COST-BENEFIT ANALYSIS FOR INVESTMENT DECISIONS, CHAPTER 3: THE FINANCIAL APPRAISAL OF PROJECTS Glenn P. Jenkins Queen s Universiy, Kingson, Canada and Easern Medierranean Universiy, Norh Cyprus Developmen Discussion Paper: 2011-3 ABSTRACT Chun-Yan Kuo Queen s Universiy, Kingson, Canada Arnold C. Harberger Universiy of California, Los Angeles, USA The financial analysis of a projec helps deermine he financial viabiliy and susainabiliy of he projec. Since he inegraed projec analysis begins wih he financial analysis and hen he economic analysis, he conceps and daa ough o be organized in a consequenial and consisen manner. The comparison of eiher financial or economic benefis wih heir corresponding coss requires ha all relevan daa should be organized ino a projec profile covering he duraion of he projec's life. While a projec profile is given by cash flows in he financial appraisal, he projec's profile in he economic appraisal provides a flow of ne economic benefis generaed by he invesmen. This chaper explains how cash flow profiles of a projec are developed and consruced in a consisen fashion. I also discusses how invesmen projec can be evaluaed from differen poins of view. To Be Published As: Jenkins G. P, C. Y. K Kuo and A.C. Harberger, Principles Underlying The Economic Analysis Of Projecs Chaper 3, The Financial Appraisal of Projecs. (2011 manuscrip) JEL code(s): H43 Keywords: Economic Analysis, Financial Appraisal, Cash Flows, Inflaion Impacs, Valuaion of Exising Asses
CHAPTER 3: CHAPTER 3 THE FINANCIAL APPRAISAL OF PROJECTS 3.1 Inroducion The financial analysis of a projec helps deermine he financial viabiliy and susainabiliy of he projec. Since he inegraed projec analysis begins wih he financial analysis and hen he economic analysis, he conceps and daa ough o be organized in a consequenial and consisen manner. The comparison of eiher financial or economic benefis wih heir corresponding coss requires ha all relevan daa should be organized ino a projec profile covering he duraion of he projec s life. While a projec profile is given by cash flows in he financial appraisal, he projec s profile in he economic appraisal provides a flow of ne economic benefis generaed by he invesmen. This chaper explains how cash flow profiles of a projec are developed and consruced in a consisen fashion. I also discusses how invesmen projec can be evaluaed from differen poins of view. 3.2 Why a Financial Appraisal for a Public Secor Projec? I may appear ha he financial appraisal of a projec is of ineres only o a privae invesor who wishes o deermine he ne financial gain (or loss) resuling from he projec. Because public secor projecs uilize public funds he analysis from he public perspecive is primarily concerned wih he projec s impac on he counry s economic welfare. From a counry s prospecive, a projec should be underaken if i generaes a posiive ne economic benefi. A projec ha yields negaive ne economic benefis should no be underaken as i will lower he economic welfare of sociey as a whole. To deermine he ne economic benefis produced by a projec he appraisal of such projecs needs o incorporae an economic analysis. There are several reasons for also conducing a financial appraisal for a public secor projec. The mos imporan one is o ensure he availabiliy of funds o finance he projec hrough 2
is invesmen and operaing phases. While an expeced posiive economic reurn is a necessary condiion for recommending ha a projec be underaken, i is by no means a sufficien reason for a successful oucome. A projec wih a high expeced economic reurn may fail if here are no enough funds o finance he operaions of he projec. Many examples of developmen projecs wih expeced high economic reurns have failed due o financial difficulies. Waer supply projecs are ypical examples of projecs ha generae subsanial economic benefis due o he large economic value aached o waer, bu receive lile financial revenues because of he low waer ariffs. If he projec is underaken solely on he basis of he favorable economic analysis wih no consideraion o he financial susainabiliy, he projec may fail due o lack of funds o mainain he sysem and service is deb. Oher examples include projecs such as public ranspor and irrigaion where services are usually provided a concessional prices. A financial analysis enables he projec analyss o esablish he financial susainabiliy of he projec by idenifying financing shorfalls ha are likely o occur over he life of he projec, hereby being able o devise he necessary means for meeing hese shorfalls. A key objecive of a financial appraisal for a governmen projec is o deermine wheher he projec can coninue o pay is bills hroughou is enire life; and if no, how can he shorfalls be me. In cerain insances he governmen approaches a projec like a privae secor invesor o deermine is financial profiabiliy. This is necessary if privae paricipaion in he projec is being conemplaed. In his case, i is imporan o deermine he profiabiliy of a projec and o esimae he value ha a privae invesor would be willing o pay for he opporuniy o paricipae. Asceraining he financial profiabiliy is also necessary when governmen policies are designed o encourage small invesors or cerain groups in sociey o underake projecs by providing hem wih grans or loans. Alhough he governmen s decision o provide grans or loans for hese aciviies should be based on wheher all small invesors underaking he projec yields posiive economic reurns or no, he governmen will need o also deermine if he projecs are financially susainable.
