data need to be obtained and if the project is viable it
should proceed to the project design stage.
• Appraisal should cover major aspects like technical, institutional, economic and
financial.
• The final product of this stage is a feasibility report. The feasibility report should
contain the following elements:
• 1. Market analysis
• 2. Technical analysis
• 3. Financial analysis
• 4. Economic analysis
• 5. Social analysis, and
• 6. Environmental analysis
• 7. Human resource & Organizational analysis
2.2 Project Preparation and Analysis

Key Issues In The Project Analysis:

Potential market
Market Analysis
Market share

Technical viability
Technical Analysis
Sensible choice

Risk
Financial Analysis
Return

Benefits and cost

Economic Analysis
Other impacts

Ecological damages
Ecological Analysis
Restoration measures
Part-I Market and Demand Analysis
 2.2.1 Market and Demand Analysis
 The first step in project analysis is to estimate the potential size of the
market for the product or service to be offered proposed to be
manufactured and get an idea about the market share that is likely to
be captured.
 The key steps involved in market and demand analysis are organized
into seven sections as follows:
a) Situational analysis and specification of objectives
It may also look at the preferences and purchasing power of
consumer’s, actions and strategies of competitors and practices
of the middlemen/distributors, whole sellers and retailers.
b) Collection of secondary information
Secondary information provides the base and the starting point
for the market and demand analysis.
 2.2.1 Market and Demand Analysis
C) Conducting market survey:
 Secondary information, though useful often, does not provide a comprehensive basis
for market and demand analysis.
 It needs to be supplemented with a primary information gathered through a market
survey, specific to the project being appraised.
 The market survey may be a census survey or sample survey.

d) Characterization of the market:

 Based on the information gathered from secondary sources and through the market
survey, the market for the product/service may be described in terms of the
following:-
o Effective demand in the past and present

o Methods of distribution and sales promotion

o Supply and competition

 2.2.1 Market and Demand Analysis

e) Demand Forecasting :
 After gathering information about various aspects of the market and demand
from primary and secondary sources, attempt may be made to estimate future
demand.
 A wide range of forecasting methods are available to the market analyst. These
may be classified into three broad categories as discussed below.

i. Qualitative Methods
 These methods rely essentially on the judgment of experts to translate
qualitative information into quantitative estimates. The important qualitative
methods are:
Jury of Executive Method: Involves asking the opinions of a group of
managers on expected future sales and combining them into a sales
estimate.
 2.2.1 Market and Demand Analysis
 Delphi Method: This method is used for bring about the opinions of
a group of experts with the help of a mail survey.
The steps involved in this method are:

o A questionnaire is sent to a group of experts by mail and asked

to express their views.
o The responses received from the experts are summarized
without disclosing their identity, and sent back to the experts
meant to probe further reasons for extreme views expressed in
the first round.
o The process may be continued for one or more rounds till
reasonable agreements emerges in the views of the experts.
2.2.1 Market and Demand Analysis
ii. Time Series Projection Methods:
 Trend Projection Method: Trend projection method involves the following
steps:
 Determine trend of consumption by analyzing past consumption
statistics
 projecting future consumption by extrapolating the trend.
NB. When trend projection method is used the most commonly employed
relationship is the linear relationship.
Y = a + bX
Where; Y = the dependent variable, a = Intercept of the relationship, b =
Slop of the relationship, and X = Independent variable (time)
 To develop a linear equation, the slop b and intercept a must 1 st be computed
using least square formula.
a = ∑x2∑y - ∑x∑xy
n∑x2- (∑X) 2
b = n∑xy - ∑x∑y
n∑X - (∑X)2
Where: n = time period
 2.2.1 Market and Demand Analysis
Example: A manufacturer is developing a facility plan to provide production capacity
for its factor. The amount of capacity required in the future depends on the number of
products demanded by its customers the data below shows past actual sales of its
products.
Year(X) Actual sales (Y) X2 XY
1 1000 1 1000
2 1300 4 2600
3 1800 9 5400
4 2000 16 8000
5 2000 25 10000
6 2000 36 12000
7 2200 49 15400
8 2600 64 20800
9 2900 81 26100
10 3200 100 32000
∑x = 55 ∑Y = 21000 ∑x2 = 385 ∑xy =13330
 2.2.1 Market and Demand Analysis
Solution
Solution for ‘a’ and ‘b’ values
a = (385) (21000)-(55)(133300)
10(385)-(55)2
= 8085000-7331500 = 753500 = 913.333
3850-3025 825
b = (10)(133300)-(55)(21000)
10(385)-(55)2
= 1333000-1155000 = 178000 = 215.758
3850-3025 825
• Y = a +bx Y = 913.333+215.758x
• Now let us substitute 11, 12 and 13 to forecast the next 3 periods for x in to a
regression equation.
Y11= 913.333+215.758(11)=3286.7 units
Y12 = 913.333=215.758(12)=3502.4 units
Y13 = 913.333+215.758(13)=3718.2 units
2.2.1 Market and Demand Analysis
 Exponential Smoothing Method:

