Cash-flow forecasting for investment projects with non-reimbursable financing

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1 Cash-flow forecastng for nvestment projects wth non-rembursable fnancng BOGDAN SACAL Department of Economc Cybernetcs LORELAI SACAL Department of Economc Cybernetcs LUCIAN PĂUNA Department of Economc Cybernetcs ADRIAN BĂDESCU Department of Economc Cybernetcs Abstract: Non-rembursable fnancng for nvestment projects s a hgh nterest subject n the post-adheraton phase of our country to European Unon. Ths new way to fnance projects mples new methods and technques for fnancal forecastng that take nto account these new challenges. The followng paper present a coherent methodology that can be used n order to justfy the necessty and opportunty for non-rembursable fnancng for nvestment projects, takng nto account the specfc requrements of the exstng fnancng programs avalable for Romanan nvestors. Key-Words: Cash-flow forecastng, Net present value, Internal rate of return, Non-rembursable fnancng 1 Introducton In 2007 Romana joned the European Unon (EU) and, as a drect consequence, started to beneft from non-rembursable fundng n order to reduce the gap n economc and socal development to the other countres n the EU. These fnancng opportuntes are drected towards nvestment projects, socal development projects and publc servces projects. Accessng the non-rembursable fnancng opportuntes mples a compettve selecton for the fnancng requests sent by applcants to the fnancng authortes. The fnancng requests are accompaned by techncal and fnancal documents of dfferent complexty degrees, documents that are meant to justfy the request for fnancng. Investment projects are a large part of the projects proposed for fnancng by applcants. These nvestment project proposals submtted to the fnancng authortes have to prove that the nonrembursable fundng s necessary and approprate, justfcaton that s made by usng fnancal ISBN:

2 forecastng of the cash-flows generated by the proposed projects. In order to prove that an nvestment project submtted for fnancng s both necessary and fnancally vable, the applcant has to forecast the projects cash-flow and calculate certan ndcators. The most often used ndcators are the Net Present Value (NPV) and the Internal Rate of Return (IRR), both of them beng well known fnancal ndcators, but when used for projects wth non-rembursable fundng they have to be adjusted n order to provde the necessary nformaton regardng the proposed project. The low rate of funds absorpton regstered by Romana at the end of 2010 and the lack of abltes both n provdng and checkng the fnancal aspects of the projects demonstrate that the problem of forecastng the cash-flows of nvestments wth nonrembursable funds s not yet solved. 2 Problem Formulaton For an nvestment project that s submtted n a call for projects for non-rembursable fnancng, the applcants have to forecast the cash-flows n order to determne the necessary fnancal ndcators, NPV and IRR. In order to analyze an nvestment project one has to establsh certan assumptons made: - the nvestment project s deployed over a pror tme perod, named forecastng perod ; - the forecastng perod s dvded nto two dstnct tme perods: the mplementaton perod (the project s mplemented n ths tme perod) and the operatng perod (start when the project s fnalzed and the project starts functonng and producng ncomes); - for the mplementaton perod the cash-flows should be presented monthly, and for the operatng perod the cash-flows should be presented yearly. The 7 th Internatonal Accountng Standard (IAS 7) defnes the cash-flows as cash and cash equvalent recepts and payments. The fnancal statements users are provded wth a useful tool for evaluatng a company s ablty to generate cash and cash equvalents, and ts requrements for usng cash and cash equvalents n current actvtes. Followng a functonal approach to an economc entty s actvtes, the standard proposes three types of cash-flows: - Investng cash-flows the acquston and dsposal of long-term assets and other nvestments that are not consdered to be cash equvalents; - Fnancng cash-flows actvtes that alter the equty captal and borrowng structure of the entty; - Operatng cash-flows man revenue-producng actvtes of the entty that are not nvestng or fnancng actvtes, so operatng cash flows nclude cash receved from customers and cash pad to supplers and employees. Calculatng the cash-flows generated by the three actvtes mentoned above can be done usng two methods: - The drect method method whch conssts of addng the dfferent types of cash-flows n order to determne the cash-flow of the project; - The ndrect method starts from the net proft or loss of the fnancal year, whch s then corrected by removng the non-monetary transactons and nformaton. 2.1 The drect method The drect method s the method used n order to forecast the cash-flows requred n the fnancng request documentaton for non-rembursable fundng, accordng to current regulatons. The forecasted cash-flows are presented usng the followng structure: C. Operatng cash-flows D. Net cash-flow of the perod (A+B+C) E. Avalable from the prevous perod F. Cumulatve cash-flow (D+E) Table 1 Forecastng the cash-flows s a straght-forward procedure usng one of the numerous methods and technques from the fnancal forecastng theory. Ths present paper wll not present any of these well-known technques and assumes them employed n order to obtan the necessary cash-flows. 2.2 Net Present Value (NPV) and Internal Rate of Return (IRR) Usng the net cash-flows of every forecasted perod, one can calculate the Net Present Value usng the followng relaton: = n CF NPV (1) =1 ( 1+ r the dscount rate CF net cash-flow generated n perod. ISBN:

3 Analyzng the value calculated for the Net Present Value, a decson-maker should decde to mplement/fnance the project f NPV > 0. The other ndcator, the Internal Rate of Return can be calculated as the value for the dscount rate that makes NPV = 0. The decson-maker should decde to mplement/fnance the project f IRR> r. The presented cash-flows and ndcators calculated based on those cash-flows can be employed by a economc entty n order to determne f an nvestment project s worth dong or not. The specfc problem adressed n ths paper s regardng those nvestment projects that are submtted for non-rembursable fundng. The applcants that submt ths projects have to prove the necessty and opportunty of the proposed nvestment projects. Forecastng the cash-flows and calculatng the fnancal ndcators for those projects requres adaptng the presented methodology to the specfcs of non-rembursable fundng. 3 Problem Soluton Forecastng cash-flows for nvestment projects wth non-rembursable fundng requres usng a specfc structure n order to apprecate the necessty and opportunty of the proposed nvestments. In order to evaluate a proposed nvestment project, one has to forecast two separate cash-flows that ntegrate dfferent elements for the three cashflow types dentfed usng the functonal approach. Evaluatng the necessty for the nonrembursable fnancng requres usng the followng cash-flow structure: - contans the nvestment value mnus the VAT (Value Added Tax), dstrbuted over the mplementaton perod - doesn t contan the fnancng sources for the project (ex: non-rembursable fnancng, the state budget, attracted fnancng sources, the applcant own fnancng sources) - doesn t contan the cash payments afferent to the attracted fnancng sources (rates and nterests) C. Operatng cash-flows - contans the operatng cash recepts and payments excludng the VAT - the resdual value s ncluded n the last forecastng perod D. Net cash-flow of the perod (A+B+C) E. Avalable from the prevous perod F. Cumulatve cash-flow (D+E) Table 2 Usng ths structure for the forecasted cashflows, by addng the dfferent cash-flows consdered, the followng relaton can be used for the Net Present Value at Investment Costs: n m I CF j RVm NPV ( C) = + + (2) j m = 1 ( 1+ j= n+ 1 ( 1+ ( 1+ { 1,..., n} the mplementaton perod j { n+ 1,..., m} the operatng perod r the dscount rate I the nvestment cost n perod CFj cash-flows generated n perod j RVm resdual value. The evaluaton of the necessty of the nonrembursable fnancng s done based on the followng conclusons: - the Net Present Value at Investment Costs has to be negatve ( NPV ( C ) < 0 ); - the Internal Rate of Return at Investment Costs has to be smaller then the employed rate of dscount ( IRR( C)< r ). If the two results presented are obtaned, the proposed project should not be mplemented n the proposed fnancng alternatve (fnancng entrely done by the applcant). In ths case, the project s not fnancally vable; mplctly t does need the nonrembursable fnancng. Once the necessty of the non-rembursable fnancng s establshed, the opportunty for the non-rembursable fnancng has to be evaluated. Usng certan assumptons gven by the fnancng program consdered, lke the ntensty of the nonrembursable fundng (ex: 1 ml. Euro or 50% of the nvestment costs), the cash-flows are constructed as follows: - doesn t contan the nvestment value - contans the fnancng sources of the applcant for the project (ex: attracted fnancng sources, the applcant own fnancng sources) - contans the cash payments afferent to the attracted fnancng sources (rates and nterests) C. Operatng cash-flows - contans the operatng cash recepts and payments excludng the VAT - the resdual value s ncluded n the last forecastng perod D. Net cash-flow of the perod (A+B+C) ISBN:

4 E. Avalable from the prevous perod F. Cumulatve cash-flow (D+E) Table 3 Usng ths method for buldng the forecasted cash-flows, we can use the followng relaton to calculate the fnancal ndcators: n m K CF j RVm NPV ( K) = + + (3) j m = 1 ( 1+ j= n+ 1 ( 1+ ( 1+ { 1,..., n} the mplementaton perod j { n+ 1,..., m} the operatng perod r the dscount rate K the applcants resources n perod CFj cash-flows generated n perod j RVm the resdual value. The evaluaton of the opportunty of the nonrembursable fnancng s done based on the followng conclusons: - the Net Present Value at Invested Captal has to be negatve ( NPV ( K ) < 0 ); - the Internal Rate of Return at Invested Captal has to be smaller than the employed rate of dscount ( IRR( K)< r ). 3.1 Numerc example Usng the methodology presented, we wll evaluate an nvestment project startng from the followng assumptons: - total nvestment costs, not ncludng VAT: 2.000; - mplementaton perod: 2 years; - annual operatng cash-flow: 700; - operatng perod: 3 years; - dscount rate: 5%; - fnancng ntensty: 50%; - applcants sources: 100% own funds. Usng these assumptons we buld the forecasted cash-flows n order to evaluate the necessty of the non-rembursable fnancng: Evaluatng the necessty of the non-rembursable fnancng Cash-Flows Year 1 Year 2 Year 3 Year 4 Year C. Operatng cash-flows D. Net CF (A+B+C) E. Avalable prevous perod F. Cumulatve CF (D+E) Net Present Value at Investment Costs - NPV(C) -130,36 Internal Rate of Return - IRR(C) 1,97% Table 4 The calculated NPV(C) s negatve and the IRR(C) s smaller than the dscount rate, so we can conclude that the proposed project requres nonrembursable fnancng. Usng the same assumptons we buld the forecasted cash-flows n order to evaluate the opportunty of the non-rembursable fnancng: Evaluatng the opportunty of the non-rembursable fnancng Cash-Flows Year 1 Year 2 Year 3 Year 4 Year C. Operatng cash-flows D. Net CF (A+B+C) E. Avalable prevous perod F. Cumulatve CF (D+E) Net Present Value at Investment Costs - NPV(K) 799,34 Internal Rate of Return - IRR(K) 35,58% Table 5 The calculated NPV(K) s postve and the IRR(K) s larger than the dscount rate, so we can conclude that the proposed project should be awarded non-rembursable fnancng. In concluson, the proposed nvestment project requres and should beneft from non-rembursable fnancng from the fnancng program. 4 Concluson The two cash-flows presented allow an applcant or a fnancng authorty to evaluate the necessty and opportunty for non-rembursable fnancng for an nvestment project. These evaluaton methods are presently used for evaluatng project for nonrembursable fnancng n Romana, wthout any exstng accepted methods for structurng and constructng the forecasted cash-flows. Ths paper proposes a coherent methodology for usng forecasted cash-flows n order to evaluate nvestment projects wth non-rembursable fnancng. Aknowledgement Ths work was supported by CNCSIS-UEFISCSU, project number PNII-IDEI_1805/2008. References: [1] Bogdan SACAL - Cost-Beneft Analyss: E- Government Investment Projects The proceedngs of the Nnth Internatonal Conference on Informatcs n Economy Educaton, Research and Busness Technologes, Edtura Economca, 2009 [2] *** Internatonal Accountng Standard nr. 7; ISBN:

5 [3] *** (2006) - Workng Document no.4: Gudance on the Methodology for carryng out Cost-Beneft Analyss ( regonal_polcy/) ISBN: