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CHAPTER 3

CONSTRUCTION OF CONSTRUCTION OF FINANCIALFINANCIAL

PROFILES FOR PROJECTSPROFILES FOR PROJECTS

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Chapter 3. Constructıon of Financial Profiles for Projects

Table of Contents1. Introduction2. Construction of Pro-forma Cash

Flow Statement3. Investment Decisions from

Alternative Viewpoints

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3.1.INTRODUCTION Data must be organized in financial

and economic values for the project life.

Financial appraisal Net Cash Flows

(Receipts / Expenditures)

Economic appraisal Net Economic Benefits (Benefits / Costs)

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3.1.INTRODUCTION (cont’t)

Financial cash flow lists the difference between receipts and expenditures against the years of project life.

Usually the net financial cash flow is negative in the first years of the project’s life, while in later years it becomes positive.

Some projects may have negative cash flows in their operating stages, and some have in the final years.

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Example of Project Cash Flow

+2.5+1.6+1.6+1.6-2.0+1.6+1.6+0.4-2.5-2.0-1.0Net (R-E)

00.40.40.43.00.40.40.62.52.01.0Expenditures

2.52.02.02.01.02.02.01.0Receipts

109876543210Year

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The Components of Cash Flow Analysis

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Ben

efit

s L

ess

Cos

ts

(-)

(+)

Year of Project Life

Initial Investment Period

Operating StageLiquidation

Project Life

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Types of Financial Statements

a. Cash-Flow Table: Shows the INFLOW and OUTFLOW of cash through a period of time

b. Income Statement: Shows the Revenues and Expenditures for a period of time.

c. Balance Sheet: Shows the ASSETS and the LIABILITIES at a certain period of time.

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INCOME STATEMENT

REVENUES Sales revenue + Other revenues +

EXPENDITURES Cost of goods sold - Administrative costs -

Gross Profit (profit before tax) (- / +) Net TaxesNET PROFIT

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BALANCE SHEET (31.12.2000)

ASSETSASSETS LIABILITIESLIABILITIESLiquid assetsLiquid assets Short term Liabilities

Cash at Bank Accounts PayableAccounts PayableBonds and stocksBonds and stocks Short Term CreditsShort Term CreditsInventoriesInventories

Fixed AssestsFixed Assests Long Term Long Term LiabilitiesLiabilities

BuildingBuilding Loan Term Loan Term LiabilitiesLiabilities

MechineryMechinery

Owner’s EquityOwner’s Equity

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2 . CONSTRUCTION OF CASH FLOW STATEMENT

a. Investment Plan - The first step in the construction of a financial cashflow is the formation of the

investment plan- Include all the expenditures, domestic-

imported, goods-services, tariffs and subsidies, year by year. -How these expenditures are to be financed i.e. from equity, domestic-foreign loans, grants etc.-Equity funds are not a cash inflow from owners point of view because he has/she to finance these funds himself.

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Investment Plan (Con’t)

Interest during construction is included as a cost by the accountants to reflect the opportunity cost of the investment (capital) that could have been used alternatively. If no interest is paid to the lender of the money, this is not cash expenditure (outflow) and should not be included as an expenditure in the investment plan. If interest payments are made during the construction, this should be included as a cash outflow from the owners’s (equity) point of view.

For most public sector projects it is the financial performance of the entire invested capital and not just the equity portion which is relevant. No distinction is made between the return received by the lenders of debt and the return received by the owners of the equity.

