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COST-BENEFIT ANALYSIS FOR INVESTMENT DECISIONS, CHAPTER 3: THE FINANCIAL APPRAISAL OF PROJECTS Glenn P. Jenkins Queen’s University, Kingston, Canada a...

COST-BENEFIT ANALYSIS FOR INVESTMENT DECISIONS, CHAPTER 3: THE FINANCIAL APPRAISAL OF PROJECTS Glenn P. Jenkins Queen’s University, Kingston, Canada and Eastern Mediterranean University, North Cyprus Chun-Yan Kuo Queen’s University, Kingston, Canada Arnold C. Harberger University of California, Los Angeles, USA Development Discussion Paper: 2011-3 ABSTRACT The financial analysis of a project helps determine the financial viability and sustainability of the project. Since the integrated project analysis begins with the financial analysis and then the economic analysis, the concepts and data ought to be organized in a consequential and consistent manner. The comparison of either financial or economic benefits with their corresponding costs requires that all relevant data should be organized into a project profile covering the duration of the project's life. While a project profile is given by cash flows in the financial appraisal, the project's profile in the economic appraisal provides a flow of net economic benefits generated by the investment. This chapter explains how cash flow profiles of a project are developed and constructed in a consistent fashion. It also discusses how investment project can be evaluated from different points of view. To Be Published As: Jenkins G. P, C. Y. K Kuo and A.C. Harberger,“Principles Underlying The Economic Analysis Of Projects” Chapter 3, The Financial Appraisal of Projects. (2011 manuscript) JEL code(s): H43 Keywords: Economic Analysis, Financial Appraisal, Cash Flows, Inflation Impacts, Valuation of Existing Assets CHAPTER 3: CHAPTER 3 THE FINANCIAL APPRAISAL OF PROJECTS 3.1 Introduction The financial analysis of a project helps determine the financial viability and sustainability of the project. Since the integrated project analysis begins with the financial analysis and then the economic analysis, the concepts and data ought to be organized in a consequential and consistent manner. The comparison of either financial or economic benefits with their corresponding costs requires that all relevant data should be organized into a project profile covering the duration of the project’s life. While a project profile is given by cash flows in the financial appraisal, the project’s profile in the economic appraisal provides a flow of net economic benefits generated by the investment. This chapter explains how cash flow profiles of a project are developed and constructed in a consistent fashion. It also discusses how investment project can be evaluated from different points of view. 3.2 Why a Financial Appraisal for a Public Sector Project? It may appear that the financial appraisal of a project is of interest only to a private investor who wishes to determine the net financial gain (or loss) resulting from the project. Because public sector projects utilize public funds the analysis from the public perspective is primarily concerned with the project’s impact on the country’s economic welfare. From a country’s prospective, a project should be undertaken if it generates a positive net economic benefit. A project that yields negative net economic benefits should not be undertaken as it will lower the economic welfare of society as a whole. To determine the net economic benefits produced by a project the appraisal of such projects needs to incorporate an economic analysis. There are several reasons for also conducting a financial appraisal for a public sector project. The most important one is to ensure the availability of funds to finance the project through 2 its investment and operating phases. While an expected positive economic return is a necessary condition for recommending that a project be undertaken, it is by no means a sufficient reason for a successful outcome. A project with a high expected economic return may fail if there are not enough funds to finance the operations of the project. Many examples of development projects with expected high economic returns have failed due to financial difficulties. Water supply projects are typical examples of projects that generate substantial economic benefits due to the large economic value attached to water, but receive little financial revenues because of the low water tariffs. If the project is undertaken solely on the basis of the favorable economic analysis with no consideration to the financial sustainability, the project may fail due to lack of funds to maintain the system and service its debt. Other examples include projects such as public transport and irrigation where services are usually provided at concessional prices. A financial analysis enables the project analysts to establish the financial sustainability of the project by identifying financing shortfalls that are likely to occur over the life of the project, thereby being able to devise the necessary means for meeting these shortfalls. A key objective of a financial appraisal for a government project is to determine whether the project can continue “to pay its bills” throughout its entire life; and if not, how can the shortfalls be met. In certain instances the government approaches a project like a private sector investor to determine its financial profitability. This is necessary if private participation in the project is being contemplated. In this case, it is important to determine the profitability of a project and to estimate the value that a private investor would be willing to pay for the opportunity to participate. Ascertaining the financial profitability is also necessary when government policies are designed to encourage small investors or certain groups in society to undertake projects by providing them with grants or loans. Although the government’s decision to provide grants or loans for these activities should be based on whether all small investors undertaking the project yields positive economic returns or not, the government will need to also determine if the projects are financially sustainable. CHAPTER 3: Another reason for conducting a financial appraisal of public-sector projects is directly related to understanding of the distributional impacts of the project. For example, the difference between the financial price an individual pays for a liter of water (found in the financial cash flow statement) and the gross economic benefit he derives from consuming the water (found in the economic resource flow statement) reflects a net gain to the consumer. Similarly, the difference between the financial price (inclusive of tax) that a project faces and the economic cost of an input required by the project measures the tax gain to the government. Gains and losses of this nature will be difficult to establish on the basis of economic analysis alone. 3.3 Construction of Financial Cash Flows: Concepts and Principles The financial cash flow of an investment project is a central piece of the financial appraisal. The cash flow statement of a project is a listing of all anticipated sources of cash and uses of cash by the business over the life of the project. It can be illustrated as in Figure 3.1, where the difference between receipts and expenditures is plotted against the sequence of years which make up the project’s life. The net cash flow profile (measured by the difference between receipts and expenditures) is usually negative in the beginning of a project’s life when the investment is being made. In later years, when revenues from sales of output become larger than expenditures, the net cash flow becomes positive. Some projects, which require significant investments to be made at intervals throughout the life of a project such as the re-tooling of a factory, may also experience negative cash flows occasionally after the initial investment has been made. Other projects may have negative cash flows in their operating stage if they are producing a good or service which experiences wide swings in price or demand. Some other projects will even have negative cash flows in the final years of the project's life as costs are incurred to rehabilitate the project site or to compensate workers for their displacement. 4  Figure 3.1: Financial Cash Flow Profile of a Project (+) Initial Investment Period Operating Stage Receipts less 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Expenditures Year of Project Life (-) 3.3.1 The Investment Phase The first step in the construction of a financial cash flow statement is the formulation of an investment plan for the project based on the information developed in the technical, demand, manpower, and financing modules. The investment plan consists of two sections: the first section deals with the expenditure on new acquisitions, and the opportunity cost of existing assets, and the second section deals with the financing aspects of the proposed investment. If there are different scales and/or locations under consideration, corresponding investment plans for each scale and/or location should be formulated. It is important that the investment plan conforms to what is a realistic time schedule given the demand for the project’s output, manpower, financial, and supply constraints in the economy, as well as the technical attributes of the project. The investment plan will contain a listing of all the expenditures to be undertaken up to the point where the facility is ready to begin its normal operations. Each of these expenditures should be identified according to the year in which it is expected to occur. In addition, every expenditure should be broken down into two parts: first, the amount spent on goods and services traded internationally and second, the amount being spent on goods and services traded domestically. These categories of expenditures are in turn divided into the payments received by the suppliers of these goods, payments to the government (such as tariffs, value CHAPTER 3: added taxes, etc.), subsidies received from the government, and subsidies for the purchase of the investment items. Expenditures on labor for the construction of the project should be identified by year and by skill level for providing a clear understanding of its cost structure and determining if there is likely shortage of skilled workers. These breakdowns are also necessary for estimating the respective shadow price of labour in the economic analysis of the project. (a) Treatment of Assets Depreciation expense or capital cost allowances are an accounting device to spread the cost of capital assets over the length of life of these investments so that net income in any given year will reflect all the costs required to