o It is also an averaging method that weights the most recent data more
strongly. It requires minimum data (forecast of current period, the actual
demand for the current period, and weighting factor called smoothing
constant. The formula is:

Ft+1 = Ft + α (Dt – Ft), or,

Ft + 1 = α Dt + (1 - (α ) Ft

Where; α = weightage factor for the current demand (the smoothing parameter
which lies between 0 and 1).

Dt = Demand during the present period

Ft + 1 = Forecast for next period t

Ft = Forecast of demand made for the present period

 2.2.1 Market and Demand Analysis
Example: Assume XYZ Company has accumulated the demand data shown in the
accompanying table for its products for the past 7 months, from which it wants to
consider exponential smoothing forecasts using smoothing constant (α) equal to 0.30.
Develop a forecast for period 2, 3 and 7.

Period 1 2 3 4 5 6 7
Demand 37 40 41 37 45 50 43
Forecast, Ft+1 --- 37 37.9 38.8 38.3 40.3 43.2

Solution
a). Ft+1 = αDt+(1- α)Ft
F2 = (0.3)(37)+(0.7)(37) = 37 units
b). F3 = (0.3)(40)+(0.7)(37) = 37.9 units
c). F7 = (0.3)(50)+(0.7)(40.3) =43.20 units
 2.2.1 Market and Demand Analysis
 Moving Average Method:

 In this method, the forecast for the next period is equal to the average of sales for several
preceding periods.
 Moving averages are computed for specific period such as three months or five months
depending on how much the forecaster desires to smooth the demand data.

Example: From records of delivery orders, management of ABC Company has accumulated
the following data for the past 10 months from which it wants to compute 3 and 5 months
moving average.
Month Jan Feb Mar Apr May Jun July Aug Sep Oct Nov.
demand 120 90 100 75 110 50 75 130 110 90 ------

Solution:

MA3 = 90+110+130 = 110 for November

3
MA5 = 90+110+130+75+50 = 91orders for November
5
2.2.1 Market and Demand Analysis
iii. Causal Methods:
 This method assumes that demand is related to some underlying factor(s) in
the environment, and that cause-and-effect relationships are at work.

f) Uncertainties in Demand Forecasting:

 Demand forecasts are subject to error and uncertainty which arise from three
principal sources:
o Data about past and present market

o Methods of forecasting

o Environmental change

g) Market Planning:
 Prepare a marketing plan for the new product. A marketing plan usually has
the following components :Current market situation, Opportunity and issue
Part-II Technical Analysis
Introduction

