Unit 3-4_Financial Analysis.pptx

DEPARTMENT OF PLANN ING DEPARTMENT OF PLANN ING BSc. Human Settlement Planning 3 SP 358: Project Analysis & Management UNIT 3-4: FINANCIAL ANALYSIS Course instructor: Dr. Charles Oduro D...

DEPARTMENT OF PLANN ING DEPARTMENT OF PLANN ING BSc. Human Settlement Planning 3 SP 358: Project Analysis & Management UNIT 3-4: FINANCIAL ANALYSIS Course instructor: Dr. Charles Oduro Dr. G. Camynta  DEPARTMENT OF PLANN ING Meaning of Financial Analysis What is Financial Analysis about?  It is about determining and comparing the financial costs and returns of projects to inform investment decisions  In financial analysis, the following two variables are key:  Cost (i.e. investments) and Benefit (i.e. returns)  Both cost and benefit are measured in Monetary terms  Another important variable is Time 10:10 PM Unit 4: Financial Analysis 2  DEPARTMENT OF PLANN ING Meaning of Financial Analysis What is COST in Financial Analysis?  The Opportunity Cost incurred as a result of carrying out a project and using the product(s) delivered by the project  Opportunity cost = the value that could have been derived from resources expended on a given investment had those resources been allocated to the next best alternative foregone  Simply put, it is the market value of all inputs (resources) used on a project and its output  It includes such things 10:10 PM as: Initial Investment, 3 Unit 4: Financial Analysis  DEPARTMENT OF PLANN ING Meaning of Financial Analysis Investments  E.g. initial investment cost, replacement cost, residual values Operating Costs  Cost of inputs (materials, human, tools, etc) required to utilize (operate) a facility Maintenance costs  Includes cost of routine maintenance, periodic maintenance, repairs, etc 10:10 PM Unit 4: Financial Analysis 4  DEPARTMENT OF PLANN ING Meaning of Financial Analysis What are Benefits in Financial Analysis?  Financial returns (revenues) accruing directly from the products produced by a project  The nature, quantum and flow of benefits depends on the project in question 10:10 PM Unit 4: Financial Analysis 5  DEPARTMENT OF PLANN ING The Role of Money in Financial Analysis What is money? What are the Functions of money?  Unit of account: as a standard measure of the value of goods and services  Medium of exchange: facilitates the exchange of goods and services  Store of value: can be saved, stored and retrieved 10:10 PM Unit 4: Financial Analysis 6  DEPARTMENT OF PLANN ING The Role of Money in Financial Analysis What is the relevance of these functions of money in financial analysis?  The unit of account function makes it possible to measure inputs and outputs in a standard way  As a medium of exchange, it facilitates acquisition of project inputs and disposal of project outputs (goods and services)  The store of value function allows us to compare the values of inputs and outputs 10:10 PM Unit 4: Financial Analysis 7  DEPARTMENT OF PLANN ING Time-Value of Money DISCUSSION QUESTION: As a rational being, which of the following will you prefer, and why:  Receiving GHC100 today? or  Receiving GHC100 five years after today? 10:10 PM Unit 4: Financial Analysis 8  DEPARTMENT OF PLANN ING Time-Value of Money  Usually, for a given amount of money to retain its real value over time (acceptability), people expect its nominal value to increase  Time value of money is the real value of a given (nominal) amount of money at different times How do we Preserve the Real Value of money over time?  