produce the output. However, depreciation expense is not a cash outflow and thus should not be included in the financial cash flow profile of the project. The full capital costs of an investment are accounted for in the financial cash flow profile since the amount of the investment expenditures are deducted in the year they occur. If any further capital charge, such as depreciation expense, were deducted from the cash flow profile, it would result in a double counting of investment opportunity cost of existing assets. If the project under consideration is an ongoing concern or a rehabilitation project where some of the project’s old assets are integrated into the proposed facilities, the opportunity cost of these assets should be included in the cash flow statement together with the expenditure on new acquisitions. It is necessary to distinguish the “opportunity cost” of an asset from the “sunk cost” of an asset. The opportunity cost of using an asset in a specific project is the benefit foregone by not putting the asset to its best alternative use. To measure the opportunity cost of an asset, a monetary value has to be assigned to it in such way that should be equal to what has been sacrificed by using it in the project rather than in its next best use. On the other hand, the value of an asset is treated as a sunk cost if the asset has no alternative use.1 1 Sunk cost involves neither current nor future opportunity cost and therefore should have no influence in deciding what will be the most profitable thing to do. It should, however, be noted that while the sunk cost of an asset should not be counted as a cost to a new project in examining its feasibility, any outstanding liabilities due 6 The opportunity cost of the existing assets is generally included in the first year of the project’s cash flow profile because the assets could be sold at that time if the project is not feasible. The financial opportunity cost of an existing asset is the highest financial price that it could be sold for. The highest financial price is typically the higher of the in-use value of the asset and its liquidation value. The in-use value of the asset is what it would sell for if it were to be used as an ongoing concern. The liquidation value is what the asset would sell for if broken into its different components and sold in parts. The costs of installing machine and equipment as well as their liquidation cost are further deducted in order to derive the net liquidation value of the assets. When considering the opportunity cost of any production plant, one should consider the in-use value of the plant if it continues to be operated as it is. The most appropriate way to determine in-use and liquidation values is through reliable market assessors. When estimating in-use values using assessors, the assessor’s and sales agency’s fees should be subtracted from the quoted value to obtain the net in-use value. As well, when assessors give a liquidation value for a project’s assets, the assessors’ and sales agency’s fees as well as the expenditures incurred in dismantling the assets should be netted from the quoted price to obtain a net liquidation value. An approach to preparing an estimate of the in-use value of a set of assets is to consider their net replacement costs. The net replacement cost is the amount of expenditures that would have made today to build a facility that would provide the same amount of services in the future as would the assets that are now being evaluated. To estimate the net replacement value of an asset, two adjustments must be made to the historical purchase cost of assets. The first adjustment is for the change in the nominal prices of new assets or the same type of the asset can perform the same function as the asset being evaluated. This change in price is measured as the ratio of the current price or price index for this asset to the price or price index of the evaluated asset in the year when purchased. to that asset may become the liability of the new project if the ownership is the same. CHAPTER 3: The second parameter needed to estimate an asset’s net replacement cost is the amount of economic depreciation that the asset has experienced since it was purchased. The economic depreciation rate for an asset reflects the loss in the market value of the asset, which is generally different from the depreciation rate used for tax purposes. The purchase price of an asset adjusted for inflation and net of the cumulative amount of economic depreciation over years since it was purchased represents the opportunity cost of the asset if it is used over its remaining lifetime in a project.2 Suppose that the historical cost of a machine fully installed was A0 and the machine’s cumulated economic depreciation over years expressed as a fraction is dt, and It is the price index for this type of asset today, and Ih is the price index for this type of asset in the period it was initially purchased. Hence net replacement value (in-use value) of the machine in year t can be estimated as follows: (Net replacement value)t = A0 * (1 – Proportion of Asset Depreciated dt) * (It / Ih) The same calculation is carried out for other types of the existing asset. The sum of the above net replacement values for all existing assets needs further adjustments to account for the opportunity cost of land, inventory, and the excess of accounts receivable over accounts payable in year t in order to derive the total amount of the net replacement value. This value will be considered as the opportunity cost of the historical investments or all existing assets for the “without” and “with” the project case. (b) Treatment of Land Land has an opportunity cost like every other asset when it is used by a project. Even if the land is donated to the project by the government, it should be included as part of the investment cost at a value that reflects the market value of land in the project area. Land is a very special asset because it does not depreciate under most situations. However, 2 Economic depreciation rates for plants and equipment may be obtained from the plant manufacturer, technical journals, or insurance companies that insure a plant’s assets. 8 due to improvements in infrastructure, the value of land being used by a project may increase much faster than inflation during the life of the project. In such cases it is important not to include the increase in land value that is above inflation as part of the liquidation value of the project. In most cases the increase in the liquidation value of land (particularly in urban areas) has nothing to do with the project under evaluation. Real increases in land value usually come about because of investment being made in public sector infrastructure. It is important not to attribute the increase in the real value of land to any particular project to avoid introducing a bias toward land intensive projects. The only exception to this rule occurs when the project either improves or causes damage to the land. In such cases the amount of the land improvement or deterioration should be added to or subtracted from the real value of the land measured at the beginning of the project to determine the liquidation value of the land at the end of the project. Alternatively, the opportunity cost of land can be reflected in the cash flow profile of the project by an annual rental charge. This rental charge can be estimated by using the rental rate per dollar value of the land times the real value of the land for each period of the project's life. If the annual rental charge approach is used, then neither the initial cost of the land nor its final market value should enter into the cash flow profile of the project. (c) Investment Financing The investment plan also deals with the means and schedule of financing the investment expenditures. The financing may consist of equity, grants, domestic short-term and long-term loans, foreign loans, concessional loans and other forms of foreign aid. They should be identified and the disbursement schedules should be formulated. Which of these financings will be included in the cash flow statement depends on the point of view considered. While appraising the project from the owner’s point of view, for example, the loan disbursement is a cash inflow and the repayment of loan and interest payment are a cash outflow as the owner is looking to the net receipts after paying all debts and obligations. The analysis from a banker’s point of view, however, is not concerned with the financing but is looking to determine the financial viability of the project to all investors irrespective of debtors or shareholders. CHAPTER 3: In the case of public sector projects, it is the financial performance of the entire invested capital and not just the equity portion that is relevant for investors. Often both debt and equity financing come from the same source and the loans have been either explicitly or implicitly guaranteed by the government. We will therefore begin our development of the financial cash flows of this project by making no distinction between the return received by the lenders of debt and that received by the equity holders. In this case, the cash made available through borrowing is not considered as a cash inflow, nor are the interest or amortization payments on this debt considered as cash outflows. The analysis of the financial cash flow from alternative points of view will be discussed later in more detail. Table 3.1 provides an example of an investment phase for a medium- scale mining project. Table 3.1: Investment Phase for a Mining Project (Millions of dollars) Item Year 0 1 2…..………………..7 A. Investment Expenditures (a) Site Preparation, Exploration, and Development Materials: - Traded (cif) 500.0 500.0 Tariffs @12% 60.0 60.0 VAT @10% 56.0 56.0 - Non-traded 400.0 300.0 VAT @5% 20.0 15.0 Labor: - Skilled 150.0 100.0 - Unskilled 200.0 250.0 (b) Equipment Traded (cif) 600.0 2,000.0 Tariffs @10% 60.0 200.0 VAT @10% 66.0 220.0 Total Expenditures 2,112.0 3,701.0 B. Financing Equity 2,012.0 1,201.0 Domestic Loan (short-term) 100.0 500.0 Foreign Loan (guaranteed by government) 0 2,000.0 10  Total Financing 2,112.0 3,701.0 Interest during construction is an item that is often included as an accounting cost in the construction phase. This item is included as a cost to reflect the interest foregone because funds have been tied up in the construction of the project. It is not a measure of interest that has actually been paid, but an accounting device to measure the opportunity cost of the funds employed in the project. If no interest has been paid by the project, then interest during construction is not cash expenditure and should not be included as expenditure in the cash flow statement of the project. On the other hand, if interest payments have been made during the period of construction, then there is a cash outflow when the project is being examined from the viewpoint of the owner. 