LECTURE on FINANCIAL ASPECT/STUDY

SINCE ALL PROJECTS are considered viable only when they are expected to
be profitable to meet short-term obligations, to be liquid and to remain liquid
during adversity, to grow in their ability to finance their operations mostly from
capital sources rather than credit applications, and to service their financing
charges, the financial aspect is a very important part of every project feasibility
study.

As such, the Financial Study should show in specific terms whether the project
will be profitable even with existing competition and in unfavorable economic
conditions. Detailed figures showing the improvement of the project's financial
condition over time should be presented.

This is done through the preparation of financial statements and schedules

reflecting the expected profits, the modes of financing needed to optimize the
project's performance, the manner and period of repaying creditors, and other
financial considerations which are vital for the success of the venture.

The financial study of the project may be broken down into the following major
sections:

1. Major Assumptions 2. Total Project Cost 3. Key Forecast Variables 4. Sources

of Financing the Project 5. Preparation of Financial Statements 6. Financial
Analysis 7. Computation of Net Present Value and Internal Rate of Return 8.
Sensitivity Analysis 9. With or Without a Project Analysis

A. MAJOR ASSUMPTIONS

In the formulation of the financial projections, assumptions play an important

role because they serve as the foundation for estimating the future expenditures,
expenses, and revenues of the project as accurately as possible. These
assumptions must be based on well-considered, realistic, and workable facts.

In formulating assumptions, the analyst must consider the following sources:

1. Existing business practices in the industry may provide some valuable

information and insights on the following:

a. Credit terms

b. Credit extensions

c. Bad debt allocations

 d. Bad debt write-off

e. Quality related costs

f. Dividend policies

g. Sales returns, allowances, and discounts

h. Labor and management compensation

i. Overhead accounts

j. Inventory costing

k. Operating accounts

I. Fixed-asset requirements

m. Method of depreciation and amortization

n. Intangible-asset pre-requisites

2. Past feasibility studies directly related to the project may reveal other factors
not yet considered, specifically those items involved in the computations of:

a. Selling price

b. Sales forecasts

c. Unforeseen costs

d. Production volume

e. Product mix

3. Governmental regulations and incentives directly or indirectly affecting the

project, such as:

a. Import policies

b. Export policies

c. Tax rates

d. Tax exemptions

e. Price ceilings

f. Relevant presidential decrees or letters of instruction

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4. Other pertinent data which can justify the assumptions of the study, such as
industry profiles, pre-feasibility studies, proceedings of symposiums and
conferences, and research or policy studies of industry associations.

In general, assumptions in the preparation of the financial study should be kept at

a minimum as much as possible and formulated only when necessary.

The list of assumptions incorporated in the study, however, should remain intact
and consistent throughout the analysis and must have the following
characteristics:

a. Factual

b. Justifiable

c. Realistic

d. Workable

TOTAL PROJECT COST

The second step in the preparation of the financial aspect of a project feasibility
study is an estimation of the project's total cost or initial asset or capital
requirements.

Based on the materials, supplies, equipment, physical plant, and manpower needs
of the project specified in the technical study, the total project cost is composed
of current asset levels and planned fixed asset acquisitions.

1. Fixed Assets - In computing the project's fixed-asset requirements, the most

approximate acquisition cost of the following accounts should be determined:

a. Land and land improvements

b. Buildings, including electric and water utilities, furniture

and fixtures
c. Equipment, including installation costs

d. Purchase and installation of machinery

e. Trial-run associated with electric utilities, equipment, and

machinery

Land and land improvements consist of the cost of land, the

corresponding notary's fees associated with land acquisition, registration
expenses, transfer taxes, and other related costs.

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 Building cost includes all expenses incurred in constructing the building
and its foundations, wells, water pipes, electrical connections, gas supply,
telephone system, reservoir and tanks, waste water disposal, fencing,
roads and paths, employee housing, and fire protection. In addition to the
purchase price of machinery and equipment, sales taxes, freight charges,
insurance and customs duties (for imported equipment) are also included
in the costs.