 The technical analysis of a project tells how technically

feasible a project is with respect to:
 Materials inputs and utilities,
 Product mix, plant capacity, machinery and equipment,
 Location site,
 Structure and civil work,
 Project chart and layouts and;
 Work schedule.
1. Production Program And Plant Capacity
 Basis for Production Program:

o Production program/capacity defines the level of output to be produced during

a specific period of time. Indicates the level/quantity of output and the timing of
production over the life of the plant.
o Production program, range and volume of products to be produced depend on
market requirements, proposed marketing strategy and availability of resources.
o Full production level may not be possible during initial production operation
owing to various technological, production and commercial difficulties in
addition to marketing bottlenecks.
o Normally a production and sales target of 40-50 percent of the capacity for the
first year is considered reasonable. Picking up gradually, towards third or fourth
year full production level can be achieved.
 1. Production Program and Plant Capacity Cont’d
 Plant capacity refers to a volume or number of units that can be manufactured
during a given period.
 Plant capacity may be seen from two perspectives:

o A feasible normal capacity (FNC): refers to the capacity achievable under

normal working conditions considering the technical conditions of the plant,
normal stoppages, downtime for maintenance & tool changes, holiday’s, shift
pattern and management system applied.
o A nominal maximum capacity(NMC): is the technically feasible capacity that
corresponds to the installed capacity as guaranteed by the supplier of the plant.
To reach the maximum output figures:
 Overtime work may be needed

 It might result in excessive consumption of factory supplies, utilities, spare

parts and etc.
 2. Raw Materials and supplies study
 Raw materials and its supply study of the feasibility, experts assigned for the task

to:
 Identify the required types of inputs, their sources and brief assessment of

alternative types of inputs, their relative merits in terms of quality of product

and alternative sources of supply.
 Describe general availability of raw materials, auxiliary materials such as

chemicals, packaging materials, paints, and varnishes , factory supplies such as

maintenance tools, oils, greases, and cleaning materials, and utilities such as
electricity, water, etc.
 List annual supply requirements of material inputs

 Determine the procurement period of each input

 Outline costs related to procurement and storage of inputs

3. Location and site selection and Environmental impact
assessment
 Location and Site:
 Location refers to a relatively broad area like a city, an industrial zone,
whereas, site refers to a specific piece of land where the project would be
set up.
 Generally, choice of location is influenced by a variety of considerations:
o Proximity to raw materials and markets,
o Availability of infrastructure,
o Labor situation,
o Governmental policies and other factors (private sector projects
location is influenced by certain governmental restrictions and
incentives).
 3. Location and site selection and Environmental impact assessment Cont’d

 Environment Impact Assessment (EIA):

 Environmental benefits or costs of a project are usually externalities or

side effects that affect the society wholly or partially.
 In principle, environmental impacts should be assessed on the basis of
legal regulations and emission standards and guidelines established in
the country where the project is located.
 The objective of environmental impact assessment in project analysis is
to ensure whether the development projects are environmentally sound.
 It is well known that the immediate and long-term health and welfare of
people are linked to their natural, cultural and socio-economic
environment. Example; waste management system
4. Technology Selection
o Appropriate technology selection should be made.
o The advocates of appropriate technology urge that the technology
should be evaluated in terms of the following questions:
 Whether the technology utilizes local raw materials?
 Whether the technology utilizes local manpower?
 Whether the technology protects ecological balance?
 Whether the goods and services produced cater to the basic
needs?
 4. Technology Selection Cont’d
 While selecting best technologies for proposed project, the following
factors must also be given due attention:
 Technological impact on the environment: The technology that we
are going to select should not only the one that minimizes
pollution, but should also preserve the natural resources and saves
renewable resources.
 Careful evaluation and assessment of hazardous technologies and
the use of toxic materials at different stages of production should
be made.
 5. Organization and Human Resources
o The successful implementation of any operation of industrial project
needs different categories of human resources: management, staff and
workers-with sufficient skills and experiences.
o The following factors should be given due consideration when the
availability and employment of human resources are analyzed:-
 The general availability of relevant human resource categories in
the country and the project region.
 The supply and demand situation in the project region
 Recruitment policy and methods
 Training policy and program
 6. Institutional and Social Analysis
• This aspect is more important to public projects. Project analysts are expected to
examine the broader social implications of the proposed project. This is particularly
related to the:
• Attitude and the likely response of the beneficiary groups;
• Existence of potential implementation capacities within communities;
• Cultural factors related to implementation and outcomes of the project;
• Political factors;
• Income distribution implications of the project,
• Employment creation, income distribution.
• Issues of balanced regional development,
• Displacement impact of the project;
• Gender implication of the adopted technology.
47
 6. Institutional and Social Analysis Contn’d

