EUP 222 ENGINEER

IN SOCIETY
PROJECT FINANCE
Understand the financial concepts to appraise a project
efficiently and make decisions effectively.
Dr. Sharifah Akmam Syed Zakaria, PPKA .

email: akmam@usm.my

Outline

Lecture Objective & Context

Project Financing

Owner
Project
Contractor
Financial Evaluation
Project Income
Inflation
Operating Costs
Time value of money
Present value
Rates
Interest
NPV
Internal Rate of Return (IRR)
Return on Capital Employed (Accounting Rate of Return)
Payback period

Case Study: Mbox by ECOLEX

A small electronic firm, ECOLEX
intends to produce a magnetic
heating lunch box (Mbox)

A Cleaner Production (CP)

assessment at ECOLEX identified
some potentially profitable
investment projects that also has
environmental benefits.

Financial Information: A
Initial investment = RM 4 million
Selling price (current price terms)
= RM 40 per unit

Variable operating costs (current

price terms) = RM 16 per unit

Expected selling price inflation

= 6 % per year

Fixed operating costs (current price

terms) = RM340,000 per year

Expected operating cost inflation

= 8 % per year

Financial Information: B
Demand forecast for Mbox by ECOLEX marketing team:

Year

Demand (units)

120,000

140,000

240,000

90,000

No terminal value or machinery scrap value.

A nominal (money) discount rate = 10% per year

A target return on capital employed = 30% per year.

Ignore taxation.

Financial Information: C
Given discount rates :

Year
Discount at 10%
Discount at 20%

0
1.000
1.000

1
0.909
0.833

2
0.826
0.694

3
0.751
0.579

4
0.683
0.482

Project Income:
Selling price (current price terms)
= RM 40 per unit

Expected selling price inflation

= 6 % per year
1

Year

RM
Inflated selling
price
Demand
Income

(RM/unit)
(units/year)
(RM/year)

RM

3
RM

RM 40 +
.06 (40)
42.40

RM 42.40 +
.06(42.40)
44.94

120,000 X

140,000

4
RM

RM 44.94 +
.06(44.94)
47.64
X

240,000

RM 47.64 +
.06(47.64)
50.50
X

90,000

5,088,000

6,291,600

11,433,600

4,545,000

Operating Costs:
Fixed operating costs
(current price terms)
= RM340,000 per year

Variable operating costs

(current price terms)
= RM 16 per unit

RM

(units/year)

Total Variable costs

(RM/year)

(+) Inflated Fixed

Costs

Total Operating costs

RM

120,000

RM

RM 16 +
.08 (16)
17.28

(RM/unit)
Inflated variable cost
Demand

Expected operating
cost inflation
= 8 % per year

RM

RM 17.28 +
.08 (17.28)
18.66
X

140,000

RM 18.66 +
.08 (18.66)
20.15
X

240,000

RM 20.15 +
.08 (20.15)
21.76
X

90,000

(RM/year)

2,073,600
RM 340,000 + .08
(340,000)
367,200

2,612,400
RM 367,200
+ .08 (367,200)
396,576

4,836,000
RM 396,576 +
.08(396,576)
428,302

1,958,400
RM 428,302 + .08
(428,302)
462,566

(RM/year)

2,440,800

3,008,976

5,264,302

2,420,966

Outline
Lecture Objective & Context
Project Financing

Owner
Project
Contractor
Financial Evaluation
Project Income
Inflation
Operating Costs
Time value of money
Present value
Rates
Interest
NPV
Internal Rate of Return (IRR)
Return on Capital Employed (Accounting Rate of Return)
Payback period

Net Present Value

Suppose we had a collection (or stream, flow) of costs and revenues
in the future.

