Accounting & Financial management

Session Financial Analysis

Prof. Dr. R.A Khan

Introduction
Financial Analysis deals with the problems of investing
money or capital.
Money has nominal value and real value
Nominal value: Legal value assigned to a particular unit.
Real value: It is defined as the purchasing power and with
the passage of time real value reduce.
The Time therefore is an important element in investment
decision

Interest Factors for Discrete

Compounding, Discrete Cash Flow
Single Payment compound amount
(F/P, i%, N) = (1+i)n
Single payment present worth (Discount)
(P/F, i%, N) = 1/(1+i)n
Sinking fund
(A/F, i%, N) = i / [(1+i)n 1]
Uniform series compounded amount
(F/A, i%, N) = [(1+i)n 1] / i

Interest Factors for Discrete

Compounding, Discrete Cash Flow
Annuity factor
(P/A, i%, N) = [(1+i)n-1] / [i(1+i)n]
Capital recovery factor
(A/P, i%, N) = [i(1+i)n] / [(1+i)n -1]
Uniform gradient P.W factor
(P/G,i%, N) = (1/i) [ {(1+i)n -1/i(1+i)n} {n/(1+i)n}]
Uniform gradient annual series
(A/G, i%, N) = (1/i)- [n / (1+i)n 1]

Criteria of Financial Analysis

1. Net Present Value
2. Internal Rate of Return
3. Benefit Cost Ratio

Example - 1
A person buys a small piece of land for
$5000 down and annual payment of $500
for next 6 years from now. What is the
present worth of the investment if the
interest rate is 8% per year?

Example - 2
A person buys a small piece of land for
$5000 down and deferred annual
payments of $500 for 6 years starting 3
years from now. What is the present worth
of the investment if the interest rate is 8%
per year?

Solution
PW = 5000 + 500 (P/A, 8%, 6) (P/F, 8%,2)
= $6981.6

Example
Pakistan Railway is considering a program of
computerizing level crossings by installing
automatic barriers. They estimate that the cost
of computerizing such level crossing is
expected to be Rs.5 millions, resulting in cost
saving 0.4 million per year. If the life of the
system is 15 years and rate of interest is 8%
per year, determine the net present value of the
project in zero year.

Exercise
Mixer machines are manufactured in a factory, if no
improvements are made in the factory, the
manufacturing cost of machine is $ 2000 from 1 to 10
months, $ 1600 in moth 11th and $1800 in 12th
month. If some improvements could be made in the
factory to make it more suited for larger production,
these improvements would reduce the manufacturing
cost of mixer machine to $1500 for first 10 months,
1400 in 11th month and $1650 in 12th month. The
improvement cost is expected to be $ 2500 in year
zero.
Calculate NPV of the project in year zero, if market
rate of interest is 2% per month

Example

A University is considering installing electric valves with

automatic timers on some of their sprinkler systems.
They estimate that they need 45 valves and timers at a
cost of $85 per set. The initial installation cost is
expected to be $2000. At the present time there are
four employees who are incharg of maintaining lawns,
each of whom earns $12000 per year, spend 25% of
their time in watering. The present cost of water is
$2200 / year. If the automatic system is installed the
manpower cost for watering could be reduced by 80%
and water charges by 35%. However extra
maintenance cost on the automatic system is expected
to be $450/ year. If the automatic system is expected to
last for 8 years, which system should be used on the
basis of present worth analysis. Assume interest rate is
16% per year.