• Guidelines for ensuring the project is grounded on an

understanding of the culture and the environment of the intended
beneficiaries
• a) Consult with beneficiaries on the scope and implementation
strategy of the proposed project;
• b) Ascertain the willingness of each of the affected groups to commit
the financial resources and labour assumed in the project design;
• c) assess the likely response to the project of powerful local economic
and political groups and identify ways in which their support, can be
obtained or their potential opposition reduced;
48
 6. Institutional and Social Analysis Contn’d

• d) Assess the potential conflict the project may cause within the
community and surrounding areas, and identify ways in which the
conflict could be avoided or reduced;
• e) try to understand the “psyche” of the poor and destitute, and seek to
understand why they may be reluctant to participate in a project that
appears attractive to an outsider;
• f) use social impact assessment techniques to assess how each of the
principle socioeconomic groups are likely to be affected, place
particular emphasis on assessing the extent to which project benefits
will be accessible to the poorest and most vulnerable groups.
49
 7. Environmental or Ecological Analysis

• In recent years environmental concerns have assumed a great deal of

significance.
• Ecological analysis should be done particularly for major projects,
which have significant ecological implications like power plants and
irrigation schemes, and environmental polluting industries.
• The key questions raised in ecological analysis are:
• 1. What is the likely damage caused by the project to the
environment?
• (i) What is the cost of restoration measures required to ensure that the
damage to the environment is contained within acceptable limits?
50
Part-III Financial Analysis
 3.1 Introduction
 Project financial analysis is analytical work required to identify the critical
variables which are useful for likely to determine the success or failure of
project investment.
 It is concerned with assessing the feasibility of a new proposal for
investment on the basis of financial requirements and their availability.
• Commercial profitability analysis or Financial analysis of a project amounts
to reviewing it from the angle of the entity (private or public) that will be
responsible for its execution.
• It aims at verifying that under prevailing market conditions the project will
become and remain viable.
• It is concerned with assessing the feasibility of a new project from the
point of view of its financial results.
3.2 Purpose of financial analysis
 Project financial analysis is essentially undertaken for the
following purposes:
 It provides an adequate financing plan for the proposed
investment.
 It determines the profitability of a project.
 It assists in planning the operation and control of the project by
providing management information to both internal and external
users.
 It advises on methods of improving the financial viability of a
project entity.
 It shows the financial structure of the project and its existing
3.3 Financial Evaluation Techniques
 Projected Cash Flows:
 Cash flows are basically either receipts of cash (cash inflows)
or payments (cash outflows) related to long-term investment.
 Different techniques can be employed to examine the financial
viability of the project. However, the most common methods
for evaluating financial viability of a project are:
o Payback Period
o Return on Investment
o Net Present Value
o Internal Rate of Return
3.3 Financial Evaluation Techniques Cont’d

 The net present value and internal rate of return

techniques are classified as discounted cash flow (DCF)
methods, while payback period and return on investment
techniques are classified as non-DCF methods.
 The DCF methods take the time value of money (interest
rate) into account whereas the non- DCF methods ignore
the time value of money (dose not consider the interest
rate)
3.3.1 Non - Discounted Cash flow Method
 Payback Period:
 It is the time taken to gain a financial return equal to the initial
investment.
 The time period is usually expressed in years and months
 The initial investment outlay includes all capital investments made
before the plant starts operation as well as during plant operation.
 A payback period is a length of time from the beginning of the
project until the net cash flows of the incremental production
reaches the total of the initial investment.
 Payback Period Cont’d
 To calculate the payback period, simply work out how long it will take to recover
the initial investment through the accumulated net cash flows earned by the project.
 It can be simply computed as:
Payback period = Initial Investment
Accumulated annual cash flows
Example: A project whose initial investment outlay is Birr 50,000 is expected to have a
uniform annual cash flow of Birr 10, 000 for 8 years. How many years will be required
to get back the initial investment?
Payback period = 50,000
10,000
= 5 years
Thus, the payback period is 5 years.
Payback Period Cont’d