3.3.2 The Operating Phase The operating phase of the financial cash flow statement includes all cash receipts generated from the operation of the project and all operating expenditures. Expenditures and receipts should be projected by year of operation. Like investment expenditures, operating expenditures should be broken down into internationally traded and non-traded items; and each expenditure item should be broken down into its components, whenever possible. For example, maintenance expenditures should be broken down into materials and labor. Expenditures on different types of labor (engineers, electricians, managers, etc.) should be identified and recorded separately. Any taxes or subsidies associated with the operating expenditures should also be identified and recorded separately whenever possible. These breakdowns are necessary for the economic analysis of the project and for providing a better understanding of the cost structure of the operating expenditures. (a) Adjustment for Sales to Find Cash Receipts A project’s viability is not only determined by the sales it generates but also by the timing of the cash receipts from the sales. A cash flow statement records sales transactions only when CHAPTER 3: the cash from the transaction is received. Typically projects forecast their sales as a single line item which comprises both credit and cash transactions. A distinction must be made between sales and cash receipts. When a project makes a sale, the good or service may be delivered to the customer but no money transferred from the customer to the project. At this point the project’s accountants will record that the project has an asset called accounts receivable equal to the amount of the sale and the proportion of it that is not in cash. In other words, the buyer owes the project for the goods or services that he has purchased and not yet paid for. Until the buyer has paid for what he has received, the transaction will have no impact on the cash flow statement. When the buyer pays for the items that he previously bought from the project, the project’s accountants will record a decrease in accounts receivable by the amount that the buyer has paid and an increase in cash receipts. Thus, the cash receipts for any period can be calculated as follows: Cash receipts = Sales + Accounts receivable - Accounts receivable for period (inflow) for period at beginning of period at end of period Suppose the accounts receivable recorded on the balance sheet at the beginning of the period is equal to $2,000 and then equal to $2,600 at the end of the period. Sales for this period as recorded on the income statement are assumed to be $4,000. Total receipts or cash inflow for this period is calculated as follows: Cash Inflow = $4,000 + $2,000 – $2,600 = $3,400 Accounts receivable are typically measured as a percentage of sales. It is important to ensure that the accounts receivable selected for the project are consistent with the current performance of industry standards. Also important is to assess the likelihood for bad debts and to make allowances for them. Bad debts occur when a project’s customers default on their payments. They simultaneously reduce the amount of cash inflows to the project and reduce the amount of accounts receivable at the end of the period. 12 Suppose in the previous example bad debts of $200 had been written off during the period. In this case cash receipts for the period are determined as follows: Cash receipts = Sales + Accounts receivable - (Accounts receivable for period (inflow) for period at beginning of period at end of period + Bad debts written off During the period) Cash Inflow = $4,000 + $2,000 – ($2,600 + $200) = $3,200 It should be noted that the increase in cash receipts and the decrease in accounts receivable will be augmented by the VAT or other sales taxes associated with the sale of the items. These taxes are collected by the firm on behalf of governments and will be paid to the government later. Such sales taxes will now be included in the cash flow statement of the seller as a part of the cash inflow when these payments are received, but the amount of sales tax will be subtracted from the net cash flow when the taxes are paid to find cash expenditures. (b) Adjustment for Purchases Similar to the distinction between sales and receipts, a distinction is necessary between the purchases made by the project and its cash expenditures. The value of of the transaction will be recorded in the cash flow statement only when and to the degree that cash is paid. When the project makes a purchase, the good or service may be delivered to the project but perhaps no money is transferred from the project to its vendor. At this point the project’s accountants will record that the project has a liability called accounts payable equal to a portion of the amount of the purchase that is not paid in cash. Until the project has paid for what it has received, the transaction will have no impact on the cash flow statement. When the project pays the vendors for the items it has bought from them, the project’s accountants will record a decrease in accounts payable by the amount that the project has paid and an increase in cash expenditures. Hence, cash expenditures can be calculated from the value of purchases for the period along with the value of accounts payable both at the beginning and ending of CHAPTER 3: the period as follows: Cash expenditures = Purchases + Accounts Payable at - Accounts Payable for period (outflow) for period beginning of period at end of period Assume that total accounts payable at the beginning of a period is equal to $3,500 and at the end of the period it is $2,800, with the value of purchases from the income statement being $3,800. Therefore, total expenditure or cash outflow is calculated as follows: Cash Outflow = $3,800 +$3,500 – $2,800 = $4,500 Accounts payable are typically measured as a percentage of total purchases or that of a major input. It is important to ensure that the accounts payable on which the cash flow will be based are consistent with the industry standards. (c) Adjustment for Changes in Cash Balance Increases or decreases in cash balances can take place even when no changes occur in sales, purchases, accounts receivable, or accounts payable. When cash is set aside for the transaction of the business, a very important reason for the accumulation of cash occurs when the financial institutions that make loans to a project require that a debt service reserve account be set up and funded. The accumulation of cash for this or other purposes represents an outflow in the cash flow statement and must be financed. Similarly, a decrease in cash held for transaction purposes is a source of cash for other uses by the project and thus is a cash inflow. Thus, if the required stock of cash balances to be held to carry out transactions increases in a period, this increase is recorded a cash outflow. On the other hand, if cash balances decrease, this decrease is a cash inflow. At the end of the project, any cash set aside will ultimately be released back to the project as a cash inflow. The amount of cash to be held for facilitating the transactions of the business is typically a percentage of the project’s expenditures, sales, or its pattern of debt service obligations. 14 (d) Adjustment for Other Working Capital Items In order to carry out an economic activity, a certain amount of investment has to be made in items that facilitate the conduct of transactions. These items are working capital including cash, accounts receivable, accounts payable, prepaid expenses, and inventories. The first three items have already been dealt with as explained above. Prepaid expenses such as insurance premiums are recorded in the cash flow statement as other expenditures are made. Changes in inventories are not recorded separately in the cash flow statement. When a project purchases a certain amount of raw materials, inventories of raw materials will increase. These inventories are financed either through a cash outflow and/or an increase in accounts payable. If the inventories have been paid for in cash, then a cash outlay has been recorded in the cash flow statement. If they have been acquired on credit terms, no cash outflow will occur and they will be recorded in purchase as an increase in accounts payable. The situation is similar when dealing with changes in the inventories of the final product. In this case other inputs such as labour and energy are needed to transform raw materials into finished goods. To do this additional cash expenditures will be required. A decrease in final good inventories implies that a sale has occurred. This in turn implies an increase in cash receipts or accounts receivable. Since the components of working capital are developed independently in different ways, it is necessary to check for the overall consistency of working capital to ensure adequate provision has been made for working capital in order to carry out the business transactions of the project. This can be done by comparing the amount of working capital estimated as a proportion of total assets of the project to the industry average or with similar businesses that are operating successfully. (e) Income tax Liability Income taxes paid by the project should be included as an outflow in the cash flow statement. The income tax liability is estimated on the basis of the project’s income CHAPTER 3: statement following the accounting and tax rules of the country concerned. Year by year estimates of the cost of goods sold, interest expense, tax depreciation expenses, and overheads are all subtracted from the project’s revenues to estimate the project’s earning before taxes. While estimating the income tax liability, provisions for loss carry backward and forward if applicable should be taken into account. (f) Value Added Tax Liability Most countries levy value added taxes on the goods and services sold domestically, but zero rate sales made to customers living outside of the country. For a taxable firm the value of sales will include the value added taxes collected by the project on behalf of the government. The cost of inputs that are taxed will include the value added taxes paid on these purchases. The payment made to the government, if the firm is taxable, is the difference between the value added taxes collected on the sales and the value added taxes paid on the purchase of inputs. These payments of VAT to the government are reported in the cash flow statement as an outflow. The net effect of this tax treatment is to largely eliminate the VAT from being financial burden on the project. When a project produces an output that is exempt from VAT it will not be charging VAT when it sells its output. On the other hand, in most circumstances it will continue to pay VAT on its purchases of inputs. In this case there will not be an additional line item reporting the VAT payment to the government. The net effect of the VAT is to increase the cost of the inputs and hence the financial cash outflow of the project. The third possible situation occurs when the output of the project is expected with a rate of zero imposed on the export sales. In this case no tax is included in the sales revenues or cash inflows. The VAT will be levied and included on the inputs purchased by the project. The difference between the taxes collected on sales of zero and the taxes paid as part of the input purchases now becomes a negative tax payment or a refund of taxes paid. This should be reported as a negative cost or a cash inflow to the project. 