Use of “Interest”  Interest rate = interest expressed as a % of an amount of money at the beginning of a given Interest Period Unit 4: Financial Analysis 10:10 PM 9  DEPARTMENT OF PLANN ING Economic equivalence What is Economic Equivalence?  The idea that different amounts of money are equal in value at different times  E.g., GHC100 now and GHC125 in 5 years time could be economically equivalent if the real value is the same 10:10 PM Unit 4: Financial Analysis 10  DEPARTMENT OF PLANN ING Simple and Compound Interests What do you understand by “Simple Interest” and “Compound Interest”? What is the Difference b/n them? Simple Interest:  If P = present amount of money, r = simple interest, then the future amount, F, after t years is given as: F = P + rtP ⇒ F = P(1 + rt) 10:10 PM Unit 4: Financial Analysis 11  DEPARTMENT OF PLANN ING Simple and Compound Interests Compound Interest:  If P = present amount of money, r = compound interest, then the future amount, F, after t years is given as: F = P(1 + r)t Discounting:  If F = future amount of money after t years , r = discountP rate, F then the present value of that amount,(1  rP, ) is given as: t  The process of converting a future amount to a present value 10:10 PM using a discount rate is Unit 4: Financial Analysis 12  DEPARTMENT OF PLANN ING Methods of Financial Analysis Do you know of any methods used in Financial Analysis?  In this course, we will consider:  Financial Cost-Benefit Analysis  Financial Net Present Value, Benefit- Cost Ratio, Internal Rate of Financial Return  Return on Investment (ROI)  Pay-Back Period 10:10 PM Unit 4: Financial Analysis 13  DEPARTMENT OF PLANN ING Financial Cost-Benefit Analysis 10:10 PM Unit 4: Financial Analysis 14  DEPARTMENT OF PLANN ING Meaning and Rationale of Financial Cost-Benefit Analysis What Financial Cost-Benefit Analysis is all about  It involves the identification and assessment of the financial costs and benefits of a project, or a set of projects, and the application of a suitable decision criterion to make an investment decision.  In other words, it entails a comparison of the costs and benefits of a single project or alternative projects based purely on FINANCIAL considerations 10:10 PM Unit 4: Financial Analysis 15  DEPARTMENT OF PLANN ING Meaning and Rationale of Financial Cost-Benefit Analysis Rationale behind Financial Cost-Benefit Analysis  It is intended to help project decision makers to determine whether the financial benefits to be derived from a project would be worth the financial costs involved  It is a means to identify the most EFFICIENT investment alternative  Thus, EFFICIENCY is at the heart of CBA 10:10 PM Unit 4: Financial Analysis 16  DEPARTMENT OF PLANN ING Meaning and Rationale of Financial Cost-Benefit Analysis What is Efficiency in investment terms?  An efficient investment is one in which returns exceed costs  When two or more alternative investments are involved, the most efficient alternative is the one that yields the most returns for a given amount of inputs, or the one that produces the most NET returns  Efficiency is used as the basis for making rational allocation of scarce financial resources 10:10 PM Unit 4: Financial Analysis 17  DEPARTMENT OF PLANN ING Basic Steps in Financial CBA  Identify project alternatives to be evaluated  Identify all expected financial costs and financial benefits of each alternative (in monetary terms)  Determine appropriate CBA decision criterion(a)  Assess