Example: A company wishes to buy a new machine for a 4-year

project. The manager has to choose between machine A and machine
B. Although both machines have the same initial cost (Birr 35,000)
their cash flows perform differently over the four-year period.
Cash-Flow (Birr)
Year
Machine A Machine B

0 (35,000) (35,000)
1 20,000 10,000
2 15,000 10,000
3 10,000 15,000
4 10,000 20,000
Payback period 2 years 3 years
 Payback Period Cont’d
 Machine A: The total cash flow at the end of the second year will be
Birr 35,000 (20,000 + 15,000).
 The initial investment will be recovered at the end of the second year.
Thus, the payback period is 2 years.
 Machine B: The total cash flow at the end of the third year will be
Birr 35,000 (10,000 + 10,000 + 15,000).
 The initial investment will be recovered at the end of the third year.
Thus, the payback period is 3 years.
 It can be, therefore, concluded that machine A will recover its outlay 1
year sooner than machine B. When projects are ranked by the shortest
payback period, machine A is selected in preference to machine B.
 Payback Period Cont’d

 Selection criteria for pay back method:

We will accept all independent projects having payback
period less than or equal to acceptable payback period.
Usually a firm that employees this method may specify
the maximum acceptable payback period.
For mutually exclusive projects we will accept a
project with the shortest payback period.
Return on Investment (ROI):
 ROI is a measure of profitability that relates income to
investment, both measured in accounting terms.
 This method first calculates the average profit, which is simply
the project initial outlay deducted from the total gains or cash
flows, divided by the number of years the investment will run.
Average Annual Profit = (Total gains) – (Total outlay)
Number of years
Return on Investment = Average Annual Profit x 100
initial investment
 Return on Investment (ROI) Cont’d

Example: Consider the machine selection example introduced earlier.

Using this example compute the Return on Investment. Look at the
table below.

Cash-Flow (Birr)
Year Machine A Machine B

0 (35,000) (35,000)
1 20,000 10,000
2 15,000 10,000
3 10,000 15,000
4 10,000 20,000
Total gains 55,000 55,000
 Return on Investment (ROI) Cont’d
 The ROI for machines A and B can be calculated as follows.

 Machine A: Profits = 55,000 - 35,000 = 20,000

Average Profit = 20,000/4 years = 5,000 per year

Return on Investment = (5000 x 100)/ 35,000 = 14%
 Machine B: Profits = 55,000 - 35,000 = 20,000

Average Profit = 20,000/4 years = 5,000 per year

Return on Investment = (5000 x 100)/ 35,000 = 14%
 Selection criteria for ROI:

 We will accept all independent projects having ROI equal to or greater

than a pre - specified ROI are accepted.
 For mutually exclusive projects we will accept a project with higher the
ROI.
 3.3.2 Discounted Cash flow Method
 The discounted cash flow technique takes into consideration the time
value of money.
 In other words, it includes time dimension in project appraisal.
 Money has a specific value according to the time in which it is used or
received.
 In economics, the time value of money is defined by its alternative
use.
 Alternative uses for capital are investments with implications for
interest rate.
 Therefore, interest rate is used as a value, which allows comparing the
value of money today and in the future.
 3.3.2 Discounted Cash flow Method Cont’d
 There are two methods of valuation:
o Compounding
o Discounting
 Compounding: Is commonly used in saving accounts. It is used to calculate the
future value of money, which increases year by year according to the interest rate.
Example: You have Birr 100 now. If you put it in the bank, you will get 5% interest.
o After one year, that money is worth (1 + 0.05) x100 = Birr 105
o After two years, it is worth (1.05)(1.05)(100) = (1.05)2 (100)
= $110.25
o After three years, it is worth (1.05)(1.05) (1.05) (100) = (1.05)3 (100) =
$115.76

Future Value = X (1 + r) t

Where: X=is principle amount,

r = is interest rate
t = is time period
(1 + r) t = is the compounding factor or future value factor
 3.3.2 Discounted Cash flow Method Contn’d
 Discounting: is the reverse of compounding. It is used to calculate the present
value of money, which decreases year by year according to the interest rate.
 The method of discounting weighs all value in the future with a discounting to
arrive at their present value.

