Bachelor of Commerce

in Project Management

PROJECT FINANCE

Module Guide

Copyright © 2024
MANCOSA
All rights reserved; no part of this book may be reproduced in any form or by any means, including photocopying machines,
without the written permission of the publisher. Please report all errors and omissions to the following email address:
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 Bachelor of Commerce
in Project Management
PROJECT FINANCE

Preface ............................................................................................................................................................... 5

Unit 1: Introduction to Project Financial Management .................................................................................... 15

Unit 2: Time Value of Money........................................................................................................................... 27

Unit 3: Capital Budgeting ............................................................................................................................... 43

Unit 4: Investment Criteria .............................................................................................................................. 62

Unit 5: Project Portfolio Management ............................................................................................................. 84

Unit 6: Financial Estimates and Projections .................................................................................................. 104

Unit 7: Break Even Analysis.......................................................................................................................... 124

Unit 8: Project Cost Management Components and Planning Tasks ........................................................... 144

Unit 9: Financing the Project ......................................................................................................................... 157

Answers to Revision Questions ...................................................................................................................... 178

Reference List................................................................................................................................................. 204

Bibliography .................................................................................................................................................... 205

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Project Finance

List of Contents
List of Tables

Table 1.1: Project finance stakeholders ............................................................................................................ 23

Table 2.1: Loan Amortisation table ................................................................................................................... 37

Table 3.1: Basic Format of Calculating the Initial Investment ........................................................................... 50

Table 3.2: Calculating Initial Investment ........................................................................................................... 52

Table 3.3: After tax operating Cash flows .......................................................................................................... 54

Table 3.4: Annual Incremental cash flows ......................................................................................................... 54

Table 3.5: Calculating the terminal cash flow of a replacement project. ........................................................... 55

Table 3.6: Solution ............................................................................................................................................ 56

Table 6.1: Pro Forma Statement of Comprehensive Income .......................................................................... 108

Table 6.2: Pro Forma Statement of Financial Position.................................................................................... 111

Table 7.2: Marginal Statement of comprehensive Income Format ................................................................. 128

Table 8.1: Variable versus Fixed Costs .......................................................................................................... 149

Table 8.2: Project management costs ............................................................................................................ 149

Table 8.2: Indirect Cost ................................................................................................................................... 150

List of Figures and Illustrations

Figure 5.1 PPM Connects Strategy with Execution .......................................................................................... 87

Figure 5.2: Project screening matrix ................................................................................................................. 91

Figure 5.3: Markowitz Efficient Frontier, Bodie et al, 2017:97........................................................................... 96

Figure 7.1: Break Even Point, Drury, 2018:753 .............................................................................................. 132

Figure 8.2 Budgeting Flow, PMBOK®, 2014:164 ........................................................................................... 152

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Preface
A. Welcome
Dear Student
It is a great pleasure to welcome you to Project Finance (PRF7). To make sure that you share our passion about
this area of study, we encourage you to read this overview thoroughly. Refer to it as often as you need to, since it
will certainly make studying this module a lot easier. The intention of this module is to develop both your confidence
and proficiency in this module.

The field of Project Finance is extremely dynamic and challenging. The learning content, activities and self- study
questions contained in this guide will therefore provide you with opportunities to explore the latest developments in
this field and help you to discover the field of Project Finance as it is practiced today.

This is a distance-learning module. Since you do not have a tutor standing next to you while you study, you need to
apply self-discipline. You will have the opportunity to collaborate with each other via social media tools. Your study
skills will include self-direction and responsibility. However, you will gain a lot from the experience! These study
skills will contribute to your life skills, which will help you to succeed in all areas of life.

We hope you enjoy the module.

MANCOSA does not own or purport to own, unless explicitly stated otherwise, any intellectual property rights in or to
multimedia used or provided in this module guide. Such multimedia is copyrighted by the respective creators thereto
and used by MANCOSA for educational purposes only. Should you wish to use copyrighted material from this guide
for purposes of your own that extend beyond fair dealing/use, you must obtain permission from the copyright owner.

