11.9 - Financial evaluation

Introduction

Financial analysis is a method to evaluate the viability of a project by assessing its cash flows. This differs from economic evaluation in the:

• scope of investigation
• range of input
• methodology used.

Financial analysis views the costs and revenues of the project from a ‘commercial’ investment point of view, ie the cashflow impact on government and any private sector party. By contrast economic efficiency analysis also considers external benefits and costs of the project whether or not they involve monetary payments.

Other differences include:

• Market prices and valuations are used in assessing benefits and costs in financial analysis, instead of measures such as willingness to pay and opportunity cost used in economic analysis. Market prices include all applicable taxes, tariffs, trade mark-ups and commissions.
• The discount rate used in financial analysis represents the weighted average costs of debt and equity capital rather than the estimated social opportunity cost of capital.
• The discount rate used in financial analysis and the cashflows to which it is applied are usually specified in nominal terms (allowing for future inflation), as the cost of debt and equity are observed only in nominal terms.

Undertaking an economic evaluation does not remove the need for a financial evaluation.

Feasibility of private sector financing

Where consideration is being given to private sector involvement in financing land transport infrastructure, it is important to ensure that the involvement is commercially feasible and that it offers a more cost-effective solution that the traditional public sector funding approach.

Cash flows to be measured

All incremental costs, revenues and risks associated with a project and its best alternative should be identified and measured as nominal cashflows in the period in which they occur. Cashflows should be on an after tax basis. An estimate of the asset’s residual value must be included at the end of the analysis period to represent the asset’s remaining service potential. The residual value should not be such as to bias the viability of the project.

Typical inward cashflows to be considered include:

• operating revenues
• subsidies from external parties
• operational savings occurring in other areas as a result of the project
• sale of surplus assets
• residual values of assets.

Typical cash outflows to be considered include:

• capital costs (including land, equipment, buildings)
• maintenance and operating costs
• taxes, were appropriate
• operating lease payments
• contract termination payments
• revenue losses to existing operations affected by the project
• the opportunity cost of resources (including land) that would otherwise be available for sale or lease.

Treatment of specific items

Financing costs (interest) should be excluded in the cashflows because the opportunity cost of debt is accounted for in the weighted average cost of capital (WACC).

Accounting, depreciation, economic multiplier effect and sunk costs should be excluded in financial analysis.

The effect of dividend imputation needs to be taken into account in financial analysis.

Operating leases should be evaluated in the form of a series of regular payments and compared to an outright purchase alternative, with consideration for the value of options such as renewal or purchase rights if these features are present. Financing leases do not form part of a financial analysis as these are merely an alternative means of financing the project.

Weighted average cost of capital

A weighted average cost of capital (WACC) is used in financial analysis. The WACC is the weighted average of the required return on equity and the (interest) cost of any debt financing.

The WACC should reflect the appropriate risk and norms associated with the industry.

Summary measures of commercial merit

The more common measures for evaluating the financial viability of a project are, for example:

• Net present value (NPV) of cash flows.
• NPV per $ of capital invested (NPVI).
• Internal rate of return (IRR) of cash flows.
• Payback period.
• Profitability indices.

Measures used in commercial evaluations will vary between projects and private sector proponents. Specialist advice should be sought on financial evaluations and detailed descriptions of these evaluations are not included here.