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Table 3-1. Investment Plan for a Medium Scale Public Table 3-1. Investment Plan for a Medium Scale Public Sector Mining ProjectSector Mining Project

Item Year 0 1 2…..………………..7

(A) EXPENDITURES (thousands of dollars)

1. Site Preparation, exploration, and development

(A) Materials: (I) Traded net of taxes Tariffs(15%) Sales tax (5%)

500

75 29

500

75 29

(II) Non-nontraded net of taxes Sales Tax (5%)

400 20

300 15

(B) Skilled Labor (domestic) (C) Unskilled Labor

150 200

100 250

2. Equipment

Traded, net of taxes Tariffs (10%) Sales Taxes (10%)

600 60 66

2000 200 220

Total Expenditures 2100 3689

(B) FINANCING

Government Equity 2000 2000 1189

Government Loan (short-term) 100 500

Foreign Loan (guaranteed by

government)

0 2000

Total Financing 2100 3689

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b. The Operating Plan

Future expected performance of a project can be analyzed through the financial statements which include:

(i) balance sheet (ii) Income (profit and loss) statements (iii) cash flow statements

Cash flow statement can be constructed from balance sheets and income statements over a series of years.

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i. Accounts Receivable and Accounts Payable The net cash flow statement is calculated as the difference

between total receipts (not total income) and total expenditures (not total expenses).

One has to differentiate sales from receipts and purchases from expenditures. For this we must consider accounts payable and accounts receivable.

When a sale is made the goods may be delivered but no money is transferred. This is recorded as accounts receivable for the seller and accounts payable for the buyer (difference between sales and receipts).

When a buyer purchases goods but not pay for it, it is recorded as accounts payable (difference between purchases and expenditures).

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Example for Cash Receipt (inflow)

Cash Inflow Case:

If a sale at an amount of $4000 is generated throughout 2002, total Accounts Recievable (at the beginning of the period, from previous years sales) was $2000 and if at the end of the same year total A/R was $2600 (both from current year sales and from previous year sales) total cash flow will be as follows:

Cash Receipt = Sales for + A/R beginning - A/R end (inflow) Period of Period of

period

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Example for Cash Receipt (inflow) (Con’t)

Example: Example:

Sales in Year 1 Sales in Year 1 = $10,000 = $10,000Accounts Receivable in Year 0 = $5,000Accounts Receivable in Year 0 = $5,000Accounts Receivable in Year 1 = $8,000Accounts Receivable in Year 1 = $8,000

Cash FlowCash Flow = Sales in 1 + ( A/R 0 – A/R 1 )= Sales in 1 + ( A/R 0 – A/R 1 )

7000 = 10000 + (5000 – 8000)7000 = 10000 + (5000 – 8000)

Note: A/R recorded as asset for the sellerNote: A/R recorded as asset for the seller A/P recorded as liability for the purchaser on BALANCE A/P recorded as liability for the purchaser on BALANCE

SHEETSHEET

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Example for Cash Receipt (outflow)

Cash Outflow Case:

If a purchase at an amount of $3800 is generated throughout 2002 and if the total Accounts Payable (at the beginning of the 2002, from previous year purchases) was $3500 and if at the end of the same year total A/P was $2800 (both from current year purchases and from previous year purchases) total cash outflow will be as follows:

Cash Expend. = Purchases + A/P beginning - A/P end (outflow) for Period of Period of period

4500 = 3800 + 3500 - 2800

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i. Depreciation Expenditures Depreciation expense or capital cost allowance

is not a cash outflow. It should not be included in the financial cash flow of the project as an outflow.

Full cost of the capital investment is included in the financial cash flow i.e. full amount of the investment expenditures are deducted in the year (year 0, 1, 2) they occur.

If further depreciation expense (capital cost) is deducted from the cash flow profile a double counting of the costs will occur.

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Salvage valueSalvage value or or in-use valuein-use value is entered into the cash is entered into the cash flow as a positive item after the year project ends flow as a positive item after the year project ends

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Project Cash Flow Profile

R – E Expenditure net cash flow from

of operation

t3

Investment

t4Net Income

year 3

Depreciation expense for year 3

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Cash Held to Carry Out Transactions A cash ( Petty cash) is set aside to facilitate

the transactions of a business. If the stock of cash balance held increases in a

period (beginning - end of period), this is recorded as a cash outflow, and likewise if it decreases it is recorded as cash inflow.

