Chapter-4

Chapter-4
Project Evaluation and Analysis
Dr. Andualem Ufo Baza

Assistant Professor
International Leadership Institute
E-mail: bazzafin.au@gmail.com
Mobile: +251-9 11 60 35
Copyright © 2011 The McGraw-Hill Companies, All Rights Reserved.

17–1
COMPONENTS OF FEASIBILITY
STUDIES
–Market and Demand Analysis

–Technical Analysis
– Financial Analysis
– Project Risk Analysis
– Social Cost-Benefit Analysis
– Investment Criteria analysis
4.1.MARKET/DEMAND ANALYSIS
Market/demand analysis: meaning & purposes

– Market: any set of individuals, households, or
organizations with potential/actual demand to be
satisfied.
– Demand: the ability as well as willingness to acquire
and use something (goods/services) of value.
4.1. MARKET/DEMAND ANALYSIS
Market and demand analysis involves and focuses on

– a process of assessing the level of demand for the product or
service to be produced by the project.
– determining the marketability of the product or the service of
the project under consideration.
– the market and demand determining factors and environment to
decide if there is market/demand potential for the project
alternative.
– Using different techniques of demand forecasting and analysis
in assessing the availability and level of demand.
4
Major Dimensions of Market/Demand Analysis

+ Planning
• General Indicators of the Economy
• Product
• Demand
• Supply
• Marketing Environment
• Marketing mix/Strategy
Process of Market and Demand Analysis
Process of Market and Demand Analysis + Planning

are:
• Situational analysis and specification of objectives
• Collection of secondary information
• Conduct of market survey (primary information)
• Characterization of the market
• Demand forecasting
• Market planning
6
Collection of
Demand
secondary
Information
Forecasting
Situational
Analysis and Characterization
Specification of of the market
Objectives
Conduct of
Marketing
Market
Survey
Planning
Key steps in a Market and Demand Analysis and their relationships

Step1: Situational Analysis and Specification of

Objectives
– It is where the project analyst may informally talk to
customers, competitors, middlemen, and others in the
industry
Purpose
– to get a "feel" for the relationship between the
product and its market.
– to answer the following questions:
• Who are the buyers of the product?
Purposes of situation analysis…
– What is the total current demand for the product?
– How is the demand distributed temporarily (pattern of
sales over the year) and geographically?
– What price will the customers be willing to pay for the
improvement in the product?
– How can potential customers be convinced about the
superiority of the new product?
– What channels of distribution are most suited for the
product? What trade margins will induce distributors to
carry it?
– What are the prospects immediate sales?
9
Step 2: Collection of Secondary Information

General/Major Source of Secondary Information
»National Census reports
»National sample survey report
»Economic survey
»Annual survey of industry
»Industry potential survey
Evaluation of Secondary Information
– Who gathered the information and What was the

objective?
– When was the information gathered? When was it
published?
– How representative was the period for which the
information was gathered?
– Have the terms in the study been carefully and
unambiguously defined?
– What was the target population?
11
Evaluation of Secondary Information
– How was the sample chosen? How representative

was the sample?
– How satisfactory was the process of information
gathering?
– What was the degree of misrepresentation by
respondents?
– How accurately was the information edited,
tabulated and analyzed?
– Was statistical analysis properly applied?
12
Step 3: Conduct of Market Survey

Focus points
Total demand and rate of growth of demand
Demand in different segments of the market
Income and price elasticity's of demand
Motives for buying
Purchasing plans and intentions
Satisfaction with existing products
Unsatisfied needs
Attitudes towards various products
Distributive trade practice & preferences
Socio-economic characteristics of buyers

Steps in market Survey
Define the target population
Develop the questionnaires (data collection
instruments)
Recruit and train field investigators
Obtain information as per the questionnaire
from the sample of respondents
Scrutinize the information Gathered
Analyze and interpret the information
Report the findings
14
Step 4: Characterization of the Market

– Based on the information gathered from secondary sources
and through the market survey, the market of the
product/service may be described in terms of the following:
• Effective demand in the past and present
• Breakdown of demand
• Price
• Methods of distribution and sales promotion
• Consumers
• Supply and competition
• Government policy

Step 5: Demand/Sales Forecasting
techniques/methods
I. Qualitative methods/techniques of forecasting
a. Expert opinion method
b. Delphi method
II. Quantitative techniques of forecasting
1. Time series analysis techniques
a. Moving average method/techniques
i. Simple moving average technique
ii. Weighted moving average technique
b. Exponential smoothing method
c. Trend projection method
2. Causal Methods
a. Regression analysis
b. Consumption Level Method
Income Elasticity of Demand
Price Elasticity of Demand
I. Qualitative Methods/Techiniques of
forecasting
A. Expert opinion Method: is soliciting the
opinions of group of managers on expected future
sales and combining them into a sales estimate.
B. Delphi Method: is used for eliciting the
opinions of a group of experts with the help of a
mail survey. On this method for a group of experts
the questionnaires are sent by mail & ask to
express their views. The process continue for one
or more times until a reasonable agreement
emerges.
1. Time series analysis techniques

a. Moving average method/techniques
i. Simple moving average technique
Ft = di
n
ii. Weighted moving average technique
Ft= W1(Ft-1)+W2(Ft-2)+………………Wn(Ft-n)
b. Exponential smoothing method
Ft = Ft-1 + α (At-1 - Ft-1)
c. Trend projection method
Y= a + bx
Year Demand
1 200,000
2 250,000
3 300,000
4 350,000
5 250,000
Required:
A. Simple Moving Average Method:
i. Forecast demand for year six using the simple moving average of
the recent three years.
Solution: Ft = di
n
F6 = 300,000+350,000+250,000
3
= 300,000 tons of cement shall be demanded
B. Weighted Moving Average Method:
ii. Assume that a weight of 0.5 has been assigned for the most
recent data followed by weights of 0.3 and 0.2 for the next recent
figures. Demand for year 6 is? (use: weighted moving average techiniques).
Solution: Ft= W1(Ft-1)+W2(Ft-2)+………………Wn(Ft-n)
F6 = 0.5(250,000)+0.3(350,000)+0.2(300,000)
= 125,000+105,000+60,000
= 290,000 tons is the forecasted demand
C. Exponential Smoothing Method:

iii. Assuming that demand forecasted for year 5 for the product was 400,000 tons.
Assuming further that the value of smoothing constant (α) is 0.50, what is
demand forecast for year 6? (exponential Smoothing method).
Solution
F t = Ft-1 + (At -1- Ft-1)
F6 = 400,000+ 0.5(250,000 – 400,000)
F6 = 400,000+0.5(- 150,000)
F6 = 400,000+(- 75,000)
= 325,000 tons is the forecasted demand for year 6
D. Trend Projection Method:
iv. Forecast sales for the next year using the trend projection technique.
Solution: Y= a + bx
b= 20,000 a= 190,000
y= 190,000 + 20,000x
F6= 190,000 + 20,000(6)
= 310,000 tons
2. Causal Methods
A. Regression Analysis
• Regression analysis is a causal forecasting model, which
usually considers several variables that are related to
the variable being predicted.
• Regression analysis uses the least squares approach on
one or more independent variables to develop a
forecasting model.
• Assume that triple construction Company renovates
old homes in Albany. Overtime, the company has found
that their dollar volume of renovation work is
dependent on the Albany area payroll. The figures for
Triple A’s revenues and the amount of money earned by
wage earners in Albany for the years 1982-87 are
presented below.
2. Causal Methods
Regression Analysis
i. What are the values of a & b using least
square regression analysis? Y = a + bx
Y X
Year [Triple A’s Sales ] [Local payroll]
(100.000’s) (100,000,000’s)
1982 2.0 1
1983 3.0 3
1984 2.5 4
1985 2.0 2
1986 2.0 1
197 3.5 7
Regression Analysis
Sales Payroll
x2 XY Y2
(Y) ( x2)
2.0 1 1 2.0 4.0
3.0 3 9 9.0 9.0
2.5 4 16 10.0 6.25
2.0 2 4 4.0 4.0
3.5 7 49 24.5 12.25
X = ∑x = 18/6 =3 ( see previous table).

N
Y= ∑y = 15/6=2.5 (see previous table).
N
b = ∑xy - nxy = 51.5-(6(3)(2.5)) = 51.5- 45= 6.5 = 0.25
∑x2 – nx2 80 – 6(9) 26 26
a= y-bx = 2.5 – 0.25(3) = 1.75
Therefore, the estimated regression equation is :
Y= 1.75 + 0.25x [ i.e., Sales = 1.75 + 0.25(payroll)]
Regression Analysis
Thus, following is the five years(1988-1992) sales

projection.
Year Payroll(P),where Sales(y) ,where
P=3+0.63t Y=1.75+0.25payroll
(Forecasted using Trend Analysis) (100,000’s)
(100,000,000’s)
1988 5 3
1989 6 3.25
1990 7 3.5
1991 7 3.5
1992 8 3.75
B. Consumption Level Method
Step 6: Market Planning

i. Analysis of Current marketing situation
ii. Opportunity and issues analysis
ii. Specification of Marketing Objectives
iii. Marketing Mix Strategies
• Product management strategy/ customer value
• Pricing management strategy/ customer costs
• Place (Distribution) management strategy /customer convenience
• Promotion management strategy/customer communication
iv. Developing Action Plan and Programme
Step 6: Market Planning

i. Analysis of Current marketing situation
− Examine the market situation, competitive situation, distribution
situation and the macro environment.
− The market situation deals with the size, growth, consumer
aspiration and the buying behaviour in the market under
considération.
− Competitive situation deals with the major competitors, their
objectives, strategies, strengths, etc. Basically, the market share.
− Distribution situation deals with comparision of capabilities of
competitors.
− The macro environments deals with the effect of social, political,
economic, technological and other external variables on the market.
For example: when there is an economic downturn, consumption
moves towards low priced items.
ii. Opportunity and issues analysis: deals with the SWOT( strength,
Weakness, Opportunity and Threats) be conducetd for the company
and core issues should be identified.
ii. Specification of Marketing Objectives
− The objectives should be specific, clear-cut, and achievable.
For example:
− achieve the breakeven in three years for the company.
− Attain sales of $20million in first year, $80million in second year
and $120million in third year.
− Achieve a top-of-mind recognition of 75percent in target segment
for the company in the first year and 90percent in the second.
iii. Marketing Mix Strategies
• Product management strategy
• Pricing management strategy
• Place (Distribution) management strategy
• Promotion management strategy
iv. Developing Action Plan and Programme
Action plan and programme operationalize the strategy.
The following steps give an idea of how the company like to roll out its
marketing plan in the next one year.
Quarter 1: company should attain a top-of-mind awareness of 60 percent
in target segment. This is done by spending 60 percent of company’s
advertising budget on unconventional media and the rest on conventional
media. Company shall reach 100,000 outlets by ensuring all outlets that
currently stock X, stock Y also.
Quarter 2: Company shall reach 200,000 retail outlets. This means
doubling the number of outlets stocking X.
Quarter 3: Company shall reach 300,00 retail outlets. The aggressive
derive for distribution started in the second quarter shall be continued.
Top- of-mind awareness shall reach 75 percent.
Quarter 4: Company shall consolidate its postion in 300,000 outlets. Dip-
stick tests to be conducted on consumer preferences to determine
whether the strategies adopted have been successful.
4.2. TECHNICAL ANALYSIS
General framework
– After gathering and analyzing information on market and
demand and determining the market feasibility of the project
, we need to conduct technical analysis concerned primarily
with:
»Materials inputs and utilities
»Product mix
»Plant capacity
»Location site
»Machinery and equipment
»Structure and civil work
»Project chart and layouts
»Work schedule
I. Raw material and Supplies Study

Importance
– Materials and supplies are the major inputs (ingredients) of any
project
– Some (raw materials and supplies) will be incorporated in the
finished product as tangible and visible items.
– There is a closer relationship between the definition of input
requirements and other aspects of the project formulation, such
as the definition of plant capacity, location, and selection of
technology and equipment.
Issues to be raised in relation to materials analysis:
» What types of materials are needed?
» Where are the sources of the materials and supplies?
» How the materials and supplies are obtained?
» What are the costs of each material?
» What environmental factors should be considered?

1. Classification of Raw Materials and Supplies

A. Unprocessed and semi-processed raw materials
• Livestock and forest products
• Agricultural products
• Marine products
• Mineral products
B. Processed industrial materials and components
• Base metals
• Semi processed material
• Manufactured parts, components and sub-assemblies
C. Auxiliary materials factory supplies
• Packaging materials, containers and crates
• Other supplies
• Recycled waste
D. Utilities
• Electricity, Fuel, and Water
E. Spare parts
F. Supplies for social and external needs
2. Specification of Requirements
Why specification of material requirements?
– It is the basis for the assessment and analysis of the availability of
the project inputs.
– only when the detailed specifications of the inputs available are
known, the final engineering design of the project can be prepared.
– It describes and analyzes features and characteristics in such a way
that a good understanding of what the project requires is developed.
– It will form the basis for the supply program and the subsequent
cost estimates. The supply program and cost estimates may be known
as bill of materials (BOM) in production/operations management.
Factors Considered
» Technical factors
» Commercial and financial factors
» Socio-economic factors
3. Availability and Supply
i. Availability and sources of materials
issues to be precisely determined:
– Materials and inputs available from local sources: location and
area of supplies, concentrated or dispersed, alternative uses,
transportability and transport costs.
– Materials and inputs to be imported: sources, foreign exchange
restrictions, reliability of supplies and uncertainty that relate to the
import etc.
ii. Supply Marketing and Supply Programs
a. Supply Marketing
– Objectives are cost minimization, risk minimization, and cultivation of
relations with supplier.
b. Supply Programme
– should deal with the following:
» Identification of supply sources and suppliers, Agreements and
regulations, Quantities and qualities, Consignments, Means of
transport, Storage, Risk assessment
c. Considerations in selecting supplier/s
– location
– ownership
– main activities
– financial strength and profitability
– production capacity, output over last years
– key customers and business experience
d. the supply program shall indicate the following clearly
– The quantities and qualities that can be supplied from various
sources (in comparison with the specified requirements in terms of
all relevant factors)
– Means of transport for key materials and inputs such as by air,
water, road, or rail including their availability, capacity, reliability
and technical condition
– Loading, unloading, and storage facilities at the ports as well as at
the plant
4. Cost of Raw Materials and Parts
Objective
• to estimate the current and projected prices of materials and inputs in
the context of past trends and future prospects for both locally
available and imported items.
i. Unit costs
• Domestic materials costs: are projected set in the context of past
trends and future projections of the elasticity of supply.
• Imported material inputs: CIF (cost, insurance, and freight) should be
adopted with clearing charges such as loading, unloading, port charges,
tariffs, local insurance and taxes, and costs of internal transport to the
plant.
ii. Annual costs
• cost estimates should be associated to a hypothetical level of production
and capacity utilization levels
• A distinction should be made between materials and inputs to be
purchased and those actually to be consumed in a particular year the
difference being stocked.
• calculating indirect costs should be established per unit of production or
per accounting period whichever is appropriate.
• material and input requirements of other project components (service,
administration, and sales) should also be considered.
39
II. PRODUCT MIX
Product Mix Decisions
– The breadth of the product line/s being managed
currently
– The depth of the product line/s being managed currently
– The number of product line/s being managed currently
Project Analysis & Initiation Vs Product Mix Options
»Expansion
»Contraction
»Differentiation
»Trading up vs trading down
»Substitution
III. PROJECT CAPACITY AND PRODUCTION PROGRAM

A. Project/Plant Capacity
• the volume or number of units that can be produced during a
given period. This definition implies the output expectation
from the production of a plant.
Capacity Decision Factors
»Technological Requirement
»Input constraints
»Investment cost
»Market conditions
»Resources of the firm
»Government policy
Capacity Decision Levels/Terms

I. Nominal Maximum Capacity (NMC)
• Is the technically feasible capacity, frequently corresponds to the installed
capacity as guaranteed by the supplier of the plant and includes reserve
and stand-by capacity.
II. Feasible Normal Capacity

• is achievable under normal working conditions taking into account the
installed equipment and technical conditions of the plant, such as Normal
stoppages, Downtime, Maintenance, Tool checks, Desired shift patterns,
Indivisibilities of major machines and the management system.
Determination of the Feasible Normal Plant Capacity

» Economies of Scale
» Minimum Economic Size and Equipment Constraints
B. Production Program
 It should define the levels of output to be achieved during specified
periods and, from this viewpoint, should be directly related to the
specific sales forecasts.
Functions
(1) indicates the basic products, by – products, and wastes during the
process.
(2) Plans changes in time during project life.
(3) Plans/determines extraction rates and operating ratios effectively
and adequately
(4) Once a production program defines the levels of outputs in terms of
end product, and possibly of intermediate products and the operating
ratio between various production lines and processes, the specific
requirements of materials and labor should be qualified for each stage.
(5)The specific quantities needed for each stage of the production
program and costs that these entail should be determined. The input
requirements and costs have to be assessed for:
Basic materials such as raw materials, semi – process, bought –
out items
Auxiliary materials and factory supplies
Major utilities and
Direct labour requirements
IV. LOCATION AND SITE ANALYSIS AND SELECTION
Basic Considerations in Location and Site Selection:
 The choice of location should be made from a fairly wide geographic
area, within which several alternative sites can be considered.
 An appropriate location could extend over a considerable area, such as
along a river bank or 15 kilometer radices around an urban area in a
particular geographic district.
 Within a recommended location, one or more specific project sites
should be identified and assessed in detail.
 For each project alternative, the environmental impact of erecting and
operating the industrial plant should be assessed.
 The main criteria or key requirements for selecting proper location
and sites should always be identified at an early stage of the study.
The qualitative analysis of these key requirements would then allow
the assessment of a number of potential locations and site, and the
rejection of those not fulfilling the key requirements.
 The remaining alternatives are then subject to a more in depth
qualitative and quantitative analysis of technical and financial criteria ,
including social, environmental, and economic aspects of location and
site selection.
44
Location Analysis
– The strategic orientation of the choice of suitable locations
requires an assessment of
– Market and marketing aspects
– The availability of critical project inputs, such as raw
materials and factory supplies
– Technical project requirements
– The type of industry
– Technology and process
– Characteristics of products and outputs
– Size of the plant
– Organizational requirements and management structure
45
Location selection factors
i. Proximity to Raw Materials and Market
• A resource based project like a cement factory or still mill should be
located close to the source of basic materials;
• A product based on imported materials may be located near the port;
and
• A project manufacturing a perishable product should be close to the
center of consumption.
ii. Availability of Infrastructure
• Availability of electric power, transportation, water, and
communications should be carefully assessed before a location decision
is made.
iii. Government Policies
• Government policies have a bearing on location.
• In the case of public sectors projects, location is directly decided by
the government.
• There are also some private sector projects on which government
makes subsidies.
Choice of Site
selection factors
• Ecological conditions of sites
• Environmental impacts
• Socio–economic conditions (restrictions, incentives,
requirements)
• Costs of land
• Infrastructure
• Site preparation and development costs
• Strategy of the projects such as future expansion
• Cost of utility lines extension
• Size and shape of the available area
• Nature of goods (products) produced (perishables or no)
• Proximity of centers of consumption (market orientation
• Distance to seaport (import and export)
V. TECHNOLOGY/ENGINEERING (Analysis & Selection)
Focuses on (involves)
• The selection of an appropriate technology, and
• Planning of the acquisition and absorption of this technology
and the corresponding know – how.
a. Engineering analysis and design
– Is responsible to design the functional and physical layout for the
industrial plant necessary to produce the defined output and to
determine the corresponding investment expenditures as well as
the costs arising during the operational phase.
– The scope of engineering also includes
• Infrastructure
• Factory and other buildings and civil works
• Their inter relationship with utilities, material flows, machinery
installations
• Other aspects of plant construction and operations.
b. Technology Choice
considerations
– Plant capacity
– Principal inputs
– Investment outlay and production cost
– Use by other units
– Product mix
– Latest developments
– Ease of absorption
d. Technology Acquisition and Transfer