CHAPTER 3: Anoher reason for conducing a financial appraisal of public-secor projecs is direcly relaed o undersanding of he disribuional impacs of he projec. For example, he difference beween he financial price an individual pays for a lier of waer (found in he financial cash flow saemen) and he gross economic benefi he derives from consuming he waer (found in he economic resource flow saemen) reflecs a ne gain o he consumer. Similarly, he difference beween he financial price (inclusive of ax) ha a projec faces and he economic cos of an inpu required by he projec measures he ax gain o he governmen. Gains and losses of his naure will be difficul o esablish on he basis of economic analysis alone. 3.3 Consrucion of Financial Cash Flows: Conceps and Principles The financial cash flow of an invesmen projec is a cenral piece of he financial appraisal. The cash flow saemen of a projec is a lising of all anicipaed sources of cash and uses of cash by he business over he life of he projec. I can be illusraed as in Figure 3.1, where he difference beween receips and expendiures is ploed agains he sequence of years which make up he projec s life. The ne cash flow profile (measured by he difference beween receips and expendiures) is usually negaive in he beginning of a projec s life when he invesmen is being made. In laer years, when revenues from sales of oupu become larger han expendiures, he ne cash flow becomes posiive. Some projecs, which require significan invesmens o be made a inervals hroughou he life of a projec such as he re-ooling of a facory, may also experience negaive cash flows occasionally afer he iniial invesmen has been made. Oher projecs may have negaive cash flows in heir operaing sage if hey are producing a good or service which experiences wide swings in price or demand. Some oher projecs will even have negaive cash flows in he final years of he projec's life as coss are incurred o rehabiliae he projec sie or o compensae workers for heir displacemen. 4
Figure 3.1: Financial Cash Flow Profile of a Projec (+) Iniial Invesmen Period Operaing Sage Receips less Expendiures 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Year of Projec Life (-) 3.3.1 The Invesmen Phase The firs sep in he consrucion of a financial cash flow saemen is he formulaion of an invesmen plan for he projec based on he informaion developed in he echnical, demand, manpower, and financing modules. The invesmen plan consiss of wo secions: he firs secion deals wih he expendiure on new acquisiions, and he opporuniy cos of exising asses, and he second secion deals wih he financing aspecs of he proposed invesmen. If here are differen scales and/or locaions under consideraion, corresponding invesmen plans for each scale and/or locaion should be formulaed. I is imporan ha he invesmen plan conforms o wha is a realisic ime schedule given he demand for he projec s oupu, manpower, financial, and supply consrains in he economy, as well as he echnical aribues of he projec. The invesmen plan will conain a lising of all he expendiures o be underaken up o he poin where he faciliy is ready o begin is normal operaions. Each of hese expendiures should be idenified according o he year in which i is expeced o occur. In addiion, every expendiure should be broken down ino wo pars: firs, he amoun spen on goods and services raded inernaionally and second, he amoun being spen on goods and services raded domesically. These caegories of expendiures are in urn divided ino he paymens received by he suppliers of hese goods, paymens o he governmen (such as ariffs, value
CHAPTER 3: added axes, ec.), subsidies received from he governmen, and subsidies for he purchase of he invesmen iems. Expendiures on labor for he consrucion of he projec should be idenified by year and by skill level for providing a clear undersanding of is cos srucure and deermining if here is likely shorage of skilled workers. These breakdowns are also necessary for esimaing he respecive shadow price of labour in he economic analysis of he projec. (a) Treamen of Asses Depreciaion expense or capial cos allowances are an accouning device o spread he cos of capial asses over he lengh of life of hese invesmens so ha ne income in any given year will reflec all he coss required o produce he oupu. However, depreciaion expense is no a cash ouflow and hus should no be included in he financial cash flow profile of he projec. The full capial coss of an invesmen are accouned for in he financial cash flow profile since he amoun of he invesmen expendiures are deduced in he year hey occur. If any furher capial charge, such as depreciaion expense, were deduced from he cash flow profile, i would resul in a double couning of invesmen opporuniy cos of exising asses. If he projec under consideraion is an ongoing concern or a rehabiliaion projec where some of he projec s old asses are inegraed ino he proposed faciliies, he opporuniy cos of hese asses should be included in he cash flow saemen ogeher wih he expendiure on new acquisiions. I is necessary o disinguish he opporuniy cos of an asse from he sunk cos of an asse. The opporuniy cos of using an asse in a specific projec is he benefi foregone by no puing he asse o is bes alernaive use. To measure he opporuniy cos of an asse, a moneary value has o be assigned o i in such way ha should be equal o wha has been sacrificed by using i in he projec raher han in is nex bes use. On he oher hand, he value of an asse is reaed as a sunk cos if he asse has no alernaive use. 1 1 Sunk cos involves neiher curren nor fuure opporuniy cos and herefore should have no influence in deciding wha will be he mos profiable hing o do. I should, however, be noed ha while he sunk cos of an asse should no be couned as a cos o a new projec in examining is feasibiliy, any ousanding liabiliies due 6
The opporuniy cos of he exising asses is generally included in he firs year of he projec s cash flow profile because he asses could be sold a ha ime if he projec is no feasible. The financial opporuniy cos of an exising asse is he highes financial price ha i could be sold for. The highes financial price is ypically he higher of he in-use value of he asse and is liquidaion value. The in-use value of he asse is wha i would sell for if i were o be used as an ongoing concern. The liquidaion value is wha he asse would sell for if broken ino is differen componens and sold in pars. The coss of insalling machine and equipmen as well as heir liquidaion cos are furher deduced in order o derive he ne liquidaion value of he asses. When considering he opporuniy cos of any producion plan, one should consider he in-use value of he plan if i coninues o be operaed as i is. The mos appropriae way o deermine in-use and liquidaion values is hrough reliable marke assessors. When esimaing in-use values using assessors, he assessor s and sales agency s fees should be subraced from he quoed value o obain he ne in-use value. As well, when assessors give a liquidaion value for a projec s asses, he assessors and sales agency s fees as well as he expendiures incurred in dismanling he asses should be need from he quoed price o obain a ne liquidaion value. An approach o preparing an esimae of he in-use value of a se of asses is o consider heir ne replacemen coss. The ne replacemen cos is he amoun of expendiures ha would have made oday o build a faciliy ha would provide he same amoun of services in he fuure as would he asses ha are now being evaluaed. To esimae he ne replacemen value of an asse, wo adjusmens mus be made o he hisorical purchase cos of asses. The firs adjusmen is for he change in he nominal prices of new asses or he same ype of he asse can perform he same funcion as he asse being evaluaed. This change in price is measured as he raio of he curren price or price index for his asse o he price or price index of he evaluaed asse in he year when purchased. o ha asse may become he liabiliy of he new projec if he ownership is he same.
