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These parameters serve as the foundational criteria for either endorsing or rejecting the evaluated project. The breadth of information required for project preparation and evaluation spans diverse disciplines, prompting the need for specialized teams.
Modeling and setting parameters of an investment project include the following:
• Defining quantitative and qualitative aspects throughout the project's phases.
• Identifying relationships between prices, costs, and outcomes to increase profitability.
• Scrutinizing the effectiveness of the project and benchmarking results against similar initiatives and the broader context within the sector or host country.
The list of project parameters that should be planned first includes the scale of investment, capital costs, operating costs, revenue plans, working capital requirements, etc. A special place in this regard is occupied by the choice of sources of project financing, a combination of which must be selected and configured so in a manner that best aligns with the strategic goals of the participants.
ESFC Investment Group brings together a team of experienced specialists in the field of project financing, financial engineering and legal support for international business projects. We are ready to provide our clients with comprehensive professional support, from calculations, modeling, planning and legal advice to raising long-term capital in accordance with the customer's needs.
Basics of project parameterization
The key to a properly conducted planning of the effectiveness of investment projects lies primarily in understanding the mechanisms behind economic outcomes.Investment is a process with cause-and-effect relationships. Only by understanding parameters and their effects project team can build a model for economic outcome analysis. Given that the process of preparing and evaluating an investment project is complex and time-consuming, it is highly recommended to employ specific solutions that facilitate analyses based on data used in the project assessment.
One of the techniques applied involves organizing available information and grouping it into sets related to selected issues linked to each investment project (time, total costs, sales, and financing sources). The classical approach to the basic project parameters can be limited to time, cost, scope, and project quality. Sets of such information are then used to construct more precise investment programs, allowing for the streamlining of data collection processes or obtaining results that form the basis for investment decisions.
It is advisable to develop fundamental project elements, such as:
• Initial investment assumptions.
• Forecasting sales revenue.
• Planning investments in fixed assets.
• Planning operational costs.
• Net working capital demand plan.
• Financing sources program for investment outlays.
• Cash flow statement, profit and loss account, and balance sheet.
The preparation of plans is carried out separately for each period of the project's operation (associated with the fiscal year), requiring meticulous precision from the project preparation team. It is essential to note that all mentioned elements should be developed with great care to serve as a reliable and robust source of data, enabling an assessment of the profitability of the project.
It is imperative that data sources ensure the credibility, timeliness, completeness, and relevance of the data used in the parameterization of the investment project. The process of collecting data necessary for the preparation and evaluation of the project should adhere to procedures already in place during the pre-investment phase of the investment process. This approach is crucial to mitigate the risk of capital misallocation resulting from a superficial handling of such data.
The importance of assumptions in investment process
In deciding to initiate business activities within the pre-investment phase of the project, it is crucial to first establish the fundamental guidelines for the project, often referred to as initial investment assumptions.This involves determining the basis on which computational processes will be easily conducted within the developed plans and models necessary for evaluating the profitability of the investment project, commonly specified as either constant or current prices.
The role of inflation in project planning
Economic and financial analyses are generally carried out in constant prices, which do not account for inflation occurring in the sector.This is because inflation significantly impacts the changing value of money over time, distorting the course of economic processes when expressed numerically. Therefore, the reported increase in profit or sales by the business project in the current prices compared to the previous year may not necessarily indicate real growth.
An understanding of the profitability of an investment project is only achieved by supplementing the above data with the scale at which inflation occurred. Assessing the profitability of investment projects in constant prices is typically driven by the substantial challenges in predicting future inflation levels. Overestimating or underestimating estimated inflation by just one percentage point can result in a 5% error on an annual scale, significantly impacting the forecasts of the project over a 10-year planning horizon. Another factor that increases the risk of error in forecasting in current prices is the varying pace of price growth for different groups of goods and services.
The inflation complicates determining the change in input prices relative to the outcomes achieved. As a result, estimating the real magnitude of project-generated outcomes based on the incurred costs becomes flawed.
The use of constant prices eliminates the aforementioned risks since, by design, these prices are free from such complications and provide more transparent results.
