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 prices Constant 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

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 Costs b) 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. Items Replacement period in yrs Land preparation-20 Building4060 Machinery8 40 Vehicles3 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 capital a. 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 Economics Economic and Financial Analysis of Projects BSc IV Assignment 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 Costs Labor [administration]150 Non tradable office supplies100 Total Fixed costs250 Variable costs Material [traded]250 Utilities [Non traded]70 Labor [operating] 90 Total 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 level WIP yr 1= [material [yr1] +1/2{T. op cost yr 1- TFC yr 1- materials yr 1}]*[production period / total working days] 

Year Capacity Utilization 60%70%80%90%100% Operating cost FC Variable power Variable materials Variable labor T. Op Cost Year Working Capital Initial stock Change in Initial stock Final stock Change in final stock Work in progress Change in Work in progress T.WC Change in WC