Present Value = X /(1 + r) t

Where: 1/ (1 + r) is the discount factor

Example: How much is worth today Birr 100 paid after one year.

Present value = X = 100/1.05 = $95.24

o There are two basic discounted cash flow methods, which take the effect of time value of

money.
 Net present value and

 Internal rate of return.

 Net Present Value (NPV)
 NPV is a measure of the value or worth added to the company by carrying out the
project.
 The NPV can be defined as the present worth of cash flow streams generated by an
investment.
 The NPV is calculated by adding the values obtained by discounting the annual cash
flows occurring throughout the life of a project as follows:
n
NCFi
NPV  n
i 0 (1  r )

Where:

n = is the life of the project

r = is the interest rate

NCF = is net cash flow(In cash flow – out cash flow)

 Net Present Value (NPV) Cont’d

Example: Consider the machine selection example again, this time

using NPV. Assume the discount factor is 20%, set up the NPV format.
Cash flow(Birr)
Year Machine A Machine B

0 (35,000) (35,000)
1 20,000 10,000
2 15,000 10,000
3 10,000 15,000
4 10,000 20,000
 Net Present Value (NPV) Cont’d
 Solution: Machine A- Net Present Value Calculation (DF 20%)
Column 1 Column 2 Column 3 = (2) x (3)
Years Cash Flow Discount Factor 20% Present Value
0 (35,000) 1 (35,000)
1 20,000 0.8333 16,666
2 15,000 0.6944 10,416
3 10,000 0.5787 5,787
4 10,000 0.4823 4,823
Total NPV 2,692

NPV = (35,000)/(1+0.2)0 + 20,000/(1+0.2)1 + 15,000/(1+0.2)2 +

10,000/(1+0.2)3 + 10,000/(1+0.2)4
= (35,000) + 16, 666 + 10,416 + 5,787 + 4,823
= Birr 2,629
 Net Present Value (NPV) Cont’d
 Solution Machine B- Net Present Value Calculation (DF 20%)
Column 1 Column 2 Column 3 = (2) x (3)
Years Project Cash Flow Discount Factor 20% Present Value
0 (35,000) 1 (35,000)
1 10,000 0.8333 8,333
2 10,000 0.6944 6,944
3 15,000 0.5787 8,681
4 20,000 0.4823 9,646
Total NPV (1,396)

• NPV = (35,000)/(1+0.2)0 + 10,000/(1+0.2)1 + 10,000/(1+0.2)2 +

15,000/(1+0.2)3 + 20,000/(1+0.2)4
= (35,000) + 8333+ 6944 + 8681 + 9646
= Birr (1396)
 Net Present Value (NPV) Cont’d
 Interpretation: Therefore the NPV for machine A is Birr 2696 and for machine B
is Birr (1396). The NPV analysis would select machine A in preference to
machine B because it has a higher NPV. Machine B would be rejected in any case
because it has a negative NPV. A negative NPV indicates the company would lose
money by carrying out this project.
 Decision Rule:
 NPV < 0: The present value of the income stream is less than the present value of
the cost stream, i.e. insufficient to cover investment.
 NPV = 0: The present value of the income stream equals the present value of the
cost stream. (At Break – even point).
 NPV > 0: The present value of the income stream is greater than the present value
of the cost stream; yield from investment is higher than the discount rate assumed.
(Therefore it is Promising alternative).
 3.3.2 Internal Rate of Return (IRR)
 It is another DCF method, which represents the actual rate of return when profit

and time value of money are taken in to account

 The IRR is the discount rate that makes the present value of cash inflows is equal

to the present value of cash outflows, i.e., NPV is zero.

 It is the maximum interest rate a project could pay for the resources used if the

project is to recover its investment and operating costs and still break even.