The net present value (NPV) is the sum of the present values for all
of these costs and revenues.
Treat revenues as positive and costs as negative

Calculation of Net Present Value

Total Revenue (R) (+)

Various Costs (C) (-)

Calculate Gross Return

Tax (-)
Calculate Net Return
Discount Rate (r)
PV of Net Return

Initial Invest (-I)

NPV of the Project

Net Present Value Decision Rule:

>
NPV =
<

Accept the project

Indifferent to the project
Reject the project

Accept a project which has 0 or positive NPV

Alternatively,

Use NPV to choose the best among a set of

(mutually exclusive) alternative projects
Mutually exclusive projects: the acceptance of a project precludes
the acceptance of one or more alternative projects.

Discount Rate in NPV:

NPV (and PV) is relative to a discount rate

In the absence of risk or inflation, this is just the interest rate of the
reliable source (opportunity cost)

Correct selection of the discount rate is fundamental. If too high, projects

that could be profitable can be rejected. If too low, the firm will accept
projects that are too risky without proper compensation.

Its choice can easily change the ranking of projects

An investment has money going out (invested or spent), and

money coming in (profits, dividends etc).
You hope more comes in than goes out, and you make a profit!
But before adding it all up you should calculate the time value of
money.
Money now is more valuable than money later on.

Financial Information: A
Initial investment = RM 4 million
Selling price (current price terms)
= RM 40 per unit

Variable operating costs (current

price terms) = RM 16 per unit

Expected selling price inflation

= 6 % per year

Fixed operating costs (current price

terms) = RM340,000 per year

Expected operating cost inflation

= 8 % per year

Financial Information: B
Demand forecast for Mbox by ECOLEX marketing team:

Year

Demand (units)

120,000

140,000

240,000

90,000

No terminal value or machinery scrap value.

A nominal (money) discount rate = 10% per year

A target return on capital employed = 30% per year.

Ignore taxation.

Financial Information: C
Given discount rates :

Year
Discount at 10%
Discount at 20%

0
1.000
1.000

1
0.909
0.833

2
0.826
0.694

3
0.751
0.579

4
0.683
0.482

Net present value with discount rate at 10% :

Project Income:
Selling price (current price terms)
= RM 40 per unit

Expected selling price inflation

= 6 % per year
1

Year

RM
Inflated selling
price
Demand
Income

(RM/unit)
(units/year)
(RM/year)

RM

RM

RM 40 +
.06 (40)
42.40

RM 42.40 +
.06(42.40)
44.94

120,000 X

140,000

5,088,000

3
RM
RM 44.94 +
.06(44.94)
47.64
X

240,000

6,291,600 11,433,600

RM 47.64 +
.06(47.64)
50.50
X

90,000

4,545,000

Operating Costs:
Fixed operating costs
(current price terms)
= RM340,000 per year

Variable operating costs

(current price terms)
= RM 16 per unit

RM

(units/year)

Total Variable costs

(RM/year)

(+) Inflated Fixed

Costs

Total Operating costs

RM

RM

RM 16 +
.08 (16)
17.28

(RM/unit)
Inflated variable cost
Demand

Expected operating
cost inflation
= 8 % per year

120,000

RM

RM 17.28 +
.08 (17.28)
18.66
X

140,000

RM 18.66 +
.08 (18.66)
20.15
X

240,000

RM 20.15 +
.08 (20.15)
21.76
X

90,000

(RM/year)

2,073,600
RM 340,000 + .08
(340,000)
367,200

2,612,400
RM 367,200
+ .08 (367,200)
396,576

4,836,000
RM 396,576 +
.08(396,576)
428,302

1,958,400
RM 428,302 + .08
(428,302)
462,584

(RM/year)

2,440,800

3,008,976

5,264,302

2,420,966

Net present value with discount rate at 10% :

Year
Initial investment = RM 4 million
Discount at 10%
Year

Investment
Income
(-)Operating
Costs
Net cash
flow
Discount at
10%
PRESENT VALUES