It involves:
i. Securing Industrial Property Rights

 considering patents, trade marks, copyright and proprietary
technology or be in the form of un-patented know – how that
is available from only a limited number of sources.
ii. Selecting Means of Technology acquisition and transfer
options
 Technology licensing
 Outright purchase of technology,
 A joint venture involving participation in ownership
by the technology supplier
iii. Specifying Contract Terms and Conditions
VI. Detailed Plant Layout analysis and planning
 Once data is available on the principal dimension of the project’s
market size, plant capacity, production technology, machineries, and
equipments, building and civil works, conditions at plant site and
supply of inputs to the project, then Project charts and layouts may
be prepared.
 These define the scope of the project and provide the basis for
detailed project engineering and estimation of investment and
production costs.
 The plant layout is concerned with the physical layout of factory. In
process industries, the plant layout is dictated by the production
process adopted, while in manufacturing industries, however, there
is much greater flexibility in defining the plant layout.
 The important considerations in preparing the plant layout are:
 Consistency with production technology
 Smooth flow of goods from one stage to another
 Proper utilization of space
 Scope of expansion
 Minimization of production cost
 Safety of personnel.
4.3. Financial Analysis
• Components of Financial Analysis:

– Cost of project
– Means of finance
– Cost of Production
– Projected income statement
– Projected Balance sheet
– Projected cash flow statement
4.3. Financial Analysis
–seeks to ascertain whether the proposed
project will be financially viable in the sense
of being able to meet the burden of
servicing debt and whether the proposed
project will satisfy the return expectations
of those who provide the equity capital.
Cost of project
Analysis and planning of cost of the project

Investment Costs
• represents the total of all items of outlay
associated with a project, which are
supported by long term funds.
• It is the sum of the outlays discussed below:
– Land and Site Development – includes
– Building and Civil Works
– Plant and Machinery
– Miscellaneous Fixed Assets
– Preliminary and Capital Issue Expense
– Pre - Operative Expense
– Provision of Contingencies
Means of finance
Analysis and planning of means/sources of

financing a project
A. sources/means of financing project
i. Share capital
– is a means of generating capital from potential
investors through the sale of shares/representation of
ownership rights.
– Equity capital: refers to contribution made by
owners of the business, equity shareholders who
bears risk and enjoys reward on ownership.
– Preferred capital: refers to the contribution
made by preference shareholders and the dividend
paid on it is generally fixed.
Means of finance
ii. Term loan

– provided by financial institutions and commercial
bank’s credit facilities.
»Secured loan
»Unsecured loan
iii. Debenture capital
– similar to that of the promissory note, which is a
promise to pay some day in the future, debentures
are instruments for raising debts capital. Such as
issuing bond, which is long term financing.
Means of finance
iv. Deferred credit

– often suppliers of plant and machinery offer a deferred
credit facility under which payment for the purchase of
plant and machinery can be made over a long period.
v. Incentive source: financial assistance from the
government & its agencies for promoter.
Example: Seed capital assistance, tax deferment, tax
exemptions, etc.
vi. Miscellaneous sources: a small portion of finance
comes from this sources for project.
Example: unsecured loans, public deposit, lease and hire
purchase finance.
Means of finance
Selecting the project financing means

– Guide lines that should be born in mind are:
i. Norms of regulatory bodies and Financial
Institutions.
• In many countries including Ethiopia, the
proposed means of financing for a project must
be either approved by a regulatory body or
conform to a certain norms laid down by the
government or financial institutions in this
regard.
Means of finance
ii. Key business considerations.

• Cost – cost of debt is lower than cost of equity.
• risk – two main types of risks. Business risk and
financial risks. Business risk is caused by
variability of return and financial risk is caused
by raising of leverage.
• Control- controlling the project financing cost
is fundamental from promoters point of view
• Flexibility- ability of firms to raise additional
capital to meet financing needs is fundamental.
Cost of production
Production Costs
• categories
i. Direct material costs:
• cover those materials directly involved in the
production/operational process of the project
and includes costs of acquiring raw materials and
processed materials.
ii. Direct labour costs:
• are costs incurred to mobilize labour to direct
operational activities and are determined as
periodic salaries/wages.
Cost of production
iii. Indirect material and labour costs:

• address those materials and labour adopted in
supportive functions. Such costs are committed
to acquire accessories, establish power and IT
systems, storage and warehousing, mobilize
materials handling personnel, etc.
Overhead costs
– are classified as:
»Administrative overhead costs
»Marketing and sales overhead costs
»Factory overhead costs
»Service overhead costs
Analysis and projection of financial
statements
– To examine the project’s financial feasibility,
however, we need to analyze and project its
financial statements particularly the cash flow
statements whose accounts shall be initiated from
the balance sheet and income statements.
•
Projected income statement
Project A
Income statement
For the year n( in million dollar)
Sales 1600
- Cost of good sold 1200
- Depreciation 80
Profit before interest and tax 320
- Interest 80
Profit before tax 240
- Tax 120
Profit before tax (Net Income) 120
- Dividends 40
retained earning /surplus 80
Projected Balance sheet
The sources information for the cash flow statement are:
» balance sheet for the end of period n
» expected changes for the period n +1
» changes on the income statement for period n+1
Project A
Balance sheet
Dec. 31, year n( in million Dollar)
Assets Liabilities + capital
Fixed assets 720 secured loans 320
Investments unsecured loans 200
Current assets: Accounts payable 320
Cash 80 provisions 80
Receivables 320 share capital 400
Inventories 320 reserve and surpluses 80
Total $ 1,440 Total $ 1,440
Projected cash flow statement
– shows the movement of the firm and its net impact on
the cash balance with in the firm./project
– Analyzes and presents the future cash
movement of the project in relation to:
» Investment
» Operations
» Capital mobilization
• The following format provides us with a structure
to prepare a comprehensive cash flow statement.

Illustration: cash flow statement
i. Sources of funds (A) Disposition of funds (B)
– share issue 1. capital expenditures
– profit before taxation and interest 2. increase in working capital
– depreciation 3. decrease in loans
– reserves 4. repayment of debts
– New /increased loans 5. decrease in accounts payable
– increase in deposits 6. increase in investments
– increase in accounts payables 7. interest
– sale of fixed assets 8. taxation
– sale of investments 9. dividends
– sale of equity /shares 10. buy back of equity
Total of A Total of B
ii. Computing the ending balance of cash for a period
Opening balance of cash on hand for the period.
+ Net surplus /deficit (A-B)
= Closing (ending) balance of cash for the period
Expected commitments and changes for n+1
• Raising a secured term loan of $ 80
• Repaying a term loan of $20
• Depreciation $ 80
• Increasing un secured loan of $40
• Acquisition of fixed assets worth $ 120
• Increase in inventories $ 40 and accounts receivables $ 60
Project A
For period n+1
Sources of funds (A)
• Profit before interest and tax $320
• Depreciation 80
• Increase in secured loans 60
• Increase in unsecured loans 40
Total of (A) $500
Disposition of funds (B)
• Capital expenditure $ 120
• Increase in working capital 100
• Interest 80
• Taxation 120
• Dividends 40
Total of (B) $460
Opening balance of cash on hand $ 80

+ Net surplus/ deficit in period n+1 (A-B) 40
Closing balance of cash on hand for n+1 $ 120
Projected Balance sheet
Project A
Projected balance sheet
Dec. 31 period n+1
Assets opening balance Changes during n+1 closing balance
Fixed assets 720 +(120) - 80(depreciation) $ 760
Investments - - -
Current assets
Cash 80 +40 (net surplus) 120
Inventories 320 +40 (Expected increase) 360
Receivable 320 +60 (Expected increase) 380
Total $1,620
Liabilities Opening Changes during closing
And capital balance the period (n+1) balance
Secured loans br 320 +80 (term Loan)-20 (Repayment) $ 380
Unsecured loans 200 +40 (proposed increase) 240
Accounts payable 360 - 360
Provisions 80 - 80
Share capital 400 - 400
Reserves and surplus 80 + 80 (retained earnings) 160
Total $ 1,620

4.4. Project Risk Analysis
• Techiniques of Risk Analysis:

–Sensitivity Analysis
–Scenario Analysis
– Breakeven Analysis
–Corporate Risk analysis
–Market Risk analysis
Project Risk Analysis
• Risk is inherent in almost every business

decision.
• More so in capital budgeting decisions as they
involve cost and benefits extending over a long
period of time during which many things can
change in unanticipated ways.
• Analysis of risk is fundamental for the project.
Sources of risk
• There are several sources of risk in a project. The most
important are: project-specific risk, competitive risk, industry-
specific risk, market risk and international risk.
• Project-specific risk: the earnings and cash flow of project may
be lower than expected because of estimation error or due to
some other factors specific to the project like the quality of
management.
• Competitive risk: the earnings and cash flows of the project
may be affected by unanticipated actions of the competitors.
• Industry specific risk: unanticipated technological
developments and regulatory changes, that are specific to the
industry to which the project belongs, will have an impact on
the earnings and cash flows of the project as well.
Sources of risk
• Market risk: unanticipated changes in macroeconomic
factors like the GDP growth rate, interest rate, and inflation
rate have an impact on all projects, albeit in varying
degrees.
• International Risk: in the case of foreign project, the
earnings and cash flows may be different than the
expected due to the exchange rate risk or political risk.
Measures of Risk
• Risk refers to variability. It is complex and multi-faceted
phenomenon.
• A variety of measures have been used to capture different
facets of risk. The more important ones are: range,
standard deviation, coefficient of variation, and semi-
variance.
• To illustrate the calculation of these measures, consider the capital
investment whose NPV has the following distribution.
• The probability weighted NPV works out to:

Measures of Risk
^
NPV  Weigted Net Present value
^ n
NPV   NPVi Pi
i 1
^
NPV  (200) (0.3)  (600) (0.5)
 (900) (0.2)  540
• Now let us look various measures of risk.
• Range: is the simplest measure of risk, the range
of a distribution is the difference between the
highest and the lowest value. The range of the
above distribution is 900- 200 = 700.
Measures of Risk
• Standard Deviation: the standard deviation

measures the stand alone risk on project.
• a standard deviation of the distribution is:
n ^
 
i 1
(NPVi  NPV ) 2 Pi
1
(200 - 540) (0.3)  (600 - 540) (0.5) 
2 2 2
 NPV  
 (900 - 540) (0.2)
2