Significant and necessary expenditures on foundation setups, tests and

startup operations, installation of electricity and telephone lines, electrical
equipment, office equipment, furniture and fixtures, employee benefits,
maintenance and cleaning equipment should all be considered and
presented.

2. Current assets - In estimating the project's initial current asset needs, it is

advantageous to divide this section into inventory investments, inventory-related
costs, and cash credits.

a. Inventory investments include purchases of materials and supplies, and

the corresponding freight charges.

b. Classified under inventory-related costs are such accounts as direct and

indirect labor with related fringe benefits; heat, light, and power; plant
maintenance; and warehousing expenses related to raw materials,
materials in process, and finished goods.

c. Cash credits include pre-paid expenses, intangible assets, operating

salaries, wages, and fringe benefits, engineering costs, operating taxes,
office supplies, communication facilities, office utilities, billing costs,
transportation costs, expenses for advertising, borrowing costs, and
provisions for unforeseen costs.

Intangible assets include patents, licenses, goodwill, reproduction rights, and

organization and pre-operating expenses, if the latter are amortized for a period
extending to more than one year.

Organization expenses include fee requirements of the Securities and Exchange

Commission, cost of issuing shares of stock such as broker's fee, interim interest,
initial advertising, personnel recruitment and training, etc.

Pre-operating expenses include costs of initial investigations, pre-feasibility

studies, research and technical studies, economic and marketing studies, financial
and profitability studies, design studies, and engineering consultant fees.

The total Current Asset costs are then multiplied by the assumed current ratio,
which is ideally 2:1, to arrive at the total cost of Working Capital.

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The Total Project Cost is the sum of Total Fixed Assets and Working Capital.

In general, the computation for project cost estimates should be as detailed as

possible. Five percent of these itemized projections are usually allocated to
unforeseen costs.

C. SOURCES OF PROJECT FINANCING

In determining the financing scheme for the project, one should take the
following steps:

1. List down all available sources of funds for both short- term and long-term
financing. Funding options range from bank credit, insurance term loans,
mortgage loans, leasing arrangements, issuance of bonds and stocks, private
placements, investment banking arrangements, etc.

2. Select the source(s) for both long-term and short-term financing according to
its maximum profitability.

3. Finalize the amount and terms for each selected source, together with an
indication of the currency, security, repayment period, interests, and other
features. It should be noted that the security, repayment period, and
interest rates of loans differ from one lending or investing institution to
another. Bonds are also settled prior to stock dividends, and preferred
stocks are issued dividends first before common stocks.

4. Determine the status of financing from each source by relating it to actual

releases already made, applications already approved, applications pending, and
applications still to be made.

5. Provide allowances for financing of contingencies and fluctuations in working

capital so that the project's liquidity and cash solvency are assured during each
operating year of the project's early stages.

6. Identify alternative sources of financing in order of priority, in case variances

from the expected outcome result, due to external conditions which affect the
project.

D. PREPARATION OF FINANCIAL STATEMENTS

Financial statements present in an orderly and understandable form the financial

condition of a business enterprise, its operating performance, as well as the status
of its liquidity.

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Financial statements depict the progress of a firm in monetary or financial terms.

There are three types of financial statements needed for the project feasibility
presentation: the Income Statement, the Cash Flow Statement, and the Balance
Sheet.

1. The Income Statement is a summary of the project's total revenues and total
costs for one period or fiscal year, thereby arriving at the net income or loss for
the period. In Exhibit 2-1, a model format for income statement preparation is
presented. An analysis of each account in the presentation follows:

a. The amount of net sales in pesos is arrived at by subtracting sales returns,

allowances, and discounts from gross sales. Sales returns represent goods sold
which do not meet customer requirements and thus have been returned.
Allowances refer to goods which

cannot be sold due to spoilage, wrong specifications, and similar causes. Sales
discounts are price reductions occasionally given in favor of customers.

b. Cost of sales is a function of raw materials used, direct labor expenses, and
factory overhead, less cost of ending inventory for the period. Factory overhead
includes

a) materials and labor expenses indirectly related with production;

b) heat, light, and power required for manufacturing;

c) repair and maintenance costs associated with productive fixed assets;

d) various supplies needed to produce goods; the depreciation of

productive fixed assets; and

e) insurance expenses related to the productive operations.

