This area of study is directly connected with the technical study of a project. Assuming that the proposal is technically feasible, then the next question is “Can the product be sold? Where? How?” In addition, one should also ask about the profitability of the proposed project.
An analytical study of the market situation, therefore, should be made. This portion of the study will involve the determination of the supply and demand conditions, both for the output and the raw materials needed by the proposed project. The production costs, proposed selling price and marketing and distribution policies and strategies should be spelled out in detail. This will also be needed in the financial study.
In addition, the contribution of the project to the national economy should be carefully evaluated. The importance of this arises whenever projects are submitted to government financial intermediaries for financing. This analysis should show the relative merits of the project proposal with respect to such economic parameters as may impact on the employment, national output, balance of payment, etc.
The next task, after determining the technical and market feasibility of the project, is to determine the profitability from both the financial and economic standpoint. Profitability is defined as the ability to earn return over and above the cost of capital with consideration of the risks involved. Financial and economic viability both determine the profitability of a project; they differ in the nature of profit they measure. While financial profit refers to the income derived from the project, economic profit pertains to the net contribution of the project to the country's socio-economic goals. The cost and revenue and evaluation may differ but the application of investment analysis techniques are essentially the same.
The following are the profitability indicators:
Any or a combination of these indicators determine the profitability of the project.
The first three profitability indicators take into account the relative timing of cost and benefit (revenue) flow through the process of discounting.
The NPV, IRR, and B/C ratio will involve discounting. Discounting is defined as a process of translating future value into their present value worth by applying a discount factor that reflects the diminishing value of the same amount of money as one moves further into the future.
The net present value is defined as the difference between the present value project benefit (B) and the value of the present value of the project cost (C).
| Where | B | = | benefits derived from the project |
| C | = | investment, operating and other associated cost incurred by the project. | |
| r | = | discount rate (Appendix D) | |
| n | = | number of years |
The decision rule for the NPV criterion is that accept project where NPV is equal to or greater than 0 and reject otherwise. Derivation of NPV of a project requires the following:
benefit and cost stream
a decision on the period over which calculations are to be made, generally the life of the project in question
the discount rate
The benefits(B) are derived from the market and financial studies while cost stream would include the investment outlay and the operating expenses, extracted from the technical and financial studies.
The benefit-cost ratio B/C is the ratio of the present value of gross benefit to the present value of gross cost.
The decision rule is: accept projects with B/C greater or equal to 1; otherwise reject.
The internal rate of return of a project is that discount rate which equates the present value of the benefit and cost. The new present value of benefit is zero and B/C = 1.
IRR could be estimated by a trial and error method or by interpolation using positive NPV and negative NPV as upper and lower limits in which NPV = 0.
| Where: | ra = | the discount rate for NPVa |
| rb = | the discount rate for NPVb |
By proportion:
triangle a na r is to triangle abc
We have
The decision rule is to accept the project if IRR is greater than or equal to the relevant discount rate; otherwise reject.
The pay-back period is just to determine the number of years it takes to recover all capital investment. The shorter the pay-back period is, the better the project.
The accounting rate of return may be obtained by comparing project earning/income with the total amount invested. This includes:
In order to assess the project's profitability preparation of the following financial statements are undertaken:
Income statement is defined as the calculation of the revenue less cost of a project. This may be the excess of revenue over expenses or the excess of expenses over revenue.
The significance of the financial analysis is that no enterpreneur will engage in a business where it is a losing proposition and never if the project will not meet its financial obligation. Financial analysis is defined as an assessment of the commercial profitability of the project and its capacity to meet its obligations. Financial analysis is defined as an assessment of the commercial profitability of the project and its capacity to meet its obligations. In the assessment of the financial profitability of the project, projection of its revenues, expenses, receipts and expenditure is necessary over the life of the project. Revenue is defined as a transaction that generates income whether or not cash in-flows are involved, and expenses are transactions that reduce income, irrespective of cash flow.
Financial projections are basically the qualified result of the marketing, technical, management and financing studies. In order to assess the profitability, and to assure the project's capacity to meet its financial obligations, the following financial statements are undertaken:
This projection could be for the first few years or the entire life of the project depending upon its objectives.
The projected income statement shows the expected revenues and the corresponding cost and expenses, hence, net profit can be calculated.
The projected cash flow shows the expected movement of cash into or out of the project. This also shows the pre-operating period whenever cash is involved.
As pointed out there are different measures of investment feasibility. The net present value (NPV) is the best measure of a project's economic worthiness; NPV measures the difference between the present value of project cost and benefits. Projects are considered economically feasible whenever benefits exceed cost or when NPV is greater than zero.
The basic guideline in identifying the cost of the project is the activity that involves the use of real resources. Cost item are classified as:
Capital cost
contingencies
Operating and maintenance cost
Benefit could be defined as an increase in the economy's real resources through increase in output or savings in resources. Actually benefit is more difficult to identify. As a general rule, B/C ratio equal or greater than 1 is economically feasible, otherwise, reject.
The break-even point technique is used in the analysis of the profit, cash generation, and debt service ability. The purpose of the break-even point analysis is to find out the level of sales (Quantity) or the selling price per unit at which the project will break even. If the projected sales volume or selling price is higher than the BEP then the project is expected to gain. The BEP may also be used to establish the level of sales volume or the selling price per unit at which the project will generate just enough cash for the operation. If the projected sales volume or selling price is higher than the BEP, then the project is expected to generate from the operations some funds which may be used to pay other obligations. This will also be used in determining the level of sales volume at which the project will generate just enough cash for operation and for payment of loan.
The formula for Break-Even Point Sales Volume is:
For BEP Selling Price:
| Where | TFC | = Total Fixed Cost |
| USP | = Unit Selling Price | |
| UVC | = Unit Variable Cost | |
| FC | = Fixed Cost | |
| VC | = Variable Cost |
Fixed Cost - Fixed cost could be defined as the cost/expenses that definitely do not vary, irrespective of the level of production or sales, e.g., depreciation, basic salaries and interest on loan.
Variable Cost - Those costs that change when production or sales volume increase or decrease.
For multiple production, the formula is:
Another tool in determining the financial viability is the Cash Pay Back Method. This determines the time in which the cost of investment can be recovered.
The faster the investment can be recovered or the shorter the payback period, the better the project. The reasons for this are:
The rate of return is the comparison of the investment with the annual net profit as shown in the income statement or with the average profit for the life of the project. The higher the rate of return, the more profitable is the project. The disadvantage of this approach is that it totally disregards time elements. Another method is the use of the discounted cash flow Rate of Return. This compares the capital invested with the net profit taking into account through the time element. The rate of return with this method could be derived a trial and error method or graphical method. Before the DCF rate return may be established the life of the project should be estimated.
- TECHNICAL ASPECT
- Project Description
Location
- Suitability of the area for fishpond development
Accessibility or nearness to market
- Development Plan
Development cost
- Production Program
Operating cost (for 10-year period)
- MANAGEMENT ASPECT
By whom and how will the project be managed?
- MARKETING ASPECT
- Mode of Distributing the Product
- FINANCIAL ASPECT
