Project Economic and Financial Evaluation

Abstract

This chapter starts with the capital investment cycle and its elements, analyzes the effect of financing a project by means of loans from banks as well as from other sources, reinvestments, interest income during construction, amortization, own capital, inflation, etc. It examines the different financial statements for the project, and as a final product gives the projected result of the operation during an operation horizon. It also comments about the necessity and possibility of performing sensitivity analyses to estimate how certain parameters, such as sales, operating costs, working capital, etc., may affect in the future the expected goals established by promoters. Special key indicators such as Internal Rate of Return, Payback period, Debt cover, Cash flow per action etc., are considered in this analysis.

7.1 The Investment Cycle

Determining the economic and financial feasibility of a project is a fundamental step since from its results a decision can be made about pursuing the project or abandoning it. However, this chapter is not intended to be a condensed financial manual – it would be impossible – and certainly not included in this book scope. It aims to provide just a necessary review because usually engineers are consulted about some aspects of a project that are significant to the economic and financial feasibility analysis, and then it is important for them to have an idea of how the feasibility of a project is estimated.

In addition, many times engineers are requested to analyze the projected financial statements, which is a set of related documents prepared by the accounting and finance departments which predict the economical and financial performance of the project during construction and for a certain time horizon in the production or operation stage. A ‘Project analysis statement’ is usually included in these documents, which condenses the results of the full operation regarding profitability (for instance computing for each year the Net Present Value and the Internal Rate of Return), and different financial ratios such as debt coverage, interest coverage, earnings per share, etc.

Additionally, the project manager is often asked by the accounting and finance people to provide information about costs, expenses, conditions of agreements reached with vendors and contractors, payment clauses, reinvestments, etc., that feed the financial process, and therefore it is important for him/her to have an understanding of the reasons for these requests. Funds assigned to the execution of a project follow a path that conforms to a cycle, since money is allocated and used, facilities built, operations started, and income, from the product or service generated by the built project, returning to the firm, presumably with a profit, although in social investments there is not a monetary gain but a social benefit rendered. This is called ‘The investment cycle’.

It commences with the origin or sources of the funds that will be applied to the project. This capital usually comes from different sources, such as:

• Company’s own capital or equity capital,

• Bank loans, which can be short or long term, according to duration,

• Tax deferral, that is, the payment of taxes such as import taxes for certain equipment is sometimes deferred or postponed by taxation authorities until the plant enters in operation and generates revenues,

• Loans from suppliers, usually for heavy equipment.

7.1.1 Financing the Project Through Bank Loans

There are different types of loans and lines of credits, however this chapter refers to two common kinds of loans: Long and short term.

• Long term loans:Their duration is usually measured in years, and have the following characteristics and definitions:

  • Loan application:It refers to the purpose of the loan, such as construction of buildings and structures, acquiring real estate, purchasing equipment, etc.

  • Interest:It is the amount, expressed as a percentage, charged by a credit institution for the use of the funds loaned. It may be constant or tied to periodic revision in agreement with some widely recognized parameters, such as the London Inter Bank Offered Rate (LIBOR).

  • Grace period:The loan recipient should start paying it back normally at the end of the first year from the date it has been granted, however, sometimes in projects it is agreed with the credit institution to start payments after a certain time called ‘Grace period’, which may include for instance the whole construction period and the first year of operation. Its purpose is clearly to lessen the financial burden on the owner or sponsor of the project and for the bank to start collecting its money when the project is generating some income.

    However, this concession is not free, since during this period interests on the loan are effective, and usually paid by the year end, or else they can accumulate, adding up to the principal, and then paying interest over the interests due. These are called ‘Interests during construction’, and if not paid yearly they can reach a considerable amount, and whatever the criterion adopted and agreed with the banks, this aspect has to be considered.

  • Payback period:The number of years in which the loan will be completely amortized or cancelled.

  • Financial charges:They refer to commissions charged by banks, and also the commission charged to hold funds in reserve for a client.

  • Penalty, if the loan is repaid before the agreed number of years.

• Short term loans:Usually have 1 year duration. They often come from banks, and their application could be for financing:

  • Inventories,

  • Letters of Credit,

  • Accounts receivable,

  • Working capital.

• Supplier credits or loans:These are credits or loans from suppliers, which are reimbursed in a couple of years as agreed with the vendor.

For detail information about project finance see Hendrickson (2008).

