FINANCIAL ANALYSIS

Corazon. T. Aragon

Objectives of Financial Analysis

To assess the project’s commercial profitability for the project operating entity and its debt-service capacity

Criteria for Determining Financial Feasibility

The project is commercially profitable – it generates a rate of return acceptable to both the project proponent and the funding institution

The project can meet it debt service obligation

Two Types of Measures of Financial Viability

1. Undiscounted Measures

2. Discounted Measures

Undiscounted Measures of Financial Viability

A major limitation of these measures is that they do not consider the time value of money The two undiscounted measures of financial viability are as follows:

1. Payback Period - the number of years it takes to recover all the capital invested.

The formula for computing the payback period if the stream of gross annual profit is constant from year to year is as follows:

Payback Period = Original Capital Investment Ave. Annual Gross Marginwhere:

 Gross Margin = Gross Revenues or

Income - Operating Expenses for

Any Year

Average Gross = Sum of Gross Margin for

Each YearMargin Number of Years of

Project Life

Table 1. Payback computation for a nata de coco project. Case 1: Constant gross profit or margin from year to year.

YEAR GROSS OPERATING GROSS

REVENUEa EXPENSES MARGINb

(P) (P) (P)

1 15,300 5,100 10,200

2 15,300 5,100 10,200

3 15,300 5,100 10,200

4 15,300 5,100 10,200

5 15,300 5,100 10,200

Total 76,500 25,500 51,000

Average Annual Gross Margin 10,200

Initial Capital Investment 51,000

Payback Period 5 years

if the initial capital investment of a project is P51,000 and the project is expected to produce a stream of annual annual gross margin of P10,200 per year, the payback would be five years (Table 1). Payback period = 51,000/10,200 = 5 years

However, if the annual gross profit is not equal from year to year, they should be summed year by year to find the year where the total is equal to the amount of the investment.

Table 2. Payback computation for a nata de coco project. Case 2: Different annual gross profit from year to year.

YEAR GROSS OPERATING GROSS

REVENUEa EXPENSES MARGINb

(P) (P) (P)

1 20,400 5,100 15,300

2 25,500 10,200 15,300

3 30,600 10,200 20,400

4 35,700 10,200 25,500

5 40,800 15,300 25,500

Total 153,000 51,000 102,000

Average Annual Gross Profit 20,400

Initial Capital Investment P51,000

Payback Period 3 years

The payback method does not really measure profitability, but is a measure of how quickly the investment will contribute to the liquidity of the business. For these reasons, it can easily lead to poor investment decisions and is not the best method for investment analysis.

The payback method quickly identifies the investments with the most immediate gross profit.

However, the payback period has two weaknesses, which leads to misleading choice of investments:

1.)  it fails to give any consideration to gross profit earned after the payback date;  2.) it fails to take into account the differences in the timing of gross profit earned prior to the payback date. No consideration is given to the time value of money. A peso received during the first year is given the same weight as a peso received in the second year.

2. Return on Investment (ROI) – The rate of return on investment expresses the average annual net revenue as a percentage of the investment. Where:

  Ave. Annual Net revenue or Net

Income = Ave. Annual Gross Margin – Ave. Annual Depreciation

The rate of return on investment is calculated from the following equation:

Return on Investment (%) = Average Annual Net Income x 100(ROI) Investment Cost

Assuming that the annual depreciation of containers and equipment amount to P5,100 in the example in Table 1, then the average annual net revenue is:

= Average Annual Gross Profit Revenue - Average Annual Depreciation

= P10,200 – P5,100 =P5,100

Then, the return on investment (%) is computed as follows :

Return on Investment (%) = Average Annual Net Income x 100

Investment Cost Return on Investment (%) = P5,100/ P51,000) x 100 = 10%

In the example in Table 2, then the average annual net revenue is:

= Average Annual Gross Profit or Gross Margin - Average Annual Depreciation = P20,400 – P5,100 = P15,300

The rate of return on investment is better than the payback period because it considers an investment’s earnings over its entire life.

However, it uses average annual earnings, which fails to consider the size and timing of annual earnings and can, therefore, cause errors in selecting investments. This is particularly true when there are increasing or decreasing net revenues.

Because of this shortcoming, the rate of return on investment is not generally recommended for analyzing investments.

Concept of the Time Value of Money and Discounting

The most commonly applied profitability indicators assume the concept of "time value of money".

The essence of this concept is that money received or spent at a particular time has greater value than the same money received or spent at some future time.

For example, a peso received today would be more valuable than the same peso received a year from now.

Discounting is the process of finding the present value of a future amount of gross benefits, gross costs, or net benefits.

The present or discounted value is determined by multiplying the future amount by the discount factor.

The discount factor maybe obtained from a discounting table or may be computed using the following formula:

D = 1/(1 + r)t

where: D is the discount factorr is the discount ratet is the year

Example: Determine the yearly discount factor at 18% discount rate for a period of three years.

 D in year 1 = 1/(1.18)1 = .847 D in year 2 = 1/(1.18)2 = .718 D in year 3 = 1/(1.18)3 = .609

Consider, for example, an expected gross benefit of P25,500/year two and three years from now. Assuming a discount rate of 18%, the present value would be: B2 = 25,500 1____ = 25,500 (.718) = (1 + 0.18)2 P18,309

 B3 = 25,500 1____ = 25,500 (.609) = (1 + 0.18)3

P15,529

Thus, at a discount rate of 18%, P25,500 two and three years from now would be worth the equivalent of only P18,309 and P15,529 today, respectively.

Financial Cash Flow Analysis

Types of Data Needed for Financial Cash Flow Analysis

1. Benefits

Types and Measurement of Benefits1.) Gross Value of Production –

This is obtained by multiplying production by the unit price of the commodity.

In financial cash flow analysis, prices of outputs and inputs are assumed to be constant throughout the project life.

Sensitivity analysis can later on be done to determine the effect of price changes on the financial viability of the investment project using NPV and/or IRR as profitability measures or indicators.

2). Residual or Terminal Value or Scrap Value - The residual value of a fixed asset like tools, equipment and machinery is the value of an asset remaining unused at the end of the project. It is taken as a resale value of an asset that is used and then put upon for resale. The residual value/terminal

value of a fixed asset is generally added in the last year of the project.

Example: Determine the residual value of 3 units of spade (worth P204/unit or a total of P612) with a life span of 3 years to be used in a coconut- vegetable project with a project life of 5 years.

Purchased in Yr 1 and Yr 4      

  Yr1 Yr2 Yr3 Yr4 Yr5   Spade 612

   612

 

           

Compute residual value as follows:

   

Residual Value = Purchase Value - Accumulated Depreciation

Assuming a salvage value of 0, the annual depreciation using the straight line method will be:

= P612/3 = P204/year For the 3 units of spade purchased in yr 4, it will be used only for two years. Its accumulateddepreciation is:

 P204/yr x 2 yrs = P408. Hence, its residual value in Yr 5 is computed as follows:

Residual Value = Purchase Value - Accumulated Depreciation

Residual Value = 612 - 408 = P204

With regard to land purchased, the terminal value is entered in the financial cash flow table at the end of the project.

The terminal value of land can be determined by interviewing farmers regarding the cost/buying price of a similar type of land in the project area. If the land is rented, it is considered not a fixed investment, but part of operating cost (cash or non-cash).

Costs Classification of

Costs 1.) Fixed Capital Investment

The value of each fixed capital item (e.g., tools, equipment, machinery, land, buildings, and transport vehicles) is entered during the year when it is purchased/constructed.

Depreciation is not entered as a cost item in the financial cash flow analysis. Instead, the actual value of the fixed capital item is considered in the analysis. This is in contrast to costs and returns analysis, which includes depreciation as a cost item rather than the total value of the fixed capital item.

2. Cash Operating and Maintenance Expenses/ Production Costs

Operating and maintenance expenses include the following production/ processing cost items: 1) raw materials and other supplies; 2) energy and fuels; 3) labor; 4) rent and insurance; 5) electricity and water consumed in the production/processing process; and repair and maintenance expenses.

3. Selling and Administrative Expenses

Selling and administrative expenses include marketing costs, office utilities, salaries of administrative personnel, and communication expenses, among others.

4. Duties and business license fees

Three Discounted Measures of Financial Viability

1. Benefit-Cost (B/C) Ratio – This is the ratio of the sum of the present value (or discounted value) of gross benefits to the sum of the present value (or discounted value of gross costs. The B/C ratio is computed using the following formula:

B/C Ratio =

i = 0

Ci

(1 + r)t

nΣ

i = 0

Bi

(1 + r) t

nΣ

The decision rule is to accept investment projects with B/C ratio greater than 1. Reject if otherwise. In the case of two competing investment projects, select the project with the highest B/C ratio.

The steps in calculating the B/C ratio are as follows

1. Calculate the discounted or present value of gross benefit in each year by multiplying the gross benefit in each year by the discount factor in each year. Then compute the total or sum of the discounted gross benefits throughout the project life.

2. Calculate the discounted or present value of gross cost in each year by multiplying the gross cost in each year by the discount factor in each year. Then compute the total or sum of the discounted gross costs throughout the project life.3. Divide the sum of the discounted gross benefits by the sum of the discounted gross costs.

Table 3. Manual calculation of NPV and BCR of a 1-ha coconut-lanzones/eggplant project, Philippines, 2002.

YEAR

GROSS BENEFITS

(P) (A)

GROSS COSTS

(P)(B)

NET BENEFITS

(P)(A - B)

DISCOUNT FACTOR

(12%)

DISCOUNTED

GROSS BENEFITS

(P) (C)

GROSS COST

(P) (D)

NET BENEFITS

(P) (C-D)

1 76,283.25 227,479.17 -151,196.17 0.893 68,120.94 203,139.12 -135,018.18

2 76,283.25 36,523.93 39,759.32 0.797 60,797.75 29,109.57 31,688.18

3 76,283.25 36,883.93 39,399.32 0.712 54,313.67 26,261.36 28,052.32

4 76,283.25 42,183.93 34,099.32 0.639 48,745.00 26,955.53 21,789.47

5 76,283.25 36,883.93 39,399.32 0.567 43,252.60 20,913.19 22,399.41

6 76,283.25 36,883.93 39,399.32 0.507 38,675.61 18,700.15 19,975.46

7 34,565.25 27,205.35 7,359.90 0.452 15,623.49 12,296.82 3,326.67

8 35,738.25 20,739.95 14,999.30 0.404 14,438.25 8,378.54 6,059.72

9 43,949.25 21,363.40 22,585.85 0.361 15,865.63 7,712.19 8,153.49

10 50,987.25 26,891.70 24,095.55 0.322 16,417.89 8,659.13 7,758.77

11 58,025.25 34,180.15 23,845.10 0.287 16,653.25 9,809.70 6,843.54

12 74,447.25 22,696.90 51,750.35 0.257 19,132.94 5,833.10 13,299.84

13 79,139.25 28,253.20 50,886.05 0.220 17,410.64 6,215.70 11,194.93

14 90,869.25 24,305.80 66,563.45 0.205 18,628.20 4,982.69 13,645.51

15 260,367.75 24,678.40 235,689.35 0.183 47,647.30 4,516.15 43,131.15

TOTAL         495,723.21 393,482.94 102,240.27

B/C Ratio = Sum of Discounted Gross Benefits = Sum of Discounted Gross Cost

495,723.71 = 1.26393,482.69

2. Net Present Value (NPV) – This is simply the present worth of the incremental net benefits or the difference between the sum of present values of gross benefits and gross costs.

Two ways of calculating NPV:

1. First method - NPV is computed by getting the difference between the sum of the discounted gross benefits and the sum of the discounted gross cost. Thus, the formula used in calculating NPV in the first method is as follows:

 If investment starts in year 1 n nNPV = Σ ______ - Σ ____ i=0 (1 + r)t (1 + r)t

Bt C1

NPV = sum of discounted gross benefits – sum discounted gross costs

495,723.21 - 393,482.94 = P102,240.27

2. Second method - NPV is calculated by computing first the yearly net benefits (i.e., gross benefits – gross cost) and then the sum of the discounted net benefits is computed. n

NPV = Σ ________ i=0 (1 + r)t

Bt - Ct

A project is financially viable if NPV is greater than 0 or if it is positive. Otherwise, reject the project. In the case of two competing investment projects, select the project with the highest NPV.

If investment starts in year 0 or at present n nNPV = Σ __Bt____ - Σ _Ct___ i=0 (1 + r)t (1 + r)t

Example of Computing NPV and Its Interpretation:

The NPV of the coconut – lanzones/ eggplant intercropped farm was also computed to determine and compare its financial viability (Table 3).

Using the second method, the steps in calculating NPV are as follows:

1. Compute the net benefit in each year. Net benefit in each year is the difference between gross benefit and gross cost in each year.  2.  Compute the discounted net benefit in each year by multiplying the net benefit in each year by the discount factor in that year.

3. Calculate the sum of the discounted net benefits. The sum or total figure obtained is the NPV.

Interpretation:

As shown in Table 3, investing in a coconut – lanzones/ eggplant intercropping project is financially viable since the NPV is positive (P102,240.27).

Annualized Net Income

Since the NPV shows the cumulative net benefits expressed in present value throughout the project life, annualized net benefit expressed in present value can be calculated using the following annuity formula:

Annuity Formula

A = NPV [ r ( 1 + r)t/ (1 + r) t – 1] Where: A is the annualized net benefit in

present value r is the discount rate t is the project life [ r ( 1 + r)t/ 1 + r)( t – 1] is the

capital recovery factor

The use of the annuity formula converts NPV into equal annual net benefits throughout the project life.

Investors are more interested to know how much profit they will get in a year.

Thus, investors will find it more acceptable to compare the profitability of two investment projects using the annualized net benefit expressed in present value.

Annualized Net Benefits or Income

From the capital recovery factor table, the capital recovery factor at 12% discount rate for a period of 15 years is 0.147. Hence, the annualized net benefit in present value is calculated as follows:

A = 102, 240.27 x 0.147 = P15,029.32

The investor will, therefore, expect an annual net income amounting to P15,029.32 every year for a period of 15 years from coconut–lanzones/eggplant intercropping .

4. Financial Internal Rate of Return (FIRR) - This is the discount rate that equates the present values of the project’s benefits and costs, so NPV is equal to zero or the B/C ratio is equal to 1. This is also referred to as the

average earning power of money used in the new investment project over the project’s life after all costs have been recovered.

The actual rate of return with proper accounting for the time value of money is the internal rate of return, which is also called the marginal efficiency of capital or yield on the investment.

The financial internal rate of return is the maximum rate of return that an investment project could pay if all resources were borrowed or if the investment project is to recover the investment and operating costs and still break even. It can be explained as a measure of the return on the resources engaged in the investment project.

In equation form, FIRR is that r where:

i = 0

Bt

(1 + r)t

nΣ

i = 0

Ct

(1 + r)t

nΣ=

i = 0

Ct

(1 + r)t

nΣ

-i = 0

Bt

(1 + r)t

nΣ

NPV = = 0

So that;

FIRR is calculated by the interpolation method or by trial and error method. The common practice is to apply two discount rates that result in a negative and a positive NPV and hence, enclose the zero NPV.

The following are the steps in calculating FIRR:

1. Choose a discount rate at which the NPV is expected to be positive, and compute for the NPV. If the NPV is positive, proceed to step 2. If the NPV turns out to be negative, choose one or more lower discount rates until a positive NPV is obtained. Then proceed to step 2.

2. Choose another higher discount rate at which the NPV is expected to be negative. If the NPV turns out to be negative, proceed to step 3. Otherwise, choose an even higher discount rate until a negative NPV is obtained. Then, proceed to step 3.

3. Once two discount rates, one yielding a positive NPV and another yielding a negative NPV have been obtained, interpolate for the discount rate at which NPV equals zero. This is the internal rate of return.

Table 4. Manual calculation of FIRR of 1-ha coconut-lanzones/eggplant project, Philippines, 2002.

YEARGROSS

BENEFITS (A)

GROSS COSTS

(B)

NET BENEFITS

(A - B)

DISCOUNT FACTOR

(25%)

DISCOUNTED

GROSS BENEFITS

(C)

GROSS COST

(D)

NET BENEFITS

(C-D)

1 76,283.25 227,479.17 -151,196.17 0.800 61,026.60 181,983.64 -120,956.94

2 76,283.25 36,523.93 39,759.32 0.640 48,821.28 23,375.32 25,445.96

3 76,283.25 36,883.93 39,399.32 0.612 46,685.35 22,572.97 24,112.38

4 76,283.25 42,183.93 34,099.32 0.410 31,276.13 17,295.41 13,980.72

5 76,283.25 36,883.93 39,399.32 0.328 25,020.91 12,097.93 12,922.98

6 76,283.25 36,883.93 39,399.32 0.262 19,986.21 9,663.59 10,322.62

7 34,565.25 27,205.35 7,359.90 0.210 7,258.70 5,713.12 1,545.58

8 35,738.25 20,739.95 14,999.30 0.168 6,004.03 3,484.14 2,519.88

9 43,949.25 21,363.40 22,585.85 0.134 5,889.20 2,862.70 3,026.50

10 50,987.25 26,891.70 24,095.55 0.107 5,455.64 2,877.41 2,578.22

11 58,025.25 34,180.15 23,845.10 0.086 4,990.17 2,939.49 2,050.68

12 74,447.25 22,696.90 51,750.35 0.083 6,179.12 1,883.84 4,295.28

13 79,139.25 28,253.20 50,886.05 0.055 4,352.66 1,553.93 2,798.73

14 90,869.25 24,305.80 66,563.45 0.044 3,998.25 1,069.46 2,928.79

15 260,367.75 24,678.40 235,689.35 0.035 9,112.87 863.74 8,249.13

TOTAL         286,057.11 290,236.58 -4,179.47

YEARGROSS

BENEFITS (A)

GROSS COSTS

(B)

NET BENEFITS

(A - B)

DISCOUNT FACTOR

(23%)

DISCOUNTED

GROSS BENEFITS

(C)

GROSS COST (D)

NET BENEFITS

(C-D)

1 76,283.25 227,479.17 -151,196.17 0.813 62,018.28 184,940.77 -122,922.49

2 76,283.25 36,523.93 39,759.32 0.661 50,423.23 24,142.32 26,280.91

3 76,283.25 36,883.93 39,399.32 0.537 40,964.11 19,806.67 21,157.43

4 76,283.25 42,183.93 34,099.32 0.437 33,335.78 18,434.38 14,901.40

5 76,283.25 36,883.93 39,399.32 0.355 27,080.55 13,093.80 13,986.76

6 76,283.25 36,883.93 39,399.32 0.289 22,045.86 10,659.46 11,386.40

7 34,565.25 27,205.35 7,359.90 0.235 8,122.83 6,393.26 1,729.58

8 35,738.25 20,739.95 14,999.30 0.191 6,826.01 3,961.14 2,854.87

9 43,949.25 21,363.40 22,585.85 0.155 6,812.13 3,311.33 3,500.81

10 50,987.25 26,891.70 24,095.55 0.126 6,424.39 3,388.35 3,036.04

11 58,025.25 34,180.15 23,845.10 0.103 5,976.60 3,520.56 2,456.05

12 74,447.25 22,696.90 51,750.35 0.083 6,179.12 1,883.84 4,295.29

13 79,139.25 28,253.20 50,886.05 0.068 5,381.47 1,921.22 3,460.25

14 90,869.25 24,305.80 66,563.45 0.055 4,997.81 1,336.82 3,660.99

15 260,367.75 24,678.40 235,689.35 0.045 11,716.55 1,110.53 10,606.02

TOTAL   298,304.72 297,904.43 400.29

The interpolation is shown below:

IRR = Lower

discount rate

+

Difference between the two discount

rates

(NPV of lower discount rate)

(absolute sum of NPVs of the two discount rates)

Any project or investment with an FIRR greater than the opportunity cost of capital would be a profitable investment. Otherwise, reject the project. In the case of two competing investment projects, select the project with the highest FIRR.

The internal rate of return of a series of cash flow can exist only when at least one value is negative. If all the values are positive, no discount rate can make the net present worth of the stream equal to zero. No matter how high the discount rate, the net present worth of a series would have to be positive if it includes no negative number.

Please refer to Table 3 for the manual calculation of IRR of 1-ha coconut-lanzones/ eggplant project.

IRR = 23 +

2 (400.29)

(4,179.47 + 400.29)

IRR = 23.17%

Interpretation of FIRR Result: The estimated FIRR of a 1-ha

coconut-lanzones/ eggplant project is 23.17%. Hence, the project is financially viable because FIRR is greater than the opportunity cost of capital (12%). The FIRR of 23.17% is the break-even discount rate that would make the sum of the discounted or present value of gross benefits equal to the sum of the discounted or present value of gross costs.

Sensitivity Analysis

Sensitivity analysis is a straightforward measure of analyzing the effects of risks and uncertainty in investment analysis. Given the uncertainty that may exist about future prices and costs used to estimate net cash revenues (or net benefits) and the terminal or residual value, it is often useful to look at what would happen to NPV or FIRR if the prices and costs were different.

In agriculture, investment projects are sensitive in four areas:

1. Changes in prices of inputs and outputs - The analyst can make alternative assumptions about future prices and see how these affect the NPV and the FIRR

a. Farmers’ failure to adopt new practices as rapidly as anticipated or they may find it harder to master new techniques.b. Delays in ordering and receiving new equipment and supplies

c. Administrative problems

2.   Delay in implementation due to:

3. Changes in yield or sales

The reasrcher/analyst should determine how sensitive NPV or FIRR is to lower yields and/ or sales.

4. Cost overrun (for construction)

The analyst should determine if it is sensitive to cost overrun, that is, if costs early in the implementation stage increase significantly.

Examples of Sensitivity Analysis: Sensitivity analysis was

conducted to assess the effects of the following risk factors on the financial viability of the coconut-lanzones/ eggplant project presented earlier: a. 20% decrease in sales (Please

refer to Table 5) o In Table 5, the sales figures are

80% lower than the sales figures in Table 3.

Table 5. Sensitivity analysis of 1-ha coconut-lanzones/eggplant project, Scenario 1:20%  

decrease in sales, Philippines, 2002.

YEARGROSS

BENEFITS (A)

GROSS COSTS

(B)

NET BENEFITS

(A - B)

DISCOUNT

FACTOR (12%)

DISCOUNTED  

GROSS BENEFITS (C)

GROSS COST

(D)

NET BENEFITS (C-D)

 

1 61,026.60 227,479.17 -166,452.82 0.893 54,496.75 203,139.12 -148,642.37  

2 61,026.60 36,523.93 24,502.67 0.797 48,638.20 29,109.57 19,528.63  

3 61,026.60 36,883.93 24,142.67 0.712 43,450.94 26,261.36 17,189.58  

4 61,026.60 42,183.93 18,842.67 0.639 38,996.00 26,955.53 12,040.47  

5 61,026.60 36,883.93 24,142.67 0.567 34,602.08 20,913.19 13,688.89  

6 61,026.60 36,883.93 24,142.67 0.507 30,940.49 18,700.15 12,240.33  

7 27,652.20 27,205.35 446.85 0.452 12,498.79 12,296.82 201.98  

8 28,590.60 20,739.95 7,851.65 0.404 11,550.60 8,378.54 3,172.07  

9 35,159.60 21,363.40 13,796.00 0.361 12,692.54 7,712.19 4,980.36  

10 40,789.80 26,891.70 13,898.10 0.322 13,134.32 8,659.13 4,475.19  

11 46,420.20 34,180.15 12,240.05 0.287 13,322.60 9,809.70 3,512.89  

12 59,557.80 22,696.90 36,860.90 0.257 15,306.35 5,833.10 9,473.25  

13 63,311.40 28,253.20 35,058.20 0.220 13,928.51 6,215.70 7,712.80  

14 72,695.40 24,305.80 48,389.60 0.205 14,902.56 4,982.69 9,919.87  

15239,847.9

0 24,678.40 215,169.50 0.183 43,892.17 4,516.15 39,376.02 

TOTAL         402,352.90 393,482.94 8,869.96  

To arrive at the new sales figures in Table 5, multiply the sales figures in Table 3 by 0.80. Then compute the new NPV.

NPV (12%) = Sum of Discounted Gross Benefit –

Sum of Discounted Gross Cost

= Total ( C ) - Total ( D ) or NPV = Sum of Discounted Net Benefits = Total (C – D)

= P8,869.96

Interpretation: Although the coconut-lanzones/

eggplant project is still financially viable since the NPV is positive (P8,869.96), there has been an 91% reduction in NPV as a result of a 20% decrease in sales of coconut and the intercrops.

b. 20% increase in total cost (Please refer to Table 6)

In Table 6, the total cost are 120% (i.e., 100 + 20) higher than the total cost in Table 3.

To arrive at the new total cost in Table 6, multiply the total cost in Table 3 by 1.20. Then compute the new NPV.

Table 6. Sensitivity analysis of 1-ha coconut-lanzones/eggplant project, Scenario 2:20% increase in total cost, Philippines, 2002.

GROSS BENEFITS

(A)

GROSS COSTS

(B)

NET BENEFITS

(A - B)

DISCOUNT FACTOR

(12%)

DISCOUNTED  

GROSS BENEFITS

(C)

GROSS COST (D)

NET BENEFITS (C-D)

 

76,283.25 272,975.01 -151,196.17 0.893 68,120.94 243,766.68 -175,645.74  

76,283.25 43,828.72 39,759.32 0.797 60,797.75 34,931.49 25,866.26  

76,283.25 44,260.72 39,399.32 0.712 54,313.67 31,513.63 22,800.04  

76,283.25 50,620.72 34,099.32 0.639 48,745.00 32,346.64 16,398.36  

76,283.25 44,260.72 39,399.32 0.567 43,252.60 25,095.83 18,156.77  

76,283.25 44,260.72 39,399.32 0.507 38,675.61 22,440.18 16,235.43  

34,565.25 32,646.42 7,359.90 0.452 15,623.49 14,756.18 867.31  

35,738.25 24,887.94 14,999.30 0.404 14,438.25 10,054.73 4,383.52  

43,949.25 25,636.08 22,585.85 0.361 15,865.63 9,254.62 6,611.01  

50,987.25 32,270.04 24,095.55 0.322 16,417.89 10,390.95 6,026.94  

58,025.25 41,016.18 23,845.10 0.287 16,653.25 11,771.64 4,881.61  

74,447.25 27,236.28 51,750.35 0.257 19,132.94 6,999.72 12,133.22  

79,139.25 33,903.84 50,886.05 0.220 17,410.64 7,458.84 9,951.80  

90,869.25 29,166.96 66,563.45 0.205 18,628.20 5,979.23 12,648.97  

260,367.75 29,614.08 235,689.35 0.183 47,647.30 5,419.38 42,227.92  

        495,723.21 472,179.75 23,543.46  

NPV (12%) = Sum of Discounted Gross Benefit –

Sum of Discounted Gross Cost

= Total ( C ) - Total ( D ) or NPV = Sum of Discounted Net Benefits = Total (C – D)