0
RM

0
1.000

RM

1
0.909
2

RM

2
0.826

3
0.751
3

RM

4
0.683
4

RM

(4,000,000)
5,088,000
2,440,800

6,291,600
3,008,976

11,433,600
5,264,302

4,545,000
2,420,966

2,647,200

3,282,624

6,169,298

2,124,034

0.909

0.826

0.751

0.683

(4,000,000)

2,406,305

2,711,447

4,633,143

1,450,715

1.000

Net present value with discount rate at 10% :

PRESENT VALUES

(4,000,000)

2,406,305

2,711,447

4,633,143

1,450,715

Net present
7,201,610
value:
INVESTMENT EVALUATION:
The investment proposal has a positive net present value (NPV) of RM 7,201,610 and is
therefore financially acceptable.
The results of the other investment appraisal methods do not alter this financial
acceptability, as the NPV decision rule will always offer the correct investment advice.

Outline

Lecture Objective & Context

Project Financing

Owner
Project
Contractor
Financial Evaluation
Project Income
Inflation
Operating Costs
Time value of money
Present value
Rates
Interest
NPV
Internal Rate of Return (IRR)
Return on Capital Employed (Accounting Rate of Return)
Payback period

Internal Rate of Return (IRR)

Internal rate of return is used to evaluate the attractiveness of a project
or investment.

If the IRR of a new project exceeds a companys required rate of return, that
project is desirable.

If IRR falls below the required rate of return, the project should be rejected.

 The IRR is a good way of judging different investments.

First of all, the IRR should be higher than the cost of funds.
If it costs you 8% to borrow money, then an IRR of only 6% is not good

enough!
It is also useful when investments are quite different.
Maybe the amounts involved are quite different.
Or maybe one has high costs at the start, and another has many small costs
over time.

Financial Information: C
Given discount rates :

Year
Discount at 10%
Discount at 20%

0
1.000
1.000

1
0.909
0.833

2
0.826
0.694

3
0.751
0.579

4
0.683
0.482

Net present value with discount rate at 10% :

Year
Initial investment = RM 4 million
Discount at 10%
Year

Investment
Income
(-)Operating
Costs
Net cash
flow
Discount at
10%
PRESENT VALUES

0
RM

0
1.000

RM

1
0.909
2

RM

2
0.826

3
0.751
3

RM

4
0.683
4

RM

(4,000,000)
5,088,000
2,440,800

6,291,600
3,008,976

11,433,600
5,264,302

4,545,000
2,420,966

2,647,200

3,282,624

6,169,298

2,124,034

0.909

0.826

0.751

0.683

(4,000,000)

2,406,305

2,711,447

4,633,143

1,450,715

1.000

Net present value (discount rate 10%):

PRESENT VALUES

(4,000,000)

Net
present
value:

7,201,610

2,406,305

2,711,447

4,633,143

1,450,715

Internal Rate of Return (IRR) with discount rate at 20%,

For investment appraisal purposes, this company uses a nominal
(money) discount rate of 10% per year.
Net cash
flow
Discount at
20%
PRESENT
VALUES

(4,000,000)

2,647,200

3,282,624

6,169,298

2,124,034

0.833

0.694

0.579

0.482

(4,000,000)

2,205,118

2,278,141

3,572,024

1,023,784

1.000

Net Present Value (discount rate of 20%)

: RM 5,079,067

Internal Rate of Return (IRR) with discount rate at 20%,

Given: a nominal (money) discount rate of 10% per year.
= nominal discount rate per year + [ (current discount rate - nominal discount
rate per year) X NPV of nominal discount rate] / (NPV of nominal discount
rate + NPV of current discount rate)

= 10 + [ (20 10) X 7,201,610 ] / (7,201,610 + RM 5,079,067)

= 10 + 5.9
= 15.9%

INVESTMENT EVALUATION:
The internal rate of return (IRR) method also recommends accepting the investment
proposal, since the IRR of 15.9 % is greater than the 10% return required by this
company.
If the advice offered by the IRR method differed from that offered by the NPV
method, the advice offered by the NPV method would be preferred.

