2. Purpose of Financial Feasibility Analysis
• For investors to engage in a new investment project, the
project has to be financially viable.
• Invested capital must show the potential to generate an
economic return to investors at least equal to that available
from other similarly risky investments, i.e. the return on
investment needs to be equal or higher.
• For example, an investor expects a manufacturing facility to
generate sufficient cash flows from operation to pay for the
construction of the facility and ongoing operating expenses
and, have an attractive interest rate of return.
3. Cont’d
• Estimates the cost of operating and maintaining a
manufacturing plant, as well as expected income generated.
• Financial feasibility analysis is an analytical tool used to
evaluate the viability of an investment.
• A financial decision is dependent on two specific factors,
expected return and expected risk, and a financial feasibility
analysis is a means for examining those two factors.
4. -
Main reason to conduct financial feasibility
study) to (Reference Chapter 3 Reason Why
Feasibility Study
5. Cont’d
• It should be conducted before proceeding with the development
of a business idea, and that also applies for financial feasibility
analysis.
• Determining early that a business idea is not financially feasible
can prevent loss of money and waste of valuable time.
• Financial feasibility analysis is usually done during the project
planning process and the results indicate how the project will
perform under a specific set of assumptions regarding
technology, market conditions and financial aspects.
6. Cont’d
• Analyzing the financial feasibility of a project is an essential part of the
decision making process.
• Even though the analysis is used on the first stages of the decision-
making process as a screening method, the analysis should also be used
throughout the process and should be updated every time any of the
assumptions it is based on changes.
• if the results of the analysis show that the proposed project does not
meet the return on investment requirements of the investor, the
business idea is discarded.
• It is therefore very important to regularly update the analysis and
verify that, given the newest information, the project is financially
feasible.
7. Feasibility Study vs. Business Plan
• Feasibility studies and business plans are two separate tools used
for decision making in project development.
– Both tools have common components, but should nevertheless not be
confused as their roles are different.
A feasibility study is a tool for investigating the viability of the
prospective project.
• A business plan is a tool for planning the actions needed to take
the project proposal from an idea to reality.
• The feasibility study refines the initial business idea, while the
business plan uses information from the feasibility study to
further prepare the project to evolve into an operating business.
8. Cont’d
• A feasibility study is conducted on the very first stages of project
development, before financing is secured and a GO/NON-GO
decision has been made.
• The purpose of the study is to reveal whether or not the project
is viable from all aspects, feasibility study components
• If the results of the study are positive, indicating that the project
will be successful, much of the information from the study is
incorporated into a business plan.
• However, if the results are negative, there is no need to create a
business plan (Matson, 2000).
• A feasibility study usually analyzes several project alternatives or
methods of achieving success.
9. Cont’d
• The purpose is to narrow the scope of the project and to
identify the best scenario.
– A business plan only deals with one scenario, i.e. the scenario found to be
most prominent by the feasibility study.
• A business plan captures the goals and objectives of a business
idea.
• The plan serves as a blueprint for the implementation of the project, as
well as the actions taken during and after project
implementation.
10. Cont’d
• A feasibility study is used throughout the whole process, first as a
screening tool and then as a part of a business plan.
– As the financial feasibility of a project is a key element in a
feasibility study, it is also a key element in a business plan.
• The business plan is often used as a sales document, helping the
project owners to secure financing for the project.
– It is also used to persuade specialists to participate in the
project and public authorities to give permissions for
operations.
11. Conducting Financial Feasibility Analysis
• Financial feasibility analysis is conducted by developing a base
case financial plan and assessing the sensitivity of the
profitability of the project, and the projected return, on the
investor’s equity to various contingencies.
• Needed for analyzing fluctuation in product price, changes in
operating and maintenance cost, the effects of cost overruns,
delay in completion, interruptions of project operations and
other significant factors.