16 3.3.3 Cessation of Project Operations When a new project acquires an asset, the entire expenditure on the asset is accounted for in the cash flow statement at the time that the expenditure actually occurs. It is quite possible, however, that the life of the project will not coincide with the life of all its assets, or that the span of the analysis will not extend as far in the future as the project may be expected to operate (e.g., railway projects). Then the residual value of the asset should be included in the cash flow statement as an inflow in the year following the cessation of operations. When determining the residual value of the assets at the end of the project, it is preferable to break down all the assets into different categories: land, building, equipment, vehicles, etc. The residual value is taken as the in-use value unless it is clear the facility will be shut down at the end of the project period. If it is to be shut down, then the liquidation value should be used as the residual value. The in-use value of the plant is the value of the plant under the assumption that it will continue to operate as an on-going concern. The liquidation value is the value of the assets if all components of the project are sold separately and perhaps even the plant is taken apart and sold. While dealing with the in-use and liquidation in the future, general guidelines are to use the cumulative economic depreciation over years. The depreciation rates can be obtained from plant manufacturers, technical journals or the depreciation rates used by insurance companies. Land is a special asset that generally does not depreciate. The residual value of land recorded in the cash flow statement should be equal to the real market value of the land recorded at the beginning of the project, unless the project results in some improvement or deterioration to the land. For example, if a project involves an investment to improve the property such as drainage of a swamp, the residual value of the project should include the increase in land value resulted directly from an investment made by the project. The opposite is the case if the project damages the land and its value. The residual value of the land must be reduced by the amount of damage caused by the project. Notwithstanding, in many cases expectations CHAPTER 3: may indicate that land values are likely to rise faster than inflation but the increase is totally unrelated to the project.3 3.3.4 Format for the Pro-Forma Cash Flow Statement While there is no specific format for presentation of the pro-forma cash flow statement for an investment project, it is important that the data should be set out in sufficient details so that the adjustments required by the economic and distributive appraisal can be easily applied to the financial cash flows. Entries for receipts and payments must be classified as outlined in the above discussion of investment and operating phases for the project. Receipts must be identified according to whether they arise from sales of tradable or non-tradable goods with all taxes. Payments should also be presented in a similar fashion with all taxes, tariffs, and subsidies itemized separately. Labor costs must be identified according to the type of labor used. To illustrate the construction of the financial cash flow statement, we continue with the example of the mine. The investment phase of the project is outlined in Table 3.1. Now, we assume that mining project has an operating life of five years, and the machinery and equipment will be liquidated as scrap at the closure of mine. This is carried out in the year following the mine closure at which time the scrap is expected to yield $1 billion. The land is assumed to have zero value after being mined. Table 3.2 contains the basic operating information required to develop the pro-forma cash flow statements for this project. For example, accounts receivable and accounts payable are assumed at 20 percent of annual sales and purchases inclusive of VAT, respectively. Desired cash balances are assumed to be equal to 10 percent of purchases of inputs. As the output of the mine is assumed to be exported the export sales will be zero rated for VAT taxation. 3 Expected increases in land values are generally speculative which implies that building such increases in the residual value of land may not occur. Moreover, the purpose of the analysis is to appraise the project and determine its impact on its sponsors. Large increases in land value may be sufficiently large, leading to the implementation of the project and a misallocation of resources. Thus, the residual value of land should be generally the same as its real price at the start of the project. 18 A 10 percent royalty is charged on the value of export sales. This is paid directly to the government. No income tax is levied on this mining activity. Table 3-2: Operating Information for the Case of a Mining Project (Millions of dollars) Item Year 0 1 2 3 4 5 6 7 Sales - Traded 2,000.0 3,000.0 3,500.0 3,000.0 2,000.0 - VAT @ 0% 0 0 0 0 0 Purchases of Inputs - Traded (cif) 600.0 750.0 800.0 700.0 600.0 Tariffs @10% 60.0 75.0 80.0 70.0 60.0 VAT @10% 66.0 82.5 88.0 77.0 66.0 - Non-traded 200.0 250.0 320.0 200.0 200.0 VAT @5% 10.0 12.5 16.0 10.0 10.0 Operating Labor - Skilled 100.0 150.0 200.0 150.0 125.0 - Unskilled 50.0 70.0 90.0 80.0 60 Working Capital (end of period values) - Account Receivables 0 400.0 600.0 700.0 600.0 400.0 0 - Account Payables 0 187.2 234.0 260.8 211.4 187.2 0 - Cash held as working capital 0 93.6 104.5 130.4 105.7 93.6 0 With the data presented in Tables 3.1, and 3.2, the pro-forma cash flow statement can be constructed in detail broken down by commodity and labor type as Table 3.3. This pro-forma cash flow statement provides the basis for the financial and economic analysis of the project which will follow. It is the net cash flow from this statement that gives us the project profile shown in Figure 3.1. It should be noted that no VAT is collected on the sales on behalf of the tax authority while VAT paid on purchases can be claimed back as input tax credits under most consumption type VAT system. Thus, a row of VAT input tax credit in Table 3.3 is created in order to derive the impact of the net VAT payments or refund of VAT paid on inputs on the net cash flow for the project.  Table 3.3: Pro-Forma Financial Cash Flow Statement for an Investment in a Mine (Millions of dollars) Item Year 0 1 2 3 4 5 6 7 A. Receipts: Foreign Sales (traded goods) 2,000.0 3,000.0 3,500.0 3,000.0 2,000.0 0 VAT @ 0% 0 0 0 0 0 Change in Account Receivables -400.0 -200.0 -100.0 +100.0 +200.0 +400.0 Liquidation Value (scrapped 1,000.0 assets) Cash Inflow 1,600.0 2,800.0 3,400.0 3,100.0 2,200.0 1,400.0 B. Expenditures: a) Site Preparation, Exploration and Development: Materials: - Traded Goods (cif) 500.0 500.0 Tariffs @12% 60.0 60.0 VAT @10% 56.0 56.0 - Non-traded Goods 400.0 300.0 VAT @5% 20.0 15.0 Equipment: - Traded (cif) 600.0 2,000.0 Tariffs @10% 60.0 200.0 VAT @10% 66.0 220.0 b) Input Purchases - Traded Goods (cif) 600.0 750.0 800.0 700.0 600.0 Tariffs @10% 60.0 75.0 80.0 70.0 60.0 VAT @10% 66.0 82.5 88.0 77.0 66.0 Change in Accounts Payable -145.2 -36.3 -12.1 24.2 24.2 145.2 - Non-traded Goods 200.0 250.0 320.0 200.0 200.0 VAT @5% 10.0 12.5 16.0 10.0 10.0 Change in Accounts Payable -42.0 -10.5 -14.7 25.2 0 42.0 c) Construction Labor: - Skilled 150.0 100.0 - Unskilled 200.0 250.0 d) Operating Labor: - Skilled 100.0 150.0 200.0 150.0 125.0 - Unskilled 50.0 70.0 90.0 80.0 60.0 e) Change in Cash Held as 93.6 23.4 13.4 -24.7 -12.1 -93.6 Working Capital Cash Outflow 2,112.0 3,701.0 992.4 1,366.6 1,580.62 1,311.7 1,133.1 93.6 C. Tax Payments (a) VAT (Payment, (Refund)) -142.0 -291.0 -76.0 -95.0 -104.0 -87.0 -76.0 0 (b) Royalty 0 0 200.0 300.0 350.0 300.0 200.0 0 D. Net Cash Flow -1,970.0 -3,410.0 483.0 1,228.4 1,573.4 1,575.3 942.9 1,306.4 3.4 Use of Consistent Prices in the Cash Flow Forecast When conducting a financial appraisal of a project, it is necessary to make a projection of prices for the inputs and outputs over its life. These prices are influenced by movements in 20 the real price of the good in question and the effect of inflation. The factors affecting the real price and inflation are quite different. Real prices are determined by changes in the market demand and/or supply for the specific items while inflation is usually determined by the growth of the country's money supply relative to its production of goods and services. Forecasts of inflation are generally beyond the capability or responsibility of the project analyst. The rate of inflation is basically a risk variable, and the analysis of a project should be subjected to a range of possible inflation rates. The critical issue for the analyst is to construct a projection of nominal prices that are consistent with assumed pattern of inflation rates through time and the projection of changes in real prices. The projection of the future path of real prices is of particular importance if the price of one or more input or output is significantly above or below its normal level or trend. To understand the impact of real price changes and inflation on the financial viability of a project and how they are incorporated in the analysis, we first consider the definition or derivation of various price variables employed in the analysis. 