= P23,543.46

Interpretation: Although the coconut-lanzones/eggplant

project is still financially viable since the NPV is positive (P23,543.46), there has been a 77 % reduction in NPV as a result of a 20% increase in total cost. The project is more sensitive to a decrease in sales as evidenced by a lower NPV (P8,869.96)

Sensitivity Indicator

A sensitivity indicator (SI) compares the percentage change in a variable with the percentage change in a measure of project worth (e.g., NPV)

. The SI is calculated as the ratio of the percentage change in the NPV to the percentage change in a variable.

Sensitivity Indicator

SI = (NPVb - NPV1) ___NVb_____ (Vb - V1) Vb

a. Scenario 1: 20% decrease in sales NVb= P 102,240.27

NV1= P8,869.96

V1 = 100% or 1.0 in decimal

V2 = 80% or 0.8 in decimal (i.e.,

100-20)

SI = (102,240.27 – 8,869.96) (1 - .8)

102,240.27 1

SI = 4.57

b. Scenario 2: 20% increase in total cost NVb= P 102,240.27

NV1= P 23,543.46

V1 = 100% or 1.0 in decimal

V2 = 120% or 1.2 in decimal (i.e., 100 +

20)

SI = (102,240.27 – 23,543.46) (1 - 1.2)

102,240.27 1

Note: disregard sign of 1.2 (i.e., the difference between 1 – 1.2)

SI = 0.77

A high value for the sensitivity indicator indicates project sensitivity to the variable.

In the examples above, NPV is more sensitive to a 20% decrease in sales (SI =4.57) compared to the same percentage in total cost (SI = 0.77).

Switching Value

Switching value (SV) identifies the percentage change in a variable for the NPV to become zero, the IRR to fall to the cut-off rate (i.e., opportunity cost of capital), and the project decision to change

Switching Value

SV (%) = 100 * _____NVb___ ___ * (Vb - V1)

(NPVb - NPV1) Vb

a.Scenario 1: 20% decrease in sales

SV = 100 x (102,240.27)/ (102,240.27 – 8,869.96) x (1 -0.8)/1

SV = 21.9%

This means that NPV will become zero (or FIRR will be equal to the opportunity cost of capital) if sales will decrease by 21.9%. A decrease in sales by more than 21.9% will result in a negative NPV and will make the proposed investment project unprofitable.

b. Scenario 2: 20% increase in total cost

SV = 100 x (102,240.27)/ (102,240.27 –23,543.46) x (1 – 1.2)/1

Disregard negative sign of 1.2SV = 26%

This means that NPV will become zero (or FIRR will be equal to the opportunity cost of capital) if total cost will increase by 26%. An increase in total cost by more than 26% will result in a negative NPV and will make the proposed investment project unprofitable.

How to Estimate the Measures of Project Worth/Financial Viability

Using the Excel

NPV can be calculated using the following formula:

= NPV(r, NB1: NBt)

IRR can be calculated using the following formula:

= IRR(NB1: NBt, r)

where: r is the guess discount rate

The steps in computing BCR are as follows:

Compute the sum of the discounted gross benefits. Use NPV formula above, but instead of highlighting the net benefits figure

highlight the stream of gross benefits.= NPV(r, GB1: GBt)

where: r is the discount rateGB1: GBt is the stream of gross benefits or annual gross

benefits

Compute the sum of the discounted gross costs. Use NPV formula above, but instead of highlighting the net benefits figures,

highlight the stream of gross costs. = NPV(r, GC1: GCt)

where: r is the discount rate GC1: GCt is the stream of gross costs or annual gross costs

Divide the sum of the discounted gross benefits estimated in step 1 by the sum of the discounted gross costs in step 2.