alternatives based on CBA decision criteria chosen  Report results for consideration by decision makers 10:10 PM Unit 4: Financial Analysis 18  DEPARTMENT OF PLANN Decision Criteria in ING Financial Cost-Benefit Analysis There are three CBA-based decision criteria: Net Present Value (NPV) Cost-Benefit Ratio (CBR) Internal Rate of Return (IRR) 10:10 PM Unit 4: Financial Analysis 19  DEPARTMENT OF PLANN ING Net Present Value (NPV)  Generic formula: NPV = PVB – PVC  Benefits and costs have to be discounted Let Bt = benefit in year t Ct = cost in year t r = discount rate; t = year 0, 1, 3, ….., n 20 10:10 PM  DEPARTMENT OF PLANN ING Net Present Value (NPV) Generic formula (cont.): n n Bt Ct NPV  (1r )t   (1 r ) t t 0 t 0 OR n Bt  Ct NPV  (1r )t t 0 21 10:10 PM  DEPARTMENT OF PLANN ING Net Present Value (NPV) Interpretation:  NPV tells us whether discounted benefits exceed discounted costs, or vice versa, and by how much.  E.g. NPV of GHC1.56 million means the discounted benefits of the project exceed its discounted costs by GHC1.56 million  NPV of –GHC576,000 means the discounted costs of the project exceed its discounted benefits by GHC576,000 22 10:10 PM  DEPARTMENT OF PLANN ING Net Present Value (NPV) Decision Rules: Single Alternative  If NPV > 0, the proposed project is viable;  If NPV = 0, the benefits are just enough to offset costs; consider other criteria  If NPV < 0, the proposed project is not viable, reject it Decision Rules: Two or More Alternatives  All alternatives with NPV > 0 are viable  Out of these, select alternative with the highest positive NPV 23 10:10 PM  DEPARTMENT OF PLANN ING NPV: Example 1 As a planner working with a District Assembly (DA) you have been tasked to evaluate the viability of a proposed economic development project. The forecasted financial costs and benefits of the project for the Yearnext 8 years 0 1 are 2shown 3 in4 the5table 6 below. 7 8 Cost (in $ million) 48.0 - - 8.5 8.5 12.0 4.5 4.5 4.5 Benefits (in $ million) 12 12 12 12 20 20 20 20 (i) Using a discount rate of 8% calculate the NPV of the project and interpret your result. (ii) Based on the result, determine whether the project is viable. (iii)PM What should be the decision of the DA regarding 10:10 24  DEPARTMENT OF PLANN ING NPV: Solution to Exercise 1 (i) NPV: how do we go about it? Complete the table t (years) 0 1 2 3 4 5 6 7 8 Ct (in $ million) 48.0 - - 8.5 8.5 12. 4.5 4.5 4.5 0 Bt (in $ million) - 12 12 12 12 20 20 20 20 Bt – Ct - 48.0 Discounted (Bt – - n Ct) 48.0 Bt  Ct NPV  (1r )t t 0 25 10:10 PM  DEPARTMENT OF PLANN ING NPV: Solution to Exercise 1 (i) NPV: t (years) 0 1 2 3 4 5 6 7 8 Ct (in $ million) 48.0 - - 8.5 8.5 12. 4.5 4.5 4.5 0 Bt (in $ million) - 12 12 12 12 20 20 20 20 B t – Ct - 12 12 3.5 3.5 8 15. 15.5 15.5 48.0 5 Discounted (Bt – - 11. 10. 2.8 2.6 5.4 9.8 9.0 8.4 C t) 48.0 1 3 8 Bt  Ct NPV  (10.08)t $11.6mil. t 0 26 10:10 PM  DEPARTMENT OF PLANN ING NPV: Solution to Exercise 1 Interpretation of result Discounted value of the benefits of the proposed project exceeds the discounted value of its costs by $11.6 million. (ii) Viability of proposed project: The proposed project is financially viable because its NPV is greater than zero (iii) What the DA should do: The proposed project should be adopted because its NPV shows it is financially viable 27 10:10 PM  DEPARTMENT OF PLANN ING Benefit-Cost Ratio (BCR)  Defined simply as:  Algebraically, the above formula is written as: n Bt  (1r )t BCR  t n0 Ct  t 0 (1r )t 28 10:10 PM  DEPARTMENT OF PLANN ING Benefit-Cost Ratio (BCR) Interpretation of BCR  The BCR gives us an indication of how much benefit will be produced (in GHC terms) for every GHC1 of cost incurred on a project  E.g.  