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B. Module Overview
• The purpose of this module is to help the student explore the field of project finance which is extremely dynamic
as well as challenging. This module thus provides the opportunity to explore the latest developments in the
field of Project finance and discover the ways in which it is practiced today. The module guide as such, has
been designed to facilitate an easy understanding of the module and allows the student the opportunity to
integrate the theoretical concepts from the prescribed textbook and the recommended readings
• Project Finance has emerged as an important method of financing largescale, high-risk domestic and
international business ventures
• Utilise appropriate financial methods and non-financial methods in the project evaluation and selection
processes and come up with a balanced portfolio
• Understand the project cost drivers and financing decisions including calculations relating break even and cost
of cost of financing
• The module is a 15-credit module at NQF level 7
• Read the introduction first, followed by the text, wok through examples, and the activities and check your
solutions against the ones provided at the end of each unit.

C. Exit Level Outcomes and Associated Assessment Criteria of the Programme

Exit Level Outcomes (ELOs) Associate Assessment Criteria (AACs)

• Know and understand the tools, • Foundational knowledge of Project Management is

techniques, principles, practices and explored and understanding is reflected through the correct
methodologies of Project Management; use of terminology

• Fundamental concepts in Project Management are

acquired and knowledge of appropriate application of
methodologies in managing projects reflects understanding

• Gain an understanding of the • Similarities of Project Management and generic

interrelationship among the various tools, management methodologies are investigated and
techniques, practices and methodologies familiarity is shown by the ability to distinguish between the
of commerce and project management; two disciplines

• Correlations between Project Management and

Management methodologies are analysed and knowledge
is reflected by proper integration of various tools and
techniques from both disciplines to successfully manage
projects

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• Develop the practical skills to apply • The Theory of Constraints and other theories are examined
theory to the processes of project and knowledge is demonstrated through the ability to strike
management to achieve project success a balance between constraints and successful delivery of
within project constraints; projects within the specified schedule, budget and scope
without compromising quality

• The determinants of project success are investigated and

knowledge is reflected by an understanding of factors and
criteria that most significantly enable Project Managers to
replicate successful outcomes

• Acquire the skills to undertake research • Research Methodology is examined and familiarity is
in project management; reflected through an understanding of the research process
in Project Management

• Fundamental concepts in research are evaluated and

knowledge is reflected by the ability to apply basic
concepts and strategies and analysing the study's findings

• Acquire the competencies to satisfactorily • The Project Management Body of Knowledge (PMBOK) is
complete the Project Management understood and applied by ensuring a discernible
Professional Examination; knowledge of all the PMBOK knowledge areas

• The correlation of knowledge areas and process groups

are examined and an understanding of how to implement
the approaches in the project environment prepares the
student to satisfactorily complete the Project Management
Profession (PMP) exam

• Demonstrate an understanding to act • Ethics and Governance in Project Management is probed

ethically and professionally, and justify and knowledge is reflected through an understanding of
decisions made and actions taken using the Project Management Institute’s Code of Ethics
relevant ethical values and approaches;
• Correlation between Ethics and Project success is
explored and an understanding of the ethics knowledge,
origins, linkages, and implications in project success
reflects understanding

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• Communicate ideas, concepts and • Knowledge of the Project Management Processes is

practical application of the project life investigated and comprehension is demonstrated by an
cycle, including the stages of initiation, understanding of tools and techniques used in each
planning, implementation and monitoring process group
and closing;
• The interrelation between the process groups is examined
and familiarity is reflected by an understanding how
processes overlap, interact and depend on each other

• Apply technology, innovation, people and • The role of technology in Project Management is
systems-thinking concepts which are investigated and awareness is reflected by an
sometimes in unfamiliar and variable understanding of the dynamics of managing projects in the
contexts to transform individuals, global marketplace
organisations and communities;
• The effects of technological advancements is examined
and understanding is shown by knowledge of challenges in
embracing technological change and how to overcome
barriers to change

• Be able to exercise the necessary • Essential leadership skills for Project Managers are
rational judgment and decision-making investigated and knowledge is shown by an understanding
skills, in a context of personal of the roles and responsibility of a Project Manager as well
responsibility and accountability, which as leadership
will assist in management planning
• The correlation between leadership and project success in
decisions and judicious use of resources
explored and familiarity is reflected by an understanding of
in a context of ensuring sustainability and
competencies required to manage teams effectively and
environmental ethics within the project
deliver successful projects
environment.

