Chapter--6

Investment Evaluation
Course outline:
1.Total investment costs
2. Project financing
3.Financial evaluations
 6.1 Total investment costs
Is sum of fixed capital and net working capital.
6.1.1 Fixed Assets (Capital):- fixed investment plus
pre-production capital costs.
a) Fixed investments:-
 Land and site preparation
 Building and civil work
 Plant machinery and equipment including auxiliary
equipment
 Certain incorporate fixed assets such as industrial
property rights.
b) Pre-production capital expenditure:
 Preliminary and capital issue expenditures.
 Consultant fee
 Other expenditure for planning projects
 Salaries, fringe benefits and social security
 Travel expenses
 Preparatory installations like camps, temporary
offices, stores, etc.
 Training costs
 Interest on loan during construction
6.1.2 Working Capital
The financial means required to operate the
project according to its production program.
Is the current assets minus current liabilities.(fig.1)
 Current asset: comprise receivables, inventories (raw
mtls, auxiliary mtls, supplies packaging mtls, WIP,
finished products) and cash.
 Current Liabilities: consists mainly of accounts payable
(creditors) and are free of interest.
 Pre-production
Capital cost

Permanent capital
Equity and reserves
Fixed Capital

Fixed
Investment

Long-term
Liabilities
Working Capital
Current
Asset

Current Liabilities

Fig.1 Assets and Liabilities

 • Working Capital = Current Assets – Current
Liabilities
OR
• Working Capital = Permanent Capital – Fixed
Capital
 2. Project financing
• Financing of new project continued to be a
problem, since corporate guarantees would
usually be required for loans to finance projects.
• Companies are risking their total asset if project
failed.
– Development of project financing shield such risks.
• Creditors provide financing to a project based on
the merits of the project itself.
  Types of capital
• Three types of project capitals:
– Equity
– Debt and
– Mezzanine capital.
Equity Capital:
Funds provided by the owners
The lowest ranking capital of all in terms of its claims
on the assets of a project.
 any distributions that can be made to equity
investors is done after all other project obligations
are satisfied.
If project fails all other claims must be met before
any claims can be made by equity investors.
Therefore , equity investors bear a higher degree of
risk than any other providers of capital.
Is also called risk capital
But if project becomes successful it leads biggest
gain
  Debt capital
• Senior debt has 1st claim over all the assets of the
project and must be repaid first.
• A project’s senior debt has the highest ranking of
all capital.
• Claim of others can be considered only after
claims of senior debt satisfied.
• Bears lowest risk of all capital
• The returns are limited to just interest payment
on loans, irrespective of how successful the
project
• Equity investors would prefer a debt-equity ratio
– Higher ratio reduces exposure of equity investors
– Lower ratio increases certainty that loans will be
repaid and hence lowers the risk to creditors
• Sponsors want high debt ratio in order to retain
funds for other potential projects
• From project company perspective
– Highest debs-equity ratio less sound financial
structure and the more vulnerable it would be to
deteriorate in the business environment
  Mezzanine capital
• It has both debt and equity features and has a
risk profile in between.
• Payments are subordinated to senior debt and
payment only be made when project funds are
available.
– When funds are not available mezzanine financing
considered as equity
 Source of financing
i. Equity capital provider
ii. Commercial Bank
iii. Export credit agencies
iv. Bilateral and Multilateral Aid Agencies
v. Institutional Investors
vi. National and Regional Development Banks
Vii. Capital Markets
Viii. Loan Currency Funding
  Financial Structuring Techniques
• Establishing appropriate mix of debt, equity and
mezzanine, which optimizes the use of financial
resource.
1. Components of project costs:
– Used to identify main components of project costs,
including financing costs, to decide type of capital and
financial sources.
• Main components of project costs include:
a. pre-investment costs
b. Bidding and procurement-related costs
c. Project development cost
d. Construction costs
e. Termination costs
2. Sequencing the Financial Package:
– Once project costs are identified, then appropriate
financing for each can be arranged in the following
sequence.
a. pre-investment and project development cost
b. Bidding and procurement related costs
c. Construction costs
d. Operating costs
3. Financial evaluations
– Study of new enterprise
– Design of new plant
– Evaluation of two or more alternative solutions
• Require economic considerations:
  Interest formulas
• Interest:- excess amount which one earns over
one’s money lent to someone else.
– Compensation for a current income foregoing.
– Reward of somebody for his sacrifice of present
pleasure
• There are different ways of computing interest
based on repayment condition:
Simple Interest:
Calculated based on the remaining principal amount
Let: i = interest rate per interest period
n = sum of interest periods (time periods)
C = capital (present sum of money)
S = capital (Future sum of money)
R = an end period payment in a uniform series.
Simple interest (I)
I = C*n*i
S=C+I
= C + Cni = C(1 + ni)
Compound Interest:
Calculated based on remaining principal plus any
accumulated interest charges at the beginning of that
period.
If C is invested at interest I
At n=1; S= C+C*1*i = C+Ci = C(1+i)
n=2; S=C(1+i) + C(1+i)i=C+Ci+Ci2=C(1+i)2
n=3; S=C(1+i)3
Therefore, at n period S = C(1+i)n; and
C = S 1/(1+i) n
o (1+i) n single payment Compound Amount Factor
(C.A.F) and 1/(1+i) n Present Worth Factor (P.W.F)
Uniform-Series of payment situation:
The equation S = C(1+i)n gives the sum S collected at
the end of a time period.
C represents the actual value of S at an interest i. thus
C = S* 1/(1+i)n
• Let Vn = 1 /(1+i)n
where V measures the actual value of 1 Birr after a
single interest period.
C = SVn
 Basic concept of Evaluating an Investment
Investment Initial cost Net cash proceeds per year
(Birr)
Year 1 Year 2
A 10,000 10,000 ---