CHAPTER 3: The second parameer needed o esimae an asse s ne replacemen cos is he amoun of economic depreciaion ha he asse has experienced since i was purchased. The economic depreciaion rae for an asse reflecs he loss in he marke value of he asse, which is generally differen from he depreciaion rae used for ax purposes. The purchase price of an asse adjused for inflaion and ne of he cumulaive amoun of economic depreciaion over years since i was purchased represens he opporuniy cos of he asse if i is used over is remaining lifeime in a projec. 2 Suppose ha he hisorical cos of a machine fully insalled was A 0 and he machine s cumulaed economic depreciaion over years expressed as a fracion is d, and I is he price index for his ype of asse oday, and I h is he price index for his ype of asse in he period i was iniially purchased. Hence ne replacemen value (in-use value) of he machine in year can be esimaed as follows: (Ne replacemen value) = A 0 * (1 Proporion of Asse Depreciaed d ) * (I / I h ) The same calculaion is carried ou for oher ypes of he exising asse. The sum of he above ne replacemen values for all exising asses needs furher adjusmens o accoun for he opporuniy cos of land, invenory, and he excess of accouns receivable over accouns payable in year in order o derive he oal amoun of he ne replacemen value. This value will be considered as he opporuniy cos of he hisorical invesmens or all exising asses for he wihou and wih he projec case. (b) Treamen of Land Land has an opporuniy cos like every oher asse when i is used by a projec. Even if he land is donaed o he projec by he governmen, i should be included as par of he invesmen cos a a value ha reflecs he marke value of land in he projec area. Land is a very special asse because i does no depreciae under mos siuaions. However, 2 Economic depreciaion raes for plans and equipmen may be obained from he plan manufacurer, echnical journals, or insurance companies ha insure a plan s asses. 8
due o improvemens in infrasrucure, he value of land being used by a projec may increase much faser han inflaion during he life of he projec. In such cases i is imporan no o include he increase in land value ha is above inflaion as par of he liquidaion value of he projec. In mos cases he increase in he liquidaion value of land (paricularly in urban areas) has nohing o do wih he projec under evaluaion. Real increases in land value usually come abou because of invesmen being made in public secor infrasrucure. I is imporan no o aribue he increase in he real value of land o any paricular projec o avoid inroducing a bias oward land inensive projecs. The only excepion o his rule occurs when he projec eiher improves or causes damage o he land. In such cases he amoun of he land improvemen or deerioraion should be added o or subraced from he real value of he land measured a he beginning of he projec o deermine he liquidaion value of he land a he end of he projec. Alernaively, he opporuniy cos of land can be refleced in he cash flow profile of he projec by an annual renal charge. This renal charge can be esimaed by using he renal rae per dollar value of he land imes he real value of he land for each period of he projec's life. If he annual renal charge approach is used, hen neiher he iniial cos of he land nor is final marke value should ener ino he cash flow profile of he projec. (c) Invesmen Financing The invesmen plan also deals wih he means and schedule of financing he invesmen expendiures. The financing may consis of equiy, grans, domesic shor-erm and long-erm loans, foreign loans, concessional loans and oher forms of foreign aid. They should be idenified and he disbursemen schedules should be formulaed. Which of hese financings will be included in he cash flow saemen depends on he poin of view considered. While appraising he projec from he owner s poin of view, for example, he loan disbursemen is a cash inflow and he repaymen of loan and ineres paymen are a cash ouflow as he owner is looking o he ne receips afer paying all debs and obligaions. The analysis from a banker s poin of view, however, is no concerned wih he financing bu is looking o deermine he financial viabiliy of he projec o all invesors irrespecive of debors or shareholders.
CHAPTER 3: In he case of public secor projecs, i is he financial performance of he enire invesed capial and no jus he equiy porion ha is relevan for invesors. Ofen boh deb and equiy financing come from he same source and he loans have been eiher explicily or implicily guaraneed by he governmen. We will herefore begin our developmen of he financial cash flows of his projec by making no disincion beween he reurn received by he lenders of deb and ha received by he equiy holders. In his case, he cash made available hrough borrowing is no considered as a cash inflow, nor are he ineres or amorizaion paymens on his deb considered as cash ouflows. The analysis of he financial cash flow from alernaive poins of view will be discussed laer in more deail. Table 3.1 provides an example of an invesmen phase for a mediumscale mining projec. Table 3.1: Invesmen Phase for a Mining Projec (Millions of dollars) Iem Year 0 1 2....7 A. Invesmen Expendiures (a) Sie Preparaion, Exploraion, and Developmen Maerials: - Traded (cif) Tariffs @12% VAT @10% - Non-raded VAT @5% Labor: - Skilled - Unskilled (b) Equipmen 500.0 60.0 56.0 400.0 20.0 150.0 200.0 500.0 60.0 56.0 300.0 15.0 100.0 250.0 Traded (cif) Tariffs @10% VAT @10% 600.0 60.0 66.0 2,000.0 200.0 220.0 Toal Expendiures 2,112.0 3,701.0 B. Financing Equiy 2,012.0 1,201.0 Domesic Loan (shor-erm) 100.0 500.0 Foreign Loan (guaraneed by governmen) 0 2,000.0 10
Toal Financing 2,112.0 3,701.0 Ineres during consrucion is an iem ha is ofen included as an accouning cos in he consrucion phase. This iem is included as a cos o reflec he ineres foregone because funds have been ied up in he consrucion of he projec. I is no a measure of ineres ha has acually been paid, bu an accouning device o measure he opporuniy cos of he funds employed in he projec. If no ineres has been paid by he projec, hen ineres during consrucion is no cash expendiure and should no be included as expendiure in he cash flow saemen of he projec. On he oher hand, if ineres paymens have been made during he period of consrucion, hen here is a cash ouflow when he projec is being examined from he viewpoin of he owner. 3.3.2 The Operaing Phase The operaing phase of he financial cash flow saemen includes all cash receips generaed from he operaion of he projec and all operaing expendiures. Expendiures and receips should be projeced by year of operaion. Like invesmen expendiures, operaing expendiures should be broken down ino inernaionally raded and non-raded iems; and each expendiure iem should be broken down ino is componens, whenever possible. For example, mainenance expendiures should be broken down ino maerials and labor. Expendiures on differen ypes of labor (engineers, elecricians, managers, ec.) should be idenified and recorded separaely. Any axes or subsidies associaed wih he operaing expendiures should also be idenified and recorded separaely whenever possible. These breakdowns are necessary for he economic analysis of he projec and for providing a beer undersanding of he cos srucure of he operaing expendiures. (a) Adjusmen for Sales o Find Cash Receips A projec s viabiliy is no only deermined by he sales i generaes bu also by he iming of he cash receips from he sales. A cash flow saemen records sales ransacions only when
CHAPTER 3: he cash from he ransacion is received. Typically projecs forecas heir sales as a single line iem which comprises boh credi and cash ransacions. A disincion mus be made beween sales and cash receips. When a projec makes a sale, he good or service may be delivered o he cusomer bu no money ransferred from he cusomer o he projec. A his poin he projec s accounans will record ha he projec has an asse called accouns receivable equal o he amoun of he sale and he proporion of i ha is no in cash. In oher words, he buyer owes he projec for he goods or services ha he has purchased and no ye paid for. Unil he buyer has paid for wha he has received, he ransacion will have no impac on he cash flow saemen. When he buyer pays for he iems ha he previously bough from he projec, he projec s accounans will record a decrease in accouns receivable by he amoun ha he buyer has paid and an increase in cash receips. Thus, he cash receips for any period can be calculaed as follows: Cash receips = Sales + Accouns receivable - Accouns receivable for period (inflow) for period a beginning of period a end of period Suppose he accouns receivable recorded on he balance shee a he beginning of he period is equal o $2,000 and hen equal o $2,600 a he end of he period. Sales for his period as recorded on he income saemen are assumed o be $4,000. Toal receips or cash inflow for his period is calculaed as follows: Cash Inflow = $4,000 + $2,000 $2,600 = $3,400 Accouns receivable are ypically measured as a percenage of sales. I is imporan o ensure ha he accouns receivable seleced for he projec are consisen wih he curren performance of indusry sandards. Also imporan is o assess he likelihood for bad debs and o make allowances for hem. Bad debs occur when a projec s cusomers defaul on heir paymens. They simulaneously reduce he amoun of cash inflows o he projec and reduce he amoun of accouns receivable a he end of he period. 12
Suppose in he previous example bad debs of $200 had been wrien off during he period. In his case cash receips for he period are deermined as follows: Cash receips = Sales + Accouns receivable - (Accouns receivable for period (inflow) for period a beginning of period a end of period + Bad debs wrien off During he period) Cash Inflow = $4,000 + $2,000 ($2,600 + $200) = $3,200 I should be noed ha he increase in cash receips and he decrease in accouns receivable will be augmened by he VAT or oher sales axes associaed wih he sale of he iems. These axes are colleced by he firm on behalf of governmens and will be paid o he governmen laer. Such sales axes will now be included in he cash flow saemen of he seller as a par of he cash inflow when hese paymens are received, bu he amoun of sales ax will be subraced from he ne cash flow when he axes are paid o find cash expendiures. (b) Adjusmen for Purchases Similar o he disincion beween sales and receips, a disincion is necessary beween he purchases made by he projec and is cash expendiures. The value of of he ransacion will be recorded in he cash flow saemen only when and o he degree ha cash is paid. When he projec makes a purchase, he good or service may be delivered o he projec bu perhaps no money is ransferred from he projec o is vendor. A his poin he projec s accounans will record ha he projec has a liabiliy called accouns payable equal o a porion of he amoun of he purchase ha is no paid in cash. Unil he projec has paid for wha i has received, he ransacion will have no impac on he cash flow saemen. When he projec pays he vendors for he iems i has bough from hem, he projec s accounans will record a decrease in accouns payable by he amoun ha he projec has paid and an increase in cash expendiures. Hence, cash expendiures can be calculaed from he value of purchases for he period along wih he value of accouns payable boh a he beginning and ending of
CHAPTER 3: he period as follows: Cash expendiures = Purchases + Accouns Payable a - Accouns Payable for period (ouflow) for period beginning of period a end of period Assume ha oal accouns payable a he beginning of a period is equal o $3,500 and a he end of he period i is $2,800, wih he value of purchases from he income saemen being $3,800. Therefore, oal expendiure or cash ouflow is calculaed as follows: Cash Ouflow = $3,800 +$3,500 $2,800 = $4,500 Accouns payable are ypically measured as a percenage of oal purchases or ha of a major inpu. I is imporan o ensure ha he accouns payable on which he cash flow will be based are consisen wih he indusry sandards. (c) Adjusmen for Changes in Cash Balance Increases or decreases in cash balances can ake place even when no changes occur in sales, purchases, accouns receivable, or accouns payable. When cash is se aside for he ransacion of he business, a very imporan reason for he accumulaion of cash occurs when he financial insiuions ha make loans o a projec require ha a deb service reserve accoun be se up and funded. The accumulaion of cash for his or oher purposes represens an ouflow in he cash flow saemen and mus be financed. Similarly, a decrease in cash held for ransacion purposes is a source of cash for oher uses by he projec and hus is a cash inflow. Thus, if he required sock of cash balances o be held o carry ou ransacions increases in a period, his increase is recorded a cash ouflow. On he oher hand, if cash balances decrease, his decrease is a cash inflow. A he end of he projec, any cash se aside will ulimaely be released back o he projec as a cash inflow. The amoun of cash o be held for faciliaing he ransacions of he business is ypically a percenage of he projec s expendiures, sales, or is paern of deb service obligaions. 14