7.1.2 Applications of Funds

The capital from banks and equity is applied to:

• Investment in capital goods, that is in buildings, structures, machinery, equipment, tools, etc., designed for manufacturing consumer goods such as aluminium, cars, dishwashers, electric energy, etc., or for providing services such as the construction of a Court House, a school or a hospital. Capital goods that can be depreciated¹ are also called ‘fixed assets’ or ‘non-current assets’, except land, which does not depreciate,

• Working capital. It is a financial tool, and in general terms can be expressed as the amount of capital necessary to pay liabilities. From the accounting point of view it is also defined as the difference between current assets and current liabilities.

7.1.3 Preparation of the Investment Schedule During the Construction Period

We need to know what must be done and when, that is, it is necessary to break down the construction work and installation of fixed assets along the construction period, to determine the amount of funds that must be spent each year, and considering the different main parts or areas in which he project has been divided. Therefore, we need a schedule of investments.

The first step is to classify the different costs as direct or indirect. Why is this classification needed? Because usually the credit institutions want to know what will be the application of the funds that they are willing to lend, since it is uncommon for them to finance some expenses, such as custom fees or taxes. It is also convenient to discriminate between local and non-local costs; the reason is related with different interest rates. There is however another motive and it is linked with the sensitivity analysis that is explained further when analyzing for instance the influence of inflation. Probably there is inflation in both the country providing equipment and the recipient country; by discriminating among costs it is easier to determine the influence of each one. With these concepts exposed we can now proceed with an example, as shown in Table 7.1 which considers an undertaking where four areas A, B, C and D exist.

Table 7.1 Computation of direct and indirect costs

Data for each part comes from contractors and suppliers. For instance, in a project that involves site preparation as well as building construction, electrical and plumbing, information about costs per each part or area will come from the main civil contractor. Probably this contractor will subcontract the electrical installation and plumbing; these costs can be incorporated into the contractor’s estimate or considered separately. Similarly, there will be vendors or manufacturers for process and ancillary equipment and the corresponding cost data will come from their approved tenders. If the manufacturer is in charge of the installation and testing of his equipment, this price could be incorporated to this data or perhaps shown as a separate item, such as ‘Process equipment installation’. Contractors and vendors also must submit their programs or schedules indicating when these different activities will be performed, by presenting their CPM (see Sect. 9.1.3) and Gantt chart (see Sect. 9.2).

These partial values and schedules from different contractors are sent to the Planning Department, where all of them are merged and integrated in a master schedule (see Sect. 9.3.1 about merging networks).

From here, it is possible to proceed with the computation about how much money will be invested in each year during the construction period, preparing tables as shown in Table 7.1, where for each area, and for each year the different costs are broken down into direct and indirect costs. Then, in our example the first year of the construction period will consume 47,552,000 Euros, the second year 59,049,000 and the third and final year 25,371,000 Euros, as shown in Table 7.2.

Table 7.2 Schedule of investment in fixed assets during the construction period

As would be expected, in this report all costs, no matter category and contractor, are added up for each year, and this is the data that constitutes the invested capital for that first year, and following the same criterion for the following periods. This document is essential for the finance department to define with the credit institutions the amount of funds needed for each year of the construction period, since, of course, there is no advantage in paying interest for funds that are idling because they cannot be used, or the reverse, being short of funds, even momentarily, which can produce havoc in the development of the project. It is also a valuable tool to use in discussions with the taxation agency about the payment of import taxes and for negotiating, if so wished, a deferred tax allowance, as well as interest that will be charged.

7.1.4 Depreciation and Taxes

These two aspects are always present. Depreciation, as already commented, is an accounting process for the gradual conversion of fixed assets in expenses. Any asset, except land, has a useful life – determined for each type of assets by tax agencies – as a consequence of wear and tear, obsolescence, enhanced technology, etc. which produces a decrease in the service it renders. For instance, in the commercial airlines business where the useful life of an aircraft is broken down in several components, it is about 25 years for the airframe, 10 years for the engines and about 7 years for the undercarriage. The same happens for buildings, machinery and equipment, although each type of asset has a different depreciation rate according to taxation regulations.

At the end of its life, the asset usually has a remaining value called ‘residual value’, or else ‘salvage value’, which is the net amount that can be obtained from the asset after its removal and sale (albeit sometimes the removal cost overcomes monetarily the benefit that can be obtained by selling the asset). At the same time the asset has to be amortized, that is to make a reserve to purchase a new one, as in the case of a machine for instance. Consequently, a fixed asset decreases in value due to its depreciation but increases because of amortization, however, depreciation is a cost, not cash, and because of that taxes to pay are reduced according to depreciation.

Fixed assets depreciation usually follows two different procedures for its calculation, with a final identical result but with different advantages and disadvantages. The two procedures are (a) Straight line depreciation method and (b) Decreasing balance depreciation method.

