ECONOMIC AND FINANCIAL

ANALYSIS OF PROJECTS

CHAPTER 2 (CONTD)

Drawing up Project Resource Statements and Project Financial

Statements

Today’s Lecture

Types of prices Types of projects Directly productive and indirectly

productive projects Making Resource statement

Constant and Current pricesConstant prices (valued at

specified set of prices)

Helpful when project is long term

Useful for decision making

Using constant prices ensures that the future costs and benefits of the identified project alternatives are estimated in the same units as the costs and benefits measured in year 0.

Current Prices (forecast prices in future years)

Helpful when project is short term

Used for implementation of projects

Can convert current prices into constant by using discounting technique

Financial and Economic prices

Financial prices are the actual prices at which inputs are bought and outputs sold and are used in financial analysis.

In economic analysis, where prices are distorted due to market or government failure, it is necessary to impute the price that reflects the real economic value of an input or an output its shadow price.

Nominal and Real Prices

Nominal price is interchangeably used with current price, includes the effects of inflation

Real price can be used interchangeably with constant price

Absolute and Relative price

Absolute prices refer to the value attached to an input or output.

Relative prices refer to the value of an input or output in terms of each other.

 

Types of Projects

1. New Investments

Designed to establish a new productive process independent of previous lines of production

New organization, financially independent of the existing one

Eg. Setting up an IPP – government calls forth application for tenders from independent entities for the project

 

 

Types of projects

2.Expansion Projects

Involve repeating or extending an existing economic activity with the same output, technology and organization.

Eg. Unilever decides to introduce a new brand of shampoo

Types of projects

3.Updating Projects

Involves replacing or changing some elements in an existing activity without a major change in output.

Eg. Gul Ahmed Textiles buying new state of the art machinery for textile manufacturing in order to increase productivity.

New Resources Versus Resources without the Project In all the three types of projects, the effect of using new resources

will have to be identified.

 

Q. How do you measure this effect?

A. By identifying the additional costs and benefits – resources that would be used in the project over and above what would otherwise be used, and the benefits over and above what would otherwise have occurred without the project.

For a new project, the whole of output and the whole of costs will be additional (incremental)

For expansion or updating projects, the effect of new resources will have to be separated from the effects of resources without the project

 

Directly productive and Indirectly productive

Directly Productive Indirectly Productive:

Where the project costs and benefits accrue to a single organization eg. Unilever’ launch of a new shampoo

 

Where the benefits derived from the project do not accrue to organization responsible for carrying out the costs.

  Most public infrastructure

projects like roads, sewerage systems etc – benefits accrue to users or the producers while costs are borne by the government.

Conventions used in drawing up Project Resource Statements

In a project resource flow statement, annual time periods are used.

Year end

In the series of consecutive annual time periods over the life of the project, investment costs will usually occur in the earlier periods.

First period can be called year 0 or year 1

INVESTMENT COSTOPERATING COSTWORKING CAPITAL COSTSRESOURCE BENEFITS

ELEMENTS of PRS

1) Investment Costs

These include

a) Initial Investments to implement the project

Refers to the costs involved in establishing and commissioning a project eg. Land,machinery, construction

These will be one of the largest items on the project statement. For relatively small projects, they may all occur in the first year. For larger projects like dams and canals, these expenditures may be spread out over two or even more years.

1) Investment Costsb) Replacement expenditures – cost of equipment and other

investment items in the operating phase of a project in order to maintain its productive capacity. Eg. Replacement of machinery

Replacement expenditures are needed because each of the investment items have a different operating life – eg. Land is permanent and does not need replacement, but buildings, machinery and vehicles they all need repair or replacement at fixed intervals depending on their rate of depreciation.

Table 2.2. replacement costs are entered in the resource statement a year before the replaced asset is acquired in order to ensure continuous operations.

ItemsReplacement period in

yrs 0 1 2 3 4 5 6 7 8 9 10                         

Land preparation - 20                    

Building 40 60                    Machinery 8   40               40  Vehicles 3   12     12     12     12

1) Investment Costs

c) Residual Values- value of all the investment items at the end of the

project life Or final value of investment items if they are used for

some other project Calculated as purchase price less accumulated

depreciation. Residual Value = Initial Cost of an asset –

accumulated depreciation  Although conventionally entered under investment

costs, residual values represent the value of assets to the project at the end of its life and hence are benefits

2. Operating Costs

Combination of fixed and variable costs. Diagram Depend on the level of output – increase

as capacity utilization increases. As output increases total operating costs

per unit of output go down (why?)

3. Working Capital

What is working capital? Physical stock needed to allow

continuous production may have residual value at the end of the period

Three elements of working capital

a) Initial stock of materials

b) Final stock of output

c) Work in progress

3. Working capitala. Initial Stock Required at the beginning of the production process

  As capacity utilization increases, output increases and initial stocks

requirements would increase until output reaches its maximum sustainable level.

Initial stocks need to be purchased in advance of production, thus will be entered in the year before the output level to which they refer.

 

b. Final Stock The production period will give rise to final outputs that will be

stored for a period of time before distribution.

The level of final stock also depends on the level of annual production. Eg one month of output valued at operating cost – why not at market price

3)Working Capital

c. Work in progress At any point in time after the start of the project,

some materials will be passing through the production process.

Work in Progress is typically valued at ((Initial stocks – Final stocks)/2) * (production period/ number of working days in a yr)

Production period = number of days it takes for initial stocks to get transformed into finished product

Lahore School of EconomicsEconomic and Financial Analysis of Projects

BSc IVAssignment No 1

 Name: ___________________________________ Section:  Q. Use the given data to prepare annual operating costs of the project from ten years at given percentage of capacity utilization Fixed CostsLabor [administration] 150Non tradable office supplies 100Total Fixed costs 250Variable costs Material [traded] 250Utilities [Non traded] 70Labor [operating] 90Total Variable costs 410 Total operating cost [TOC] = FC+ VC  Capacity utilization builds up over 4 years at utilization rate of 50, 70, 80, 100percent and is sustained at maximum capacity till the end The project has a 1 year construction period and a 10 year operating period Find annual change in working capital for 10 years and the corresponding residual value to be entered into the project statement[ if whole of

the working capital is recovered in the last year] using the given assumption: Initial stocks of materials equivalent to 2 months requirement for the following years production level [2 months worth of materials [variable].Assume Initial stock [yr 1] = 2/12 of material in yr 2 Final Stocks of outputs equivalent to one month’s sales in current year [one month’s sales at total operating costs]. Assume Final stock in yr 1 = 1/12 of total operating costs in yr 1 Work in progress based on a production period of 25 days and a working year of 250 days, at current year’s production levelWIP yr 1= [material [yr1] +1/2{T. op cost yr 1- TFC yr 1- materials yr 1}]*[production period / total working days]   

   

Year 0 1 2 3 4 5 6 7 8 9 10Capacity Utilization

60% 70% 80% 90% 100% 100% 100% 100% 100% 100%

Operating costFCVariable powerVariable materialsVariable labor

T. Op Cost

Year 0 1 2 3 4 5 6 7 8 9 10Working Capital

Initial stock  

Change in Initial stockFinal stockChange in final stockWork in progressChange in Work in progress

T.WC

Change in WC