economic feasibility study chapter 7

Economic feasibility study

Chapter 7 Feasibility Study

Econ 4315

prepared by: Abd ElRahman J. AlFar

Balance sheet • A balance sheet is a financial statement that summarizes a company's

assets, liabilities and shareholders' equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by shareholders.

The balance sheet adheres to the following formula:• Assets = Liabilities + Shareholders' Equity

BREAKING DOWN 'Balance Sheet'The balance sheets gets its name from the fact that the two sides of the equation above – assets on the one side and liabilities plus shareholders' equity on the other – must balance out. This is intuitive: a company has to pay for all the things it owns (assets) by either borrowing money (taking on liabilities) or taking it from investors (issuing shareholders' equity).

For example, if a company takes out a five-year, $4,000 loan from a bank, its assets – specifically the cash account – will increase by $4,000; its liabilities – specifically the long-term debt account – will also increase by $4,000, balancing the two sides of the equation. If the company takes $8,000 from investors, its assets will increase by that amount, as will its shareholders' equity.

Assets• Within the assets segment, accounts are listed from top to bottom in

order of their liquidity, that is, the ease with which they can be converted into cash. They are divided into current assets, those which can be converted to cash in one year or less; and non-current or long-term assets, which cannot.

current assets:• Cash and cash equivalents: the most liquid assets, these can include Treasury

bills and short-term certificates of deposit, as well as hard currency• Marketable securities: equity and debt securities for which there is a liquid

market• Accounts receivable: money which customers owe the company, perhaps

including an allowance for doubtful accounts (an example of a contra account), since a certain proportion of customers can be expected not to pay• Inventory: goods available for sale, valued at the lower of the cost or market

price• Prepaid expenses: representing value that has already been paid for, such as

insurance, advertising contracts or rent

Long-term assets• Long-term investments: securities that will not or cannot be

liquidated in the next year• Fixed assets: these include land, machinery, equipment, buildings and

other durable, generally capital-intensive assets• Intangible assets: these include non-physical, but still valuable, assets

such as intellectual property and goodwill; in general, intangible assets are only listed on the balance sheet if they are acquired, rather than developed in-house; their value may therefore be wildly understated—by not including a globally recognized logo, for example—or just as wildly overstated

Liabilities• Liabilities are the money that a company owes to outside parties,

from bills it has to pay to suppliers to interest on bonds it has issued to creditors to rent, utilities and salaries. Current liabilities are those that are due within one year and are listed in order of their due date. Long-term liabilities are due at any point after one year.

Current liabilities• Short term debts• Interest payable• Wages payable• Customer prepayments• Dividends payable and others

Long-term liabilities • Long-term debt: interest and principle on bonds issued• Pension fund liability: the money a company is required to pay into its

employees' retirement accounts

Shareholders' equity• Shareholders' equity is the money attributable to a business' owners,

meaning its shareholders. It is also known as "net assets," since it is equivalent to the total assets of a company minus its liabilities, that is, the debt it owes to non-shareholders.• Retained earnings: are the net earnings a company either reinvests in

the business or uses to pay off debt; the rest is distributed to shareholders in the form of dividends.• Common stocks and preferred stocks

What is an 'Income Statement'• An income statement is a financial statement that reports a company's

financial performance over a specific accounting period. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses through both operating and non-operating activities. It also shows the net profit or loss incurred over a specific accounting period.

• Unlike the balance sheet, which covers one moment in time, the income statement provides performance information about a time period. It begins with sales and works down to net income and earnings per share (EPS).

• The income statement is divided into two parts: operating and non-operating. The operating portion of the income statement discloses information about revenues and expenses that are a direct result of regular business operations. For example, if a business creates sports equipment, it should make money through the sale and/or production of sports equipment. The non-operating section discloses revenue and expense information about activities that are not directly tied to a company's regular operations. Continuing with the same example, if the sports company sells real estate and investment securities, the gain from the sale is listed in the non-operating items section.

Cash flow statement • A cash flow statement is a financial report. The document provides

aggregate data regarding all cash inflows a company receives from its ongoing operations and external investment sources, as well as all cash outflows that pay for business activities and investments during a given quarter.

• Cash flow from operations• Cash flow from investment • Cash flow from financing

Cash flow from operations• The first set of cash flow transactions is from operational business

activities. Cash flows from operations starts with net income and then reconciles all noncash items to cash items within business operations. For example, accounts receivable is a noncash account. If accounts receivables go up, it means sales are up, but no cash was received at the time of sale. The cash flow statement deducts receivables from net income because it is not cash. Also included in cash flows from operations are accounts payable, depreciation, amortization and numerous prepaid items booked as revenue or expenses but with no associated cash flow.