In the first method the total cost of the asset is divided by its corresponding life time expressed in years, therefore, the depreciation amount is constant.

In the second method a decrease in value is assumed which is a constant percentage of the residual value of the asset at the beginning of each year, and it is computed using the following formula; the depreciation amount is not constant but decreasing.

$$ {\hbox{D}} = {\hbox{S}}{\left( {{1} - {\hbox{r}}} \right)^{{{\rm{n}} - {1}}}} \cdot \,{\hbox{r}} $$

(7.1)

Where:

• D = Depreciation for a certain year

• S = Initial book value

• r = Percentage to be used

• n = Year considered

Which method to use?

Naturally, taxes to be paid are the same irrelevant of the method used; the difference lies in the partial amounts to depreciate. In the decreasing balance method the depreciation amount during the first years of the project life is larger than in the straight-line method, and further on, this amount is smaller. This is an advantage of the decreasing balance method since it allows for fewer taxes to be paid at the beginning of the project. That is, it permits the generation of more earnings at the beginning of the operation phase of the project when possibly cash is more needed, and as a consequence the Net Present Value increases.

7.1.5 Reinvestment

Sometimes it is foreseen, as early as in the project planning phase, that at a certain time during the operation phase some equipment will have to be replaced because it will have reached its useful life² and it is not worth revamping. This happens for instance in a metallurgical project with a rotary furnace working at high temperature and subject to abrasion. Even when its inside is covered by a protective layer, experience says that in 10 years time this protective coating will have been replaced three times, and the steel structure affected and weak due to abrasion produced by breaks in the coating, and stressed because of heat, and then it should be replaced. This is called a ‘reinvestment’ which must be scheduled and the corresponding amount of money saved or assigned for a new purchase, transportation, installation and tests. This is also important because there is usually investment assignment money which is deducted from earnings before taxes, and consequently decreasing them, although normally it is not possible to deduct the total amount of the reinvestment. This is another situation where the project manager has an important role to play in assessing accounting and finance people in their management of this reinvestment.

7.1.6 Operating Costs

Those costs relate to manpower, energy, supplies, maintenance, depreciation and amortization; they appear when the plant is finished and has started producing the good it was designed for. To manufacture a good or render a service it is necessary to consider the assets that we have analyzed, however, there is also need of inputs in the form of labor, infrastructure, services, supplies, etc., which constitute the ‘Operating costs’.

To compute operating costs a similar process used for determining fixed assets is followed. Table 7.3 shows its calculation corresponding to the fourth and fifth years of operation. Information comes from the Engineering Department.

Table 7.3 Computation of operating costs

The computation of operating costs is very important; they enter in the income statement and are deducted from revenue produced by sales.

7.1.7 Working Capital (WC)

It has already been defined, and it is devoted to:

• Holding a raw materials inventory,

• Goods in process of manufacture,

• Finished goods,

• Cash requirements,

• Spare parts,

• Receivables.

Since the WC is the difference between current assets³ and current liabilities⁴ it can be computed from the Balance Sheet. As an example, if values for current assets and liabilities are known, the WC is:

$$ \begin{array}{llllll} {\rm{Current assets at}}:{ 31}/{12}/{2}0{11} = {17}0,{236},000{\rm{ Euros}} \\{\rm{Current liabilities at}}:{ 31}/{12}/{2}0{11} = {74},{436},000{\rm{ Euros}} \\\end{array} $$

$$ {\rm{Therefore}},{\rm{ the WC is}}:{ 17}0,{236},000 - {74},{436},000 = {95},{8}00,000{\rm{ Euros}}. $$

7.1.7.1 Analysing the Working Capital

• Significance of its amount

  Suppose now that the WC is zero. What does it mean?

  It means that the company is theoretically able to pays its debts, however, it would be a very dangerous situation because accounts receivable and accounts payable are neither due at the same time nor for the same quantities, which means that there is no guarantee that money will be available in quantity and in time when needed.

• The current ratio

  Let us see now another important concept. Assume that for a firm, the WC is:

  $$ {\hbox{WC}} = {\hbox{Current assets}} - {\hbox{Current liabilities}} = {6}00,000 - {25}0,000 = {35}0,000{\hbox{ Euros}}. $$

  The ratio between current assets and current liabilities is called ‘current ratio’, and thus equal to: 600,000/250,000 = 2.4:1, meaning that current assets overcome by 2.4 times the current debts. This current ratio is a measure of financial solvency, which is the capacity of the borrower to repay a short-term obligation (normally within a year); in this case it shows that even if its current assets decrease by 58% the company is still able to cancel its liabilities.

