GOVERNMENT vs. PRIVATE PROJECTS GOVERNMENT PROJECTS IS MORE FOCUS ON SERVICE PRIVATE PROJECTS IS MORE FOCUS ON PROFIT
WHAT IS FINANCIAL ANALYSIS? • Usually done after the market and technical studies • To quantify or put costings to the various inputs in the technical and market studies as basis in pursuing the project • Entails the preparation of the financial statements which are prepared, analyzed and forecasted
WHAT IS FINANCIAL ANALYSIS? It is concerned with determining the income that the project would generate for the project-operating entity; e.g. water supply If there is no income, how to finance and sustain its operation e.g. FMR
WHY THE NEED FOR FINANCIAL STUDY? Government does not have enough money to pursue all projects. Government can only afford only the best project proposals. For private projects, there is a need to recover investments.
WHY FINANCIAL STUDY FOR GOVERNMENT PROJECT? To ensure financial sustainability Availability of funds to finance investment up to operation stage Projects with high economic returns may still fail when funds to finance its operation is not enough (water supply, irrigation and public transport)
WHY FINANCIAL STUDY FOR GOVERNMENT PROJECT? To determine project’s financial profitability Government approaches a project like a private sector does, especially when privatization is considered. To estimate true value of the project To know if project is profitable or not
PROFITABILITY AND SUSTAINABILITY Sustainability- a project can continue to pay its bills throughout its entire life, whether these funds come from user charges or from regular budget sources. Profitability- a project can generate more than enough revenues to cover annual expenditures and service obligations and still post profit
IMPORTANT VARIABLES IN FINANCIAL ANALYSIS • Revenues and cost items • Sources of financing • Financial viability
FINANCIAL STATEMENTS 1. Cash Flow Statement; 2. Income or Profit and Loss Statement; 3. Balance Sheet Statement.
1. CASH FLOW STATEMENT • Profile of project’s receipts and expenditures overtime • Shows the expected annual movement of cash into (receipts) or out (expenditures) of the project
TWO MAJOR SECTIONS Cash inflows- detail the expected financial receipts generated by the projects 2.Cash outflows- shows the expected financial expenditures to be incurred to generate the cash inflows of the project.
NET CASH FLOW Cash outflows Cash inflows - =
Different Financial Project Profiles (+) Operating Stage Initial Investment Period RECEIPTS LESS EXPENDITURES 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 Cessation Stage YEAR OF PROJECT LIFE (-)
STEPS IN CASH FLOW STATEMENT Formulation of an Investment Plan Formulation of an Operating Plan Formulation of End of Project Operations Plan
A. FORMULATION OF AN INVESTMENT PLAN Combines information from the market and technical analysis to establish a detailed plan for annual incremental expected capital expenditures during project’s investment phase: • Land • Buildings • Machinery • Equipment • Building materials and construction • Management labor
A. FORMULATION OF AN INVESTMENT PLAN 2 sections of the Investment Plan Expenditure on new acquisition of assets (e.g. equipment) Financing aspect of Proposed Investment
Loan Balance – Rate (R) Previous Loan Balance- Principal Amortization-Interest AMORTIZATION
B. DEVELOPMENT OF AN OPERATING PLAN Combines information from the market and technical analysis to establish a detailed plan for the project’s operating phase Provides projection of expected sales revenues and expected operating costs (i.e. operating material inputs and operating labor) for each year during the operations phase;
B. DEVELOPMENT OF AN OPERATING PLAN • To determine the flow of cash in the operation of the project. • The plans include all cash receipts generated from the operations of the business/project and all operating expenditures.
2. INCOME OR PROFIT AND LOSS STATEMENT It shows the financial operation of a project for a given period. Various items of expected revenues/income and expenses are determined thereby permitting calculation of the project’s or firm’s net profit on a periodic basis
2. INCOME OR PROFIT AND LOSS STATEMENT 1. Income/Revenue • total sales/receipts (cash and credit basis) earned in a given period • For sales of goods (e.g. commodity products), the cost of the goods should be deducted from the gross sales to get the net sales.