12. Cont’d
The following outline when conducting financial feasibility analysis:
Estimate the total capital requirements – seed capital, capital for facilities and
equipment, working capital, start-up capital, contingency capital, etc;
Estimate equity and credit needs - identify equity sources and capital
availability, identify credit sources, assess expected financing requirements,
and establish debt to equity levels;
Budget expected costs and returns of various alternatives – estimate expected
cost and revenue, the profit margin and expected net profit, the sales or usage
needed to break-even, the returns under various production, price and sales
levels,
13. Project financing
• There are two types of project financing:
– equity and
– debt financing.
– When looking for money, you must consider your company’s debt-to-
equity ratio.
– The relation between amounts borrowed and amounts invested to the
business by the owners. The more money owners have invested in their
business, the easier it is to attract financing.
14. Equity Financing:
Most small or growth-stage businesses use limited equity financing.
As with debt financing, additional equity often comes from non-
professional investors such as friends, relatives, employees, customers,
or industry colleagues.
– However, the most common source of professional equity funding
comes from venture capitalists.
– These are institutional risk takers and may be groups of wealthy
individuals,
15. Cont’d
• Government-assisted sources, or major financial institutions.
• Most specialize in one or a few closely related industries.
• Venture capitalists may scrutinize thousands of potential
investments annually, but only invest in a handful.
• The possibility of a public stock offering is critical to venture
capitalists.
• Quality management, a competitive or innovative advantage,
and industry growth are also major concerns
16. Debt Financing:
• There are many sources for debt financing:
• banks,
• savings and loans
• , commercial finance companies, and
• the microfinance institutions.
17. Cont’d
• State and local governments have developed many programs
in recent years to encourage the growth of small businesses in
recognition of their positive effects on the economy.
• Family members, friends, and former associates are all
potential sources, especially when capital requirements are
smaller.
18. Cont’d
• Traditionally, banks have been the major source of small
business funding.
• Their principal role has been as a short-term lender offering
demand loans, seasonal lines of credit, and single-purpose
loans for machinery and equipment.
• In addition to equity considerations, lenders commonly require
the borrower’s personal guarantees in case of default. This
ensures that the borrower has a sufficient personal interest at
stake to give paramount attention to the business. For most
borrowers this is a burden, but also a necessity.
19. Project Decision Making Criteria
The investment criteria could be classified into two:
1. Non-discounting Criteria
2. Discounting criteria
What is the difference between these techniques?
8/1/2021 19
20. 20
1. Non-discounted techniques:
• These techniques are simple to understand and easy to compute.
• They don’t recognize the time value of money
• Though these techniques are simple to understand and easy to
compute, they suffer from the following limitations.
They don’t recognize the time value of money
They fail to recognize the projects return in totality-they
ignore cash flows beyond the payback period
8/1/2021
21. 8/1/2021
2. Discounted appraisal techniques considers both the estimated
total cash inflows and the time value of money.
That is:
Recognize the time value of money
Recognize the benefits of the project in totality (except
discounted pay back period)
21
22. 1) Non-discounting Criteria
a) Payback period
b) Accounting rate of return
2) Discounting criteria include:
a) Net present value
b) Profitability Index/Benefit cost ratio
c) Internal rate of return
d) Discounted pay back period
8/1/2021 22
23. Methods of Evaluating Projects:
• In order to evaluate the financial feasibility of an investment
project, relevant measurements or criteria need to be
specified. Remer and Nieto (1995) categorize the evaluation
methods into five basic types:
Discounting Non discounting
1. Net Present Value 4. Payback period
2. Benefit-Cost Ratio 5. accounting rate of return
3. Internal rate of return 6. ROI.
24. Net Present Value:
• Net Present Value (NPV) is the difference between the present
value of all cash inflows and cash outflows associated with an
investment project.
• Net present value of a project is the sum of the present values
of all the cash flows associated with it. The cash flows can be
positive or negative.
25. NPV
• In order to calculate the NPV, (considerate )
– the interest rate used for discounting the cash flows needs to
be determined. The interest rate is often referred to as
Minimum
– Attractive Rate of Return (ARR) and it represents the rate at
which the investor can alternatively invest his money, i.e. the
return of the most preferable alternative investment.