(d) Adjusmen for Oher Working Capial Iems In order o carry ou an economic aciviy, a cerain amoun of invesmen has o be made in iems ha faciliae he conduc of ransacions. These iems are working capial including cash, accouns receivable, accouns payable, prepaid expenses, and invenories. The firs hree iems have already been deal wih as explained above. Prepaid expenses such as insurance premiums are recorded in he cash flow saemen as oher expendiures are made. Changes in invenories are no recorded separaely in he cash flow saemen. When a projec purchases a cerain amoun of raw maerials, invenories of raw maerials will increase. These invenories are financed eiher hrough a cash ouflow and/or an increase in accouns payable. If he invenories have been paid for in cash, hen a cash oulay has been recorded in he cash flow saemen. If hey have been acquired on credi erms, no cash ouflow will occur and hey will be recorded in purchase as an increase in accouns payable. The siuaion is similar when dealing wih changes in he invenories of he final produc. In his case oher inpus such as labour and energy are needed o ransform raw maerials ino finished goods. To do his addiional cash expendiures will be required. A decrease in final good invenories implies ha a sale has occurred. This in urn implies an increase in cash receips or accouns receivable. Since he componens of working capial are developed independenly in differen ways, i is necessary o check for he overall consisency of working capial o ensure adequae provision has been made for working capial in order o carry ou he business ransacions of he projec. This can be done by comparing he amoun of working capial esimaed as a proporion of oal asses of he projec o he indusry average or wih similar businesses ha are operaing successfully. (e) Income ax Liabiliy Income axes paid by he projec should be included as an ouflow in he cash flow saemen. The income ax liabiliy is esimaed on he basis of he projec s income
CHAPTER 3: saemen following he accouning and ax rules of he counry concerned. Year by year esimaes of he cos of goods sold, ineres expense, ax depreciaion expenses, and overheads are all subraced from he projec s revenues o esimae he projec s earning before axes. While esimaing he income ax liabiliy, provisions for loss carry backward and forward if applicable should be aken ino accoun. (f) Value Added Tax Liabiliy Mos counries levy value added axes on he goods and services sold domesically, bu zero rae sales made o cusomers living ouside of he counry. For a axable firm he value of sales will include he value added axes colleced by he projec on behalf of he governmen. The cos of inpus ha are axed will include he value added axes paid on hese purchases. The paymen made o he governmen, if he firm is axable, is he difference beween he value added axes colleced on he sales and he value added axes paid on he purchase of inpus. These paymens of VAT o he governmen are repored in he cash flow saemen as an ouflow. The ne effec of his ax reamen is o largely eliminae he VAT from being financial burden on he projec. When a projec produces an oupu ha is exemp from VAT i will no be charging VAT when i sells is oupu. On he oher hand, in mos circumsances i will coninue o pay VAT on is purchases of inpus. In his case here will no be an addiional line iem reporing he VAT paymen o he governmen. The ne effec of he VAT is o increase he cos of he inpus and hence he financial cash ouflow of he projec. The hird possible siuaion occurs when he oupu of he projec is expeced wih a rae of zero imposed on he expor sales. In his case no ax is included in he sales revenues or cash inflows. The VAT will be levied and included on he inpus purchased by he projec. The difference beween he axes colleced on sales of zero and he axes paid as par of he inpu purchases now becomes a negaive ax paymen or a refund of axes paid. This should be repored as a negaive cos or a cash inflow o he projec. 16
3.3.3 Cessaion of Projec Operaions When a new projec acquires an asse, he enire expendiure on he asse is accouned for in he cash flow saemen a he ime ha he expendiure acually occurs. I is quie possible, however, ha he life of he projec will no coincide wih he life of all is asses, or ha he span of he analysis will no exend as far in he fuure as he projec may be expeced o operae (e.g., railway projecs). Then he residual value of he asse should be included in he cash flow saemen as an inflow in he year following he cessaion of operaions. When deermining he residual value of he asses a he end of he projec, i is preferable o break down all he asses ino differen caegories: land, building, equipmen, vehicles, ec. The residual value is aken as he in-use value unless i is clear he faciliy will be shu down a he end of he projec period. If i is o be shu down, hen he liquidaion value should be used as he residual value. The in-use value of he plan is he value of he plan under he assumpion ha i will coninue o operae as an on-going concern. The liquidaion value is he value of he asses if all componens of he projec are sold separaely and perhaps even he plan is aken apar and sold. While dealing wih he in-use and liquidaion in he fuure, general guidelines are o use he cumulaive economic depreciaion over years. The depreciaion raes can be obained from plan manufacurers, echnical journals or he depreciaion raes used by insurance companies. Land is a special asse ha generally does no depreciae. The residual value of land recorded in he cash flow saemen should be equal o he real marke value of he land recorded a he beginning of he projec, unless he projec resuls in some improvemen or deerioraion o he land. For example, if a projec involves an invesmen o improve he propery such as drainage of a swamp, he residual value of he projec should include he increase in land value resuled direcly from an invesmen made by he projec. The opposie is he case if he projec damages he land and is value. The residual value of he land mus be reduced by he amoun of damage caused by he projec. Nowihsanding, in many cases expecaions