BCR of 1.5 means for every GHC1 of cost incurred, GHC1.5 worth of benefits will be produced  BCR of 0.7 means for every GHC1 of cost incurred, GHC0.7 worth of benefits will be produced  What about: BCR of 2.0? BCR of 1.0? 29 10:10 PM  DEPARTMENT OF PLANN ING Benefit-Cost Ratio (BCR) Decision Rules: Single Alternative  If BCR > 1, the project is financially viable because its benefits exceed its costs; accept it.  If BCR = 1, the benefits are just enough to offset the costs; consider other decision criteria  If BCR < 1, the project is not financially viable because its costs exceed its benefits; reject it. Decision Rules: Two or More 10:10 PM 30  DEPARTMENT OF PLANN ING BCR: Exercise 2 As a planner working with a District Assembly (DA) you have been tasked to evaluate the viability of a proposed economic development project. The forecasted costs and benefits of the project for the next 8 years are shown in the table below. Year 0 1 2 3 4 5 6 7 8 Cost (in $ million) 48.0 - - 8.5 8.5 12.0 4.5 4.5 4.5 Benefits (in $ million) 12 12 12 12 20 20 20 20 (i) Using a discount rate of 8% calculate the BCR of the project and interpret your result. (ii) Based on the result, determine whether the project is viable. (iii)PMWhat should be the decision of the DA regarding 31 10:10  DEPARTMENT OF PLANN ING BCR: Solution to Exercise 2 (i) BCR: how do we go about it t (years) 0 1 2 3 4 5 6 7 8 ∑ Ct (in $ 48. - - 8.5 8.5 12. 4.5 4.5 4.5 million) 0 0 Discounted Ct 48. - - 0 Bt (in $ - 12 12 12 12 20 20 20 20 million) n Discounted Bt 0 Bt  (1 r ) t BCR  t n0 Ct  t 0 (1 r ) t 32 10:10 PM  DEPARTMENT OF PLANN ING BCR: Solution to Exercise 2 (i) BCR: t 0 1 2 3 4 5 6 7 8 ∑ Ct (in $ million) 12. 48.0 - - 8.5 8.5 4.5 4.5 4.5 0 Discounted Ct 77.0 48.0 - - 6.7 6.2 8.2 2.8 2.6 2.4 6 Bt (in $ million) - 12 12 12 12 20 20 20 20 Discounted Bt 88.4 0 11.0 10.0 9.5 8.8 14.0 13.0 12.0 11.0 4 88.44 BCR  1.15 77.06 Therefore, BCR = 1.15 33 10:10 PM  DEPARTMENT OF PLANN ING BCR: Solution to Exercise 2 Interpretation of BCR: BCR of 1.15 means, for every $1 of costs incurred on the project, $1.15 worth of benefits will be produced. (ii) Viability of the Project: The project is financially viable because its BCR is greater than 1 (iii) Recommendation: Adopt the project 34 10:10 PM  DEPARTMENT OF PLANN ING Internal Rate of Return (IRR) What is IRR? The discount rate that gives zero NPV. It is the value of ‘r’ such that n Bt  Ct NPV  (1r )t 0 t 0 Decision Rule: undertake the project if IRR is greater than the target discount rate 35 10:10 PM  DEPARTMENT OF PLANN ING Internal Rate of Return (IRR) How can we determine an IRR? There are 2 possible ways: 1. By Graph 2. By Formula 36 10:10 PM  DEPARTMENT OF PLANN ING Internal Rate of Return (IRR) Calculating IRR by Graph:  Plot a graph of ‘NPV’ (vertical axis) over ‘r’ (horizontal axis)  Use two different values of ‘r’ such that one gives you a positive NPV and the other gives you a negative NPV  Use the two NPVs to plot a strainght- line graph  From the graph estimate the value of ‘r’ at the point where NPV = 0 37 10:10 PM  DEPARTMENT OF PLANN ING Internal Rate of Return (IRR) Calculating IRR by Formula:  Let: a = discount rate that gives positive NPV e = discount rate that gives negative NPV b = (e-a); i.e. difference b/n ‘a’ and ‘e’ c = NPV at discount rate ‘a’ c IRR a  b d = (NPV at ‘a’) minus (NPV d at ‘e’)  IRR is calculated as: 10:10 PM 38  DEPARTMENT OF PLANN ING IRR: Exercise 3 A rural District Assembly is considering an investment in cottage industry for which the net cash flows have been estimated as follows: Year 0 1 2 3 4 Net cash -5,000 1,500 1,300 1,800 2,000 flow (GHS) i) What is the NPV if the discount rate is 10%? ii) What is the IRR? iii) Is this project acceptable? 