3.4.1 Definition of Prices and Price Indices (a) Nominal Prices The nominal prices of goods and services are those found in the marketplace, and are often referred to as current prices. Historical data for nominal prices are relatively easy to obtain, but forecasting nominal prices in a consistent manner is a notoriously difficult task. The nominal price of an item is the outcome of two sets of economic forces: macroeconomic forces which determine the general price level or inflation, and the forces of demand and supply for the item which causes its price to move relative to other goods and services in the marketplace. In order to construct a cash flow forecasts in nominal prices, we must take into consideration the movement of both real prices and the general price level. (b) Price Level and Index The price level for an economy ( PLt ) is calculated as a weighted average of a selected set of nominal prices: P1t , P2t , P3t ,………. Pnt The price level PLt can be calculated for any period (t) as follows: n t PLt = ∑P W i i (3.1) i =1 where: i denotes the individual good or service included in the market basket; Pit denotes the price of the good or service at a point in time; Wi denotes the weight given to the price of a particular good or service (i); and ∑Wi=1. The weights used for calculating a price level are defined as of a certain date. This date is referred to as the base period for the calculation of the price level. The weights established at that time will rarely change because we want to compare the level of prices of a given basket of goods between various points in time. Hence, it is only the nominal prices which change through time in equation (3.1), while the weights (W1, W2, …,Wn) are fixed. Instead of calculating the price level for the entire economy, a price level may be created for a certain subset of prices such as construction materials or consumer goods. It is generally useful to express the price level of a basket of goods and services at different points in time as a price index ( PIt ). The price index simply normalizes the price level so that in the base period the index is equal to one. If we wish to calculate a price index that compares the price levels in two distinct periods, we can write the equation as follows: PIt = PLt / PLB (3.2) 22 where PIt denotes the price level in period (t), and PLB denotes the price level for the base period (B). For example, the consumer price index is a weighted average of the prices for a selected market basket of consumer goods. The investment price index is created as a weighted set of goods and services that are of an investment nature. The change in the price index for a broad set of goods and services is used to measure the rate of inflation in the economy.4 Suppose there are three commodities in a basket of consumer goods and their prices in Year 1 are $30, $100, and $50 as shown in Example 1. The corresponding weights of these goods are 0.2, 0.5, and 0.3. The price level in Year 1 is $71 using equation (3.1). If the prices of these three goods in Year 2 become $40, $110, and $40, respectively, the weighted average of the price level will be $75. Similarly, the price level in Year 3 as shown in the example is $73. Example 1: Nominal Prices and Changes in Price Assume Year 1 is Base Year Goods 1 2 3 Weights 0.2 0.5 0.3 1 Nominal Prices Year 1: P1 = 30 P21 = 100 P31 = 50 PL1 = 0.2 (30) + 0.5 (100) + 0.3 (50) = 71 PLB = 71 Price Index PI1 = 1.00 Nominal Prices Year 2: P12 = 40 P22 = 110 P32 = 40 PL2 = 0.2 (40) + 0.5 (110) + 0.3 (40) = 75 Price Index PI2 = 1.056 Nominal Prices Year 3: P13 = 35 P23 = 108 P33 = 60 PL3 = 0.2 (35) + 0.5 (108) + 0.3 (60) = 79 Price Index PI3 = 1.113 Inflation Rate: Changes in General Price Level (Measured in terms of a price index) g PI2 = [( PI2 – PI1 )/( PI1 )] * 100 = [(1.056 – 1.00)/(1.00)] * 100 = 5.63% g PI3 = [( PI3 – PI2 )/( PI2 )] * 100 = [(1.113 – 1.056)/(1.056)] * 100 = 5.33% 4 In some countries the consumer price index is the best instrument for the measurement of inflation, for others it is the implicit GDP deflator. Using the price level in Year 1 as the base period, we can calculate the price indices based on equation (3.2) as 1.00, 1.056, and 1.113 for Year 1, Year 2, and Year 3, respectively. (c) Changes in General Price Level (Inflation) Inflation is measured by the change in the price level divided by the price level at the beginning of the period. The price level at the beginning of the period becomes a reference for determining the rate of inflation throughout that particular period. Hence, inflation for any particular period can be expressed as in equation (3.3). gPIe = [( PIt – PIt −1 )/ PIt −1 ] × 100 (3.3) Inflation is much more difficult to forecast than the changes in real prices, because inflation is primarily determined by the supply of money relative to the availability of goods and services in an economy to purchase. The supply of money, in turn, is often determined by the size of the public sector deficit and how it is financed. If governments finance their deficit by borrowing heavily from the Central Bank, inflation is inevitably the end result. In the evaluation of an investment, we need not attempt to make an accurate forecast of the rate of inflation. It is essential, however, to make all the other assumptions concerning the financing and operation of the project consistent with the assumed pattern of future inflation. In most countries, the rate of inflation is a risk variable which we must try to accommodate through the financial design of the project. For example, even though the historical rates of inflation in the economy may be only 5 or 6%, we may want to see if the project can survive if the rate of inflation is much higher and much lower. If the analysis demonstrates that it will be severely weakened, then we may want to ask whether the project can be redesigned so as to better withstand such unanticipated rates of inflation. (d) Real Prices Real prices ( PiRt ) are an important subset of relative prices where the nominal price of an item is divided by the index of the price level at the same point in time. They express prices 24 of the goods and services relative to the general price level. This is shown by equation (3.4). p iRt = p it / p It (3.4) where Pi t denotes the nominal price of good or service at time (t), and PIt denotes the price level index at time period (t). Dividing by a price level index removes the inflationary component (change in the general price level) from the nominal price of the item. This allows us to identify the impact of the forces of demand and supply on the price of the good relative to other goods and services in the economy. Example 2 illustrates how real prices are calculated using equation (3.4). For instance, the real price of good 1 in Year 2 is $37.87, which is obtained from dividing the nominal price $40 by the price index 1.056.  Example 2: Real Prices and Changes in Real Price Goods 1 2 3 Weights 0.2 0.5 0.3 1 1 Nominal Prices Year 1: P1 = 30 P2 = 100 P31 = 50 Price Index PI1 = 1.00 Real Prices Year 1: P11R = 30/1 P21R = 100/1 P31R = 50/1 = 30 = 100 = 50 2 2 Nominal Prices Year 2: P1 = 40 P2 = 110 P32 = 40 Price Index PI2 = 1.056 Real Prices Year 2: P12R = 40/1.056 P22R = 110/1.056 P32R = 40/1.056 = 37.87 = 104.16 = 37.87 Nominal Prices Year 3: P13 = 35 P23 = 108 P33 = 60 Price Index PI3 = 1.113 Nominal Prices Year 3: P13R = 35/1.113 P23R = 108/1.113 P33R = 60/1.113 = 31.45 = 97.04 = 53.91 Changes in Real Prices Year 2: Change in P12R = [( P12R – P11R )/( P11R )] = (37.87 – 30)/30 (104.16 – 100)/100 (37.87 – 50)/50 = 0.2623 = 0.0416 = – 0.2426 Changes in Real Prices Year 3: Change in P13R = [( P13R – P12R )/( P12R )] = (31.45 – 37.87)/37.87 (97.04 – 104.16)/104.16 (53.91 – 37.87)/37.87 = -0.1695 = –0.0683 = 0.4235 (e) Changes in Real Prices The change in the real price of a good or service can be expressed as: piRt − piRt −1 Δ piRt = (3.5) piRt −1 where p iRt denotes the real price of good (i) as of a specific period. Using Example 2 and equation (3.5), we can compute that the change in real price of good 1 in Year 3 is -16.95%. 26 For each of the inputs and outputs a set of projections must be prepared in the path of its real price over the life of the project. For items where rapid technological change is taking place, such as computers or telecommunication equipments, we would expect that the real price of those goods would fall. There is one important input, however, whose relative price is almost certain to rise if there is economic development in the country. This is the real wage rate. If economic development takes place, the value of labor relative to other goods and services will have to rise. Hence, in the forecasting of real prices for a project we should consider the potential for real wages to rise and build this into the cost of inputs for a project over its life. (f) Inflation Adjusted Values Inflation adjusted values for prices of inputs and outputs are the result of our best forecast of how real prices for particular goods and services are going to move in the future, and this forecast is then adjusted by an assumed path of the general price level over future periods. In other words, we are producing a set of nominal prices which are built up from their basic components of a real price and a price level. These inflation adjusted values are generated in a consistent fashion. A common mistake of project evaluators is to assume that many of the prices of inputs and outputs for a project are rising relative to the rate of inflation. This is highly unlikely. The price level itself is a weighted average of individual goods and services prices. Hence, in the forecast of the real price of the goods and services used or produced by our project, we would expect that approximately as many real prices will be falling as are rising. To forecast the movement of the real price of a good or service, we need to consider such items as the anticipated change in the demand for the item over time, the likely supply response, and the forces which are going to affect its cost of production. This analysis is very different from that which goes into the forecast of the general price level. This forecast is not so much a prediction, but a set of consistent assumptions. It is the inflation-adjusted values which we use in the estimation of the nominal cash flows of a project. They can be estimated using equation (3.6): ∧ t +1 P i = Pi t (1 + gPiRt +1 )(1 + gPIt +1 ) (3.6) ∧ t +1 Where P i denotes the estimated nominal price of good (i) in year t+1; Pi t denotes the nominal price of good (i) in year t; gPiRt +1 denotes the estimated growth in real price of good (i) between year t and t+1; and gPIt +1 denotes the assumed growth in price level index from year t to year t+1. (g) Constant Prices It should be noted that real prices are sometimes referred to constant prices, which, as the name implies, do not change over time. They are simply a set of nominal price observations as of a point in time that is used for each of the subsequent periods in a project appraisal. While nominal prices are affected by changes in real prices as well as changes in the price level, constant prices reflect neither of these economic forces. If constant prices are used throughout the life of the project, then we are ignoring both the changes in real prices, which may have a profound impact on the overall financial position of the project, and the impact which inflation can have an impact on the performance of an investment. The use of constant prices simplifies the construction of a cash flow profile of a project, but it also eliminates from the analysis a large part of the financial and economic information that can affect the future performance of the project. Two specific prices are discussed below due to the important role they play in the financial analysis of projects. These are the interest rate and the price of foreign exchange. 