Cash Flows From Investing

• Cash flows from investing activities includes cash spent on property, plant and equipment. This is where analysts look to find changes in capital expenditures (CAPEX). While positive cash flows from investing activities is a good thing, investors prefer companies that generate cash flows primarily from business operations, not investing and financing activities.

Cash Flows From Financing• Cash flows from financing is the last business activity detailed on the

cash flow statement. The section provides an overview of cash used in business financing. Analysts use the cash flows from financing section to find the amount paid out in dividends or share buybacks. Cash obtained or paid back from capital fundraising efforts, such as equity or debt, is also listed.

Depreciation valueThe annual rate deducted from the parent value of the asset

Depreciation value = asset value - junk value Life time

• Noting that: The current assets have no depreciation value because it must be returned at the end productive operation, which length depends on the nature of the commodity itself.

profits and commercial Evaluation measures 

accounting based profitability measures

economic based profitability measures

time based profitability measures

1. Time based profitability measures:• Pay-back period (pp): It’s simply the time (period) which investment

cost is recovered.

1. If the average cash flow constant for every years of the project life.2. If the cash flow (unequal) over the years.

If the average cash flow constant for every years of the project life.Example:Project with five-year span and with the total investment costs of 760.000 NIS, having annual cash flow 200,000 NIS. What would be recovery period for this project? Or (what is the time needed for this project to recover its initial investment costs)?Answer:

= initial investments Annual cash flow 760.000 = 3.8 year

200.000

If the cash flow (unequal) over the years.Project with six -year span and with the total investment costs of 760.000 NIS, having annual as shown in the following table.

Life time

Annual Cash flow

1 200.0002 230.0003 200.0004 180.0005 190.0006 140.000

What would be recovery period for this project?

To answer this example we must follow the following steps:• For the first year: Initial investments - cash flow = 760.000 - 200.00 = 560.000

remaining from the Initial investments• For the second year: remaining Initial investments from the pervious year- Cash flow for

the new year = 560.000- 230.000 = 330.000 • For the third year: remaining Initial investments from the pervious year- Cash flow for

the new year = 330.000 - 200.000 = 130.000.• For the fourth year: remaining Initial investments from the pervious year- Cash flow for

the new year = 130.000 - 180.000 = (-50.000) surplus over the Initial investments

Recovery period for this project is 3.86 months

Disadvantages of payback period1. Ignoring the time value of money:Payback period dealing with money recovered in the first year and last year of the project with equal value. This treatment is not viable economically because the real value of the cash flows at the beginning of the project lifetime are usually larger than the actual value of the cash flows at the end of six years in our last example.

Disadvantages of payback period (cont.)2. ignoring the cash flows tacks place after the return of initial invested capital:in our 2nd example when the project recovered its initial investment in three years and 8.6 month this criterion do not inform us what to do with the cash flow take place after recovery period which almost 1/3 of the initial investment.

Disadvantages of payback period (cont.)3. Suitable only with short-term projects that do not seek for the consolidation of its relationship to society and continuity.In spite of the disadvantages of this measure, it cannot be ignored as gives an idea to the entrepreneur on the time required to restore the initial investment is also appropriate for investor who wants to invest in businesses with quick and short-term return.

2. Accounting based profitability measures:1. Return on capital: is a profitability ratio. It measures the return that an investment generates for capital contributors, i.e. bondholders and stockholders. Return on capital indicates how effective a company is at turning capital into profits.

Net operating profit is the EBIT

2. Return on equity (ROE) is a measure of the profitability of a business in relation to the book value of shareholder equity, also known as net assets or assets minus liabilities. ROE is a measure of how well a company uses investments to generate earnings growth.

ROE = [Net income / shareholders equity] * 100%

3. economic based profitability measures:• Net present value(NPV).• Profit index• Rate of Return/cost . • Internal Rate of Return(IRR).

Net present value(NPV).• It indicates the difference between the current value of the in cash flows for

the project and current value of the out cash flow. A decision-making using this criteria is based on:• If we have (+)result i.e. cash inflows larger than cash outflows then project is

profitable• If we have (-)result i.e. cash outflows larger than cash inflows then th project

unattractive .• if result is (0) i.e. cash outflows equal cash inflows then the project does not

make any loss or profit for this type of project we have to consider other considerations such as the strategic importance of the project within national economic and development plan.