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D. Learning Outcomes and Associated Assessment Criteria of the Module

LEARNING OUTCOMES OF THE MODULE ASSOCIATED ASSESSMENT CRITERIA OF THE MODULE

• Understand why a knowledge of elements • Basic accounting concepts are interrogated to gain an
of both financial accounting and understanding of project financial management
management accounting is necessary for
• Different cost drivers are expounded to bring informed
the study of project financial management.
understanding of the interrelatedness of variable and fixed
costs, quantity sold and profitability for optimal financial
outcomes.

• Define basic financial accounting concepts • Forecasting methods are discussed and analysed to help
and cost concepts understand estimation and projection of financial
statements 2.2 Percentage of sales approach was
employed to help understanding financial forecasting and
projections

• Pro forma financial statements are prepared to

communicate and track performance over a period of time

• Utilise appropriate financial methods in the • Methods appropriate for project evaluation and selection
project evaluation and selection processes are identified and discussed to understand their
acceptance and rejection criteria

• South African operating environment is critiqued to

understand the economic climate for project investment.

E. Learning Outcomes of the Units

You will find the Unit Learning Outcomes on the introductory pages of each Unit in the Module Guide. The Unit
Learning Outcomes lists is an overview of the areas you must demonstrate knowledge in and the practical skills you
must be able to achieve at the end of each Unit lesson in the Module Guide.

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F. Notional Learning Hours

Notional Learning Hour Table for the Programme

Learning time
Types of learning activities
%

Lectures/Workshops (face to face, limited or technologically mediated) 10

Tutorials: individual groups of 30 or less 0

Syndicate groups 0

Practical workplace experience (experiential learning/work-based learning etc.) 0

Independent self-study of standard texts and references (study guides, books, journal 65
articles)

Independent self-study of specially prepared materials (case studies, multi-media, etc.) 20

Other: Online 5

TOTAL 100

G. Acronyms

PF Project Finance

PFM Project Financial Management

PPM Project Portfolio Management

SPV Special Purpose Vehicle

TVM Time Value of Money

CAPM Capital Asset Pricing Model

EBIT Earnings Before Interest Taxation

EBITDA Earnings Before Interest Taxation Depreciation Tax

NOPAT Net Operating Profit After Tax

NPV Net Present Value

IRR Internal Rate of return

PBP Payback Period

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PI Profitability Index

FV Future Value

PV Present Value

WACC Weighted Average Cost of Capital

YTM Yield to Maturity

DDM Dividend Discount Model

DCF Discounted Cash Flow

NDCF Non-Discounted Cash Flow

EFN External Financing Needed

MPT Modern Portfolio Theory

H. How to Use this Module

This Module Guide was compiled to help you work through your units and textbook for this module, by breaking
your studies into manageable parts. The Module Guide gives you extra theory and explanations where necessary,
and so enables you to get the most from your module.

The purpose of the Module Guide is to allow you the opportunity to integrate the theoretical concepts from the
prescribed textbook and recommended readings. We suggest that you briefly skim read through the entire guide to
get an overview of its contents. At the beginning of each Unit, you will find a list of Learning Outcomes. This outlines
the main points that you should understand when you have completed the Unit/s. Do not attempt to read and study
everything at once. Each study session should be 90 minutes without a break.

This module should be studied using the prescribed and recommended textbooks/readings and the relevant sections
of this Module Guide. You must read about the topic that you intend to study in the appropriate section before you
start reading the textbook in detail. Ensure that you make your own notes as you work through both the textbook
and this module. In the event that you do not have the prescribed and recommended textbooks/readings, you must
make use of any other source that deals with the sections in this module. If you want to do further reading and want
to obtain publications that were used as source documents when we wrote this guide, you should look at the
reference list and the bibliography at the end of the Module Guide. In addition, at the end of each Unit there may be
link to the PowerPoint presentation and other useful reading.