39 10:10 PM  DEPARTMENT OF PLANN ING IRR: Solution to Exercise 3 i) Calculating NPV at r = 10% (apply discounting formula) GHS1500 GHS1300 GHS1800 GHS 2000 NPV  GHS5000   2  3  (1  0.1) 1  0.1 1  0.1 1  0.1 4 NPV  GHS5000  GHS1363.64  GHS1074.38  GHS1352.37  GHS1366.03 GHS156.42 Therefore, NPV = GHS156.42 40 10:10 PM  DEPARTMENT OF PLANN ING IRR: Solution to Exercise 3 (cont.) ii) Determining IRR (by Graph Method) NPV at Discount Rate r = 10% (a) GHS156.42 NPV at Discount Rate r = 14% (e) -GHS284.79 500 From graph, 400 NPV (GHS) IRR ≈ 11.5% 300 200 100 0 0 2 4 6 8 10 12 14 16 -100 Discount Rate (r%) -200 -300 41 10:10 PM  DEPARTMENT OF PLANN ING IRR: Solution to Exercise 3 (cont.) ii) Calculating IRR (using Formula) a = 10%; e = 14%; b = e – a = 14 – 10 = 4%; c = NPV at ‘a’ = 156.42; NPV at ‘e’ = - 284.79 d = (NPV at ‘a’) – (NPV at ‘e’) = 156.42-(-284.79) = 441.21 Therefore, IRR is approximately 11.4% iii) Is this project acceptable? Why? 42 10:10 PM  DEPARTMENT OF PLANN ING Return on Investment (ROI) and Payback Period 10:10 PM Unit 4: Financial Analysis 43  DEPARTMENT OF PLANN ING Return on Investment (ROI) What is Return on Investment (ROI)? It is the net gain (or profit) made from an investment It is a measure of project efficiency that compares the size of the expected net gain with the size of investments ROI is also known as Average Rate of Return (ARR). 10:10 PM Unit 4: Financial Analysis 44  DEPARTMENT OF PLANN ING Return on Investment (ROI) ROI is calculated as: (Total Discounted Benefits – Total ROI Discounted Costs) x 100 = Total Discounted Costs OR NPV ROI 10 Total Discounted x = 0 Costs OR n Bt n Ct  t   t t 0 (1  r ) t 0 (1  r ) ROI  100 n Ct  t 0 (1  r ) t 10:10 PM Unit 4: Financial Analysis 45  DEPARTMENT OF PLANN ING Return on Investment (ROI) Decision Rule:  The higher the ROI the better  Choose the alternative with the highest ROI  But, NPV must be greater than zero 10:10 PM Unit 4: Financial Analysis 46  DEPARTMENT OF PLANN ING Return on Investment (ROI) Example: You want to undertake a project that will cost GHS 20,000 in today’s terms. It is forecast that your investment will yield returns totalling GHS 22,500 in today’s terms. What is the ROI of this investment? Answer: GHS 22,500  GHS 20,000 ROI  100 12.5% GHS 20,000 10:10 PM Unit 4: Financial Analysis 47  DEPARTMENT OF PLANN ING Payback Period What is Payback Period?  The time (years) it takes to recoup an investment in a particular project—i.e. when net cash flows add up to zero  Payback analysis tells you how much time will elapse before accrued benefits ‘overtake’ accrued costs Total Cost of Project Payback Pe riod  Annual Cash Inflows 10:10 PM Unit 4: Financial Analysis 48  DEPARTMENT OF PLANN ING Payback Period Example  A project has a total cost of GHC250,000 in real terms and an annual return of GHC50,000 in real terms. What will be the payback period? Solution: Payback Pe riod  GHC250,000 5 GHC50,000  Therefore, payback period is five years 10:10 PM Unit 4: Financial Analysis 49