Change in cash Cash held Cash held beginning held = end of period - of period

($120) ($100)

$ 20 outflow ( a positive item in the expenditures)

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vi. Working Capitalvi. Working Capital

Working capital is composed of: Working capital is composed of: Accounts receivable Accounts receivable Accounts payable Accounts payable Cash balance Cash balance Inventories and stocksInventories and stocks

A certain amount of investment is made A certain amount of investment is made in cash. A/R. less A/P. and inventories or in cash. A/R. less A/P. and inventories or stocks. If there is any change in these stocks. If there is any change in these items they are automatically reflected in items they are automatically reflected in the cash flow.the cash flow.

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working capital (Con’t)

Woring Capital = Cash for Transactions + Accounts Receivable- Accounts Paybale+ Inventories+ Prepaid expenses- Accrued Liabilities

(i.e. Tax liabilities)

Working capital is an importan part of investment project (usually around 30 % of the investment)

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2.6 Opportunity Cost Opportunity cost of using a resource in a project is the

forgone benefit for not using it in another activity.

A farm may be converted from tobacco plantation to

peanut planting. The opportunity cost of planting

peanut is the income sacrificed for not planting

tobacco. This income should be included in the cash

flow statement of peanut project as an outflow (it is a

negative item for the project).

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2.7 Sunk Costs or Incremental Costs

Many investment projects are additions to existing ongoing activities. Any financial obligations of the existing facility should not be included in the incremental benefits and costs of the new project.

The previous expenditures that were made are the “historical costs” (the money paid when it was bought) or the “sunk costs” and should not be included in the evaluation of incremental investments.

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2.7 Sunk Costs or Incremental Costs (Con’t)

The only occasion that the assets of the old facility can be included is when the asset has a chance to be sold. In this case, not the historical cost but the liquidation value (or in-use value) of the existing facility is included as an opportunity cost. If this is not included, the total cost of the project is significantly underestimated.

The existing facility can be sold as an ongoing business with a price called “in-use value” of the asset. The resource cost of the existing facility is taken, the greater of the liquidation or in-use value of the existing asset.

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2.7 Sunk Costs or Incremental Costs (Con’t)

While estimating the value of some of the assets of the project at the end of its life, the greater of their liquidation or in-use values are taken.

The most accurate way of estimating the liquidation or in-use value of an asset is to investigate their values in second hand markets.

Less accurate but more practical way of estimating liquidation or in-use values is through using the current book values, installation and set up costs. These values must be adjusted for inflation.

It is a very common error to assume that all costs and benefits are incremental to the new project when in fact they are not. A “base case” should be defined and its costs and benefits should be identified as if no additional investment is made.

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2.8 Land

Land used in a project has an opportunity cost. Even if the land is donated by the government, its market value should be included as an investment cost.

The land under most situations do not depreciate. The end of project value of land should not be taken above the value adjusted for inflation unless a real increase in value has taken place as a result of the project i.e. quality of the soil is improved or harmed.

If the real value of the land is improved due to an infrastructure project carried out nearby, such an improvement in land value will not be considered as it is not the direct result of the project.

Alternatively (alternative to using the value of the land at the beginning and the liquidation value at the end of the cash flow of the project), the land use cost can be entered as an annual rental charge.

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2.9 Format for the Pro-Forma Cash Flow Statement

There is no set format for the fro-forma cash flow statement. It is expected to have sufficient detail so that the financial cash flows to be prepared could easily be adjusted for the economic and distributive appraisal.

Receipts must be identified as traded and non-traded goods, taxes, tariffs and subsidies should be detailed. Financial charges, such as interest, must be excluded from the cost of inputs and presented in a separate line.

Example of mine (investment plan was given in Table 3-1).Life of the mine is 5 years.Liquidation value of the mine is $1,000,000 Land has no value after being mined.

Table Table 3-3 gives the financial cash flow statement of the mine project.

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(Thousands of dollars) Item Year 0 1 2 3 4 5 6 7 RECEIPTS:

Sales: Traded Change in account receivables Liquidation Value (scrapped assets)

2000 -500

3000 -250

3500 -250

3000 +250

2000 +250

0 +500 1000

CASH INFLOW (+) 1500 2750 3250 3250 2250 1500 EXPENDITURES: a) Site preparation, exploration and development: Materials: Traded material Tariffs (traded) Sales Taxes (traded)

500 75 29

500 75 29

Non-traded material Sales taxes

400 20

300 15

Equipment: Traded-Net Sales Tax Tariffs

600

66 60

2000

220 200

b) Material Purchases Traded Non-traded Tariffs Taxes

600 200

60 20

750 250

75 25

800 320

80 32

700 200

70 20

600 200

60 20

c) Labor Operating Cost Skilled Labor Unskilled Labor

100

50

150

70

200

90

150

80

125

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d) Labor :Construction cost Skilled Labor Unskilled Labor

150 200

100 250

e) Change in Account Payables f) Change in Cash held as working capital

0 20

-160 10

-40 15

-100 5

+100 -5

+50 -25

+150 -20

CASH OUTFLOW (-) 2100 3709 880 1295 1427 1315 1090 130

NET CASH FLOW -2100 -3709 -620 +1455 +1823 +1935 +1160 +1370

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3. INVESTMENT DECISIONS FROM ALTERNATIVE VIEWS

3.1Types of Analysis

An investment project can be evaluated by using below perspectives:

a. Financial analysis: It uses market prices for inputs/outputs

b. Economic analysis: Prices are adjusted for market distortions

(taxes/subsidies). True resource cost or economic benefit.

c. Distributive analysis: Net economic benefits are shared.

d. Basic needs analysis: Externalities for the whole society.

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3.2 Various Viewpoints

• Different actors are involved in an investment project:

a. Owners (equity) point of view

b. Banker or financial institution (total investment) point of view

c. Government point of view

d. Economy point of view

• If the outcome of the project is attractive to the owner but not to the

banker or to the government, the project could face official approval

and funding problems. In the alternative case it faces problems of

implementation.

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Figure 3-2: Analyses of Investment Decisions from Different Viewpoints

Types of Analysis

Financial Economic Distributive Basic Needs

Viewpoints: (I) (II) (III) (IV)

Banker Yes na Yes na 

Owner Yes na Yes na

Government

(budget office) Yes na Yes na

Country na Yes Yes Yes

Note: na = not applicable

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Table 3-4: Net Resource Flow from Different Viewpoints

Analysis: Financial Economic

Viewpoints: Owner Bank Budget Country(cell Fig 3.2) (B) (A) (C) (D)

Year: 0 1 0 1 0 1 0 1

Sales 300 300 300Operation Cost -140 -140 -140Equipment -1000 950 -1000 950 -1000 950

Subsidy 150 150 -150Taxes -100 -100 100Loan 500 -500Interest -50 Externality -50Opportunity Cost of Land -30 -30 -30 -30 -30 -30Net Resource Flow -530 580 -1030 1130 -50 -1030 1030

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3.3 Interests of Private Sector/Economy in a Project• Analysis of a project from private sector (business) and economy

perspective can lead to 4 possible results (Figure 3-3).• In cell (a) the project have to be carried out as it generates net benefit

for both the owner and the economy. • In cell (d) the project generates net losses to both parties and should

not be undertaken. • In cell (b) the project is profitable to the owner and unprofitable to the

society. Ex. Use of extensive pesticides. The government by increasing the taxes can make the project unprofitable to the owner. The project moves from (b) to (d). In any case the project should not be undertaken if it is unprofitable to the society.

• In cell (c) the project generates net benefits to the society but net losses to the owners. Ex. Cultivation of trees. The government by giving subsidies can make the project profitable to the owner. This shifts the project from (c) to (a). In this case it becomes profitable to both society and owner.

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Profitability Calculations from Owner’s and Economy’s View

___________________________________________________________

Economic Country (+) (-)

___________________________________________________________

Financial + (a) (b)

(Owner) (-) (c) (d)