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  1. 1. -1- A BRIEF OUTLOOK ON PROJECT ECONOMIC AND FINANCIAL ANALYSIS ♦ You have a great idea for a project, but is your concept financially feasible? Here are some basic steps for deciding whether it should get the go ahead. All projects, whether local or foreign, require some form of economic analysis at the study stage (pre-investment phase). The basic questions to be addressed may be summarized as follows: • Is it worth investing C dollars now, in order to generate annual net revenues of R dollars for the next Y years? • If so, how should the capital investment C be financed to ensure a maximum return to potential investors? This is where the technical and economic aspects of a project intersect to define what is economically viable and financially feasible. An efficient analysis must be carried out in two successive steps. The economic analysis deals with the viability of the project as a whole, independently of the possible sources of funds. Only when the viability of a project is clearly demonstrated, the financial analysis is carried out to evaluate the optimum financial and fiscal structure that would make the project “bankable”. A viable project may be sometimes difficult to finance because of some local circumstances (particularly on foreign ventures), but there is obviously no point in trying to finance a non viable project unless significant grants can be secured on the strength of other, less tangible, benefits (social benefits, environmental advantages, regional development, political support, etc.). Therefore, an efficient analysis should be a step by step process in which one stage is triggered only when the previous one shows positive results. The overall sequential procedure in conducting an economic and financial analysis is schematically shown in Figure 1. A brief explanation follows. 1. Economic analysis: The original concept of a project is generally sketched out on a piece of paper showing the production process and a rough estimate of costs and profits. When this “back of the envelope” concept justifies further investigation, an opportunity study is launched to determine, on a preliminary basis, the fundamental economic parameters of the project. ¨ This paper was originally submitted in 1999 by S. Benzimra, P.Eng. to Dimensions, the magazine of Professional Engineers of Ontario and printed in their Mars-April 2000 issue. The present text includes a few minor changes. Power Business Decisions Corp.
  2. 2. -2- Estimates of capital costs, sales and operating costs (split between variable and fixed costs) lead to a rough assessment of the return on investment (ROI), the break-even point (BEP) and a comparative evaluation of two or more competing options. This phase of the economic analysis may be called “static” as it only reflects the operations of a typical year. It assumes implicitly that all the capital investment is engaged at a given time and full operations are in place immediately thereafter. The project performance shown in this “snapshot” does not account for any time variation of sales, costs, or additional investment. Data req uired Analys is level Results Œ • Preliminary Capital Cost • ROI ECONOMIC ANALYS IS • Preliminary Operating Costs • BEP • Projected Sales S te p 1: " s tatic " • Comparing two options & A lyze na  NET OPERATING INCOME • Detailed Feasibility Study against ECONOMIC ANALYS IS • Detailed Cost Estimates TOTAL INVESTMENT • Projected Escalation Factors S te p 2: " dynamic " ( IRR, NPV, NRR, PB ) & A lyze na • Working Capital Ž • Debt-to-Equity ratio FINAL CASHFLOW SURPLUS • Loans: Interest and Term against • Loans: Debt Servicing FINANCIAL ANALYS IS EQUITY INVESTMENT • Grants' ratio (optional) ( IRR, NPV, NRR, PB ) • Fiscal parameters & Op im t ize Final Re po rt Figure 1: Analysis Summary Procedure The next stage involves the forecast of all economic parameters throughout the lifetime of the project. This “dynamic” evaluation calls for a detailed feasibility study in which logistics, marketing, escalation of prices and costs, phased capital investments, variable production rates, etc. play a prominent role in the determination of actual operating scenarios. This leads to the projected Operating Income Statement which shows the yearly progression of all sales and costs, against the capital cost of the project. A series of Project Performance Indicators are then calculated on a discounted cashflow (DCF) basis to account for the time value of money. Power Business Decisions Corp.
  3. 3. -3- The static ROI is replaced by the more meaningful Internal Rate of Return (IRR) and project profitability is determined by the Net Rate of Return (NRR) at various discount rates, so that the “average cost of capital” is implicitly embedded. Also, the Payback Period (PB), calculated at various discount rates, estimates the time during which the investment may be considered at risk. As an example, consider a $1 million capital investment engaged in 2000, and projected annual net revenues of $300,000/yr. assumed to be constant for the next five operating years (2001-2005). The ROI of this project is 30% (Project ‘A’, shown in Table 1). But given the time value of money, it is obvious that the $300,000 generated in 2001 are more valuable than the same amount earned in later years. By discounting these revenues at 15.2% per year from 2001 to 2005, the sum of the annual revenues drops from $1,500,000 to $1,000,000, thus making the Net Present Value (NPV) of the project equal to zero. This particular discount rate that makes NPV = 0 is called the Internal Rate of Return (IRR). Therefore, as long as the “average cost of capital” is lower than 15.2%, the project will show some profitability. For instance, at a discount rate of 6%, the sum of the discounted revenues equals $1,263,709 and NPV = $263,709. The average Net Rate of Return (NRR) over the whole venture life (6 years) is then equal to 4.4%, over and above the 6% estimated cost of capital. [NRR = (263,709/1,000,000)/6] = 4.4%. As for the Payback Period (PB), it would be tempting to think that the initial investment of $1 million could be covered in a little over 3 years. Actually, the higher the discount rate, the longer the PB will be: at a discount rate equal to the IRR (15.2%), it will take the full project lifetime (5 years) to recover the initial investment, while no profits will be generated. Discount Rate  0.0% 6.0% 13.9% 15.2% 18.1% Year 0 -1,000,000 -1,000,000 -1,000,000 -1,000,000 -1,000,000 1 300,000 283,019 263,391 260,330 254,027 2 300,000 266,999 231,250 225,906 215,098 Project 'A' 3 300,000 251,886 203,030 196,034 182,136 IRR = 15.2% 4 300,000 237,628 178,254 170,112 154,224 5 300,000 224,177 156,502 147,618 130,590 NPV  500,000 263,709 32,427 0 -63,925 NRR  8.3% 4.4% 0.5% 0.0% Year 0 -500,000 -500,000 -500,000 -500,000 -500,000 1 300,000 283,019 263,391 260,330 254,027 2 250,000 222,499 192,708 188,255 179,249 Project 'B' 3 50,000 41,981 33,838 32,672 30,356 IRR = 18.1% 4 50,000 39,605 29,709 28,352 25,704 5 24,500 18,308 12,781 12,055 10,665 NPV  174,500 105,411 32,427 21,665 0 NRR  5.8% 3.5% 1.1% 0.7% 0.0% Table 1: Comparing two competing options Power Business Decisions Corp.
  4. 4. -4- Project Performance Indicators should not be looked at in isolation. For example, a project showing a high IRR, say 30%, may be actually less attractive than a project showing a much shorter PB, even though its IRR is significantly lower. Furthermore, when considering alternative options, the highest IRR is not necessarily indicative of the highest profitability: the two sets of Net Present Values (NPV), calculated as a function of the discount rate, may intersect at some point, as shown in Table 1, thus leaving the analyst to judge on the more realistic alternative. Table 1 shows a higher IRR for Project ‘B’ (18.1% vs. 15.2%). But as long as the discount rate is lower than 13.9%, the NPV of Project ‘A’ is larger. Therefore, if the average cost of capital is relatively low, Project ‘A’ is the most attractive option. On the other hand, Project ‘B’ can sustain a high cost of capital and still generate a profit. 2. Financial analysis: When the results of this economic analysis show a reasonable presumption of success for a relatively broad range of scenarios, a financial analysis is warranted. But we should keep in mind that the viability of a project is independent of the source of funds. The economic analysis demonstrates the viability of a project. The financial analysis shows the best route to structure the project so that it can be optimally implemented. The financial analysis requires the introduction of additional parameters, such as working capital, debt-to-equity ratio, percentage of grants, if any, fiscal depreciation and tax structure, loans’ interest rate and term, debt servicing method, etc. Most of these parameters can be negotiated within limits, hence, the necessity to optimize them globally. For instance, reimbursing a loan as an annuity (constant total payments throughout the term of the loan) generally translates into lower taxes in the early years because of higher interest payments. But the overall debt servicing is more demanding than when the loan is being reimbursed by the standard method of constant principal payments. The introduction of interest (loans) and working capital leads to a global investment which may be substantially higher than the initial capital cost used in the economic analysis. This is especially true if a significant portion of the investment is being borrowed, thus accumulating “interest during construction” (IDC), which is capitalized prior to start-up and rolled over into the loan’s principal. On the other hand, the investor puts up only a portion of the global investment (equity) but the net proceeds of the project (final cashflow surplus) are far smaller than the operating income, once taxes, interest charges and debt repayment are deducted. The primary objective of the financial analysis is to maximize the profitability of the equity investment throughout the project lifetime. The same Performance Indicators (IRR, NPV, NRR, PB) are calculated but, this time, on the final cashflow surplus (after tax, interest charges and debt repayment), against the equity investment. In most instances, the IRR on equity (also called “Discounted Cashflow Return on Equity”, or DCFROE) is higher than the IRR on the total investment (“Discounted Cashflow Return on Investment”, or DCFROI). This “leveraging effect” increases with the debt-to-equity ratio but it is generally tempered by the limits imposed by the financing institution. Throughout the evaluation process, a number of documents should guide the analyst: Power Business Decisions Corp.
  5. 5. -5- • Operating Cost Summary: shows the relative ratios, by categories (staff, materials, transport, utilities, etc.), as a useful comparison with industry standards, • Break-even analysis: to assess the sensitivity of fixed and variable costs on the minimum acceptable operating capacity, • Investment Schedule: shows the projected yearly capital outlays and their funding source (equity, grants, loans), • Operating Income Statement: shows the projected annual evolution of sales, costs, margins and break-even points, • Cashflow Statement: shows the projected annual disbursements of financial and fiscal charges, working capital adjustments and possible short-term borrowings. 3. A software tool: In actual practice, a proper analysis may be quite a complex operation, especially when dealing with two currencies (overseas projects), a multiplicity of products and materials, each having specific escalation factors, temporarily hired personnel, indexed royalties, phased investments, etc. A simple, yet powerful, software application has been designed to that effect: Biz Proof ™ integrates the technical, economic, financial and fiscal aspects of a project to provide the analyst with a global picture of project profitability. It also features a full interface with Microsoft Excel and an extensive Help menu. August 2000 For any additional information, please feel free to contact: Power Business Decisions Corp. 715, Square Victoria, 4th Floor Montreal (Quebec) H2Y 2H7 - Canada Fax: (514) 849-0645 Email: bizproof@pbdcorp.com Power Business Decisions Corp.

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