• The acid ratio

  There is another more astringent ratio called the ‘Acid ratio’ which has the same meaning as the current ratio, however, the acid ratio does not considers inventories as part of the current assets, but only ‘liquid assets’, which are defined as cash or assets that can be quickly and easily converted to cash.

• Current ratio value

  One question arises: Is it convenient to have always a constant WC in order to have a healthy current ratio? Not really; in some projects and during some periods, the WC can remain constant or near constant because both current assets and liability increase in a similar amount, however, in this case, it is likely that a deeper analysis reveals that the current ratio is decreasing, and with it the solvency of the firm. How can this be explained?

  If the firm is expanding, the current ratio decreases because for the same or near the same capital increment for both, current assets and liabilities, the percentage of expansion increases more in the latter than in the former, and consequently the firm’s solvency is decreasing.

  To clarify this important issue, see Table 7.4 where it is shown that the WC remains constant at 350,000 Euros during 4 years, because both current assets and liabilities are increasing in the same amount, however the current ratio is decreasing, due to a faster increase in the ratio denominator.

  Table 7.4 Changes in the current ratio

  Assume now that the company finds that said current ratio is adequate and wants to keep it constant. Let us see what will happen with the WC. See Table 7.5 for this new condition.

  Table 7.5 Changes in working capital

  It can be verified that, in order to keep constant the current ratio to 2.41:1, either the obligations have to reduce the increases or the current assets have to raise the increases, and in both cases the WC increases, as shown in the last column.

• Selecting a current ratio value

  What reasons does the company apply to select a current ratio? The answer comes from comparing the obtained value with those published for similar industries, since it varies from one industry to another; this is called ‘Cross-sectional analyses. Many government’s statistics departments as well as banks in several countries, publish annually the average figures for each type of industry; therefore, there is a source with which to compare.

• Where the funds for assets increase come from?

  They come from the ‘Retained Earnings’, or from a bank short term loan.

  What are ‘retained earnings’?

Profits from the result of an operation are distributed as dividends; however, many companies keep or ‘retain’ part of these profits and hold them as a reserve. This amount is called ‘Retained earnings’, and they are also a source for future investments or reinvestments.

7.1.8 Difference Between Fixed Assets and Working Capital

So far we have analyzed the two types of destinations where capital is applied, that is in fixed assets and in the formation of the WC, but what is the difference between both of them? The difference lies in the fact that fixed assets are subject to depreciation, and at the end of the project or at the end of their useful life, they are worth only a fraction of their original cost, which is known as ‘residual value’, which can bear a scrap value or may be sold to other users. Regarding the WC it is recovered at the end of the project.

7.1.9 Project Manager Involvement

Even when the computation of some costs is usually not a function of the project manager but for the accounting and financial department, nevertheless his/her input is necessary, as shown for instance in Table 7.3 used for the calculation of operating costs; consequently, information about facts or works affecting production – such as when the plant is scheduled for maintenance work – has to come from this department. Also consider that a potential improvement or a new method to accelerate concentration will affect the WC calculation, and it might be that the accounting and financial departments are not aware of it. The same could apply to spare parts and operations requirements.

7.2 The Investment Cycle in Statements

We have briefly analyzed in a very general way the different components of the investment cycle, and now it is time to put them all together which is done through the ‘Financial statements’. Therefore, we can examine in more detail the investment cycle, starting with the formation of capital from different sources.

Investments produce benefits, and in their formulation intervene different concepts such as sales, unit price, depreciation, interest for the loan, interest during construction, and then it is necessary to deduct taxes, which produces ‘Benefits after taxes’.

Benefits are also influenced by assets depreciation and generate the project cash flow, that is, the comparison between the source and the destination of funds for each year, making sure that there is money when it is needed. The cash flow is integrated by the net benefit, working capital, operating costs, interests during construction, loan amortization, and deferred taxes. From here dividends, that is payment to shareholders is withdrawn, as well as money for loan repayments. The final result is the ‘Retained earnings’, which then closes the investment cycle.

All this information is linked and not stored in a sole document but in a series of closely interrelated documents called ‘Financial statements’, which can be thought of as the analytic version of the investment cycle and used to assess the performance of investments. Any modification in any of the financial statements, if relevant, will have immediate repercussion on the others. Finally the information of the individual financial statements is condensed in the Project Analysis statement. There are financial software packages to produce the financial statements and also allowing for a fast and very effective way of performing sensitivity analysis (see Sect. 7.3).

Each of these statements will be now briefly commented on to understand their meaning and the information they contain.