B 10,000 10,000 1100

C 10,000 3762 7762

D 10,000 5762 5762

Table. E.g..Four Hypothetical Investment

1. Ranking by Inspection:
 Two investments have identical cash flows
each year through final year of short-lived
investment, the one that continues to earn
would be more desirable.
 B is better than A
 Two investments have same initial outlay &
same earning life & same total proceeds.
 If at the end of every year net proceeds become
variable,
The one with higher proceeds in the first year is more
profitable
D is Profitable than C
2. The Pay Back Period:
Length of time required to recover one’s investment.

𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Pay back period =
𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒 𝑓𝑟𝑜𝑚 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

From the above hypothetical eg.

Investment Payback period ranking
A 1 1
B 1 1
C 1.8 4
d 1.7 3
Select investments with sooner payback period.
3. Proceeds Per Birr of Outlay:
Investments ranked based on total proceeds divided
by amount of investments
It fails to consider time value of money
Investment Total proceeds Investment Proceeds per Birr ranking
outlay outlay
A 10,000 10,000 1.00 4

B 11.100 10,000 1.11 3

C 11,524 10,000 1.15 1

d 11,524 10,000 1.15 1

4. Average Annual Proceeds Per Birr of Outlay:
Total proceed divided by number of years and then
this result also divided by original outlay

Investme Total Average Original A.A.P. Per birr ranking

nt proceeds annual outlay outlay
proceeds
A 10,000 10,000 10,000 1.00 1

B 11.100 5550 10,000 0.555 4

C 11,524 5762 10,000 0.5762 2

d 11,524 5762 10,000 0.5762 2

5. Average Income on the Book Value of the
Investment:
Measure of efficiency, use the ratio of the firms
income to the book value of its asset.
Average income is computed after depreciation
Investment Average Average Average Average Income ranking
proceeds depreciation income book book
value value

A 10,000 10,000 0 10,000 0 4

B 5550 5000 550 5000 11 3

C 5762 5000 762 5000 15 1

d 5762 5000 762 5000 15 1

6. The Yield of an Investment:
Use present value concept but seeks to avoid arbitrary
choice of ratio of interest.
𝑛
𝑆𝑟
𝐹𝐴 =
(1 + 𝑖)𝑟
𝑟=1

If interest rate i is already fixed, then for

FA > FC, investment is profitable
FA = FC , investment neither loss nor profit
FA < FC , investment non-profitable
Where, Sr = cash flow in year r
FA = present worth of net cash flow
FC = initial investment
i = required interet rate
r = number of years
• The rate of interest i that makes
– FA = FC is called the yield of the investment
7. Net Present Value (NPV):
 Reason to determine NPV
The business man live in uncertain world, payment
after some period of time is just a promise.
By nature humans give more weight to present
pleasure than more distant joys
 present money is more valuable to investment
possibilities available now
• NPV is reverse of compound interest
𝑝𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑝𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑
Net Present Val𝑢𝑒 = − −𝐼
𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑓𝑎𝑐𝑡𝑜𝑟

𝑛
NPV = 𝑡=1 𝑉𝑡 − 𝐶𝑡 𝑎𝑛 𝑖 − 𝐼

Where, i = rate of interest per year, in percent

I= initial investment made at present time, in birr
n = life of investment, in year
Vt = income or receipts occurring in period t, in birr
Ct = expense or disbursements in period t, in birr
 Advantage of NPV:
– Introduces time value of money
– Express all future cash flows in today’s values
• This enables direct comparison
– It allows inflation and escalation
– Give more accurate forecast of profit & loss
 Limitations
– Its accuracy is limited by the accuracy of predicted
future cash flows and interest rate
– Biased towards short run projects and
– It does not include non-financial data like
marketability of the product
….???