28 3.4.2 Nominal Interest rate One of most important features for integrating expectations about the future rate of inflation (gPe) into the evaluation of a project is to ensure that such expectations are consistent with the projections of the nominal rate of interest. Lenders increase the nominal interest rate on the loans they give to compensate for the anticipated loss in the real value of the loan caused by inflation. As the inflation rate increases, the nominal interest rate will be increased to ensure that the present value of the interest and principal payments will not fall below the initial value of the loan. The nominal interest rate, as determined by the financial markets, is made up of three major components: the real interest rate (r) which reflects the real time value of money that lenders require in order to be willing to forego consumption or other investment opportunities, a risk factor (R) which measures the compensation lenders demand to cover the possibility of the borrower defaulting on the loan, and a factor (1+r+R)gPe which represents the compensation for the expected loss in purchasing power attributable to inflation. The expected real interest rate will be relatively constant over time because it is primarily determined by the productivity of investment and the desire of consumption and saving in the economy. The risk premium is typically associated with the sector and investor and is known. Inflation reduces the future value of both the loan repayments and real interest rate payments. Combining these factors, the nominal (market) rate of interest (i) can be expressed as: i = r + R + (l + r + R) gPe (3.7) To explain this concept more fully, let us consider the following financial scenarios. When both risk and inflation are zero, a lender would want to recover at least the real time value of money. If the real interest rate r is 5 percent, then the lender would charge at least a 5 percent nominal interest rate. If the lender anticipates that the future rate of inflation will be 10 percent, then he would want to increase the nominal interest rate charged to the borrower in order to compensate for the loss in purchasing power of the future loan and interest rate payments. Maintaining the assumption that there is no risk to this loan, we can apply the equation (3.7) to determine what nominal interest rate he would need to charge to remain as well off as when there was no inflation: i = r + R + (l + r + R) gPe = (0.05) + (0) + (1+ 0.05 + 0)· 0.1 = 15.5% Thus, the lender will need to charge a nominal interest rate of at least 15.5 percent to achieve the same level of return as in the zero inflation scenarios. If now suppose the risk premium (R) is 3 percent. In this case the nominal interest rate that is consistent with a 5 percent expected real interest rate and an expected rate of inflation of 10 percent is: i = (0.05) + (0.03) + (1+0.05+0.03)· 0.1 = 0.188. If the rate of inflation is expected to change through time and if refinancing of the project's debt is required, then the nominal interest rate paid must be adjusted to be consistent with this new expected rate of inflation. This should have little or no direct effect on the overall economic viability of the project as measured by its NPV; however, it may impose very severe constraints on the liquidity position of the project because of its impact on interest and principal payments if not properly planned for. 3.4.3 Expected Nominal Exchange Rate A key financial variable in any project using or producing tradable goods is the market rate of foreign exchange (EM) between the domestic and the foreign currency. This market exchange rate is expressed as the number of units of domestic currency (#D) required to purchase one unit of foreign exchange (F). The market exchange rate refers to the current nominal price of foreign exchange. It needs to be projected over the life of the project. The market rate between the domestic and the foreign currency can be expressed at any point in time (t) as: 30  t = (#D/F)t EM (3.8) The real exchange rate, E R t , can be defined as follows: n #D I tDn F # D I tn EtRn = = F F I tDn I tFn I Ftn or, E Rtn = E M tn (3.9) ID tn where E M denotes the market rate of exchange in year tn and ID and I Ftn represent the price tn tn indices in year tn for the domestic currency country and the foreign currency country, respectively. The difference between the real and the nominal exchange rate at a given point in time, tn, lies in the relative movement of the price index of foreign to the domestic country as measured from an arbitrary chosen point in time, tb (base year) to the time of interest, tn. The cumulative inflation for the domestic country over a period of time is given by the domestic price index ID. The domestic price index at any point in time tn can be expressed as the price tn index in any initial year t0, I D , times the cumulative change in the price level from time t0 to t0 tn. This is given as follows: n D D (de I t = I t ∏ 1 + gp t0 +i n 0 ) (3.10) i =1 where gp de i is the rate of inflation in the domestic economy. Similarly, the foreign price index at any point in time tn, using the same reference year t0 as the base year, can be expressed as the price index in any initial year t0, I F , times the t0 cumulative change in the price level from time t0 to tn. This is given as follows: n F F ( fe I t = I t ∏ 1 + gp t0 +i n 0 ) (3.11) i =1 fe where gp i is the rate of inflation in the foreign economy. By substituting (3.10) and (3.11) into equation (3.9), we can calculate the nominal exchange rate in a future time period n as: n de I tD0 ∏ ⎛⎜1 + gp ⎞⎟ i =1 ⎝ t 0 + i ⎠ EM tn = ER tn × n (3.12) fe I F t0 ∏ ⎛⎜⎝1 + gp i =1 t0 + i ⎞⎟ ⎠ For convenience when conducting a financial appraisal of a project, we can select the first year of the project, t0, as the arbitrary reference point or base year for the calculation of the relative price indices. Using t0 as the base year, then both the values for ID t 0 and I Ft 0 will be equal to one in that year. Hence, there will be no difference between the real and nominal exchange rates in that base period. In the case where the initial price levels for the domestic and the foreign country are set equal to 1 in time period t0, then the expression (3.12) for the market exchange rate can be simplified to, n de ∏ ⎛⎜⎝1 + gp t0 + i ⎞⎟ ⎠ EM = ER i =1 tn tn × n (3.13) fe ∏ ⎛⎜1 + ⎝ gp ⎞⎟ t 0 + i ⎠ i =1 32 The real exchange rate will move through time because of shifts in the country's demand and supply for foreign exchange. It is very difficult to predict the movement of the real exchange rate unless it is being artificially maintained at a given level through tariffs or quantitative restrictions on either the supply or demand of foreign exchange. In some situations when the real exchange rate is believed to be currently either above or below its longer term equilibrium level then a trend in the real exchange rate for a limited number of years may be projected. The ratio of the two price indices is known as the relative price index. If through time the domestic economy faces a rate of inflation different than that of foreign trading partner, the relative price index will vary over time. If the real exchange rate remains constant in the presence of inflation, then the change in the relative price index must result in a corresponding change in the market exchange rate. Since the future real exchange rate is only likely to be known with some uncertainty, and the market exchange rate might not adjust instantaneously to changes in the rate of inflation, it is more realistic to allow some flexibility in the estimation of the market exchange rate. This is carried out by assuming a range for the distribution of possible real exchange rates around an expected mean real exchange rate. To incorporate this aspect we write the above equation as follows: ⎛ n ⎛ de ⎞ ⎜ ∏ ⎜1 + gp ⎞⎟ ⎟ ⎝ t 0 ⎠ ⎟ + i Et n = E * (1 + k )⎜⎜ i =n1 ⎛ M R (3.14) fe ⎞ ⎟ ⎜ ∏ ⎜1 + gp +i ⎟ ⎟ ⎝ i =1 ⎝ t 0 ⎠ ⎠ where k is a random variable with a mean value of zero. 3.4.4 Incorporating Inflation in the Financial Analysis Much of the published literature on project evaluation recommends the exclusion of inflation from the appraisal process.5 These methods only account for projected changes in relative 5 Squire, L. and van der Tak, H.G., Economic Analysis of Projects, Baltimore: The Johns Hopkins University Press, (1975), p. 38. prices of inputs and outputs over the life of the investment.6 However, experience with projects suffering from financial liquidity and solvency problems has demonstrated that inflation can be a critical factor in the success or failure of projects. Correctly designing a project to accommodate both changes in relative prices and changes in the rate of inflation may be crucial for its ultimate survival. Improper accounting for the impacts of inflation when conducting the financial analysis could have detrimental effects not only on the financial sustainability of a project but also on its economic viability. Assumptions regarding inflation will have a direct impact on the financial analysis of the project and may require adjustments in the operating or investment policies. Since an inadequate treatment of inflation may adversely affect the financial sustainability of the project, ultimately the economic viability of the project may be compromised if inflation is not properly accounted for. It is important to realize that the ultimate analysis of the financial cash flows should be carried out on a statement prepared in real domestic currency. It is difficult to correctly analyze nominal net cash flow statements as one will be attempting to understand figures that reflect two changes: changes in the real price and changes in inflation. Moreover, when preparing the cash flow statement, certain variables such as tax liabilities, cash requirements, interest, and debt repayments need to be estimated in the current prices of the years they incur. The correct treatment of inflation requires that preparatory tables be made using nominal prices, and then deflate the nominal cash flow statements to obtain the cash flow statements in real prices. By constructing the financial analysis in this manner, we ensure that, all the effects of change in real prices as well as inflation are consistently reflected in the projected variables. 