Economic feasibility studyChapter 7

Feasibility Study

Econ 4315

prepared by: Abd ElRahman J. AlFar

Balance sheet

• A balance sheet is a financial statement that summarizes a company'sassets, liabilities and shareholders' equity at a specific point in time.These three balance sheet segments give investors an idea as to whatthe company owns and owes, as well as the amount invested byshareholders.

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 theequation above – assets on the one side and liabilities plus shareholders'equity on the other – must balance out. This is intuitive: a company has topay for all the things it owns (assets) by either borrowing money (taking onliabilities) or taking it from investors (issuing shareholders' equity).

For example, if a company takes out a five-year, $4,000 loan from a bank, itsassets – 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 frominvestors, its assets will increase by that amount, as will its shareholders'equity.

Assets

• Within the assets segment, accounts are listed from top to bottom inorder of their liquidity, that is, the ease with which they can beconverted into cash. They are divided into current assets, those whichcan 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 includeTreasury bills and short-term certificates of deposit, as well as hardcurrency

• Marketable securities: equity and debt securities for which there is a liquidmarket

• Accounts receivable: money which customers owe the company, perhapsincluding an allowance for doubtful accounts (an example of a contraaccount), since a certain proportion of customers can be expected not topay

• Inventory: goods available for sale, valued at the lower of the cost ormarket price

• Prepaid expenses: representing value that has already been paid for, suchas insurance, advertising contracts or rent

Long-term assets

• Long-term investments: securities that will not or cannot beliquidated in the next year

• Fixed assets: these include land, machinery, equipment, buildings andother durable, generally capital-intensive assets

• Intangible assets: these include non-physical, but still valuable, assetssuch as intellectual property and goodwill; in general, intangibleassets are only listed on the balance sheet if they are acquired, ratherthan developed in-house; their value may therefore be wildlyunderstated—by not including a globally recognized logo, forexample—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, coupon rate on bonds which hasissued to creditors, Due Rent, utilities and salaries.

• Current liabilities are those that are due within one year and arelisted in order of their due date. Long-term liabilities are due at anypoint after one year.

Current liabilities

• Short term debts

• Interest payable

• Suppliers 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 acompany's financial performance over a specific accounting period.Financial performance is assessed by giving a summary of how thebusiness incurs its revenues and expenses through both operatingand non-operating activities. It also shows the net profit or lossincurred over a specific accounting period.

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

• The income statement is divided into two parts: operating and non-operating. The operating portion of the income statement disclosesinformation about revenues and expenses that are a direct result ofregular business operations. For example, if a business creates sportsequipment, it should make money through the sale and/orproduction of sports equipment. The non-operating section disclosesrevenue and expense information about activities that are not directlytied to a company's regular operations. Continuing with the sameexample, if the sports company sells real estate and investmentsecurities, the gain from the sale is listed in the non-operating itemssection.

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 period.

• 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 businessactivities. Cash flows from operations starts with net income and thenreconciles all noncash items to cash items within business operations.For example, accounts receivable is a noncash account. If accountsreceivables go up, it means sales are up, but no cash was received atthe time of sale. The cash flow statement deducts receivables fromnet income because it is not cash. Also what included in cash flowsfrom operations are; accounts payable, depreciation, amortizationand numerous prepaid items booked as revenue or expenses but withno 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 incapital expenditures (CAPEX). While positive cash flows from investingactivities is a good thing, investors prefer companies that generatecash flows primarily from business operations, not investing andfinancing activities.

Cash Flows From Financing

• Cash flows from financing is the last business activity detailed on thecash flow statement. The section provides an overview of cash usedin business financing. Analysts use the cash flows from financingsection to find the amount paid out in dividends or share buybacks.Cash obtained or paid back from capital fundraising efforts, such asequity or debt, is also listed.

Depreciation value

The 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 measurestime 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 of760.000 NIS, having annual as shown in the following table.

Life time Annual Cash flow

1 200.000

2 230.000

3 200.000

4 180.000

5 190.000

6 140.000

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 = 750.000 - 200.00 =

550.000 remaining from the Initial investments• For the second year: remaining Initial investments from the pervious year-

Cash flow for the new year = 550.000- 230.000 = 32 0.000

• For the third year: remaining Initial investments from the pervious year-Cash flow for the new year = 320.000 - 200.000 = 120.000.

• For the fourth year: remaining Initial investments from the pervious year-Cash flow for the new year = 120.000 - 180.000 = (-50.000) surplus over the Initial investments

Recovery period for this project is 3 years& 8 months

Disadvantages of payback period

1. Ignoring the time value of money:

Payback period dealing with money recovered in the first year and lastyear of the project with equal value. This treatment is not viableeconomically because the real value of the cash flows at the beginningof the project lifetime are usually larger than the actual value of thecash flows at the end of six years in our last example.

Disadvantages of payback period (cont.)

2. ignoring the cash flows take place after the return of initial invested capital:

in our 2nd example when the project recovered its initial investment in three years and 8 months 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.

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 invested capital. Return on capital indicates how effective a company is at turning capital into profits.

Net operating profit is the EBIT

Invested capital = total assets – non bearing

Interest current liabilities NIBCLS

2. Return on equity (ROE) is a measure of the profitability of a businessin relation to the book value of shareholder equity, also known as netassets or assets minus liabilities. ROE is a measure of how well acompany 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 cashflows for the project and current value of the out cash flow. Adecision-making using this criteria is based on:

• If we have (+)result i.e. cash inflows larger than cash outflows thenproject is profitable

• If we have (-)result i.e. cash outflows larger than cash inflows thenthen project unattractive .

• if result is (0) i.e. cash outflows equal cash inflows then the projectdoes not make any loss or profit for this type of project we have totake other considerations such as the strategic importance of theproject 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)

2 150 250 200

3 140 150 150

4 100 200 200

5 0 180 180

6 0 0 0If 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 ) 1

2 150* .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 Profit index ratio the better is the project profitability and vice versa.

• If the Profit index ratio less than one (1) the project unattractive and vice versa.

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

Invested capital

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

Invested capital

Return on cost ratio

• This standard refers to the relationship between the current value ofexpected return from the investment in the project and the currentvalue of the projected costs of investment throughout the life time ofthe project. It can be determined by:

• 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑐𝑜𝑠𝑡 𝑟𝑎𝑡𝑖𝑜 =𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛

𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑜𝑠𝑡− 1

• 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 = 8%?

year cost Return

0 120 -

1 75 115

2 80 120

3 85 125

4 95 135

5 100 140

year Cost present value Return present value

0 120 * 1 = 120 ZERO

1 75 * .926 = 69.45 115 * 926.0 = 106.49

2 80 * 0.857 =68.56 120 * 0.857 = 102.84

3 85 * .794 = 67.49 125 * 0.794 = 99.25

4 95* .73 =69.83 135 * 0.735 = 99.225

5 100 * .681 = 68.10 140 * 0.681 = 95.34

total 463.43 503.15

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑐𝑜𝑠𝑡 𝑟𝑎𝑡𝑖𝑜 =𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛

𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑜𝑠𝑡− 1

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑐𝑜𝑠𝑡 𝑟𝑎𝑡𝑖𝑜 =503.15

463.43− 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 is

0 = P0 + P1/(1+IRR) + P2/(1+IRR)^2 + P3/(1+IRR)^3 + . . . +Pn/(1+IRR)^nwhere 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.