It is also important to adjust the realistically obtained results during project implementation for specific price growth indicators for certain groups of goods and services and compare the values obtained in this way with the postulated values. This allows project team for drawing conclusions regarding the actual profitability of the intended investment. Regardless of the chosen pricing formula, consistency is crucial in forecasting and discounting cash flows.
Determining the planning horizon
Another factor influencing the accuracy of preparing investment programs within a given project is determining the planning horizon and the investment project.This horizon is defined as the period during which the proponent intends to manage activities related to the project or for which guidelines and plans are formulated. The planning horizon must take into account the project's lifespan, understood as the period during which the project generates net benefits.
It is crucial not to overestimate the life of the project. Establishing, during the feasibility study stage, the length of the period for which forecasts are to be prepared appears to be a challenging task. However, it is essential for conducting a proper assessment of the investment project.
The choice of the analysis period is a significant element in evaluating the project's effectiveness because the time factor influences the overall results and indicator values that serve as decision criteria. However, it should be remembered that extending the forecasting period increases the risk of error and deepens the difficulties in correctly interpreting the results obtained, especially since there is no universal formula defining the “standard” analysis period for a project.
The simplest method for determining the planning horizon of the investment project is to establish it by determining the useful life of fixed assets used in the project based on weighted average depreciation rates. Rapid changes in the scientific and technological environment devalue this method and suggest the search for other methods of determining the planning horizon.
Another approach to determining the length of the planning horizon is associated with the period during which the return on investment exceeds the weighted average cost of capital calculated for it. This is a purely mathematical approach to the project planning, which does not directly consider external conditions, too significant to be ignored in an economy of dynamic changes.
When establishing the planning horizon, it is essential to understand the essence of the project and determine whether, after the adopted period, the project will conclude, and a new implementation will begin, or if the project will continue to function with additional replacement costs.
Residual value of the project
The length of the project's lifespan has a significant impact on its so-called residual value (liquidation value), calculated in the last year of the project's operation, determining the value of the remaining assets.As a result, the residual value expresses the project's worth at the end of the period for which cash flow forecasts have been developed.
To accurately calculate the residual value, it is necessary to determine the forecast period for the investment in such a way that the analyzed project reaches normal operating level in the final years, for which cash flows are estimated. Meeting this condition eliminates situations, which are either very favorable or unprofitable for the project and do not reflect typical reality, such as sudden low or high profitability, abrupt changes in receivables, liabilities, etc.
There are several methods for determining the residual value of the project, such as using the market value method, income capitalization method, or discounted cash flow method. In simplified terms, assessing the liquidation value boils down to determining the amount of money that can be obtained by selling the entire facility at the final moment of estimating the cash flow stream and, if necessary, discounting it to the start of the investment project.
In large investment projects with a predetermined lifespan, profitability analysis is conducted for the entire period of their operation. The residual value of such an investment then refers to the value of the assets remaining after its conclusion and is equal to the market value of the components of this asset.
If determining this value proves impossible, project team should use its net value, which is the difference between the value of the asset and its total depreciation.
When the project is to operate beyond the planning horizon, the residual value should correspond to the discounted net cash flows value for the period beyond the analysis. In turn, the total net value of the investment project determined for a pre-established lifespan is equal to the sum of discounted net cash flows occurring in the subsequent years of the planned implementation period and the discounted residual value of the project at the planned moment of its conclusion. As the analysis period lengthens, the residual value of the project will decrease in favor of the increase in the value of cash flows, with the total net value for a given period remaining unchanged.
Sales revenue plan
The next stage in the process of preparing information for evaluating the profitability of an investment project is estimating potential sales revenue.For promoters, this serves as the initial criterion for verifying the justification of project implementation, primarily considering the magnitude of achievable sales revenue. Examining the project's ability to generate sufficient revenue forms the basis for a positive decision to continue it.
The sales revenue plan is a planned quantity of goods and services to be sold in various years of the project's operation, expressed in terms of value or quantity. The plan should be based on a thorough analysis of the project's production capabilities, an analysis of the existing effective demand and supply in target markets, as well as a competitive analysis.