CHAPTER 3: may indicae ha land values are likely o rise faser han inflaion bu he increase is oally unrelaed o he projec. 3 3.3.4 Forma for he Pro-Forma Cash Flow Saemen While here is no specific forma for presenaion of he pro-forma cash flow saemen for an invesmen projec, i is imporan ha he daa should be se ou in sufficien deails so ha he adjusmens required by he economic and disribuive appraisal can be easily applied o he financial cash flows. Enries for receips and paymens mus be classified as oulined in he above discussion of invesmen and operaing phases for he projec. Receips mus be idenified according o wheher hey arise from sales of radable or non-radable goods wih all axes. Paymens should also be presened in a similar fashion wih all axes, ariffs, and subsidies iemized separaely. Labor coss mus be idenified according o he ype of labor used. To illusrae he consrucion of he financial cash flow saemen, we coninue wih he example of he mine. The invesmen phase of he projec is oulined in Table 3.1. Now, we assume ha mining projec has an operaing life of five years, and he machinery and equipmen will be liquidaed as scrap a he closure of mine. This is carried ou in he year following he mine closure a which ime he scrap is expeced o yield $1 billion. The land is assumed o have zero value afer being mined. Table 3.2 conains he basic operaing informaion required o develop he pro-forma cash flow saemens for his projec. For example, accouns receivable and accouns payable are assumed a 20 percen of annual sales and purchases inclusive of VAT, respecively. Desired cash balances are assumed o be equal o 10 percen of purchases of inpus. As he oupu of he mine is assumed o be expored he expor sales will be zero raed for VAT axaion. 3 Expeced increases in land values are generally speculaive which implies ha building such increases in he residual value of land may no occur. Moreover, he purpose of he analysis is o appraise he projec and deermine is impac on is sponsors. Large increases in land value may be sufficienly large, leading o he implemenaion of he projec and a misallocaion of resources. Thus, he residual value of land should be generally he same as is real price a he sar of he projec. 18
A 10 percen royaly is charged on he value of expor sales. This is paid direcly o he governmen. No income ax is levied on his mining aciviy. Table 3-2: Operaing Informaion for he Case of a Mining Projec (Millions of dollars) Iem Year 0 1 2 3 4 5 6 7 Sales - Traded - VAT @ 0% Purchases of Inpus - Traded (cif) Tariffs @10% VAT @10% - Non-raded VAT @5% Operaing Labor - Skilled - Unskilled Working Capial (end of period values) - Accoun Receivables - Accoun Payables - Cash held as working capial 0 0 0 2,000.0 0 600.0 60.0 66.0 200.0 10.0 100.0 50.0 400.0 187.2 93.6 3,000.0 0 750.0 75.0 82.5 250.0 12.5 150.0 70.0 600.0 234.0 104.5 3,500.0 0 800.0 80.0 88.0 320.0 16.0 200.0 90.0 700.0 260.8 130.4 3,000.0 0 700.0 70.0 77.0 200.0 10.0 150.0 80.0 600.0 211.4 105.7 2,000.0 0 600.0 60.0 66.0 200.0 10.0 125.0 60 400.0 187.2 93.6 0 0 0 Wih he daa presened in Tables 3.1, and 3.2, he pro-forma cash flow saemen can be consruced in deail broken down by commodiy and labor ype as Table 3.3. This pro-forma cash flow saemen provides he basis for he financial and economic analysis of he projec which will follow. I is he ne cash flow from his saemen ha gives us he projec profile shown in Figure 3.1. I should be noed ha no VAT is colleced on he sales on behalf of he ax auhoriy while VAT paid on purchases can be claimed back as inpu ax credis under mos consumpion ype VAT sysem. Thus, a row of VAT inpu ax credi in Table 3.3 is creaed in order o derive he impac of he ne VAT paymens or refund of VAT paid on inpus on he ne cash flow for he projec.
A. Receips: Table 3.3: Pro-Forma Financial Cash Flow Saemen for an Invesmen in a Mine (Millions of dollars) Iem Year 0 1 2 3 4 5 6 7 Foreign Sales (raded goods) VAT @ 0% Change in Accoun Receivables Liquidaion Value (scrapped asses) 2,000.0 0-400.0 3,000.0 0-200.0 3,500.0 0-100.0 3,000.0 0 +100.0 2,000.0 0 +200.0 0 +400.0 1,000.0 Cash Inflow 1,600.0 2,800.0 3,400.0 3,100.0 2,200.0 1,400.0 B. Expendiures: a) Sie Preparaion, Exploraion and Developmen: Maerials: - Traded Goods (cif) Tariffs @12% VAT @10% - Non-raded Goods VAT @5% Equipmen: - Traded (cif) Tariffs @10% VAT @10% b) Inpu Purchases - Traded Goods (cif) Tariffs @10% VAT @10% Change in Accouns Payable - Non-raded Goods VAT @5% Change in Accouns Payable c) Consrucion Labor: - Skilled - Unskilled d) Operaing Labor: - Skilled - Unskilled e) Change in Cash Held as Working Capial 500.0 60.0 56.0 400.0 20.0 600.0 60.0 66.0 150.0 200.0 500.0 60.0 56.0 300.0 15.0 2,000.0 200.0 220.0 100.0 250.0 600.0 60.0 66.0-145.2 200.0 10.0-42.0 750.0 75.0 82.5-36.3 250.0 12.5-10.5 800.0 80.0 88.0-12.1 320.0 16.0-14.7 700.0 70.0 77.0 24.2 200.0 10.0 25.2 600.0 60.0 66.0 24.2 200.0 10.0 0 145.2 42.0 100.0 150.0 200.0 150.0 125.0 50.0 70.0 90.0 80.0 60.0 93.6 23.4 13.4-24.7-12.1-93.6 Cash Ouflow 2,112.0 3,701.0 992.4 1,366.6 1,580.62 1,311.7 1,133.1 93.6 C. Tax Paymens (a) VAT (Paymen, (Refund)) (b) Royaly -142.0 0-291.0 0-76.0 200.0-95.0 300.0-104.0 350.0-87.0 300.0-76.0 200.0 0 0 D. Ne Cash Flow -1,970.0-3,410.0 483.0 1,228.4 1,573.4 1,575.3 942.9 1,306.4 3.4 Use of Consisen Prices in he Cash Flow Forecas When conducing a financial appraisal of a projec, i is necessary o make a projecion of prices for he inpus and oupus over is life. These prices are influenced by movemens in 20
he real price of he good in quesion and he effec of inflaion. The facors affecing he real price and inflaion are quie differen. Real prices are deermined by changes in he marke demand and/or supply for he specific iems while inflaion is usually deermined by he growh of he counry's money supply relaive o is producion of goods and services. Forecass of inflaion are generally beyond he capabiliy or responsibiliy of he projec analys. The rae of inflaion is basically a risk variable, and he analysis of a projec should be subjeced o a range of possible inflaion raes. The criical issue for he analys is o consruc a projecion of nominal prices ha are consisen wih assumed paern of inflaion raes hrough ime and he projecion of changes in real prices. The projecion of he fuure pah of real prices is of paricular imporance if he price of one or more inpu or oupu is significanly above or below is normal level or rend. To undersand he impac of real price changes and inflaion on he financial viabiliy of a projec and how hey are incorporaed in he analysis, we firs consider he definiion or derivaion of various price variables employed in he analysis. 3.4.1 Definiion of Prices and Price Indices (a) Nominal Prices The nominal prices of goods and services are hose found in he markeplace, and are ofen referred o as curren prices. Hisorical daa for nominal prices are relaively easy o obain, bu forecasing nominal prices in a consisen manner is a nooriously difficul ask. The nominal price of an iem is he oucome of wo ses of economic forces: macroeconomic forces which deermine he general price level or inflaion, and he forces of demand and supply for he iem which causes is price o move relaive o oher goods and services in he markeplace. In order o consruc a cash flow forecass in nominal prices, we mus ake ino consideraion he movemen of boh real prices and he general price level.