2. The Cash Flow Statement or the "cash budget" is a presentation of cash

receipts and disbursements for a given operating period or fiscal year. Exhibit 2-
2 illustrates a cash budget model, showing the inflow and outflow of cash during
project operations. It likewise indicates how the ending cash balance in the
Balance Sheet was arrived at. The cash budget is also used to predict or
anticipate when loans will need to be drawn during an operating period to
optimize the timing of project financing, and maximize profitability by efficient
cash utilization.

a. Cash receipts are classified into two: cash from project financing and
cash from sales revenues. Cash flows from financing may take the
form of stocks issued, bond issues, and long-term loans.

b. Cash disbursements include payments for intangible assets, fixed

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 assets acquisitions and actual operating expenses. Payments for credit
purchases, bank loans as well as cash purchases of inventories fall
under this category. Cash dividends issued and income tax payments
are also part of cash disbursements.

The beginning cash balance for the period is then added to the net cash
flow to arrive at the ending cash balance in the Balance Sheet.;

3. The Balance Sheet reflects the assets acquired by the project and the
corresponding liabilities it incurred and the owners' equity (net worth) as of a
specific date. Exhibit 2-3 presents a model balance sheet.

a. The Assets are broken down into the following: current assets, fixed assets,
and intangible assets. Current assets include cash accounts and other
accounts expected to be converted into cash within one year, such as
marketable securities, receivables, and inventories. Prepaid expenses and
deferred charges are also classified under Current Assets, except that, for
accounting purposes, they will be adjusted as an expense within one year.
An example of a prepaid expense is insurance premiums good for one year.

b. Fixed Assets are tangible assets of an enterprise, the service life of which
usually extends to over one year. Land, building, machinery and equipment
are typical examples of fixed assets.

c. Other Assets include the organization's pre-operating expenses and

intangible assets such as patents, copyrights, leases, licenses and
franchises. Intangible assets, like fixed assets, have a service life of more
than one year.

d. Liabilities are classified into current and long-term liabilities. Current

liabilities are those which are expected to be paid for within one year.

Typical current liabilities include accounts payable (for credit purchases of

materials and supplies), short term bank loans, taxes payable, and accrued
expenses.

Accrued expenses refer to cost of services rendered but have not yet been
paid such as salaries payable, interest payable, etc.

Long-term liabilities are expected to be paid over a period of more than

one year. Mortgage bonds payable and long-term notes payable are typical
representatives of this category.

e. Equities are asset claims due to owners of the firm. If the firm is a
corporation, the Equity is further divided into Capital Stock, Paid in capital
surplus, and Retained Earnings. If ownership is one individual or several
partners (single proprietorship or partnership), the Equity account is simply
stated as the name(s) of the proprietor or partners, followed by, the term

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 "capital" such as "De la Cruz and Pedro Capital."

E. FINANCIAL ANALYSIS

This aspect of the financial study evaluates the project's profitability,

liquidity, cash solvency, and growth over time. It should be noted that the
functions elaborated below are meaningful only when compared with other
functions of the same type computed in one-year intervals. Charts and other
illustrative devices may be used to present the analysis more effectively.

1. Tests of liquidity - These financial measures are used to determine a

firm's ability to meet short-term obligations, and to remain solvent
during hard times. They include:

a. Current ratio = (Current assets)/(Current liabilities)

b. Quick or acid-test ratio= (Current assets -inventories)/(Current

liabilities)

c. Liquidity of inventories = (Cost of sales)/ Average inventory

d. Defensive position= (Cash+ marketable securities +

receivables)/(projected operating expenditure/number of days)

2. Tests of debt-service - These ratios are used to test the project's ability
to meet long-term obligations.

a. Debt-to-net worth ratio = (Total liabilities)/(Total equities)

b. Total capitalization ratio= (Long-term liabilities)/(Long-term liabilities

and equities)

3. Tests of profitability - These show the operational performance and

efficiency of the project.