7.2.1 The Balance Sheet

It gives information about the financial position of a company. It is like a snapshot at a certain time, normally once a year, and in it the nature of assets and liabilities are exposed.

Assets are listed as:

$$ {\mathbf{TOTAL}}\;{\mathbf{ASSETS}} = {\hbox{a}} + {\hbox{b}} - {\hbox{c}} + {\hbox{d}} + {\hbox{e}} + {\hbox{f}} $$

Where:

• (a) + Working capital

• (b) + Increase in cash

• (c) − Depreciated fixed assets

• (d) + Depreciated plant

• (e) + Interests during construction

• (f) + Deferred charges

Liabilities and equity are listed as:

$$ {\mathbf{TOTAL}}\;{\mathbf{LIABILITIES}}\;\& \;{\mathbf{EQUITY}} = {{\rm g}} + {{\rm h}} - {{\rm i}} + {{\rm j}} + {{\rm k}} + {{\rm l}} $$

Where:

• (g) + Short term loans

• (h) + Long term loans

• (i) − Principal withdrawn

• (j) + Deferred taxes

• (k) + Shares

• (l) + Retained earnings

$$ {{\rm{TOTAL}}\;{\rm{ASSETS}} = {\rm{TOTAL}}\;{\rm{LIABILITIES}}\;{\rm{AND}}\;{\rm{EQUITY}}} $$

It is clear that for a certain year TOTAL ASSETS must coincide with TOTAL LIABILITIES AND OWN EQUITY

7.2.2 Cash Flow Statement

Briefly, it depicts where the funds from different sources come (inflow), and where the funds to diverse uses or applications go (outflow). Even if a firm has the necessary funds to pay for its liabilities, i.e. it is economically sound, it does not necessarily mean that those funds are available at the time when they are actually needed, and keeping track of an adequate and timely equilibrium is the purpose of the cash flow statement. The composition of the cash flow statement is as follows:

SOURCE OF FUNDS	FUNDS APPLICATION
Net earning	Fixed assets
Depreciation	Construction interests
Amortization	Long term loan repayments
Deferred taxes	Deferred charges
Own capital	Short terms loans
Long term loan	Dividends
Short term loan	Increase in working capital
Decrease in working capital	Increase in cash
Decrease in cash

It is clear that for any year of the project TOTAL FROM SOURCES must coincide with TOTAL TO APPLICATIONS

7.2.3 Income Statement

Composed of:

Income from sales

• Operating costs

• Depreciation

• Interests on loans

• Amortization of deferred charges

• Amortization of interests during construction

• Taxes

= TOTAL EARNINGS

7.2.4 Project Analysis

This is the condensation of the information from the above schedules and others such as ‘Assets depreciation and amortization’, ‘Long term loan schedule’, etc.

Depends on a particular construction but it can depict for each year the following information:

• Project cash flow,

• Project return,

• Debt coverage,

• Earnings per share,

• Interest cover,

• Current ratio,

• Acid ratio,

• Benefit margin. (Ratio between net benefit and sales)

This information allows for a clear and complete picture of the project performance from construction to the end of its operation life, and consequently allows for accepting or rejecting the project.

7.3 Sensitivity Analysis

Whatever the project, there is no assurance about its future development and further operation, because normally there are many uncertainties. For instance, in an industrial project to produce a consumable product, uncertainties refer to demand, price, competition, acceptance, etc. In a social project such as establishing courses to train out of work people in different trades, it might be difficult to ascertain the number of people that will be attending; in a construction project there could be uncertainties about geological conditions, advance, weather, etc. For this reason, and even when certain parameters might be known with relative confidence, nobody can guarantee that they will not change, or how a change in one of them can alter other parameters, it is necessary to perform a sensitivity analysis which consists in assuming variations of one parameter at a time, or more than one together, and then find out how the main indicators of the project feasibility react.

For instance a project for developing and operating a commercial mall can badly fail if the expected average number of visitors falls beneath a certain assumed threshold or volume. Then, it is important to learn how it will affect the profit of the undertaking, which can be measured using the Internal Rate of Return (IRR) in a year, and computed considering this decrease in visitors, when compared with the minimum IRR percentage established by the sponsor at the beginning of the project, which forecasted a higher number of visitors. It also applies to the construction stage since a delay in completion can very seriously jeopardize the success of the opening, considering commitments to be tied up with perhaps hundreds of merchants to occupy the mall’s premises, who in term, have other commitments to supply their stores. This aspect of uncertainty is closely related with risk, which is examined in Chap. 6.