(b) Price Level and Index The price level for an economy ( P ) is calculaed as a weighed average of a seleced se of nominal prices: L P 1, P 2, P 3,. P n The price level P can be calculaed for any period () as follows: L n P = L i= 1 P i Wi (3.1) where: i denoes he individual good or service included in he marke baske; P i denoes he price of he good or service a a poin in ime; W i denoes he weigh given o he price of a paricular good or service (i); and W i =1. The weighs used for calculaing a price level are defined as of a cerain dae. This dae is referred o as he base period for he calculaion of he price level. The weighs esablished a ha ime will rarely change because we wan o compare he level of prices of a given baske of goods beween various poins in ime. Hence, i is only he nominal prices which change hrough ime in equaion (3.1), while he weighs (W 1, W 2,,W n ) are fixed. Insead of calculaing he price level for he enire economy, a price level may be creaed for a cerain subse of prices such as consrucion maerials or consumer goods. I is generally useful o express he price level of a baske of goods and services a differen poins in ime as a price index ( P ). The price index simply normalizes he price level so ha in he base I period he index is equal o one. If we wish o calculae a price index ha compares he price levels in wo disinc periods, we can wrie he equaion as follows: P = I P / P (3.2) L B L 22
where P denoes he price level in period (), and P denoes he price level for he base I period (B). For example, he consumer price index is a weighed average of he prices for a seleced marke baske of consumer goods. The invesmen price index is creaed as a weighed se of goods and services ha are of an invesmen naure. The change in he price index for a broad se of goods and services is used o measure he rae of inflaion in he economy. 4 B L Suppose here are hree commodiies in a baske of consumer goods and heir prices in Year 1 are $30, $100, and $50 as shown in Example 1. The corresponding weighs of hese goods are 0.2, 0.5, and 0.3. The price level in Year 1 is $71 using equaion (3.1). If he prices of hese hree goods in Year 2 become $40, $110, and $40, respecively, he weighed average of he price level will be $75. Similarly, he price level in Year 3 as shown in he example is $73. Example 1: Nominal Prices and Changes in Price Assume Year 1 is Base Year Goods 1 2 3 Weighs 0.2 0.5 0.3 1 1 1 Nominal Prices Year 1: P 1 = 30 P 2 = 100 P 3 = 50 1 P L = 0.2 (30) + 0.5 (100) + 0.3 (50) = 71 B P = 71 L Price Index 1 P I = 1.00 2 2 2 Nominal Prices Year 2: P 1 = 40 P 2 = 110 P 3 = 40 2 P L = 0.2 (40) + 0.5 (110) + 0.3 (40) = 75 2 Price Index P I = 1.056 3 3 3 Nominal Prices Year 3: P 1 = 35 P 2 = 108 P 3 = 60 3 L P = 0.2 (35) + 0.5 (108) + 0.3 (60) = 79 Price Index 3 P I = 1.113 Inflaion Rae: Changes in General Price Level (Measured in erms of a price index) 2 P = [( P P )/( P )] * 100 = [(1.056 1.00)/(1.00)] * 100 = 5.63% g 2 I I 3 I 1 I 1 I 2 2 g P = [( P P )/( P )] * 100 = [(1.113 1.056)/(1.056)] * 100 = 5.33% 3 I I I 4 In some counries he consumer price index is he bes insrumen for he measuremen of inflaion, for ohers i is he implici GDP deflaor.
Using he price level in Year 1 as he base period, we can calculae he price indices based on equaion (3.2) as 1.00, 1.056, and 1.113 for Year 1, Year 2, and Year 3, respecively. (c) Changes in General Price Level (Inflaion) Inflaion is measured by he change in he price level divided by he price level a he beginning of he period. The price level a he beginning of he period becomes a reference for deermining he rae of inflaion hroughou ha paricular period. Hence, inflaion for any paricular period can be expressed as in equaion (3.3). 1 gp = [( P P 1 )/ P ] 100 (3.3) e I I I I Inflaion is much more difficul o forecas han he changes in real prices, because inflaion is primarily deermined by he supply of money relaive o he availabiliy of goods and services in an economy o purchase. The supply of money, in urn, is ofen deermined by he size of he public secor defici and how i is financed. If governmens finance heir defici by borrowing heavily from he Cenral Bank, inflaion is ineviably he end resul. In he evaluaion of an invesmen, we need no aemp o make an accurae forecas of he rae of inflaion. I is essenial, however, o make all he oher assumpions concerning he financing and operaion of he projec consisen wih he assumed paern of fuure inflaion. In mos counries, he rae of inflaion is a risk variable which we mus ry o accommodae hrough he financial design of he projec. For example, even hough he hisorical raes of inflaion in he economy may be only 5 or 6%, we may wan o see if he projec can survive if he rae of inflaion is much higher and much lower. If he analysis demonsraes ha i will be severely weakened, hen we may wan o ask wheher he projec can be redesigned so as o beer wihsand such unanicipaed raes of inflaion. (d) Real Prices Real prices ( P ) are an imporan subse of relaive prices where he nominal price of an ir iem is divided by he index of he price level a he same poin in ime. They express prices 24
of he goods and services relaive o he general price level. This is shown by equaion (3.4). p ir= p i / p (3.4) I where P denoes he nominal price of good or service a ime (), and i level index a ime period (). P denoes he price I Dividing by a price level index removes he inflaionary componen (change in he general price level) from he nominal price of he iem. This allows us o idenify he impac of he forces of demand and supply on he price of he good relaive o oher goods and services in he economy. Example 2 illusraes how real prices are calculaed using equaion (3.4). For insance, he real price of good 1 in Year 2 is $37.87, which is obained from dividing he nominal price $40 by he price index 1.056.