When forecasting sales, it is essential to consider the current and expected market structure, along with its requirements that will determine the preparation of marketing activities. It is necessary to estimate the nominal production capacity and the size of domestic and foreign demand for products and services that may occur later during the project's operation.
Additionally, factors such as the type of product or service and its application, market structure, buyer expectations, competitive actions, supplier contracts, material and equipment availability, distribution channels, price elasticity, market reactions to economic and political factors, and the level of consumption growth should be taken into account. In developing this program, a crucial role is played by the analysis of competition and the particular sector in which the project will be implemented, including the development forecasts and anticipating competitors' actions.
The sales revenue plan is a basis upon which other investment plans and programs depend and to which they are subordinated. Given its role in investment planning, it should be complemented by research results considering the dynamics, concentration, and the likelihood of achieving sales revenue. A positive assessment of the sales revenue estimates allows for the effort to build and create further plans necessary in the process of evaluating profitability, determining the required investment costs and achieving the planned sales targets.
Planning investment costs
The next element in planning and setting parameters of the project is primarily concerning expenses incurred on fixed assets necessary for the commencement of production and normal operation of the project. Investment costs encompass all kinds of expenses that need to be considered before starting the production of a specific product or service.Generally, three groups are distinguished in the structure of investment costs:
• Investments in fixed assets.
• Pre-production capital costs.
• Working capital costs.
Financial literature clearly defines “investment costs”, indicating that they are expenses generating cash flows over a period longer than a year.
Two fundamental types of these investment costs can be distinguished based on the timing of their incurrence:
1. Initial costs on fixed assets (for example, buildings and equipment).
2. Ongoing costs on fixed assets of a replacement and supplementary nature.
Initial investment costs on fixed assets are defined as expenses incurred during the construction phase of the investment, i.e., carried out before the commencement of production and sales.
These costs are often associated with pre-production costs, such as raising capital or conducting analyses before starting the investment, as well as expenses for:
• Land purchase, preparation, and project development.
• Construction or purchase of buildings and solid structures.
• Acquisition of machinery, vehicles, and other fixed assets.
• Intangible and legal assets.
Ongoing investment costs are expenses that increase the company's fixed assets and are incurred during the operational phase of the investment project to ensure its proper functioning. They relate to the same elements of assets mentioned in initial costs, with the exception of pre-production expenses. These can only be incurred during the construction phase of the project.
When incurring investment costs to create fixed assets, it is also essential to consider information on the depreciation level of various components, determine the applicable depreciation rates (excluding land), and establish the liquidation value. The liquidation value is the value of the portion of assets that can be recovered in the event of discontinuation of production activity. It is worth noting that this information will affect the amount of operating costs incurred in connection with the operation of the investment project.
Planning operational costs of industrial projects
An estimation of the total production costs associated with the investment becomes crucial for proper parametrization of the project.It is critically important to calculate production costs in the investment project as annual costs and, simultaneously, as costs per unit.
According to the methodology by UNIDO for the preparation and evaluation of investment projects, the plan of production costs should include all costs related to the specific project, incurred in each year of operation, as well as marketing costs if they have not been previously accounted for.
Generally, operational costs of industrial facility consist of four basic categories:
• Manufacturing costs (materials, production supplies, labor costs, workshops maintenance).
• General administrative costs (salaries, taxes, rents, insurance and office maintenance costs).
• Depreciation (for example, constituting an investment costs).
• Financial costs (including interest).
The sum of manufacturing costs and general administrative costs forms operational costs, which are directly related to the conducted production and sales activities. Incurred operational costs and their structure depend on factors such as the location of the enterprise, natural conditions of host country, type of activity, technology used in production, equipment, degree of utilization of production capacity, organization of the production process, prices of raw materials, materials, and energy, labor costs, and the scale of the facility.