a. Net profit margin= (Net income after tax)/Sales

b. Operating profit margin= (Profit before interest and taxes)/Sales

c. Gross profit margin = (Gross profit)/ Sales

d. Return on financier's investment= (Net income + Interest)/(Stock

equity and long term liability)

e. Return on Owner’s investment = Net income/Stock equity

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 f. Return on common stock equity = (Net income- preferred stock
dividends)/(net worth – par value of preferred stock)

g. Return on net operating profit = (profit before interest and taxes)/(total

tangible assets)

h. Asset turnover = (Sales)/(total tangible assets)

i. Return on assets, or earning power = (Net income)/(total tangible

assets)

4. Test of total debt coverage = (Profit before interest and taxes)/(Interest +

principal payments)

5. Funds-flow analysis – this technique is employed to determine the major

uses and sources of funds within one year in a project’s life

a. Cash-flow analysis
1. Sources of Funds:
a) Net decrease in any asset other than cash
b) Net increase in any liability
c) Proceeds from the sale of stocks
d) Funds provided by operations
2. Uses of funds
a) Net increase in any asset other than cash and fixed assets
b) Gross increase in fixed assets
c) Net decrease in any liability
d) A retirement of stock
e) Cash dividends
b. Working capital flow analysis

1. Sources of funds
a) Net decrease in any asset other than current assets
b) Net increase in long-term liabilities
c) Proceeds from the sale of stock
d) Funds provided by operations

2. Uses of funds

a) Net increase in other assets

b) Gross increase in fixed assets
c) Net decrease in long-term liabilities
d) Retirement of stock
e) Cash dividends

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 6. Tests of operating leverage – These functions indicate how the project
employs assets for which it pays a fixed cost. Before these tests are
applied, a clarification should be made on what “variable” and “fixed”
costs are.

Generally, “fixed” costs are expenses which affect net income despite the
fact that they are incurred by the company irrespective of the production
volume.

A firm is charged with its fixed costs whether it produces goods or not.
Usually entered under this type of costs are depreciation charges on
machinery, equipment, buildings and land improvement; he amortization
cost of prepaid expenses, deferred charges, and intangible assets; real
estate taxes; fixed assets insurance; general and administrative salaries,
wages and fringe benefits; research and development; donations, office
supplies; administrative heat, light and power; and borrowing costs.

On the other hand, “variable’ costs vary more or less directly with
changes in production volume such as direct materials, indirect materials,
direct labor, heat and power requirements od production machinery,
maintenance of factory machinery, supplies for manufacturing,
engineering costs associated with unit output, etc.

It should be noted that cost accounts cannot always be pre-determined

“per se” as either “variable or fixed”, since their classification depends a lot
on the company’s situation.

Thus, water supply is either a fixed or a variable cost depending upon

whether it varies directly with production volume or not. If water is a main
component of a product to be manufactured such as soft drink, it is a
variable cost to the extent that it is not incurred when no goods are
produced.

The same account however, is a fixed cost if it is allocated to a manager’s

office, since office utilities generally do not affect the production rate.

a. Break-even volume analysis

BEV = Fixed costs/(selling price-variable cost/unit)

b. Break-even cash analysis

BEC = (Cash Fixed Costs)//(Selling price-cash variable

cost)/unit

c. Break-even selling price analysis

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 BESP = (Variable costs + Fixed costs)/Unit volume
= (Total Cost/Sales) * Selling price

d. Break-even sales analysis

BES = BESP * Unit Volume

= (Fixed Cost)/1-(Variable cost/net sales)

7. Tests of Financial Leverage – these techniques present how a project

employs funds which pay a fixed return.

a. Earnings per share = (Net income)/Shares

b. Dividends per share = (Net income-preferred stock

dividends-retained earnings)/common share

8. Tests of Capital Investment – these financial tools evaluate the

justification for investing in the project

a. Average rate of return = (Average Net income)/(Average net

investment)

b. Payback period in years = (Initial-year cash outflow)/(succeeding

annual net cash flow)

c. Capital recovery or cash pay-off period in years = (stocks)/(Annual

cash dividends)

F. DECISION CRITERIA

The Net Present Value can be expressed as follows:

After reviewing all three financial statements, the Income statement, the Cash
Flow Statement, and the Balance Sheet, the prospective investor must now
decide if the project is feasible or not. If the project's Cash Flow Statement
shows positive cash flows, this is a good indicator that the project is acceptable.