Exercise
A plant superintendent is trying to decide between two
excavating machines with the estimates presented below.
(a)Determine which machine should be selected on the basis of
PWC analysis, using an interest rate of 15% per annum.
(b)Use EUAC analysis

Description

Machine- A

Machine -B

First cost $

11000

18000

Annual O&M cost $

3500

3100

Salvage value $

1000

2000

Life, years

Exercise
An investment company is considering building a 25 units
apartment complex in a growing town. Because of the long term
growth potential of the town, it is felt that the company could
average 90% of full occupancy for the complex each year. If the
following items are reasonably accurate estimates, what is the
minimum monthly rent that should be charged if a 12% MARR/
year is desired? Use the annual worth method.
Land investment
$ 50,000
Building investment cost
$ 225,000
Study period
25years
Upkeep expense per month
$ 35
Property tax and insurance
10% of total
initial investment

PW of alternative evaluation
Make a present worth comparison of the equal service
machines for which the costs are shown in table
below, if i = 10% per year.
Description

Type A

Type B

First cost ($)

2500

3500

Annual operating cost ($)

900

700

Salvage value

200

350

Life years

Gradient Factor
Uniform increase or decrease in the amount is
known as gradient amount. It is designated by
letter G.
Gradient factor is used for converting gradient
amount into present worth or in annual worth

% Gradient
Amount increase or decrease by constant %.
Amount {(1+ r / 1+ i)n - 1} / ( r i)}
Where
r = % change in amount
i = rate of interest
n = Total period of change

Example
Calculate equivalent present worth of
$35000 now and annual series of $7000
per year for 5 years beginning 1 year from
now, which starts to increase annually at
12% thereafter for the next 8 years. Use
interest rate 15% per year.

Solution
PW = 35000 + 7000 (P/A,15%, 4) +
[7000(1.12/1.15)9 1/ (0.12 - 0.15)](P/F,15%,4)
PW = $83232

Capitalized Cost
Capitalized cost refer to the present worth
value of a project that is assumed last
forever or permanent or perpetual life
project.

Capitalized Cost Calculation

1.
2.
3.
4.
5.

Cash-flow diagram
Find PW of nonrecurring amounts
Find EUAW of all recurring amounts
EUAW / i% to get the capitalized cost
Add value obtained in step 2 to the value
obtained in step 4

Example
Calculate the capitalized cost of a project that
has an initial cost of $150,000 and an additional
investment cost of $ 50,000 after 10 years. The
annual operating cost will be $5000 for the first
four years and $8000 thereafter. In addition
there is expected to be major rework cost of
$15000 every 13 years. Assume interest rate is
5% per year.

Example
CDGK has estimated the first cost of new amusement
park to be $ 40,000. They expect to improve the park
by adding new rides every year for the next 5 years at
a cost of $6000 per year. Annual operating cost are
expected to be $12000the first year: These will
increase by $2000per year until year 5,after that it will
remain same. CDGK expect to receive $11000 in
income the first year, 14000 the second and amounts
increasing by $3000 per year until year 8 after which
the income will remain constant. Calculate the
capitalized cost of the park if the interest rate is 6%
per year.

Exercise
A businessman purchased a building and
insulated the ceiling with 6 inches of foam.
This cut the heating bill by $25/ month and
the air conditioning cost by $20/ month.
Assuming that the winter season is the first 6
months of the year and the summer season
is the next 6 months, what was the
equivalent amount of his savings after the
first 3 years at an interest rate of 1% per
month

Exercise
A company purchased a machine for $18000.
Its annual maintenance and operation cost was
$ 2700. After 4 years from the initial purchase,
the company decided to purchase an additional
unit for the machine which would make it fully
automatic. The additional unit had a first cost of
$9100. The cost for operating the machine in
fully automatic condition was $1200/ yr. If the
company used the machine for 13 years with
no salvage value, what was its EUAC at
interest rate of 9% per year.

Internal Rate of Return

IRR is the rate of interest that equate
present worth of benefit to present worth
of cost.
The critical value of interest rate at which
NPV = 0

Trial & Error Method for ROR

IRR = A% + [a / (a-b)] (B% - A%)
where
A% : low interest rate
B% : High interest rate
a : Positive NPV
b : Negative NPV

Example
If $5000 is invested now in common stock
that is expected to yield $100 per year for
10 years and $7000 at the end of10 years
what is the rate of return.