 NPV  249.8
Measures of Risk
• Variance: the variance of the distribution can be

calculated using the standard deviation.
• The square of standard deviation can measure
variance.
Variance   2  62,400
 2  62,400
• Therefore, the variance of the above distribution
is 62, 400.
Measures of Risk
• Coefficient of Variation(CV): the coefficient of

variation is the most precise measure of risk of
project. It can measure risk per unit of return.
Std dev 
CV   ^
Mean NPV
249.8
CV   0.46
540
• The coefficient of variation is 0.46.
Sensitivity Analysis
• What is sensitivity analysis?
• Since future is uncertain, you may like to know what
will happen to the viability of the project when some
variables like sales or investments deviates from its
expected value. It is also called “what if” analysis.
• Sensitivity analysis measures the effect of changes
in a variable on the project’s NPV.
• To perform a sensitivity analysis, all variables are
fixed at their expected values, except for the variable
in question which is allowed to fluctuate.
• Resulting changes in NPV are noted.
• To understand the nature of sensitivity analysis, let

us consider an example. Suppose you are the
financial manager of Naveen Flour Mills. Naveen is
considering setting up a new flour mill near New
York city. Based on Naveen's previous experience,
the project staff of Naveen has developed the
figures shown in the following table( Note that the
salvage value has been assumed to be nill and
cost of capital to be 12 percent.
Cash flow forecast for Naveen Flour Mill
Project
In thousand($)
Year 0 Years 1- 10
1. investment (20,000)
2. Sales 18,000
3. Variable cost(66.67% of sales 12,000
4. Fixed Costs 1,000
5. Depreciation 2,000
6. Pre-tax Profit 3,000
7. Taxes 1,000
8. Profit after taxes 2,000
9. Cash flow from Operations 4,000
10. Net Cash flows (20,000) 4,000
Project
• Since the cash flow from operation is annuity, the NPV of
the flour mill project is:
-20,000,000 + 4,000,000X,PVIFA(r=12%, n=10)
-20,000,000 + 4,000,000(5.650)
= 2,600,000
The NPV based on the expected values of underlying
variables is positive. You are, however, aware that the
underlying variables can vary widely and hence you would
like to explore the effect of such variation on NPV. So you
define the optimistic and pessimistic estimates for the
underlying variables. This are show in the table below. With
this information, you can calculate the NPV for the optimistic
and pessimistic values of each of the underlying variables.
Project
• To do this vary one variable at a time. For example, to study
the effect of an adverse variation in sales(from the expected
$18million to pessimistic $15million), you maintain the values
of the other underlying variables at their expected levels.
(This means that the investment is held at $20million,
variables costs as a proportion of sales are held at 66.67%,
fixed costs are held at $1million, so on and so forth).
• The NPV when the sales are at their pessimistic level and
other variables at their expected level is shown on the right
hand side of the table below.
• Like wise you can calculate the effect of variation in values of
underlying variables. The NPV for pessimistic, expected and
optimistic forecasts are shown on the right hand side
Sensitivity of NPV to variations in value of key
variables
Range NPV
Key variables Pessimistic Expected Optimistic Pessimistic Expected Optimistic
Investment ( in 24 20 18 -0.65 2.60 4.22
million $)
Sales ( in 15 18 21 -1.17 2.60 6.40
million $)
Variable costs( 70 66.66 65 0.34 2.60 3.73
as of % of
sales)
Fixed 1.3 1.0 0.8 1.47 2.60 3.33
Costs( in
million $)
• Evaluation: A very popular method for assessing

risk, sensitivity analysis has certain merits:
• It shows how robust or vulnerable a project is to
changes in values of underlying variables.
• It indicates where further work may be done. If the
NPV is highly sensitive to change in some factor,
it may be worthwhile to explore how variability of
that critical factor may be contained.
• It is intuitively very appealing as it articulates the
concerns that project evaluators normally have.
• Sensitivity analysis Suffer from the following

shortcomings:
• It merely shows what happens to NPV when there is
a change in some variable, without providing any
idea of how likely that change will be.
• Typically, in sensitivity analysis only one variable is
changed at a time. In real world, however, variables
tend to move together.
• The interpretation of results is subjective. The same
sensitivity analysis may lead one decision maker to
accept the project while another may reject it.
Scenario Analysis
• In sensitivity analysis one variable is varied at a time.
In scenario analysis, several variables are varied
simultaneously. Most commonly, three scenarios are
considered: expected(or normal) Scenario, Pessimistic
Scenario, and optimistic Scenario. In the normal
scenario, all variables assume their expected(or
normal values); in pessimistic scenario, all variables
assume their pessimistic values; and in optimistic
scenario all variables assume their optimistic values.
• The NPV of the project Naveen Flour Mills under three
scenarios is given in table below.
Scenario Analysis
( in million dollars)
Pessimistic Expected Optimistic
Scenario Scenario Scenario
1. Investment 24 20 18
2. sales 15 18 21
3. Variable Costs(% of sales 10.5(70%) 12(66.7%) 13.65(65%)
4. Fixed Costs 1.3 1.0 0.8
5. Depreciation 2.4 2.0 1.8
6. Pre-tax profit 0.8 3.0 4.75
7. Tax 0.27 1.0 1.58
8. Profit after tax 0.53 2.0 3.17
9. Annual Cash flow from operation 2.93 4.0 4.97
10. NPV (7.45) 2.60 10.06
(9)x PVIF(12%,10yrs)-(1)
Scenario Analysis
• Evaluation: Scenario analysis may be regarded as an
improvement over sensitivity analysis because it considers
variation in several variables together.
• However, scenario analysis has its own limitations:
• It is based on assumption that there are few well-delineated
scenarios. This may not be true in many cases. For example,
the economy does not necessarily lie in three discrete states,
viz, recession, stability, and boom. It can in fact be anywhere
on the continuum between extremes. When a continuum is
converted into three discrete states some information is lost.
• Scenario analysis expands the concept of estimating the
expected values. Thus, in a case where there are 10 inputs the
analysis has to estimate 30 expected values(3X10) to do
scenario analysis
Scenario Analysis
A B C D
1 Discount rate (A2=12%) Project Life (B2=10yrs) Tax rate( C2=33.3%)
3 Expected Values( in thousands $)

4 Investment in year 0 (20,000)
5 Variable cost (% of sales) 66.67%
6 For years 1 to 10
7 Sales 18,000
8 Variable Costs =C7*C5 12,001
9 Fixed Costs 1,000
10 Depreciation = -C4/B2 2,000
11 Pre-tax Profit = C7-C8-C9-C10 2,999
12 Taxes =C11*C2 1,000
13 Profit after taxes =C11-C12 2,000
14 Cash flow from operations =C13+C10 4,000
15 PV of cash flow stream =PV(A2,B2,-C14) 22,599
16 NPV of the project =C15 + C4 2,599
Key variables Pessimistic Expected optimistic
18 investment (24,000) (20,000) (18,000)
19 Sales 15,000 18,000 21,000
20 Variable costs( % of Sales) 70 66.67 65
21 Fixed costs 1,300 1,000 800
Breakeven Analysis
• In sensitivity analysis we ask what will happen to
the project if sales decline or costs increase or
something else happens. As financial manager,
you will also be interested in knowing how much
should be produced and sold at a minimum to
ensure that the project does not ‘lose money’. Such
an exercise is called break-even analysis and the
minimum quantity at which loss is avoided is called
the break-even point. The break-even point can be
defined as accounting term or financial term.
• Accounting Break-even Analysis: Suppose you
are the financial manager of Naveen Flour Mills.
Breakeven Analysis
Breakeven Analysis
Accounting break-even analysis
(in thousands)
Year 0 Year 1-10
1. Investment (20,000)
2. Sales 18,000
3. Variable costs(66.75% of sales) 12,000
4. Fixed Costs 1,000
5. Depreciation 2,000
6. Pre-tax profit 3,000
7.Taxes 1,000
8. Profit after taxes 2,000
9. Cash flow from operations 4,000
10. Net cash flow (20,000) 4,000
Breakeven Analysis
• By way of confirmation, you can verify that the break-even
level sales is indeed $9million.
(in million $)
Sales………………………..$9
Variable Costs……………..$6
Fixed Costs ……………….$1
Depreciation ………………$2
Profit before tax …………...$0
Tax ………………………… $0
• A project that breaks even in accounting terms is like a stock
that gives you a return of zero percent. In both the cases you
get back your original investment but you are not
compensated for the time value of money.
Financial Break-even analysis
• The focus of financial break-even analysis is on NPV and not on
accounting profit. At what level of sales will the project have zero
NPV? To illustrate how the financial break-even level of sales is
calculated, let us go back to the flour mill project. The annual cash
flow of the project depends on sales as follows:
Financial Break-even analysis
• Since the cash flow lasts for 10 years, its present value at discount
rate of 12% is:
PV(cash flow) = 0.222sales x PVIFA(10yrs, 12%)
= sales x 5.650
= 1.254 sales
• The project breaks even in NPV terms when PV of these cash flows
equals the initial investment of $20 million.
• Hence, the financial break-even occurs when
PV(cash flow) = Investment
1.254sales = $ 20 million
Sales = $ 15.95 million
Thus, the sales for the flour mill must be $15.95million per year for the
investment to have a zero NPV. Note that this is significantly higher
than $9million which represents the accounting break-even sales.
Corporate Risk Analysis
• What is corporate risk?
• The project’s risk when considering the firm’s other
projects, i.e., diversification within the firm.
• Corporate risk is a function of the project’s NPV
and standard deviation and its correlation with the
returns on other projects in the firm.
Market risk Analysis
• What is market risk?

–The project’s risk to a well-diversified investor.
–Theoretically, it is measured by the project’s beta
and it considers both corporate and stockholder
diversification.
Which type of risk is most relevant?
• Market risk is the most relevant risk for capital

projects, because management’s primary goal is
shareholder wealth maximization.
• However, since total risk affects creditors,
customers, suppliers, and employees, it should
not be completely ignored.
4.6. Social cost Benefit Analysis
Rationales of SCBA
– Imperfection in the input and output
markets
– Existence of externalities
– Consideration for income distribution
– Consideration for saving
– Treatment of certain costs and revenue lines
– Consideration for merit
Social Cost Benefit Analysis
Basic Arguments for the Application of

Social Cost Benefit Analysis
1.The price offered in the market is not a good guide to social
welfare and there are possible distortions. So the prices
should be adjusted for these impacts.
2. A project may have influences that work outside the
market rather than through it. These effects are called
“externalities.”
3. Certain accounts (subsidies, depreciation, grants) should not
regarded as returns and such accounts as taxes, interest, and
dividend should not be recorded as costs/expenses. Rather,
they should be considered as transfer payments in the
economy.
– Environmental Impact analysis(EIA) and Social Impact
Analysis(SIA) is required for industrial projects.
Human Resource and Organizational
Analysis
Project Organization and Management

Organizational Design
– depends on internal and external project requirements and
conditions & includes the following steps:
• The goals and objective for the business are stated
• The functions that are necessary to achieve the goals
• The necessary functions are grouped or related
• The organizational framework or structure is designed
• All key jobs are analyzed, designed and described
• A recruiting and training program is prepared
Human Resource and Organizational
Analysis
Human Resources requirement analysis and
planning Purpose
– To identify and describe such requirements and assess
the availability of human resources as well as the
training needs with particular attention given to the
definition and assessment of those skills and
experiences.
Outputs of the analysis and estimation HR
Requirements of the project:
• Assessment of the availability of personnel and training needs
• The cost estimates for wages, salaries
• Estimates of Other personnel related and training expenses
4.6. Investment Criteria Analysis
• Techiniques of investment criteria

Analysis:
–Payback Period
– Discounted Payback period
–Net Present Value(NPV)
–Internal Rate of Return(IRR)
–Profitability Index(PI)
What is the payback period?
• The number of years required to recover a

project’s cost, or “How long does it take to get
our money back?”
• Calculated by adding project’s cash inflows to its
cost until the cumulative cash flow for the project
turns positive.
Payback period Example 1
• Example-1: The cash flow for the two projects

are given in million dollars below. calculate
Payback period:
Year Project L Project S

Cash Flow Cash Flow
0 -$100 -$100
1 $10 $70
2 $60 $50
3 $80 $20
Calculating payback Example 1
0 1 2 2.4 3
Project L
CFt -100 10 60 100 80
Cumulative -100 -90 -30 0 50
PaybackL == 2 + 30 / 80 = 2.375 years
0 1 1.6 2 3
Project S
CFt -100 70 100 50 20
Cumulative -100 -30 0 20 40
PaybackS == 1 + 30 / 50 = 1.6 years

Discounted payback period
Example 1
• Example: Calculate the discounted cash flow of

the following project.
Year Project L Discounted
Cash Flow Cash Flow (k=10%)
0 -$100 -$100
1 $10 $9.09
2 $60 $49.59
3 $80 $60.11
Discounted payback period Example
• Uses discounted cash flows rather than raw