– The planning horizon of the project also needs to be
determined, and the cash flows for each period of the
planning horizon projected .
26. Net Present Value(Measures of Project Worth)
• The Net Present Value (NPV) of a project is the sum of the project values of all
the cash flows-positive as well as negative-that are expected to occur over the life
of the project.
• The general formula for NPV is:
• where
• Ct = net cash flow at the end of year t(
• n= life of the project
• r = discount rate
• I investment cost
I
r
c
NPV
n
t
t
t
1 )
1
(
27. CONT’D
• If the NPV(i) is positive for a single project, the project should be accepted,
since a positive
• NPV means that the project has greater equivalent value of
inflows than outflows and therefore makes a profit (Park, 2002).
• According to Park (2002) the decision rule for NPV is:
• If NPV(i) > 0, accept the investment;
• If NPV(i) =0, remain indifferent to the investment;
• NPV(i) < 0, reject the investment.
28. CONT’D
• When comparing mutually exclusive alternatives the
one with the greatest positive NPV is selected.
– However, when comparing alternatives it is important
to use the same interest rate for all alternatives.
– All projects must also be compared over equal time
periods.
• In the case of mutually exclusive alternatives
generating the same revenues, compare the projects
on a cost-only basis.
– Then the project resulting in the smallest, or least
negative, NPV should be accepted, since the objective is
to minimize cost.
29. Measures of Project Worth ( example 1)
Year Cash flow
0 Birr (1,000,000)
1 200,000
2 200,000
3 300,000
4 300,000
5 350,000
If the cost of capital (discount rate) is 10%, then NPV is calculated
as follows
273
,
5
000
,
000
,
1
)
10
.
1
(
000
,
350
)
10
.
1
(
000
,
300
)
10
.
1
(
000
,
300
)
10
.
1
(
000
,
200
)
10
.
1
(
000
,
200
5
4
3
2
1
NPV
NPV/I = Profitability Index
30. Measures of Project Worth
• The NPV represents the net benefit over and above the
compensation for time and risk.
• Hence, the decision rule associated with the net present value
criterion is:
–accept the project if the NPV is positive and
–reject it if NPV is negative.
32. Project Analysis & Management
(ASA)
Example 3
After tax cash flows of a small scale tannery project is given
below. Find the profitability index if discount rate is assumed to
be 12%?
Year 0 1 2 3 4 5
CFs 40,000 15,000 14,000 13,000 12,000 11,000
…Cont’d
34. CONT’D
Advantages:
• It takes into account the time value of money with changing
discount rate.
• It can be used to evaluate mutually exclusive projects.
• It takes into consideration the total benefits arising out of the
project over its lifetime.
Disadvantages
• It does not take into account the life of the project and may
not give dependable result for projects having different lives.
• The NPV method is an absolute method and may not give
dependable results in case the projects have different outlays.
35. Benefit-Cost Ratio
• The benefit-cost method is often used for public projects.
• The method compares project benefits to the cost of the
project, and for the project to be viable, the benefits have to
be greater than the cost.
• Park (2002) describes benefit-cost analysis as “a decision-
making tool used to systematically develop useful
information about the desirable and undesirable effects of
public projects”.
• Benefit-Cost Ratio BCR= Present value of inflows/Initial
Investments PI= Present value of cash inflows/Present value
of cash outflows
– If BCR is greater than 1, accept the project If BCR is less than 1,
reject the project.
36. CONT’D
• three types of benefit-cost analysis problems:
1. Maximizing the benefits for any given set of cost;
2. Maximizing the net benefits when both benefits and
costs vary;
3. Minimizing cost to achieve any given level of benefits.
• The worthiness of a public project can be expressed by
comparing the benefits (B) of the project to the cost (C) of the
project by taking the ratio B/C, i.e. the Benefit- Cost ratio.