Table: Typical structure of production costs with their key elements
| № | Elements of costs structure for industrial enterprises |
|
Manufacturing сosts
|
|
| 1 | Costs of purchasing raw materials and supplies (including transportation and other necessary fees) |
| 2 | Energy costs (calculated separately if their share is significant, otherwise combined with other categories) |
| 3 | General production costs (including services outsourced, external processing) |
| 4 | Cost of equipment and other technical components of the investment project |
| 5 |
Labor costs with overheads (relevant for production department employees) |
| 6 | Maintenance costs (including equipment repairs, maintenance, renovations) |
| 7 | Costs of purchasing spare parts and maintenance services |
|
Administrative costs
|
|
| 1 | Administrative and payroll costs (salaries for administrative staff) |
| 2 | Other administrative costs (including purchasing office supplies, taxes, insurance, rent, leasing costs) |
|
Marketing costs
|
|
| 1 | Costs related to procurement, distribution, and sale of products and services (including advertising, promotion, transportation insurance, border fees, trade delegations, packaging, warranty, consumer complaints) |
|
Financial costs (all types)
|
|
|
Depreciation costs (all types)
|
|
This structure enables precise monitoring and management of costs in various areas, facilitating the identification of areas where optimizations can be implemented and allowing efficient management of financial resources for the investment project.
When determining the level of operating costs for full production capacity, it is essential to distinguish between variable and fixed components of these costs. Dividing costs into “variable” and “fixed” allows identifying the relationship between variable costs and the degree of utilization of the production capacity of the investment project. Variable costs include raw materials, direct labor costs, plant services and supplies. Fixed costs, primarily encompassing general production costs and long-term service costs, remain relatively constant regardless of the production level, although they may change in the case of long-term analysis.
When calculating the amount of production and marketing costs incurred in the investment project, it is necessary to classify them into direct and indirect costs. Direct costs are defined as costs that can be attributed to a production unit or service due to their direct connection. In contrast, indirect costs are considered expenses related to the production process but do not have a direct impact on the manufactured products or services.
This is because they cannot be directly assigned to products but only based on allocation keys.
Planning working capital requirements
Determining the appropriate level of working capital is another critical element of an investment project, as underestimating this parameter effectively jeopardizes its smooth operation during the operational phase.In investment practice, it often happens that the financial difficulties faced by a new project result from a lack of funds for net working capital (NWC).
Net working capital is calculated as the difference between current assets and current liabilities. The primary goal of the net working capital planning requirements is to determine a size that ensures the current implementation of production tasks throughout the investment period.
Current assets include, among others, finished goods inventory, work in progress, spare parts, materials and raw materials, energy and equipment, receivables, and cash. Current liabilities consist of obligations to suppliers, tax obligations, etc. NWC ensures the maintenance of financial liquidity by determining the amount of assets necessary to immediately settle incurred obligations.
There are several methods for estimating the optimal level of NWC.
One of them involves determining, for each element of working capital, corresponding to them total cost positions, such as manufacturing costs, operating costs, or cost of goods sold, which form the basis for their estimation.
The calculation is based on specific turnover ratios. Turnover ratios for current assets and liabilities are calculated by dividing the number of days in the accounting period by the number of days of minimum coverage for a given element of net working capital. Then, the costs forming the basis for estimating selected elements of working capital are divided by the appropriate turnover ratios. This yields the annual requirement for a specific working capital position. Summing up all working capital positions results in the annual requirement for NWC.
An alternative method for estimating the amount of investment required to create working capital necessary for initiating and sustaining operational activities consists of the following stages:
1. Dividing the annual operating costs incurred in a normal operating year by the number of days in one year to obtain the daily operating cost.
2. Determining the average period (days) over which inventories will be accumulated.
3. Determining the average duration of the full production cycle (days) from the day of material acquisition to the completion of the production process.
4. Determining the average period of storing finished goods from the completion of the production process to the day of their sale.
5. Determining the average sales terms, the number of days between delivering the goods and the date of receiving payment.
6. Determining the average terms of purchasing raw materials, the number of days between receiving materials from suppliers and making payment for them.
7. Adding the obtained number of days from stages 2 to 5, subtracting from this sum the number of days determined in stage 6, and then multiplying the result by the average daily production cost from stage 1. This will yield an estimated value determining the working capital requirement within the given investment project.
The presented method allows for an approximate estimate of the demand for NWC, but project team should remember to update the obtained result when the investment project is launched, i.e. when we will be able to precisely determine the amount of expected costs and coverage ratios for selected components of current assets and current liabilities.