Outline

Lecture Objective & Context

Project Financing

Owner
Project
Contractor
Financial Evaluation
Project Income
Inflation
Operating Costs
Time value of money
Present value
Rates
Interest
NPV
Internal Rate of Return (IRR)
Return on Capital Employed (Accounting Rate of Return)
Payback period

Return on Capital Employed (Accounting Rate of

Return)
Defined as the rate of return that makes the NPV of the project
equal to zero.

To see whether the projects rate of return is equal to or higher

than the rate of the firm to expect to get from the project.

Return on Capital Employed (Accounting Rate of

Return)
Oftentimes, IRR and NPV give the same decision/ranking among

projects.
IRR only looks at rate of gain not size of gain
IRR does not require you to assume (or compute) a discount rate.
IRR ignores capacity to reinvest
IRR may not be unique

Use both NPV (size) and IRR together (rate)

However, Trust the NPV: It is the only criterion that ensures wealth
maximization. It measures how much richer one will become by
undertaking the investment opportunity.

Financial Information: A
Initial investment = RM 4 million
Selling price (current price terms)
= RM 40 per unit

Variable operating costs (current

price terms) = RM 16 per unit

Expected selling price inflation

= 6 % per year

Fixed operating costs (current price

terms) = RM340,000 per year

Expected operating cost inflation

= 8 % per year

Net present value with discount rate at 10% :

Year
Initial investment = RM 4 million
Discount at 10%
Year

Investment
Income
(-)Operating
Costs
Net cash
flow
Discount at
10%
PRESENT VALUES

0
RM

0
1.000

RM

1
0.909
2

RM

2
0.826

3
0.751
3

RM

4
0.683
4

RM

(4,000,000)
5,088,000
2,440,800

6,291,600
3,008,976

11,433,600
5,264,302

4,545,000
2,420,966

2,647,200

3,282,624

6,169,298

2,124,034

0.909

0.826

0.751

0.683

(4,000,000)

2,406,305

2,711,447

4,633,143

1,450,715

1.000

Return on Capital Employed (Accounting Rate of Return):

Given: a target return on capital employed of 100% per year. Ignore taxation.

Total net cash flow = 2,647,200 + 3,282,624 + 6,169,298 + 2,124,034 = RM 14,223,156

Total depreciation and initial investment are same, as there is no scrap value.
Total accounting profit = Total net cash flow - Initial investment

= RM 14,223,156 RM 4,000,000 = RM 10,223,156

Average annual accounting profit = RM 10,223,156 /4 = RM 2,555,789 (A)
Average investment = 4,000,000/4 = RM 1,000,000(B)
Return on capital employed = (A) / (B) X 100
= RM 2,555,789 / RM 1,000,000(B) X 100
= 256 %

INVESTMENT EVALUATION:

The calculated return on capital employed of 256% is more than the target
return of 100%.

So, the project is acceptable.

As indicated earlier, the investment proposal is financially acceptable as it has
a positive NPV.

The reason why this company has a target return on capital employed of
100% cab be investigated. This may be due to changed economic
circumstances with high demand on sustainable products.

Outline

Lecture Objective & Context

Project Financing

Owner
Project
Contractor
Financial Evaluation
Project Income
Inflation
Operating Costs
Time value of money
Present value
Rates
Interest
NPV
Internal Rate of Return (IRR)
Return on Capital Employed (Accounting Rate of Return)
Payback period

Payback Period
Payback period (Time to return)
Minimal length of time over which benefits repay costs
Typically only used as secondary assessment

What are we Assuming Here?

That only quantifiable monetary benefits matter.

Certainty about future cash flows:

Main uncertainties:
Financial concerns
Currency fluctuations (international projects)
Inflation/deflation
Taxes variations
Project risks

Project Management Phase

FEASIBILITY

DESIGN
PLANNING

DEVELOPMENT

Financing & Evaluation

Risk

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