NPV EQUATION

This Data were obtained for three investment project proposals, as shown in the following table:

time

Cash in flow for project (a)

Cash in flow for project (b)

Cash in flow for project (c)

1 (400) (600) (800)2 150 250 2003 140 150 1504 100 200 2005 0 180 1806 0 0 0

If the interest rate 10%, use NPV to decide which project is the best alternative

Time Cash-in flow for project (a)

Cash-in flow for project (b)

Cash-in flow for project (c)

Present value at 10%

1 ( 400 ) ( 600) ( 800 ) 12 150 *.909 = 136.4 250 * .909= 227.25 200 * .909 =181.8 .909

3 140 * .826 = 115.64 150 * .826= 123.9 150 * .826=123.9 .826

4 100 * .751 = 75.1 200 * .751=150.2 200 * .751=150.2 .751

5 0 * .683 = 0 180 * .683= 122.94 150 * .683 =02.45 .683

6 0 * .821 = 0 0 * .821 = 0 150 * .821= 123.15 .621

total 327.14 624.29 681.5 Indebted capital ( 400 ) ( 600 ) ( 800 )

Net flow ( 72.86 ) 24.29 ( 118.5 )

decision rejected Accepted rejected

Profit index • It's the ration of present value of future cash flows to the invested

capital in the project.• The higher the cost benefit ratio the better is the project profitability

and vice versa. • If the cost benefit ratio less than one (1) i.e. the in cash flows is less

than out cash flow so the project unattractive and vice versa.Profit index (PI) = The total present value of cash inflows

Investment cost

PI example Project 1 Project 2 Project 3

NPV out cash flow ( 400 ) ( 600) ( 800 )NPV in cash flow 327.14 624.29 681.5

By using the above information, you are required to determine the profitability index for the three project proposals?

PI for project 1= 327.5/400 = .871 note its less than one its rejected

PI for project 2= 624.29/600 = 1.04 note its greater than one its accepted

PI for project 3= 681.5/800 = .85 note its less than one its rejected

Recall that Profit index (PI) = The total present value of cash inflows

Investment cost

Return on cost ratio• This standard refers to the relationship between the current value of

expected return from the investment in the project and the current value of the projected costs of investment throughout the life time of the project. It can be determined by:

• If the return for cost ratio is ZERO or more then the project is accepted and economically feasible project. Other-wise the project not economically feasible and should be rejected.

Example• The following data from a project's feasibility studies and you are

required: calculate the return cost ratio, if the discount rate for the cost of capital = 15%?

year cost Return0 120 -1 75 1152 80 1203 85 1254 95 1355 100 140

year Cost present value Return present value

0 120 * 1 = 120 ZERO1 75 * .926 =69.45 115 * 926.0 = 106.492 80 * 0.857= 68.56 120 * 0.857 = 102.843 85 * .794 = 67.49 125 * 0.794 = 99.254 95 *.73 = 69.83 135 * 0.735 = 99.2255 100 * .681 = 68.10 140 * 0.681 = 95.34

total 463.43 503.15

𝑅𝑒𝑡𝑢𝑟𝑛𝑜𝑛𝑐𝑜𝑠𝑡 𝑟𝑎𝑡𝑖𝑜=𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛𝑝𝑟𝑒𝑠𝑒𝑛𝑡𝑣𝑎𝑙𝑢𝑒𝑜𝑓 𝑐𝑜𝑠𝑡 −1

= .08 OR 8%

because the rate of return on cost is greater than ZREO the project is acceptable.

Internal rate of retune (IRR):• Internal rate of return is a discount rate that makes the net present

value (NPV) of all cash flows from a particular project equal to zero.

• The formula for IRR is0 = P0 + P1/(1+IRR) + P2/(1+IRR)^2 + P3/(1+IRR)^3 + . . . +Pn/(1+IRR)^n

where P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . . n, respectively; and IRR equals the project's internal rate of return

Example • Assume Company XYZ must decide whether to purchase a piece of

factory equipment for $300,000. The equipment would only last three years, but it is expected to generate $150,000 of additional annual profit during those years. Company XYZ also thinks it can sell the equipment for scrap afterward for about $10,000. Using IRR, Company XYZ can determine whether the equipment purchase is a better use of its cash than its other investment options, which should return about 10%.

• Here is how the IRR equation looks in this scenario:• 0 = -$300,000 + ($150,000)/(1+.2431) + ($150,000)/(1+.2431)2 +

($150,000)/(1+.2431)3 + $10,000/(1+.2431)4• The investment's IRR is 24.31%, which is the rate that makes the

present value of the investment's cash flows equal to zero. From a purely financial standpoint, Company XYZ should purchase the equipment since this generates a 24.31% return for the Company --much higher than the 10% return available from other investments.