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I. Study Material
The study material for this module includes programme handbook, this Module Guide, and a list of prescribed and
recommended textbooks/readings which may be supplemented by additional readings.

J. Prescribed and Recommended Textbook/Readings

The prescribed and recommended readings/textbooks present a tremendous amount of material in a simple, easy-
to-learn format. You should read ahead during your course. Make a point of it to re-read the learning content in your
module textbook. This will increase your retention of important concepts and skills. You may wish to read more
widely than just the Module Guide and the prescribed and recommended textbooks/readings, the Bibliography and
Reference list provides you with additional reading.

The prescribed and recommended textbooks/readings for this module are:

Prescribed Reading/Textbook
• Marx, J, C Swardt, M Pretorius, W Rosslyn-Smith (2017) Financial Management in Southern Africa, Fifth
Edition. Pearson South Africa. (This is the latest edition of the textbook)

Recommended Readings
• Conradie, W.M. and Fourie, C.M.W. (2018) Basic Financial Management. Third Edition. Cape Town: Juta and
Company Ltd.
• Gitman, L.J and Zutter, C.J (2017) Principles of Managerial Finance. Thirteenth Edition. Cape Town: Pearson
Education.
• Flynn, D., Uliana, E., Wormald, M. and Dillon, J. (2019) Financial Management. Ninth Edition. Cape Town.
Juta and Company (Pty) Ltd.
• Venkataraman, R.R., and Pinto, J.K (2008) Cost and Value Management in Projects. NJ: Wiley, pp. 344–345.
• Yescombe, E.R. (2014) Principles of Finance. Second Edition: British Library: Elsevier.
• Marx, J; De Swardt, C; Pretorius, M. (2023) Financial Management in Southern Africa. Sixth Edition.
• Zutter, C.J. (2021) Principles of Managerial Finance. Sixteenth Edition. Pearson.
• Venkataraman, R.R. (2023) Cost and Value Management in Projects. Second Edition.

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K. Special Features
In the Module Guide, you will find the following icons together with a description. These are designed to help you
study. It is imperative that you work through them as they also provide guidelines for examination purposes.

Special Feature Icon Explanation

The Learning Outcomes indicate aspects of the particular Unit you have
LEARNING to master.
OUTCOMES

The Associated Assessment Criteria is the evaluation of the students’

ASSOCIATED
understanding which are aligned to the outcomes. The Associated
ASSESSMENT
Assessment Criteria sets the standard for the successful demonstration
CRITERIA
of the understanding of a concept or skill.

A Think Point asks you to stop and think about an issue. Sometimes you

THINK POINT are asked to apply a concept to your own experience or to think of an
example.

You may come across Activities that ask you to carry out specific tasks.
In most cases, there are no right or wrong answers to these activities.
ACTIVITY
The purpose of the activities is to give you an opportunity to apply what
you have learned.

At this point, you should read the references supplied. If you are unable

READINGS to acquire the suggested readings, then you are welcome to consult any
current source that deals with the subject.

PRACTICAL Practical Application or Examples will be discussed to enhance

APPLICATION understanding of this module.

OR EXAMPLES

KNOWLEDGE You may come across Knowledge Check Questions at the end of each
CHECK Unit in the form of Knowledge Check Questions (KCQ’s) that will test
QUESTIONS your knowledge. You should refer to the Module Guide or your
textbook(s) for the answers.

You may come across Revision Questions that test your understanding
REVISION
of what you have learned so far. These may be attempted with the aid
QUESTIONS
of your textbooks, journal articles and Module Guide.

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Case Studies are included in different sections in this Module Guide.

CASE STUDY This activity provides students with the opportunity to apply theory to
practice.

You may come across links to Videos Activities as well as instructions

VIDEO ACTIVITY on activities to attend to after watching the video.