However, the smart investors would want to compute a project's Payback Period,
Net Present Value, Internal Rate of Return, and Cost-Benefit Analysis before
they finally decide to go on with the project or not.

a. PaybackPeriod

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The Payback Period is a capital-budgeting decision criterion that is defined as the
number of years required to recover the initial cash investment. It generally
measures how quickly the project will return one's investments. The investor will
go ahead with the project IF it will return investment on or before the required
payback period. The time period required by the investor is based on the
industry's performance.

b. Net Present Value

The Net Present Value (NPV) criterion is a decision tool which is most favored
in business. There are three reasons why the NPV is widely used in almost all
industries:

• It deals with cash flows and not accounting profits

• It considers the time value of money and allows comparison of the benefits
and costs in a logical manner

• It uses a hurdle rate that is acceptable to the investor and would increase the
value of the firm if NPV were positive.

The Net Present Value can be expressed as follows:

n
ACF t
NPV =∑ - IO
t=1 (1+k )'

Where:

ACFt = the annual after-tax cash flow in time period t

k = hurdle rate; discount rate; required rate of return of the investor

IO = initial outlay (initial cash outlay necessary to purchase assets to put the
business
into an operating manner)
n = the project's expected life

Initial Outlay includes the after-tax cash flows such as:

 Cost of purchase of the asset plus the shipping/ transportation and installation
expenses

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 Working capital requirements (normally equal to one or two months of cash
outflow from operations which includes additional inventory, cash on hand,
and overhead expenses)
 In a decision to replace an old asset, the after-tax cash flows associated with
the sale of the old asset The project's net present value is an indicator of the
net value (the difference of the summation of the present value of the cash
flows and the initial outlay) of an investment proposal in terms of today's
peso. Whenever the NPV is greater than or equal to zero, the project should
be accepted; and rejected, if the NPV is negative.

The project's net present value is an indicator of the net value (the difference
of the summation of the present value of the cash flows and the initial outlay) of
an investment proposal in terms of today's peso. Whenever the NPV is greater
than or equal to zero, the project should be accepted; and rejected, if the NPV is
negative.

Steps to compute NPV manually:

1. Determine the after-tax cash flows of the project.

2. Determine the hurdle rate or the discount rate acceptable to the investor.
3. Multiply the after-tax cash flows with the present value factor at the given
hurdle rate.
4. Get the product for each year and the sum of the present value of cash flows.
5. The amount of the initial outlay is then deducted from the sum of the present
value of cash flows.
c. Benefit I Cost Analysis (Profitability Index)

The Benefit I Cost Analysis or the Profitability Index (PI) is a tool for measuring
the ratio of the present value of the future cash flows to its initial cost. Using this
tool will allow the investor to accept the project if the ratio is greater than or
equal to one and reject if the index is zero or less than one. It can be expressed
as’
n
AC F
∑ (1+ k )tt
t =1
PI =
IO

Where:

ACFt = the annual after-tax cash flow in time period t

k = discount rate; required rate of return

IO = initial outlay
n = the project's expected life

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In most cases, when net present value results in an accept decision, net cash flow
is greater than its initial cash outlay. This would also be the decision given by the
benefit/cost analysis, as the value of the numerator (present value of net cash
flows) is greater than its denominator (initial outlay).

d. Internal Rate of Return

The Internal Rate of Return (IRR) is the fourth decision criterion used in
determining the viability of a project. This process of measurement attempts to
answer the question: What rate of return does this project earn? Given the
internal rate of return of a project based on the computation, the investor can
immediately compare his required rate of return, which is normally based on the
current market standards, and decide whether it is beneficial to pursue the project
or not. Normally, an investor would accept the project only if the internal rate of
return is equal to or greater than his required rate of return.