7.4 Sequence to Prepare an Economic and Financial Analysis for a Project

To wrap-up the above information this section shows the departments involved and their responsibilities in an approximate sequential order. Naturally, there is not a lineal path between them but a continuous forth and back process with feed back.

Intervening departments and functions:

Marketing: Estimates:

• Potential demand,

• Price,

• Product characteristics.

Engineering: With the information of volume or annual production, produces:

• Plant layout,

• Preliminary drawings for civil works, including foundations, buildings, services, internal transport, etc.,

• Operating costs.

Planning (see Chap. 9): Establishes sequence of activities (planning), arranges those as a function time (scheduling), and assigns resources (levelling).

Purchasing (see Chap. 10): Based on specs from Engineering, calls for:

• Bids to select contractors,

• Bids for equipment.

Human Resources (see Chap. 13): Based on specs from Engineering:

• Recruits personnel.

Project Cost (see Sect. 12.1): With information from: Purchasing (Fixed assets quotations), Engineering (operating costs), Planning (Resources), prepares the costs for the project during the construction and the operation period.

Accounting: With information from Project Costs about fixed assets computes import taxes, direct and indirect costs and an estimate of inflation.

Budgeting (see Sect. 12.3): With information from Project Costs about fixed assets costs and from Planning about planning, schedule and resources, prepares the baseline S-curve.

Financing: Based on data provided by Budgeting, gets loans from banks, computes working capital, prepare projected financial statements and execute sensitivity analysis.

7.5 CASE STUDY: Construction of a Copper Concentration Plant

This case deals with a metallurgical project involving the construction of a copper concentration plant using copper sulphide ore extracted from an open-pit mine in Africa. The project encompasses the civil works for buildings and the supply and erection of the necessary equipment, as well as ancillary installations such as cone crushers and rotary mills, a furnace to roast the material to eliminate sulphur, floatation cells, belt conveyors, construction of a tailings pond, power house, etc.

The basic engineering is already done and now it is necessary to determine the economic and financial feasibility of the project, considering that there exists a huge market for this concentrate and the unit price in €/pound has been almost constant during a considerable period, however a study made by an independent consultant foresees an increase in the price of the metal in the international markets.

7.5.1 Background Information

According to the company’s planning department the construction period is estimated in 3 years with 15 years of operation as a planning horizon. Production is based on a Marketing Department sales forecast, which also wrapped up an agreement with an Asian company to refine the concentrate subject to minimum deliveries per year. The unit price is estimated at 1,400 €/ton according to an estimate made by experts.

7.5.2 Investment During Construction

The Planning Department developed the merged logic network and the Gantt chart (see Sect. 9.3.1) and from them computed the partial and accumulated investment as seen in Table 7.6 with the monthly estimated funds to be expended during construction. Therefore, the total investment amount to 131,972,000 Euros.

Table 7.6 Partial and accumulated investment – Copper concentration plant

These values allow drawing Fig. 7.1 that depicts the budget baseline (see Sect. 9.2.1).

Fig. 7.1

The budget baseline – Copper concentration plant

Figure 7.2 graphically shows the intervening departments as well as the existent interrelationships for this project.

Fig. 7.2

Information flow for a project financial analysis

7.5.3 Taxes During the Construction Period

These are taxes levied for importing machinery and equipment and computed as a percentage of CIF (Cost, Insurance, and Freight) and are as shown in Table 7.7.

Table 7.7 Schedule of taxes

7.5.4 Financing

Financing comes from equity and bank loans, as follows:

70% of the project will be financed by a long term bank loan that is:

$$ {131},{972},000 \times 0.{7}0 = {92},{38}0,000$$

€,

30% of the project will be financed by equity, i.e.:

$$ {131},{972},000 \times 0.{3}0 = {39},{592},000 $$

€.

Conditions of the long term loan are:

• Fixed interest rate: 10%/year,

• Payback period: 10 years,

• Grace period: 4 years including construction period.

Conditions for the short term loan are:

• Total amount: 5,990 €,

• Fixed interest: 10.25%/year,

• Payback period: 1 year.

Deferred taxes credit: Tax authorities have agreed to defer import taxes for equipment until the plants commences production, under these conditions:

• Amount: 9,199 €,

• Interest: 9%/year,

• Payback period: 10 years,

• Grace period: 5 years including construction period.

Considering the cost of capital as well as the opportunity cost of equity capital, the Board of Directors has put a threshold of 8.5% of project return as a average target during the operating years. That is, the available equity capital could be placed in other undertakings; however, it is believed that this project offers better growth opportunities since its product has an ever increasing rate of demand and with forecasted increasing unit prices. That threshold is considerably better than the returns offered by actual opportunities.