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Unit
1: Introduction to Project Financial
Management

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Unit Learning Outcomes

CONTENT LIST LEARNING OUTCOMES OF THIS UNIT:

1.1. Introduction • Define project financial management

1.2. Goals of a financial manager • Explain the long term and short-term financial goals of a
financial manager

1.3. Why profit maximisation is not • Explain why profit maximisation is not the right objective for
always the key motivator in project finance managers
finance

1.4. Functions of a financial manager • Explain the functions of a financial manager

and or project manager

1.5. Fundamental principles of financial • Describe the fundamental principles of financial management
management

1.6. Stakeholders in Project Finance • Identify the various stakeholders in project finance

1.7. Summary • Summarises topic areas covered in the unit

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Prescribed and Recommended Textbooks/Readings

Prescribed Reading/Textbook
• Marx, J, C Swardt, M Pretorius, W Rosslyn-Smith (2017) Financial
Management in Southern Africa, Fifth Edition. Pearson South Africa. (This
is the latest edition of the textbook)

Recommended Readings
• Conradie, W.M. and Fourie, C.M.W. (2018) Basic Financial
Management. Third Edition. Cape Town: Juta and Company Ltd.
• Gitman, L.J and Zutter, C.J (2017) Principles of Managerial Finance.
Thirteenth Edition. Cape Town: Pearson Education.
• Flynn, D., Uliana, E., Wormald, M. and Dillon, J. (2019) Financial
Management. Ninth Edition. Cape Town. Juta and Company (Pty) Ltd.
• Venkataraman, R.R., and Pinto, J.K (2008) Cost and Value Management
in Projects. NJ: Wiley, pp. 344–345.
• Yescombe, E.R. (2014) Principles of Finance. Second Edition: British
Library: Elsevier.
• Marx, J; De Swardt, C; Pretorius, M. (2023) Financial Management in
Southern Africa. Sixth Edition.
• Zutter, C.J. (2021) Principles of Managerial Finance. Sixteenth Edition.
Pearson.
• Venkataraman, R.R. (2023) Cost and Value Management in Projects.
Second Edition.

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1.1. Introduction
Conradie and Fourie (2013:4) define Financial Management as the function being responsible for the acquisition
of the necessary financial resources to ensure the most advantageous financial results for the entity over both the
short- and long-term. According to World Bank Report (1999:9) Project Financial Management (PFM) is a process
which brings together planning, budgeting, accounting, financial reporting, internal control, auditing, procurement,
disbursement and the physical performance of the project with the aim of managing project resources properly and
achieving the project’s development objectives. Project finance and financial management have a significant impact
on project cost, cash flow, and more importantly, success (Venkataraman and Pinto, 2008:154).

From the above definition, it is equally important to note that project financial management encompasses all the
functional areas necessary to accomplish a project. Financial management in projects is very critical to improve the
way managers make major investment decisions, and then structure and finance them. The financial structure of
large projects financed with a concentrated equity ownership and a high level of non-recourse debt is referred to as
Project Finance (PF) (Esty, 2004). The Basel Committee defined Project Finance as a method of funding in which
the lender looks primarily to the revenue generated by a single project, both as a source of repayment and as
security for the exposure. This funding is large, complex, and meant for expensive installations such as power plants,
chemical processing plants, infrastructure for telecommunication and transport.

Knowledge Check 1.1

Project finance and financial management do not have any significant impact on project
cash flow. (True/False)

According to Denton, (2013) Project finance (PF) is invariably more expensive than raising corporate funding. Also,
and importantly, it takes considerably more time to organise and involves a considerable dedication of management
time and expertise in implementing, monitoring, and administering the loan during the life of the project. Therefore,
financial management plays a pivotal role in structuring Project Finance deals. Financial managers can also provide
timely and relevant financial information which are critical ingredients for better decisions making that can speed up
progress of the project thus reducing delays and potential bottlenecks.

Think Point 1.1

Financial management plays an important role in project finance. What is the need for
good financial management in PF?