Solution

Assume i= 5%
NPV at 5% rate of interest = $69.46
Assume i= 6%
NPV at 6% rate of interest = -$355.19

IRR = 5% + [ 69.46/ (69.46 +355.19)](6% - 5%)

IRR = 5.16%

Amortized Loan
If a loan is to be repaid in equal periodic
amounts, it is said to be an amortized
loan.

Example
A firm borrows $10000, from a bank at 6%
per year rate of interest on balance
amount that is outstanding at the
beginning of each year. The loan is to be
repaid in three equal payment at the end
of each year. Determine the amount of
installment and develop loan amortization
table.

Solution
Installment Amount: 10000 (A/ P, 6%, 3) = $ 3741.1
Amortization Table
Year Beginning Inst.
Interest Paid
Balance
Amount
Amount Amount Principal Amount
1

$10000

$3741.1 $600

$3141.1

$6850.9

6850.9

3741.1

411.5

3329.6

3529.3

3529.3

3741.1

211.8

3529.3

0.00

Exercise
Set up an amortizing schedule for a $25000
loan to be repaid in equal installments at the
end of each of the next five years, assume
interest rate is 10% per year.

Benefit Cost Ratio

It is the ratio of equivalent worth of benefit
to equivalent worth of cost.
B/C = AWB / AWC > 1 Desirable
Modified Approach:
B/C = [AB ADB O&M] / CR

Example
A small flood control dam is expected to
have an initial cost of $2.8 million and an
annual upkeep cost of $20000. In addition
minor reconstruction will be required every
five years at a cost of 100,000. As a result
of the dam flood damage will be reduced
by an average of $120,000 per year Using
an interest rate 7% to determine B/C of
the dam. Assume the dam is expected to
last 25 years.
(b) Assume the dam will be permanent.

Example
Two independent sites are under consideration for a
business. Which site should be selected on the
basis of B/C analysis using an interest rate 12 % per
year. Assume that the financial details are as follows

Initial Cost

Site A (000)

Site B (000)

Rs.100,000

Rs.150,000

Annual maintenance Rs.800

Rs.1000

Annual Income

Rs.25000

Rs.60000

Salvage value

Rs. 20000

Rs.30000

Life, years

20

25

Mutually Exclusive Alternatives

The steps for the incremental B/C analysis are

summarized below.

1. Alternatives arrange in ascending order

according to their annual cost
2. Compare lower cost alternative to higher cost
alternative only if that lower cost alternative is
justified
3. Choose that alternative which requires heavy
cost for which funds are available and for which
incremental B/C is justified

Example
Four different building locations have been
suggested of which only one will be selected. Cost
and annual cash flow information are given in table
below. If the MARR is 10%, use B/C analysis to select
the most economically best location.

Location

A (000) B (000) C (000) D (000)

Buildg Cost ($)

200

275

190

350

Annual cash-inflow

22

35

19.5

42

Life, years

30

30

30

30

Exercise
The Corps of Engineer intends
to construct an earthen dam
on the river Indus. Six different
sites are suggested, and the
environmental impact have
been approved.
The construction cost and
annual benefits are tabulated below.
If a MARR of 6% per year for public
projects is used and dam life is long
enough to be considered infinite for
analysis purposes, select the best
location from an economic
perspective.

site

Cost,$
(miln)

A. Inc
($)

350000

420000

125000

10

400000

350000

11

700000

Example
Two road routes are under consideration for
a new inter state highway segment. The
northerly route N would be located about 5
km from central business district and would
require longer travel distance and time by
local commuter traffic. The southerly route S
would pass directly through the down town
area , and although its construction cost
would be higher, it would reduce the travel
time and distance for local commuters.
Assume that the costs for the routes are as
follows..

Cont..

Initial cost
Maintenance cost per year
Road user cost per year

Route N,
$(000)

RouteS,
$(000)

10,000
35
450

15,000
55
200

If the roads are assumed to last 30 years with no

salvage value, which route should be accepted on
the basis of B/C analysis using an interest rate of
5% per year?