7.5.5 General Specifications

• Depreciation: By the decreasing balance method (as agreed with taxation authorities),

• Equipment useful life: (as agreed with taxation authorities)

  • Processing equipment: 10 years,

  • Ancillary equipment: 10 years,

  • Reinvestment in equipment: 12 years,

  • Buildings: 20 years.

• Reinvestment: 14,694,000 Euros will be reinvested 10 years after starting of operations.

7.5.6 Operating Costs

Operating costs were computed as exemplified in Table 7.3, but for the whole life of the project, and are further used to prepare the financial statements.

7.5.7 Working Capital

It has been calculated for each one of 15 operating years. Table 7.8 records the account receivables, starting with the first year of operation. It is considered a 90 days operating cycle.

Table 7.8 Calculation of receivables – Copper concentration plant

Table 7.9 shows the calculation of working capital for the first 7 years of operation.

Table 7.9 Calculation of working capital – Copper concentration plant

	€ (×000)
Amounts receivable (from Table 7.8)	65,484
Amounts receivable in 90 days: (65,484/4)	16,371
Total current assets (from Table 7.9)	23,298
Total current liabilities (from Table 7.9)	−4,827
Working capital	18,471

7.5.8 Statement of Project Analysis

As mentioned this is the document that condenses the information from other financial statements and that shows the financial viability of the project. Table 7.10 shows the last 4 years of this projection, using different financial indexes.

Table 7.10 Statement of Project analysis (values in € ×000) – Copper concentration plant

7.5.8.1 Comments on This Projection

Refer to Table 7.10.

Project NPV:

• 1. It is negative (albeit not shown here) during the construction period because there are only investments or outflows of money, no benefits or inflows. The latter start on the 4th year of the project or the 1st of the operation due to the selling of the concentrate produced those years in the new plant.

• 2. At that time the NPV (not shown here) amount to 20,365 million Euros, it further increases up to the 3rd operation year and then starts diminishing. Why? Because the NPV reports the cash flow at present value, that is at the very beginning of the project. When the operation years move away from this early date the capital discounted factor used in the update formula gets smaller and since it multiplies the cash flow for any year, the actual value decreases.

  As already mentioned, this is one of the reasons that the decreasing balance for depreciation is sometimes preferred because then there is an increase in profit in the early years of operation of a project, which reflect in the NPV.

• 3. Albeit not shown here, on year 2026 the NPV reached a 26,365 million Euros value. Observe the NPV for next year, that is 2027, which shows a sharp decrease; it is provoked because in that year an outflow of money takes place due to reinvestment. By 2030 it shows a sharp increase. Why? Because at the last planned year the working capital is added in the amount of 18,655 million Euros as shown in Table 7.9.

Project IRR:

• 4. The IRR, as expected (although not shown here), is negative during the construction years because the money outflow and continues being negative up to the 4th operation year included, for the reason that the project still does not generate enough benefits to compensate the investments, although the situation reverts in the 5th with a small positive IRR of 0.87. From then on it is incrementing and reaching a figure of 14.90% in 2030. Not considering the construction years nor the following three operation years, the average IRR is about 9.92% which is higher than the target fixed by the Board of Directors of 8.5%.

7.5.9 Sensitivity Financial Analysis

A sensitivity analysis is performed considering variations in four variables, as follows:

• Variable 1. Unit price, a decrease of 10% in the unit price, although it is not likely to occur.

• Variable 2. Sales volume, with a decrease of 10%. Also very unlikely, because consumption has been increasing during the last 20 years; however, new mines are constantly put in operation and also old mines are now recovering raw material (ore) that were discarded in the past because of low copper content. However, with new technology, and with the new prices for the metal, it is now possible to process those poorer ores with a profit.

• Variable 3. Operating costs. This is the main concern because manpower costs are constantly rising as well as direct and indirect costs. A 10% increase is also considered here.

• Variable 4. Process equipment. Although computerized equipment is used requiring fewer personnel to operate, they are quite expensive. This heading also includes the cost and maintenance of large trucks employed in ore transportation from the open pit mine to the crushers.

Table 7.11 portrays, for each of these variables, the differences with the baseline values in column A. It can be seen that:

Table 7.11 Results from sensitivity analysis – Copper concentration plant

• 1. The largest reduction (60%) in the Project IRR corresponds to sales volume, which is understandable considering that this volume is directly linked with the economy of scale of the undertaking. That is, if for whatever reasons, for instance a drop in demand, the plant must produce less concentrate than its design capacity, it is obvious that the production cost per ton increases, since fixed costs probably would not change.

