Explicit cost are the accounting costs that are

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Unformatted text preview: One important implicit cost is the time value of money. Accounting statements such as Balance Sheet and Income Statement do not take this factor into account. Time value of money simply suggest that there is a cost associated with holding cash. The cost is the interest rate that one could get from putting the fund in a saving account (time deposit) that has zero risk. This concept plays a central role in our discussion and analysis Example: – Assume interest rate (risk free) is 8% per year, and that we have $100. If we put the money in interest baring deposited, by the end of the year we would have 100*(1.08)= 108 – If we do not put the money in interest baring instrument and keep it as cash, while in accounting term we have no cost , we have had $8 as economic cost (opportunity cost) – In our example, the Future value of $100 @8% annual interest rate is 108 at the end of the year – Alternatively, $108 of one year in future would have a present value of 108/(1.08)= 100 (approximately) – More generally for a period of one year: FV= PV *(1+r) FV is Future Value PV is Present Value r is interest rate ( r is in fraction) PV = FV/(1+r) Alternatively How does Construction Relates to Overall Project? Stages of Project In this stage we identify Whether investment is creating highest possible rate of return Operation Feasibility Study Construction Fund Requirement Heavy Investment Fund Generation This for preparing documentation, technical specifications, and preparation of bid It would include purchase of land and equipment, fund for Working capital, and payment of interest on the borrowed funds Fund requirements is for payment of interest and principle for the borrowed fund, as well as for the operational expenses. This stage, however, is net cash generator. Various Types of projects • Private sector is sponsor of project – Financing is from company (corporate finance) – Separate financing for project (project finance) • Government sponsors project but private firm is involved – Government financed through various means including issuing of bonds – Build Operate and Transfer (Public private partnership) Private sector uses corporate financing The first type is when sponsor, private sector finances construction through its own resources. Below cash transaction of project is shown Bank and other financial institutions - Equity - Repayment of loan Initial Equity Fund Initial Fund + + Sponsor + capital requirement Revenue Construction Government Financing of Project The second type is traditional public sector project finance. In these types of projects, public sector entity sponsors the project and it funds the project construction. Source of fund is either special purpose bond or over all government bond which is supported by government ability to pay it off by its future taxes collection. Bank and other financial institutions - + Sponsor/Government + Agencies + Construction Project Taxes + benefits Project Finance The third type is when the project is directly financed. This is called “Project Financed”. In these type of financing, a project company is set up and the sponsor provides equity financing to the “project company”. The remaining financial needs Of the project is raised directly through the project company. Sponsor could be either public authorities or private firms. The cash flow of the project pays for the financing cost Financial Institutions Sponsor Loan Equity Interest and Principle Payyme Profit Project Company Fund Cash Flow Project Itself Project Valuation: Cash Flow Analysis • Cash flow analysis – Each period revenue is forecast – Each period cost is determined – Difference between cost and revenue is gross return – Determine taxable income by subtracting depreciation – Subtract tax – Add back depreciation – Discount cash flow to present time take into account proper discount rate Project Evaluation • Net Present Value is when we subtract initial investment from present value of cash flow – Positive NPV means that the project created value • Internal rate of return (IRR) is the discount rate that makes NPV zero – If the IIR is equal of greater than the company “hurdle rate” then the project creates value • Payback period is the time it takes to cover the investment Financial Evaluation NPV = -I + ∑(R - C)(1- ta) /(1+r)t + ∑ta D/(1+r)t + St/ (1+r)t NPV NPV -I R-C ta r S rr* tt* > =0 < accept indifferent reject > accept r- = r* indifferent < < t- = t* > reject Net Present Value Initial Investment Revenue minus all cost in each period Tax Rate Discount Rate Salvage Value of Capital at the End of Project Internal Rate of Return Hurdle Rate Payback Period Required Payback time accept indifferent reject Role Depreciation • Tax shield is amount of taxes that a firm is allowed not to pay because of accounting rules relative to its tax base. T.S. = ta*D where ta is tax rate (34%)and D is dollar value of depreciation • Deprecation tax shield is important since it provides a free cash flow for the project Cost Structure • Over head cost which is fixed for company – Over all salaries – Energy – etc. • These costs need to be allocated to the project based on some corporate formula • Variable cost (cost related to the specific operation) – Labor – Energy used by project – Wages related to the project – Material – Leases – etc. • The...
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