2. INCOME OR PROFIT AND LOSS STATEMENT 2. Expenses • total expenses (cash and credit) incurred during the year - the excess of revenues over expenses • Profit • Loss - the excess of expenses over revenues
A. DISCOUNTING AND ALTERNATIVE INVESTMENT CRITERIA • It is not correct to simply add the total annual net revenues from year 1 to year 20 to get the total returns from project. • Money that is worth a peso today is less than a peso in the future
Time Value of Money The essence of this concept is that money received or consumed at a particular time has greater value than the same money received or consumed at some future time.
Explanations / Reasons • Normal preference for present versus future consumption • Resources on hand may be invested during the intervening period to generate income or earn interest • Risk of uncertainty factor of the future
What is discounting? • Allows comparison of revenues/costs occurring in different time periods in the future, at the initial year of the project. • It is a process of translating future values into their present worth
Why discounting is done? • The nature of a project is such that benefits and costs occur at different points in time • A given sum of money now is considered more valuable than the same amount received in a future period.
Concept of Discounting Ao = An x 1/(1+r)n where: Ao = present value of An An = expected amount at year n r = discount rate n = no. of years between year 0 and year n, i.e., discounting period
THE DISCOUNT RATE The discount rate could be the weighted average cost of capital (WACC) or the prevailing market interest rate
Weighted average cost of capital (WACC) • Usually used for most public sector projects since these projects have multiple sources of financing, which have varying interest rates. • Cost of borrowing, for borrowed capital (i.e., interest rate of loan) • The yield of alternative opportunities, for equity capital (i.e., interest rate of savings, other investments)
Weighted average cost of capital (WACC) Example: Total project cost P100,000 Fund 1: (Loan-60%) 60,000 Cost of capital (10%) Fund 2: (Equity-40%) 40,000 Cost of capital (5%) WACC = (60%x10%)+(40%x5%) = (0.06)+(0.02) = 8%
Weighted average cost of capital (WACC) Example: Total project cost P500,000 Fund 1: (Loan-50%) 250,000 Cost of capital (15%) Fund 2: (loan-40%) 200,000 Cost of capital (18%) Fund 3: (Equity-10%) 50,000 Cost of capital (10%) WACC = (50%x15%)+(40%x18%)+(10%x10%) = (0.075)+(0.072)+(0.01) = 15.7%
EXAMPLE OF DISCOUNTING A revenue of P85 is expected 2 years from now. Assuming a discount rate (WACC) of 10 percent, the present value is: Ao = 85 x 1/(1+0.10)2 = 85 x 1/(1.21) = 85 (0.826) = 70.2
B. MEASURES OF PROJECT WORTH • Net Present Value (NPV) • Benefit-Cost Ratio (BCR) • Internal rate of return (FIRR)
Net Present Value (NPV) The difference between the present values of project benefits and project costs nn NPV = ∑ bi /(1+r)i - ∑ ci /(1+r)i i= 0i=0 where bi= benefits in period i ci= costs in period i r = discount rate n= discounting period NPV=B-C
NPV Decision Rule If NPV > 0 In case of competing projects, select the project with the highest NPV. ACCEPT PROJECT REJECT PROJECT If NPV < 0
Benefit Cost Ratio (BCR) - the ratio of the present value of gross benefits to the present value of gross costs: nn BCR = ∑ bi /(1+r)i / ∑ ci /(1+r)i i=0 i=0 BCR=B/C
BCR Decision Rule If BCR > 1 ACCEPT PROJECT - In case of competing projects, selectproject with the highest BCR. REJECT PROJECT If BCR < 1
EXERCISES Compute and compare the BCR, NPV, and IRR using 15% discount factor and recommend the better project. • Project A YearCostsBenefits 1 1,400 700 2 100 600 3 100 500 4 100 400 5 100 300 • Project B 1 1,400 300 2 100 400 3 100 500 4 100 600 5 100 700
Computations: (Project A) NPV = 1769 - 1466 = P303 BCR = 1769 / 1466 = 1.21
Computations: (Project B) NPV = PVb - PVc = P_____ BCR = PVb/ PVc = ____
PROJECT A NPV = 1769 - 1466 = P303 BCR = 1769 / 1466 = 1.21 PROJECT B BCR = 1583 / 1466 = 1.08 NPV = 1583 - 1466 = P117 In case of competing projects, select the project with the HIGHEST NPV and/or the HIGHEST BCR