  Because of this, and based on this information, measures possibly might be taken now to reduce this impact if it actually happens, and perhaps a part of the solution could be the construction of silos to store the concentrate when the demand is low. There is no question that said additional construction and investment should be considered at the time of the analysis, before beginning construction, so that the new facilities can be included in the plant lay out, and in order to minimize transportation costs perhaps by making room for the future construction of a conveyor belt to feed the silos. Another solution that can be weighed up is the construction of an electrolytic refining facility to process all concentrate and to manufacture copper of high purity in bars, which has thousands of uses, and as a vertical industrial integration, which will increment the project’s profitability.

• 2. There is also a large drop (60%) in the Project IRR corresponding to operating costs, and confirming the presumption that this is a critical aspect in production. Again, considering the importance of this factor it would be wise to reconsider the type of equipment to be purchased, possibly changing to more expensive but at the same time more efficient, machines such as crushers, or a rotary furnace. Another alternative could be to take advantage of the sulphurous flue from the rotary furnace, by recovering the sulphur and using it for the production of sulphuric acid on the site, thus developing a horizontal expansion.

• 3. Earnings per share, a fundamental aspect for shareholders, are also affected badly by a drop of sales volume, with a loss of 22%.

7.5.10 Final Remarks on This Example

The proposed actual case, which description is far from complete, was developed with the objective of showing how all the computed elements enter in different financial statements, which pave the road for the construction of the project analysis statement, which in turn allows for assessing the profitability of the project and for analyzing revenues and determining the trend of financial indicators, data that is sometimes requested by the credit institutions. The other very important mission of this project analysis statement is that it permits performing a sensitivity analysis, absolutely necessary given the uncertainty of future developments external to a project and that can be only estimated or guessed.

In this example the sensitivity analysis pinpointed critical factors such as sales volume and operating costs, and more important, allowed for adopting adequate measures before the start of the project, to at least ameliorate the impacts of negative variations of those factors. Needless to say, this was only an example of a financial and economic feasibility of a project, and although it is probably true that this evaluation will be executed by the accounting and finance departments, it is useful and necessary for the PM to know and understand its different intervening concepts, elements and calculations, considering that most information will probably come from other departments and also requiring his/her intervention.

7.6 Breakeven Point Diagram

It is often of capital importance to determine the minimum amount of a product that needs to be manufactured in order to generate profits. That amount receives the name of ‘Breakeven point’ and it is the quantity that equates revenues with costs. Any magnitude below it will generate a loss and conversely any magnitude above it will make a profit. This quantity ‘n’ can be determined graphically as shown in Fig. 7.3 or algebraically through a simple formula.

Fig. 7.3

Determination of the breakeven point – Paper mill construction

This example corresponds to a project for a paper mill. In abscissas are thousands of tons, while in ordinates, dollar values. The components are as follows:

• Fixed costs: The horizontal dashed line. Includes: Labor + supervision + real estate taxes + services + administration expenses, etc.

• Variable costs: The inclined dashed line. Includes: Variable production costs + write offs + sale taxes + electric energy, etc.

• Revenues: Gross sales – short term liabilities

• Total costs: The inclined dash and dots line that is the sum of the two above mentioned,

• Revenue: represented by the solid line.

The breakeven point corresponds to the intersection of the total cost and revenue, and its value is indicated by a vertical reference line of 40,700 tons. That is, over this amount there is a net profit and a loss in case this amount is less than 40,700 tons

Graphical representation of Table 7.12 produces Fig. 7.3 and the determination of the breakeven point at 40,700 tons.

Table 7.12 Values of costs, total costs and revenues – Paper mill construction

Analytically this value can be found using formula 7.2

$$ n = \frac{{Fixed{ }cost}}{{Unit{ }sale{ }price - unit{ }n{ }variable{ }cost}} = $$

(7.2)

$$ n = \frac{{11,200,000}}{{(441 - 165.8)}} = 40,700\,{\rm{tons}} $$

(7.3)

7.7 Conclusion of This Chapter

This chapter deals with a fundamental task which allows for the decision of going ahead with a project or to cancel it. Even if this is a matter for the financial department it is impossible to even start considering the subject without information provided by other departments, most especially engineering and planning. These departments have to provide technical information about the undertaking, especially related with costs, schedules, and fundamentally by providing a schedule of investments in fixed assets during the construction period. This is the reason that this subject is considered in this book devoted to project management, considering that the PM needs to understand the intricacies of project evaluation in order to be able to provide reliable, consistent data and information and at the same time participate in the evaluation process.