6 All of the following authors recommend that expectations of inflation be ignored in the evaluation of projects: Little, I.M.D. and Mirrllees, J.A., Project Appraisal and Planning for Development Countries, London: Heineman Educational Books Ltd., (1974); United Nations Industrial Development Organization, Guidelines for Project Evaluation, New York: United Nations, (1972), and Curry, S. and Weiss, J., Project Analysis in Developing Countries, New York: St. Martin’s Press, Inc., (1993). A more satisfactory treatment of this issue is provided by Roemer, M. and Stern, J.J. , The Appraisal of Development Projects, A Practical Guide to Project Analysis with Case Studies and Solutions, New York: Praeger Publishers, (1975), pp. 73-74. 34 Outlined below are steps required for incorporating inflation into the financial cash flow of a project in a consistent manner: 1. Estimate the future changes in the real prices for each input and output variable. This will involve the examination of the present and future demand and supply forces that are expected to prevail in the market for the item. For example, an examination of real prices of many electronic goods and services will indicate that they have been dropping a few percentage points a year over the past decade. Real wages, on the other hand, tend to increase over time as the economy grows. 2. Develop a set of assumptions concerning the expected annual changes in price level over the life of the project, and calculate expected inflation rate. 3. Determine what the nominal rate of interest will likely be over the life of the project given the expected changes in the price level estimated above. 4. Combine the expected change in real prices for each input and output with the expected change in the rate of inflation to get the expected change in the nominal price of the item. 5. Multiply the nominal prices for each item by the projections of quantities of inputs and outputs through time to express these variables in the current year's prices of the period in which they are expected to occur. 6. Begin the construction of a cash flow statement using the nominal values for the inputs and outputs. 7. Determine financing requirements along with the interest payments and principal repayments and include these items in the income tax statement and also in the cash flow statement. 8. Construct income tax statement for each year of the project's life to determine income tax liabilities with all variables expressed in their nominal values. Depreciation expenses, cost of goods sold, and interest expenses and income tax liabilities are estimated according to taxation laws of the country in question. The estimated income tax liabilities are included in the cash flow statement. 9. Estimate accounts receivable, accounts payable, and any changes in the stock of cash that are reflected in the cash flow statement. This completes the construction of the  projected variables in terms of their current values. 10. Construct the nominal cash flow statement from the total investment point of view by assembling all projected annual cash receipts, annual cash expenditures in current prices and changes in cash balance over the life of the project. 11. Add loans received from bankers as cash inflow and subtract interest payments as cash outflow to become the cash flow statement in current prices from the owner’s point of view. Deflate all items in the owner’s cash flow statement by the price index to arrive at real values for the cash flow statement. Note that loans, interest payments, and loan payments are also deflated and included in the cash flow statement in real prices. 12. Discount the net financial cash flow to the owners of the enterprise. The appropriate discount rate will be the real private opportunity cost of equity financing if the owner of the enterprise is a private owner. However, in case of public sector enterprise, the appropriate discount rate will be the target financial rate of return (net of inflation) set by government. 13. Calculate the net financial cash flows accruing to any other points of view that are relevant for the project. The development of pro-forma financial cash flow statements in this way ensures that the impact of inflation on the financial performance of the project is correctly accounted for. At the same time, the final financial analysis is completed with the variables expressed in terms of the price level of a given year. In this way, the movement of such variables as receipts, labor costs and material costs can be compared over time without being distorted by changes in the general price level. When the financial analysis is carried out in terms of real prices, it is essential that the private opportunity costs of capital or the target financial rates of return used as discount rates be expressed net of any compensation for the expected rate of inflation. In other words, these discount rates must be real, not nominal, variables. If a nominal private cost of capital or target rate of return is used, the result will be a double correction for the expected changes 36 in the general price level. Such practices will greatly distort the conclusions of the analysis concerning the financial viability of the project. It should be noted that the real financial prices for the input and output variables developed above are used as the base on which to estimate the economic values for the benefits and costs of the project. Once these economic costs and benefits are estimated, an economic resource flow statement can be constructed. The structure of the statement should be similar to that of the financial cash flow statement. The difference between the two statements is analyzed to determine the impacts of the project on various stakeholders. 3.5 Analyses of Investment Decisions from Alternative Viewpoints Most investment projects can be evaluated from the prospective of different actors or institutions which are directly affected by the project. These actors or institutions in a commercial project are in fact stakeholders including the owner or equity holder, the supplier of raw materials, the workers employed in the project, the bank or financing institution, the government’s budget office, or the country as a whole. In the case of projects involving some government intervention in the form of grants, subsidies, loans, or a joint-venture, the stakeholders may be different from the above list depending upon the specific types of the project. Nevertheless, it is necessary to conduct the analyses from the viewpoints of the different important stakeholders to ensure the project’s sustainability and success. This is to minimize the situation in which one powerful stakeholder who is adversely affected by the project may be able to derail the entire project. The most commonly-undertaken financial analyses for the commercial and government- related projects are from the viewpoints of owner, banker, government, and country. These points of view are discussed below focusing on differences in the variables included in the analyses from the different perspectives. 3.5.1 The Banker’s Point of View A banker’s first and foremost interest is to determine the overall strength of the project whether potential loans the project may require are secured. A banker sees a project as an activity that generates tangible financial benefits and absorbs tangible financial resources. It disregards any distinctions in the sources of finance but asks the question whether the financial receipts generated from the operations of the project are sufficient to cover the investment and operating expenditures and to provide a sufficient return or not. Known also as the total investment point of view, the banker takes into account all financial benefits and costs of the project so that he will be able to determine the financial feasibility of the project, the need for loans, and the likelihood of repayment on loan and interest. Included in the total investment of a project are the financial opportunity costs of any existing facilities that are integrated into the new project. The historical costs of existing assets are irrelevant to the banker. The banker typically has first claim to the project’s assets and net cash flows, so the banker’s net cash flow is the project’s gross receipts net of operating and investment expenditures.7 3.5.2 The Owner’s Point of View The owner of a project examines the incremental net cash flow from the investment relative to what could have been earned in the absence of the project. Unlike the banker, the owner adds the loan to the net cash flows from the total investment point of view as cash receipt, and subtracts payments of interest and loan repayment as cash outlays. If the project receives any grants or subsidies from the government, these should be included as receipts in the cash 7 In few cases a subtle difference may exist between the point of view of total invested capital and the banker’s point of view. Consider, for example, a government department that is encouraging the construction of low- income housing projects by repaying the interest on the housing loan. An analysis from the total invested capital point of view will not be concerned with the loan at all whether subsidized or not. A banker, however, will be definitely more in favor of loaning to a project that receives a government loan subsidy than a similar project that does not receive the subsidy. 38 flow statement. Therefore, the only difference between the analysis from the owner’s point of view and that from the banker’s point of view is financing. 