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Financial appraisal - Manish Jain - 08-06-2016

Financial appraisal give approximate pay-back period and rate of return on investment.
•        Can the project be financed properly?
•        Will there be sufficient funds to cover the expenditure requirements during the life of the project?
•        Means of financing
 
 
Financial appraisal assesses:
·         project cash flows
·         the sensitivity of financial projections to key project risks
·         the adequacy of the estimated investment cost, and
·         Approximate payback period
·         The financial impact of alternative projects.

General Framework for Financial Appraisal of UD project


A. Objectives of Financial Analysis
The financial analysis of an UD sector project normally will start with an analysis/assessment of the historical financial performance of the project entity (local government or urban authority). Furthermore, projections are needed for the financial performance for the project entity as a whole as well as for the subproject under consideration, taking into account the investment and financing plan, debt service requirements, and expected return to be earned on government equity investment in the project entity, if any. Financial appraisal of UD sector projects generally should be concerned with whether or not the project can recover investment and operating and maintenance costs from project beneficiaries.
The financial appraisal of an UD sector project should also be concerned with financial viability and sustainability. Through projection of income and expenditures of local urban authorities, financial appraisal should examine whether local authorities will be able to meet their financial obligations, including debt service payments. Furthermore, through a careful review of the finances of local urban subsector authorities based on projection of income and review of cash flow statements and balance sheets, it should be ascertained whether these agencies will be able to generate sufficient funds from operations to provide working capital adequate to earn a reasonable return on fixed assets and to make a satisfactory contribution to future capital requirements.
B. Applicability of FIRR (Financial Internal Rate of Return) Analysis
In a sector loan context, a FIRR analysis generally should be carried out for all subprojects in which a clear buyer-seller relationship exists and in which the user pays direct charges for the use of goods and services, i.e., when direct cost recovery from the beneficiaries concerned is feasible and when non-payment of user charges would exclude the user from the delivery of the services.
C. Role of FIRR in Project Evaluation
The calculation of the FIRR should be based on prices/tariffs for urban products and costs (capital, operation and maintenance costs) expressed in real terms. The FIRR should be arrived at based on the real prices/tariffs, which are determined taking into account all cost factors, including the cost of capital, which may comprise loans, equity and grants. Under these circumstances, the project's FIRR would always be higher than its cost of capital pointing to the financial viability of the subproject. In such a context, determination of an appropriate level for interest rates on the loans and rate of return on equity for financing become more important than the FIRR calculation itself in the appraisal of financial viability.
The comparison of the conventionally calculated FIRR with the cost of finance14 may lead to one of the five following situations.
• First, the FIRR is greater than the cost of finance. The project is financially viable such that all project costs-capital or depreciation cost, recurrent operation and maintenance costs, and financial costs -will be recovered. Moreover, a surplus will be generated, which will strengthen the viability of the financial entity concerned.
• Second, the FIRR is equal to the cost of finance. No surplus is generated but revenues will be just sufficient to recover all costs, including financial costs.
• Third, a positive FIRR is less than the cost of finance. The project allows basic cost recovery but financial costs are only partially recovered. Without subsidization from the central or local government in the long run, this may endanger the financial viability I performance of the financial entity.
• Fourth, the FIRR is equal to zero, assuming a positive cost of finance. The project generates revenues that are sufficient to fully recover the capital, operation and maintenance costs. As the cost of finance is not recovered in this case, the financial entity is viable only through subsidization measures.
• Fifth, the FIRR is less than zero, assuming a positive cost of finance. Basic cost recovery is not possible. If recurrent operation and maintenance costs are fully recovered, capital investment costs will only be partially recovered.
D Approximate Payback period
 
The payback period formula is used to determine the length of time it will take to recoup the initial amount invested on a project or investment. The payback period formula is used for quick calculations and is generally not considered an end-all for evaluating whether to invest in a particular situation.
D. Magnitude of FIRR in Urban Development Sector Projects
The financial viability of a given revenue-yielding subproject is dependent on the level of charges, tariffs, plot values, and rental charges. These should be affordable to the intended beneficiaries with charges based on the beneficiaries' needs/preferences for urban services and willingness and financial capability to pay. If the target beneficiaries belong to middle-income groups-for example, those with incomes between the 40 to 70 percentile levels of income distribution-it may be reasonably expected that the beneficiaries will be willing and financially capable to pay the full cost of the services, including a premium to recover the cost of finance and generate a surplus. In this case, the FIRR should at least be equal to the cost of finance. However, as a general rule, Bank assisted urban development sector projects are targeted towards the poorer, low-income groups of the urban population.
E. Subsidization and Cost Recovery in Socially Oriented Projects
To the extent that urban development subprojects are socially oriented, aiming at, among other things, amelioration of urban poverty and improvement of the living environment of low-income groups, some subsidization and partial cost recovery from beneficiaries, as opposed to full or basic cost recovery, at least in the short-term, may be justified on social grounds. In such a case, detailed justification should be provided.
F. Cost Recovery and Municipal Finance
While basic cost recovery should be the long-term goal, cost recovery may not be possible in the short term. In such cases, a short-term or intermediate goal should be set, initially aiming at less than full cost recovery and a gradual increase in tariffs over time. For water supply subprojects, for example, the tariff level might initially be increased to reduce excessive consumption of the wealthier beneficiaries. The tariff structure should, however, be such that the poorest beneficiaries pay water charges that are affordable. Rationalization of water consumption through an affordable tariff structure adjustable over time should be a constant concern of water supply authorities. Through regular tariff adjustments it should be possible to approximate the tariff structure that maximizes cost recovery.
G. Financial Affordability to the Government
It is often observed in urban development sector projects that the central government is supporting local urban authorities financially for incremental administration and operation and maintenance cost during the project implementation period. Such financing of incremental recurrent cost (IRC) preferably would be done on a declining basis from year to year so that local urban authorities become increasingly self-reliant, such that they themselves would be able to meet future recurrent cost requirements.
H. Affordability to Households
Financial and economic analysis should be supplemented with and supported by a detailed affordability analysis of the targeted beneficiaries. Such an analysis aims to assess beneficiaries' specific needs for urban services and beneficiaries' willingness and financial capability to pay for such services. It is necessary to include an analysis of affordability to households as an appraisal criterion in the appraisal of subsectoral components. This analysis should focus on the poorest segment of the population while also including an assessment of the desirable level of quality of services to be provided and their affordability to beneficiaries.

Taken from "Framework for the Economic and Financial Appraisal of Urban Development Sector Projects" by ASIAN DEVELOPMENT BANK , Economics and Development Resource Center, Infrastructure Department , January 1994

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