CFs.
0 10% 1 2 2.7 3
CFt -100 10 60 80
PV of CFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Disc PaybackL = 2 + 41.32 / 60.11 = 2.7 years
Net Present Value (NPV)
• Sum of the PVs of all cash inflows and outflows

of a project:
n
CFt
NPV   t – CF0
t 0 ( 1  k )
Net Present Value (NPV)
Example 1
• Example: Calculate the Net Present Value(NPV)

of project L and S
Yea Project L Project S PV CF@ PV CF@
r Cash Flow Cash Flow (k=10%) (k=10%)
Project L Project S
0 -$100 -$100
1 $10 $70
2 $60 $50
3 $80 $20
What is Project L’s NPV?
Year CFt PV of CFt

0 -100 -$100
1 10 9.09
2 60 49.59
3 80 60.11
NPVL = $18.79
NPVS = $19.98
Rationale for the NPV method
NPV = PV of inflows – Cost

= Net gain in wealth
• If projects are independent, accept if the project
NPV > 0.
• If projects are mutually exclusive, accept
projects with the highest positive NPV, those
that add the most value.
• In this example, would accept S if mutually
exclusive (NPVs > NPVL), and would accept both if
independent.
Self-test Exercise/Home Work/
• To illustrate the calculation of NPV, consider a project

which has the following cash flow streams:
• The cost of capital for the firm is 12 percent.

Required: Calculate NPV, IRR, PI, PBP and
discounted PBP.
Internal Rate of Return (IRR)
• IRR is the discount rate that forces PV of

inflows equal to cost, and the NPV = 0:
n
CFt
0 t
t 0 ( 1  IRR )
IRR Acceptance Criteria
• If IRR > WACC, the project’s rate of return is

greater than its costs. There is some return
left over to boost stockholders’ returns.
• If IRR > k, accept project.
• If IRR < k, reject project.
Example
Calculation of IRR
• Level Cash Flows

– Let us assume that an investment would cost Rs 20,000
and provide annual cash inflow of Rs 5,430 for 6 years.
– The IRR of the investment can be found out as follows:
NPV  Rs 20,000 + Rs 5,430(PVAF6,r ) = 0

Rs 20,000  Rs 5,430(PVAF6, r )
Rs 20,000
PVAF6, r   3.683
Rs 5,430
Profitability Index (PI)
• Profitability index is the ratio of the present

value of cash inflows, at the required rate of
return, to the initial cash outflow of the
investment.
PI= Present Value
Initial investment
Profitability Index
• The initial cash outlay of a project is Rs 100,000

and it can generate cash inflow of Rs 40,000,
Rs 30,000, Rs 50,000 and Rs 20,000 in year 1
through 4. Assume a 10 per cent rate of
discount. The PV of cash inflows at 10 per cent
discount rate is:
PV  Rs 40,000(PVF1, 0.10 ) + Rs 30,000(PVF2, 0.10 ) + Rs 50,000(PVF3, 0.10 ) + Rs 20,000(PVF4, 0.10 )
= Rs 40,000  0.909 + Rs 30,000  0.826 + Rs 50,000  0.751 + Rs 20,000  0.68
NPV  Rs 112,350  Rs 100,000 = Rs 12,350
Rs 1,12,350
PI   1.1235.
Rs 1,00,000
Acceptance Rule
• The following are the PI acceptance rules:

– Accept the project when PI is greater than one.
PI > 1
– Reject the project when PI is less than one.
PI < 1
– May accept the project when PI is equal to one.
PI = 1
• The project with positive NPV will have PI greater than
one. PI less than means that the project’s NPV is
negative.
4.7. Project Selection
• Based on all the above analysis select the best

project. i.e., market and demand analysis, technical
analysis, financial analysis, project risk analysis,
social cost-benefit analysis, investment criteria
analysis.
• We also consider various qualitative aspects that
can affect the decision that we have discussed
through out the project analysis course.
• The most superior techiniques is project decision
making is NPV. The project having highest NPV is
accepted.

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Project Evaluation and Analysis

Dr. Andualem Ufo Baza

Copyright © 2011 The McGraw-Hill Companies, All Rights Reserved.

–Market and Demand Analysis

Market/demand analysis: meaning & purposes

Market and demand analysis involves and focuses on

Major Dimensions of Market/Demand Analysis

Process of Market and Demand Analysis + Planning

Key steps in a Market and Demand Analysis and their relationships

Step1: Situational Analysis and Specification of

Step 2: Collection of Secondary Information

– Who gathered the information and What was the

– How was the sample chosen? How representative

Step 3: Conduct of Market Survey

Step 4: Characterization of the Market

1. Time series analysis techniques

C. Exponential Smoothing Method:

X = ∑x = 18/6 =3 ( see previous table).

Thus, following is the five years(1988-1992) sales

Step 6: Market Planning

Step 6: Market Planning

I. Raw material and Supplies Study

1. Classification of Raw Materials and Supplies

III. PROJECT CAPACITY AND PRODUCTION PROGRAM

Capacity Decision Levels/Terms

II. Feasible Normal Capacity

Determination of the Feasible Normal Plant Capacity

d. Technology Acquisition and Transfer

i. Securing Industrial Property Rights

• Components of Financial Analysis:

Analysis and planning of cost of the project

Analysis and planning of means/sources of

ii. Term loan

iv. Deferred credit

Selecting the project financing means

ii. Key business considerations.

iii. Indirect material and labour costs:

Opening balance of cash on hand $ 80

• Techiniques of Risk Analysis:

• Risk is inherent in almost every business

• The probability weighted NPV works out to:

• Standard Deviation: the standard deviation

• Variance: the variance of the distribution can be

• Coefficient of Variation(CV): the coefficient of

• To understand the nature of sensitivity analysis, let

• Evaluation: A very popular method for assessing

• Sensitivity analysis Suffer from the following

3 Expected Values( in thousands $)

• What is market risk?

• Market risk is the most relevant risk for capital

Basic Arguments for the Application of

Project Organization and Management

• Techiniques of investment criteria

• The number of years required to recover a

• Example-1: The cash flow for the two projects

Year Project L Project S

PaybackS == 1 + 30 / 50 = 1.6 years

• Example: Calculate the discounted cash flow of

• Uses discounted cash flows rather than raw

• Sum of the PVs of all cash inflows and outflows

• Example: Calculate the Net Present Value(NPV)

Year CFt PV of CFt