Mathematically, the internal rate of return is defined as the value of IRR in the
equation below:

Where:

ACFt = the annual after-tax cash flow in time period t

IO = initial cash outlay
n = the project's expected life
IRR = the project’s internal rate of return

The challenge in this equation is to find the rate of return or the discount rate that
will equate the present value of the project's future net cash flows with the
project's initial cash outlay. Solving for IRR is quite easy using a financial
calculator or spreadsheet. In any case, the IRR can be computed manually as
follows:

1. Assign an arbitrary rate (make an assumption for the discount rate)

2. Use the arbitrary rate to discount the after-tax cash flows of the project to
present value
3. Get the sum of all the present values of thefuturecash flows

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 4. If the sum of the present values of the future cash flows is equal to the
initial outlay, then the arbitrary rate is the IRR;
5. Otherwise, the analyst must assign another arbitrary rate, and then repeat
steps 2-4 until equal values are computed.

Exhibit 3 shows the application of internal rate of return to the case model: Casa
Fernandina.

G. OTHER APPROACHES IN EVALUATING PROJECT RISKS

Simulation

Simulation is the process of evaluating the performance of the project in different

scenarios. This is sometimes called 'scenario analysis', which identifies the range
of possible outcomes under the worst, best, and most likely case. In simulation,
one randomly selects and combines all the values from the different factors that
affect the NPV and IRR of the project such as the following:

 Market size
 Selling price
 Fixed costs
 Market growth rate
 Investment required
 Residual value of investment
 Share of market
 Operating costs
 Useful life of facilities

Sensitivity Analysis

Sensitivity analysis is similar to simulation in determining how the distribution

of possible net present values and internal rates of return for a particular project
is affected by a change in one particular variable from the factors listed above. It
is the most commonly used process of evaluation other than the net present
value, internal rate of return, payback period, and benefit/ cost analysis. This
analysis requires changing one variable while holding all other variables
constant. The distribution of possible net present values and internal rates of
return that is generated is then compared with the distribution of possible returns
generated before the change was made. For some, this analysis is also called the
'What if?' analysis. See Exhibit 4 for an example of a Break-even and Sensitivity
Analysis as applied to the financial condition of the case model, Casa
Fernandina.

Probability Tree

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The probability tree is a graphic illustration of the sequence of possible
outcomes. It presents the decision maker with a schematic representation of the
problem in which all possible outcomes are accounted for. The computations and
results of the computations are shown directly on the tree, giving a clear picture
of the different scenarios.

H. WITH OR WITHOUT A PROJECT ANALYSIS

The 'With or Without a Project' analysis (WP and WOP) is used

to compare two scenarios, one in which a project is initiated
with another where no project is undertaken. The technique can
be used for the following:
 A new project
 Rehabilitation I Modernization project
 Loss prevention project
 Improvement I rehabilitation project

In a new project scenario, the investor is not involved in any

business and this is the first time that he or she would be
putting money in a project. Therefore, the investor will receive
an additional benefit, given that the project has been assessed to
be acceptable using the decision criteria. Figure 4 illustrates this
scenario:

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In a Rehabilitation/Modernization project scenario, an existing business is doing
well except that, to keep up with competition, it has to undertake some
modernization and/or rehabilitation.

Normally, the business is doing well but with competition the growth of the
business is hampered. This then calls for some modernization to stay competitive
or even ahead of the competitors. The rehabilitation I modernization project is
best illustrated in Figure 5.

In the case of a Loss Prevention Project scenario, a particular business may be

suffering losses over a period of time due to an economic crisis and other factors.
Its owners may consider looking for projects to prevent further losses and
possibly help recover past losses. See Figure 6.

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Finally, an Improvement Project scenario exists when a firm that has been
experiencing poor business initiates a project that will help improve the
performance of the ailing company, and where foregoing such a project will
mean certain bankruptcy for the business.

SUGGESTED FORMAT FOR A FINANCIAL STUDY REPORT

I. Presentation of Major Assumptions

II. Summary of ProjectCost
III. Sources of Financing the Project

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IV. Financial Statements
 Financial Analysis
 Decision Criterion (Computation of Net Present Value, Payback Period,
Internal rate of Return, Benefit-Cost Analysis)
 Sensitivity Analysis
VIII. Analysis of' With and Without a Project'

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