37. Benefit-Cost Ratio:
• Benefit-Cost Ratio: There are two ways of defining the relationship
between benefits and costs:
• Example: 12% discount
NBCR = BCR-1= 0.145
I
PVB
BCR
1
BCR
I
I
PVB
NBCR
(1)
(2)
PVB = present value of benefits, I = initial investment
100,000
Benefits Year 1 25000
Year 2 40000
Year 3 40000
Year 4 50000
145
.
1
000
,
100
)
12
.
1
(
000
,
50
)
12
.
1
(
000
,
40
)
12
.
1
(
000
,
40
)
12
.
1
(
000
,
25
4
3
2
BCR
When BCR > 1 or NBCR > 0 accept
When BCR < 1 or NBCR < 0 reject the project
38. Cont’d
• Advantages
• Evaluate the project in the relative terms
– Two projects having different cash outlays and lifetime can be evaluated
• Takes into consideration time value of money and totality of benefits
• Dis advantages
– When comparing mutually exclusive alternatives, the Benefit-Cost Ratio
cannot be used unless using incremental analysis.
– This is due to the fact that the ratio does not differentiate between
investments of different sizes, e.g. a $10 investment and a $1000
investment.
– Then the incremental differences for each term are calculated and the
B/C ratio taken from these differences (Park, 2002).
39. Internal Rate of Return:
– Internal Rate of Return (IRR) is a concept based on the
return on invested capital in terms of a project
investment.
– The internal rate of return( IRR) is defined as the rate of
discount, which brings about equality between the present
value of future net benefits & initial investment.
– The investment has zero NPV at this rate of return, noted as
r*. Therefore, r*serves as a benchmark interest rate, making
investors able to accept or reject decision consistent with the
NPV analysis.
40. CONT’D
• Internal rate of return (IRR) is the discount rate which makes
its net present value equal to zero.
• It is the value of r in the following equation.
• Where,
– I – investment cost
– Ct – Net benefit for year t
– r - IRR
– n - Life of the project
• Illustration: For project A in the table below can be formulated
as follows:
n
t
t
t
r
C
I
1 1
41. Measures of Project Worth
• The calculation of r involves a process of trial and error. We try different values r till
we find that the right-hand side of the above equation is equal to 100,000. Let us
try to use 15%. This makes the right-hand side to be:
4
3
2
1
1
000
,
45
1
000
,
40
1
000
,
30
1
000
,
30
000
,
100
r
r
r
r
Year 0 1 2 3 4
Cash flow (100,000) 30,000 30,000 40,000 45,000
IRR is the value of r which satisfies the following equation:
802
,
100
15
.
1
000
,
45
15
.
1
000
,
40
15
.
1
000
,
30
15
.
1
000
,
30
000
,
100 4
3
2
Since the value is slightly higher than our target value, which is 100,000, we
increase the value to 16%.
641
,
98
16
.
1
000
,
45
16
.
1
000
,
40
16
.
1
000
,
30
16
.
1
000
,
30
000
,
100 4
3
2
42. Measures of Project Worth
• Since this value is now less than 100,000, we conclude that the value of r lies
between 15 and 16%. For most of the purposes, this indication suffices.
• If a more refined estimate of r is needed, we use the following procedure:
1. Determine the NPV of the two closest rates of return
(NPV/15%) = 802
(NPV/16%) = 1,359
2. Find the sum of the absolute values of the NPVs obtained in Step 1
802+1,359 = 2,161
3. Calculate the ratio of the NPV of the smaller discount rate, identified in Step 1, to
the sum obtained in Step 2
802/2,161 = 0.37
4. Add the number obtained in Step 3 to the smallest discount rate
15+0.37 = 15.37
43. Project Analysis & Management
(ASA)
Class Work
A project has a total outlay of Br. 500,000 with the following pattern of
cash inflow. Compute the IRR of the project
Year 1 2 3 4 5
CFs 120 120 120 150 150
(in thousands)
…Cont’d
44. Project Analysis & Management
(ASA)
Year 1 2 3 4 5
CFs 5000 4000 3000 2000 8000
…Cont’d
Exercise
A project requires a new investment of 20,000 and produces the
following cash flows. Compute the IRR of the project
45. Cont’d
NPV Vs IRR
For making choice between two projects competing for
the funds at the disposal of a concern, the NPV method
can give a better choice because it can give idea of
ranking of the projects.