Where; IRR = Internal Rate of Return, OI = Original investment, LR = Lower Rate

LRPV = Lower Rate Present Value

HRPV = Higher Rate Present Values

RD = Higher - Lower Rates Of Discount

 3.3.2 Internal Rate of Return (IRR) Cont’d
Example: To show the calculation of IRR, consider the cash flows of a project being considered

by X Company.
Year 0 1 2 3 4
CFs (100,000) 30,000 30,000 40,000 45,000

 The IRR is the value of r which satisfies the following equation:

30,000 + 30,000 + 40,000 + 45,000

(1+r)1 (1+r)2 (1+r)3 (1+r)4

 We try different values or r till we find that the right-hand side of the above equation is equal

$100,000. Let us, to begin with, try r =15%. This makes the right-hand side equal to:

30,000 + 30,000 + 40,000 + 45,000 = 100,802

(1.15)1 (1.15)2 (1.15)3 (1.15)4

 3.3.2 Internal Rate of Return (IRR) Cont’d
 This value is slightly higher than our target value $100,000. So we must increase the value
of r from 15% to 16%. (Higher r lowers and smaller r increases the right hand side value).
 The right hand side becomes:
30,000 + 30,000 + 40,000 + 45,000 = 98,641
(1.16)1 (1.16)2 (1.16)3 (1.16)4
 Since this value is now less than $100,000 we conclude that the value of r lies between 15%
and 16%.
Where, OI = 100,000, LR = 0.15, HR = 0.16, LRPV =100,802,
HRPV = 98, 641, RD = (0.16 – 0.15 = 0.01)

= 0.15 + 100,802 – 100,000 x 0.01 = 15.37%

100,802 – 98,641
• Since the IRR analysis is a measure of the return on investment, you need to select a project
with the highest IRR.
 3.3.3 Benefit-Cost Ration (Profitability Index)
 The profitability index, also called benefit - cost ratio, is the ratio of the PV of the future net
cash inflows to the initial outlay of the project.
 It measures the desirability of the project and evaluates the worth of an investment.

PI= PV (NCF)
PV (OI)
 In the application of PI, a project is accepted if PI > 1, rejected if PI < 1 and we
remain indifferent if PI = 1. It should be noted that when PI > 1, NPV is positive;
PI < 1, NPV is negative and PI=1 when NPV is zero.
Example: After tax cash flows of a small scale tannery project is given below. Find the
profitability index if discount rate is assumed to be 12%?

Year 0 1 2 3 4 5
CFs 40,000 15,000 14,000 13,000 12,000 11,000
 3.3.3 Benefit-Cost Ration (Profitability Index) Cont’d
Solution

Year Cash Flow Rate = (12%) PV

1 15,000 0.893 13,395
2 14,000 0.797 11,158
3 13,000 0.712 9,256
4 12,000 0.636 7,636
5 11,000 0.567 6,237
Total 47,678

Therefore, PI= 47,678 = 1.192

40,000
 Decision rule:
 If (BCR) >1, then the project should be undertaken.

 If BCR) <1, then the project should not be undertaken.

 If BCR =1, then the decision would be indifferent.

 Part –IV: Economic Analysis
(Social Cost-Benefit Analysis)
 4.1 Introduction to Economic Analysis
 Financial analysis focuses on monetary costs and benefits of the
project whereas economic analysis focuses on the social costs and
benefits of the project.
 The economic analysis, also called social cost-benefit analysis
(SCBA), is a methodology developed for evaluating investment
projects from the point of view of the society or economy as a
whole.
 It appraises the project’s contribution to the economic welfare of the
region or country.
 It is made on behalf of the whole of society instead of just the
owners of the infrastructure, as in the financial analysis
 4.1 Introduction to Economic Analysis Contn’d
 Economic analysis, also refers to as social cost benefit analysis, is
concerned with evaluating the project from the large social point of view.
 In such an evaluation the focus is on the social cost benefits of a project,
which is different from its monetary cost and benefits.
 The questions needed to be answered in social cost benefit analysis are:

 What are the direct economic benefits and costs of the project in
terms of efficiency not in terms of market prices?
 What would be the impact of the project on the distribution of
income in the society?
 What would be the impact of the project on the level of salaries and
investment in the society?