Example 2: Real Prices and Changes in Real Price Goods 1 2 3 Weighs 0.2 0.5 0.3 Nominal Prices Year 1: 1 P 1 = 30 1 P 2 = 100 1 P 3 = 50 1 Price Index P I = 1.00 Real Prices Year 1: 1 P = 30/1 1R P = 100/1 2 1R P = 50/1 3 1R = 30 = 100 = 50 2 Nominal Prices Year 2: P 1 = 40 2 P 2 = 110 2 P 3 = 40 2 Price Index P I = 1.056 Real Prices Year 2: 2 P = 40/1.056 1R P = 110/1.056 2 2R P = 3 2R 40/1.056 = 37.87 = 104.16 = 37.87 3 Nominal Prices Year 3: P 1 = 35 3 P 2 = 108 3 P 3 = 60 3 Price Index P I = 1.113 Nominal Prices Year 3: 3 P = 35/1.113 1R P = 108/1.113 2 3R P = 3 3R 60/1.113 = 31.45 = 97.04 = 53.91 Changes in Real Prices Year 2: Change in 2 P = [( 1R P 1 2R P )/( 1 1R P )] = 1 1R (37.87 30)/30 (104.16 100)/100 (37.87 50)/50 = 0.2623 = 0.0416 = 0.2426 Changes in Real Prices Year 3: Change in 3 P = [( 1R 1 3R P P )/( 1 2R P )] = 1 2R (31.45 37.87)/37.87 (97.04 104.16)/104.16 (53.91 37.87)/37.87 = -0.1695 = 0.0683 = 0.4235 (e) Changes in Real Prices The change in he real price of a good or service can be expressed as: pir p Δ p ir = (3.5) p 1 ir 1 ir where p ir denoes he real price of good (i) as of a specific period. Using Example 2 and equaion (3.5), we can compue ha he change in real price of good 1 in Year 3 is -16.95%. 26
For each of he inpus and oupus a se of projecions mus be prepared in he pah of is real price over he life of he projec. For iems where rapid echnological change is aking place, such as compuers or elecommunicaion equipmens, we would expec ha he real price of hose goods would fall. There is one imporan inpu, however, whose relaive price is almos cerain o rise if here is economic developmen in he counry. This is he real wage rae. If economic developmen akes place, he value of labor relaive o oher goods and services will have o rise. Hence, in he forecasing of real prices for a projec we should consider he poenial for real wages o rise and build his ino he cos of inpus for a projec over is life. (f) Inflaion Adjused Values Inflaion adjused values for prices of inpus and oupus are he resul of our bes forecas of how real prices for paricular goods and services are going o move in he fuure, and his forecas is hen adjused by an assumed pah of he general price level over fuure periods. In oher words, we are producing a se of nominal prices which are buil up from heir basic componens of a real price and a price level. These inflaion adjused values are generaed in a consisen fashion. A common misake of projec evaluaors is o assume ha many of he prices of inpus and oupus for a projec are rising relaive o he rae of inflaion. This is highly unlikely. The price level iself is a weighed average of individual goods and services prices. Hence, in he forecas of he real price of he goods and services used or produced by our projec, we would expec ha approximaely as many real prices will be falling as are rising. To forecas he movemen of he real price of a good or service, we need o consider such iems as he anicipaed change in he demand for he iem over ime, he likely supply response, and he forces which are going o affec is cos of producion. This analysis is very differen from ha which goes ino he forecas of he general price level. This forecas is no so much a predicion, bu a se of consisen assumpions. I is he inflaion-adjused values
which we use in he esimaion of he nominal cash flows of a projec. They can be esimaed using equaion (3.6): P + 1 i = P i (1 + +1 gp ir )(1 + +1 gp ) (3.6) I Where P + 1 i denoes he esimaed nominal price of good (i) in year +1; P i denoes he nominal price of good (i) in year ; +1 gp ir denoes he esimaed growh in real price of good (i) beween year and +1; and +1 gp denoes he assumed growh in price level index from year o year +1. I (g) Consan Prices I should be noed ha real prices are someimes referred o consan prices, which, as he name implies, do no change over ime. They are simply a se of nominal price observaions as of a poin in ime ha is used for each of he subsequen periods in a projec appraisal. While nominal prices are affeced by changes in real prices as well as changes in he price level, consan prices reflec neiher of hese economic forces. If consan prices are used hroughou he life of he projec, hen we are ignoring boh he changes in real prices, which may have a profound impac on he overall financial posiion of he projec, and he impac which inflaion can have an impac on he performance of an invesmen. The use of consan prices simplifies he consrucion of a cash flow profile of a projec, bu i also eliminaes from he analysis a large par of he financial and economic informaion ha can affec he fuure performance of he projec. Two specific prices are discussed below due o he imporan role hey play in he financial analysis of projecs. These are he ineres rae and he price of foreign exchange. 28