46. Project Analysis & Management
(ASA)
Advantages
• Takes into consideration time value of money and totality of benefit
Provides the rate of return which indicates the profitability of the
proposal
• The difference between the IRR and the cost of capital indicates the
additional return for risk that the project provides.
Disadvantages of IRR
• Tedious calculations.
• May not give dependable results while evaluating mutually exclusive
projects as the project with Highest IRR will be selected.
• If a firm has to rank mutually exclusive projects, choosing the project
with the highest IRR may result in optimal outcome.
…Cont’d
47. 6.Profitability Index (PI)
• A part of discounted cash flow family
• PI = PV of Cash Inflows/initial investment
• Accept a project if PI ≥ 1.0, which means positive NPV
• Usually, PI consistent with NPV
• PI may be in conflict with NPV if
– Projects are mutually exclusive
• Scale of projects differ
• Pattern of cash flows of projects is different
• When in conflict with NPV, use NPV
8/1/2021 47
48. Profitability Index (PI)
• Modified version of NPV
• Decision Criteria
– PI > 1.0, accept project
– PI < 1.0, reject project
8/1/2021 48
49. Profitability Index (PI)
• Close to NPV as we calculate present value of future
positive cash flows (present value of benefits) and
initial cash flow (NPV)
→PI = (NPV + Initial cost) / Initial Cost
• Choosing between two different projects?
→Higher PI is best choice
8/1/2021 49
50. II. Non-Discounting Criteria
A. Payback Period
– It is one of the most popular and widely used method
– It indicates the number of years the project will take to
repay its investment cost
– The payback period can be calculated using the following
formula:
PBP = Total Investment
Annual Cash Flow
• How long will it take (usually, in years) to pay back
the project, and accrued costs:
51. Measures of Project Worth
Alternative
projects
Year Investment cost Net
incremental
benefits
Cumulative net
incremental benefits
I 1
2
3
4
5
20000 -
2000
8000
12000
9000
31000
II 1
2
3
4
5
20000 -
2000
12000
8000
12000
34000
III 1
2
3
4
5
6
7
8
20000 -
1000
5000
6000
8000
10000
5000
2000
37000
52. Measures of Project Worth
• Project I & II have a payback period of 4 year.
• But project III has a payback period of 5 years.
• Thus, based on this criterion, project I & II have equal higher rank
than project III.
• Therefore, the method fails to consider the time & amount of
net incremental benefit after the payback period- project III.
• In addition, the method results equal rank for both project I and II.
• Yet we know by inspection that we would choose project II over
project I because more of the returns to project II are realized earlier.
– This method is a measure of cash recovery, not
profitability.
53. Project Analysis & Management
(ASA)
Example 1
If a project has an investment of Br. 60,000 and annual cash inflow is Br.
15,000 per year for 10 years. Compute the PBP?
PBP = 60,000/15000= 4 years
Example 2
If the project cash inflow is not in “annuity form”, cumulative cash
inflow method may be used to compute that PBP. Assuming an initial
investment of Br. 30,000 for the following stream of cash flows and
compute the PBP.
…Cont’d
55. Project Analysis & Management
(ASA)
Cont.
Hence, PBR, is 3 years
Example 3
If the project cumulative cash flow does not exactly match to
the investment outlay, but in annuity form of inflow, then
compute the PBP in the following way (assuming initial
investment of $10,000)
57. Project Analysis & Management
(ASA)
…Cont’d
Example 4
In case the cumulative inflow does not exactly match
the amount of investment and the inflow is not in
annuity form use the interpolation method (assume
an investment outlay of 15,000); compute the PBP.
58. Project Analysis & Management
(ASA)
Year Cash in flow Cumulative
1 3,000 3,000
2 5,000 8,000
3 10,000 18,000
4 2,000 20,000
5 4,000 24,000
PBP = 2+ (12 months x 7000)=
10,000
…Cont’d
2 years and 8
months or 28/12
years
60. Project Analysis & Management
(ASA)
…Cont’d
Advantages of Payback Period
(1) Applying the technique and understanding the concept is easy to
understand
(2) It is quick and simple to use
Disadvantages of Payback Period
(1) It ignores the cash flows that occur after the payback period.
(2) It ignores the time value of money.
61. Accounting Rate of Return
• ARR differs from the payback period in using accounting profits
rather than cash flows
• It is calculated by taking the average annual profits expected
from a project as a percentage of the capital invested
Accounting rate of return =Book Value of the
Investment/Profit After Tax
The Higher the accounting rate of return, the better the project
ARR = Average annual profit x100/outlay,
62. Measures of Project Worth
• Accounting Rate of Return (ARR)
Cash Flows A B C
Outlay 120,000 120,000 120,000
After deducting depreciation
Year 1 30,000 20,000 10,000
Year 2 30,000 20,000 70,000
Year 3 30,000 20,000 80,000
Average Annual Profit 30,000 20,000 53,333
ARR of A = 30,000 x100/120,000 = 25%,
ARR of B = 20,000 x 100/120,000 = 16.7%,
ARR of C = 53,333 x 100/120,000 = 44.44%
Disadvantages Does not take into account time value of money Based on the
accounting profit and not cash flows
63. Average Return on Investment
• It is a measure of aggregate benefits that the investment will produce.
The desired ARI will reflect the bare minimum that will make investors
commit funds for the project
• Steps to compute ARI:
1. Find the total cash inflows over the project life
2. Subtract the initial investment from the total cash inflows. This is the
total net income over the project life
3. Find the average annual income by dividing total net income by the
project life in years
4. ARI is the ratio of the average annual income to the initial investment
ARI considers all the cash flows generated from a project during its life
64. Measures of Project Worth
• Exercise 2: Compute ARI from the following data
Year Initial Investment Cash
Inflows
0 2,300 -
1 - 331
2 - 430
3 - 553
4 - 544
5 - 536
Total
(1)
2,300
(2)
2,394
(3)
1. Initial Investment: (2300)
2. Total Net income: (2300)-(2394) = 94
3. Average Annual Income: 94/2300
=0.04
4. 0.04*`100= 4%
66. Quick Quiz Q1(10%)
• Assume that a minimum of 10 percent return is required and
select the best project alternative using:
A. Payback period
B. NPV
C. IRR
Expected financial Return (in Birr)
66
year Project A Project B Project C
0-Investment (1,000) (1,000) (1,000)
1 300 1,500 525
2 300 250 525
3 300 250 525
4 300 250 525
5 1,500 250 525
Total 1,700 1,500 1,625
67. Quiz 2(5%)
Year Project I Project II
0 (500) (500)
1 325 175
2 150 175
3 150 175
4 50 175
• Example: Assume that Mina PLC, a financial analyst, is doing a
consulting work for evaluating the two projects given below. The projects
costs Br. 500 million each and the required rate of return for each of the
projects is 12%, the projects’ expected net cash flows are as follows:
Required:
1. Calculate each of the project’s payback, net present value( NPV) and
Internal rate of return (IRR)
2. Which project or projects should be accepted if they are independent?
68. Q 3(5%)
• Find the NPV of the following projects and choose the best project
Projects Initial Investment (Outlay) Cash Flows
Year 1 Year 2
A 10,000 10,000
B 10,000 10,000 1,100
C 10,000 3762 7762
D 10,000 5762 5762
Cost of capital (discount rate) is 6%
Use the same discount rate and find the NPV of a project with a life of five
years and an initial investment outlay of Birr 100,000 and a cash flow of
50,000 each year across the project life span
Interest rate 6%
Investment ( -100,000)
1 Year 2 year 3 year 4 year 5 year
Cash Flow 50,000 50,000 50,000 50,000 50,000