3.5.3 The Government’s Point of View A project may require outlays from the government budget in the form of cheap credit, subsidies, grants or other transfer payments and may also generate revenues from direct or indirect taxes and fees. The analysis from the government’s point of view is to ensure that the relevant government ministries have enough resources to finance its obligations to the project. If the ministry is the project owner, then the distinction between the cash flow statements from the owner’s and the government point of view is the difference in their opportunity costs of funds. If, on the other hand, the government’s involvement is in the form of receiving taxes and/or providing some cheap credit, subsidies, or grants, then the cash flow statement from the government’s point of view will reflect these transactions. Although the three views outlined above are the most typical points of view considered when conducting the financial analysis, it is important to analyze the impacts of the project on all involved parties. For example, if the project under consideration is likely to have a negative impact on competitors, one should anticipate their reactions and proper adjustments. It is thus necessary to estimate and signify the magnitude of the negative impacts to any affected group. These affected groups could include competitors, suppliers of inputs, downstream processors, etc. as part of the stakeholders of the project. 3.5.4 The Country’s Point of View A project can be evaluated from the country’s point of view, especially when the project is undertaken by the government or involved some form of government intervention. While undertaking the evaluation from the point of view of the entire country, economic prices must be used to value inputs and outputs in order to reflect their true resource cost or economic benefit to society. The economic prices take into account taxes, subsidies and other distortions in market place. From the country's point of view, the activities that had to be foregone in undertaking the project should also be charged at real resource cost. Thus, the economic appraisal of a project adjusts the financial cash flow from the total investment viewpoint for taxes and subsidies and ignores loan and interest payments because these represent flow of funds, not real resources. 3.5.5 Relationship between Different Points of View A project can be thought as a bundle of transactions that cause different individuals or institutions to incur different costs and receive different benefits. The evaluation of a project from several perspectives is critical because it allows the analyst to determine whether the parties involved will find it worthwhile to finance, join, or execute the project. If the outcome of a project is attractive to the owner but not to the financing institution or to the government's budget office, the project could face problems securing official approval and funding. Alternatively, if a project is attractive from the viewpoint of a banker or the budget office but unattractive to the owner, the project could face problems during implementation. In short, to insure approval and successful implementation a project must be attractive to all the investors and operators associated with the project. To illustrate the different analyses available for evaluating a project, we provide an example of a project with the following stylized facts: 1. The project will last two years, labeled years 0 and 1. The project will be built during year 0, start operating at the beginning of year 1, and terminate at the end of year 1. 2. During year 0, $1,000 is spent in the purchase of machinery. 3. To finance the project, the owner will require a loan from a private bank equivalent to 50% of the initial investment cost. The repayment on the interest and the principal of the loan is due in year 1. The loan carries a 10% interest. 4. The project generates $300 in sales in year 1 and receives a subsidy equivalent to 50% of the sales value. Operating costs are $140 in year 1. Taxes amount to $100. 5. The project sells its equipment at the end of year 1 for $950. 6. The project creates pollution. The cost of cleaning up the contaminated by the project 40  has been estimated at $50 per year of operation. The government will not require the investor to clean up after the completion of the project. 7. The land for the project, currently owned by the developer of the project, has an opportunity cost as it could have been rented to others for $30 per year. The cash and/or resource flows of the project can be rearranged as viewed by different actors such as the owner, banker, government budget office, and the country as a whole following different accounting conventions. This is presented in Table 3.4. Table 3.4: Net Resource Flow from Different Viewpoints (Dollars) Financial Analysis Economic Analysis Viewpoints: Owner Bank Government Country Year: 0 1 0 1 0 1 0 1 Sales 300 300 300 Operation Cost -140 -140 -140 Equipment -1,000 950 -1,000 950 -1,000 950 Subsidy 150 150 -150 Taxes -100 -100 100 Loan 500 -500 Interest -50 Externality -50 Opportunity Cost of Land -30 -30 -30 -30 -30 -30 Net Resource Flow -530 580 -1,030 1,130 -50 -1,030 1,030 The returns of this project differ from alternative viewpoints. Moreover, the analysis of the project from a financial and an economic perspective and from the viewpoints of the owner and the country can lead to four possible results, as shown in Figure 3.2. In cell (A), the project ought to be undertaken because it generates net benefits to the owner and to the country. In cell (D), the project generates net losses to both parties and, consequently, should not be undertaken. In between, one finds cases where the owners are motivated to take actions that are not consistent with the action that is best for the economy. In cell (B) the project is profitable to the owner, but generates loss to the society. This may occur for project such as cultivation of a crop with extensive pesticides, which may harm people living in the project area. If the government increases its taxation of this activity, owners may find it unprofitable to invest in the project. If the government imposes taxes, the activity will shift from cell (B) to cell (D). In this case, the project should not be undertaken if it is unprofitable to society. Figure 3.2: Profitability Calculations from Owner’s and Economy’s View Economic (country) + (-) Financial + (A) (B) (owner) (-) (C) (D) In cell (C), the project generates net economic benefits to society but net losses to the owners. Consequently, equity holders will not endorse or undertake the project on their own. Such an activity may include the cultivation of trees, which enhance watershed protection, bio-diversity, and erosion control. Although these services benefit society, they do not generate enough income to the private owner. If the government provides subsidizes in order to lure investors to participate in the activity, the project will shift from being a cell (C) type activity to being a cell (A) type activity. In such a situation, it is both socially profitable and the owners will have an incentive to undertake the project. From this analysis, we can see how important it is to have projects that are attractive from both the financial as well as society's point of view. In order for socially profitable projects to be implemented, they must be designed to be financially viable. On the other hand, projects those are financially attractive but have negative economic returns will cause damage to the economy and are worse than doing nothing. 3.6 Conclusion 42 This chapter begins with the presentation of the main concepts, principles and conventions involved in the development of pro-forma financial statements of an investment project. As projects usually last for many years, forecasts of capital investment, quantities and prices of inputs and outputs over the life of the project are uncertain but such projections are necessary for the financial analysis of its commercial viability. We have described the process to make projections consistently over the life of the project. These include the movement of the real and nominal prices of inputs and outputs of the project, nominal interest rates and the nominal exchange rate that are projected in a way that is consistent with expectations about the future rate of inflation. Finally an investment project often involves different stakeholders. Each will be concerned with the impact the project will have on them. To ensure the project’s sustainability, the assessment of projects from different points of view is needed to minimize the adverse effect perceived by any of the stakeholders.  Appendix 3A Steps in Constructing the Pro Forma Cash Flow Statements The data requirements for conducting a project appraisal have been outlined in Chapter 3. This appendix will provide a practical approach to constructing the financial cash flow statement starting from the very beginning. The construction of a cash flow statement requires that the data be organized in a number of preparatory tables in Excel that culminate in the cash flow statement. 1. All project parameters are extracted from the project documents and placed in the Table of Parameters. The table of Parameters includes all the raw data that the construction of the cash flow statements will require. This will include prices, costs, production coefficients, financing terms, inflation and exchange rates, depreciation rates, working capital and all other data that will be used in the analysis. It is imperative that all data entry in the spreadsheet be completed in the Table of parameters. The construction of all other tables should be based on formulas and equations that are linked to the data in the Table of Parameters. This is crucial to maintain the integrity of the spreadsheets for sensitivity and risk analyses. 2. After all the required data have been recorded in the Table of Parameters, a table of inflation and exchange rates is constructed. In this table, we develop domestic inflation and foreign inflation indices for the life of the project. These indices are based on the expected rates of domestic and foreign inflation. The table also contains a relative inflation index that measures the change in the general price level of the domestic currency relative to the foreign currency. It is used to determine the nominal exchange rate over the life of the project. There will be no need for including exchange rates if none of the project’s inputs are imported and none of its outputs are exported. The reference year for estimating inflation is usually taken as the first year of the project’s life for convenience. As a result, the relative inflation index for the first year of the project will be equal to 1.00. Typically, the project analyst takes the real exchange rate 44  as constant; the nominal exchange rate is only affected by the relative change in the inflation rates of the domestic and foreign currencies. 3. The next table(s) will contain all the data on sales and purchases. It will be used to estimate the unit cost of production. On the sales side, quantities produced and quantities sold are introduced. The expected sales prices over the life of the project should be determined. Quantities sold should be multiplied by nominal prices to generate revenues. To determine