In the case of every investment, the management of the available NWC plays an important role, aiming to achieve a level of working capital that allows for the efficient use of financial resources and ensures the current liquidity of the project during ongoing business operations.
Three types of working capital management strategies are distinguished: conservative, aggressive, and moderate.
Depending on the strategy, there is a different risk of liquidity loss, and there may be higher or lower profitability. The conservative strategy involves maintaining relatively high level of cash and inventories, a low level of receivables and liabilities, and financing working capital to a large extent with fixed capital. The aggressive strategy is associated with maintaining a low level of cash and inventories, a high level of receivables and liabilities, and financing both working capital and part of fixed assets with short-term debt. The moderate strategy represents an “intermediate” solution.
Selecting sources of financing for an investment project
The availability of funds for the implementation of an investment project is a fundamental condition not only for making investment decisions but also for formulating the project itself or initiating pre-investment research and analysis.Initially, it is crucial to determine the method of financing the expenditures in the fixed assets, and this should at least partially occur during the construction phase of the plan. The final selection of financing sources for investment expenditures should be prepared only after building the program for total investment costs and for working capital.
The financing of investment costs can involve the following sources:
1. Equity capital.
2. Debt capital.
3. Project's funds.
Based on the source of origin, we distinguish between internal and external capital. Internal financing does not involve third parties and is based on the redistribution of net profit from the sale of products and services, depreciation, and asset sales. External financing relies on funds obtained from the environment and may result from the involvement of both equity and debt capital.
Equity capital consists of owner and partner contributions, as well as shareholder contributions or stock issuances.
This capital comes from additional issuances of own shares, grants, contributions, or subsidies. It forms a stable basis for financing the project, determining its financial liquidity, as it is provided for an indefinite period and does not have the nature of immediate demandability.
The capital requirements of investment projects often exceed the capabilities of the owners, forcing them to seek external sources of financing. Debt capital is mainly obtained from national or foreign commercial banks (investment loans, working capital loans) and financial institutions, constituting liabilities to these entities. It can also come from other sources of financing, such as credit or loans granted by third parties, leasing, bond or stock issuances.
Debt capital, along with the interest, is most often subject to repayment according to the terms and conditions specified in the loan agreement or other document governing the rules for its provision by the creditor.
In the case of loans, banks require collateral (bank guarantees, asset pledges), but they also allow for the replacement of repaid obligations with new loans.
It is important to remember that the use of external sources of funds, especially the conditions for obtaining them (amount, repayment terms, cost of servicing), can significantly impact the financial results achieved by the investment project. Therefore, before deciding on financing the investment project with debt capital, it is advisable to determine the possible sources, calculate the estimated amount of interest, and research the legal form of the credit security required by the bank (promissory note, government guarantee, endorsement, mortgage).
It is also worth noting that skillful use of external sources of project financing, while maintaining the proper capital structure, often results in increased profitability of equity, a phenomenon known as the financial leverage effect. The positive effect of the impact of debt capital on the amount of net profit generated is achieved on the assumption that the costs of obtaining debt in the form of interest paid will be lower than the profitability of total capital calculated as the ratio of earnings before interest and tax (EBIT) to total capital.
In other words, if the difference between the profitability of equity and total assets turns out to be positive, we talk about a positive financial leverage effect due to the project achieving additional benefits with less equity involvement.
In the case of a negative difference, the problem of project's insolvency arises because the costs of interest are higher than the profitability of the assets.
Another important source of financing that occurs only in the operational phase of large investment projects is the so-called own funds, i.e., cash flows generated during the entire project's lifecycle. These include profits not subject to distribution, depreciation, and accumulated earmarked reserves.
Therefore, in addition to finding capital, the choice of financing the implemented investment project itself is another critical element determining its business success.
The appropriate capital structure, setting optimal parameters of an investment project are particularly important issue, influenced by factors such as specific phase, organizational-legal form, economic conditions, or market environment. Financing is not only the accumulation of resources but also the management of these funds to maintain the balance and liquidity of the project.
Therefore, development and planning of financing sources should be preceded by thorough and comprehensive analyses that guarantee that the capital solutions adopted by investors will finance all investment costs and allow for the smooth implementation of the project.