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1.2. Goals of a financial manager

Every financial manager’s short, medium and long-term goal should be to maximise the value of the firm, thereby
increasing the wealth of owners. Management will use this core objective to frame decision-making. Every
investment or financing decision should be preceded by the question – does this lead to an increase in shareholder
value? As put forward by Marx, Swardt, Pretorius, Rosslyn-Smith (2017:12) the goals of a financial manager are
categorised into short term and long-term goals as illustrated below:

1.2.1 Long-term financial goals

• High expected return: Those who commit their funds into a business need to be compensated for the
time value of money during the period of commitment (2) the expected rate of inflation during the period,
and (3) the risk involved. Therefore, managers need to use company assets productively to achieve an
expected rate of return that is financially viable.
• Lower cost of capital: Firms usually use debt and equity to finance its operations. To providers of debt,
the firms creates a fixed obligation in the form of interest. To equity providers (shareholders), the firm needs
to compensate them. This may be through share price appreciation and/ dividends at the end of the year.
In both cases, the firm needs to keep the cost of acquiring capital as low as possible.

1.2.1 Short term financial goals

• Profitability: This is the ability of a company to generate positive revenues over and above its total cost.
Firms may increase profit by focusing on growth in sales while keeping cost such as marketing, distribution,
administration, and general expenses as low as possible.
• Liquidity: This is the firm’s ability to meet its short-term obligations, as and when they become due. The
firm keep its assets in their most liquid form e.g. Cash, short term marketable securities accounts
receivables etc.
• Solvency: This is the extent to which the firm’s assets exceed its liabilities.

Think Point 1.2

Projects such as road construction, power plant installations, and oil refineries take time
to complete. Should project managers focus only on long term financial goals and neglect
short term goals? Why or why not?

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1.3. Why profit maximisation is not always the key motivator in project finance.
From a project finance point of view, profit maximisation is not always the key motivator given that projects do not
involve marketing of a product or service. Gitman, (2017:14) put the following salient points regarding the
inadequacy of focusing on profit maximisation.
• Manipulation of accounting profits
Accounting profits are dependent on accounting policies and estimates and management may select policies and
estimates that may not reflect economic reality. For example, when is a sale recognised? What is the life of
depreciable assets? When is a cost an expense and when is it an asset? These offer management flexibility in
selecting accounting policies that may bolster profits in the short term.
• Timing
Profit maximisation does not directly factor in the time value of money. A project that results in a total profit of R10m
per year for 5 years would be preferred to a project that generates R5m per year for 10 years. This is because profits
that are received sooner can be reinvested to provide greater future returns.
• Cash flows
Accounting profits do not always reflect cash flows. Profits are determined by the company’s accounting policies
and estimates, whilst project finance is focused on cash flows.
• Risk
Profit maximisation ignores the impact of risk on value. A basic principle in finance is that a trade-off exists between
return (cash flow) and risk.

Activity 1.1: Profit Maximisation goal

The following table shows the profit that each investment is expected to have over its 3-
year life

Investment Year 1 Year 2 Year 3 Total

Project alpha 1400 1000 400 R2800

Project Beta 600 1000 1400 R3000

In terms of profit maximisation goal, which project would you recommend? Is this the
key motivator from project finance point of view?

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1.4. Functions of a financial manager and or project manager.

A financial manager performs two primary functions, i.e. pursue wealth creating investment opportunities and find
funds to finance the investments. This is indicated by the figure 1.1 bellow:

Operating Assets Capital Markets

#Non-current #Equity
#Current #Debt

Explores investment FINANCIAL Explores financing

opportunities and opportunities and
makes investment MANAGER makes financing
decisions decisions

Financial Assets
Money Markets

1Figure 1.1 Function of a financial manager in project management

(Flynn et al, 2019)

• Making Investment decisions

The financial manager must explore investment opportunities within the context of the type of business operation in
which the company is engaged. Only investments or projects that are likely to increase the value of the business
are pursued. These investment opportunities can be in the form of non-current assets such as property, plant,
equipment, machinery (Marx et al, 2017:14). Financial assets may include investment in equity shares, preference
shares and bonds as well as other financial instruments such as derivatives.

• Making financing decisions

The financial manager makes decisions regarding the source of funds to be used in financing the investment
projects. The decision to arrive at an optimal capital structure involves the appropriate mix of short and long-term
financing. The objective, when selecting financing alternatives, would be to obtain funds at the lowest cost.

Capital markets are markets in which long-term financing instruments (bonds and shares) are bought and sold.
Money markets are markets for short-term securities (commercial papers and treasury bills). This market exists
because there are demanders of cyclical or seasonal needs of cash. At the same time, there are suppliers with
temporal idle funds that they wish to loan at some interest. This market, therefore, brings together the suppliers and
demanders of short-term funds (Flynn et al, 2015:15)

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• Other functions of finance manager

In addition to the primary functions, a financial manager also performs the following functions
• Ensuring profitability
• Ensuring positive cash flows
• Ensuring solvency

Video 1.1

[Link]

From this video, what are the 6-financing decision arears undertaken by financial managers?

Case Study: BHP Billiton

We are BHP Billiton, a leading global resources company. We are among the world’s top
producers of major commodities, including iron ore, metallurgical and energy coal, conventional
and unconventional oil and gas, copper, aluminium, manganese, uranium, nickel and silver. As
of 30 June 2018, we had a market capitalisation of approximately US$147.1 billion. Our Net
operating cash flows of US$17.4 billion in FY2019 (FY2018: US$17.6 billion) reflects EBITDA
results and higher Australian and Chilean income tax payments in FY2019. Our balance sheet
remains strong with net debt at US$9.2 billion at FY2019 year-end (FY2018: US$10.9 billion),
a reduction of US$17 billion over three years. The reduction of US$1.7 billion in FY2019 reflects
strong free cash generation, which includes proceeds received from the sale of Onshore US,
partially offset by returns to shareholders of US$16.6 billion, dividends paid to non-controlling
interests of US$1.2 billion. Creating long-term shareholder value remains a strategic
imperative. Without that focus, BHP would not exist, because our shareholders entrust us with
their funds and expect competitive returns. Since 2016 we have strengthened our balance
sheet through a US$17 billion reduction in net debt, reinvested US$27 billion in development
options, importantly, returned more than US$29 billion to shareholders. We have entered into
money market deposits and derivative transactions. We believe that the identification and
management of risk is central to achieving our corporate purpose of creating long-term
shareholder value.

BHP Annual Report 2019, BHP Billiton, viewed 01 November 2019, <[Link]
/media/documents/investors/annual-reports/2019/[Link]>

Required:

What are the functions of a financial manager in the Billiton case study?

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1.5. Fundamental principles of financial management

According to Max et al, (2017:15) the functional departments and various stakeholders in business should
understand the following fundamental principles of financial management.
• Cost and Benefit
Sound financial and investment decisions are based on complete cost and benefit analysis. As a matter of fact,
benefits should be greater than the cost of any decision. Otherwise, the decision is not worth taking.
• Risk and return
There is no cash flow that a firm can generate without incurring an element of risk. Hence, risk becomes an
inseparable characteristic of any decision. Marx (2017:15) defines risk as the probability that the actual result of a
decision may deviate from the projected demand, with an associated financial loss or waste of funds. Investors need
to be compensated for the amount of risk that they take. It follows that the higher the risk, the greater the expected
return will be.
• Time value of money
It refers to the fact that a dollar in hand today is worth more than a dollar promised at some time in the future. This
is because cash flows received sooner can be reinvested to provide greater future returns.

Practical Application 1.1

The manager has promised to give you R10 000 for outstanding performance. The
options are that: You can take it today or wait and give it to you after 2 years.

Which option would you choose and why?

1.6. Stakeholders in PF
According to Yescombe, (2014) the following are the project finance stakeholders who also the project stakeholders.

1Table 1.1 Project Finance stakeholders

Stakeholder Explanation

Project Company A special purpose vehicle (SPV) created to construct and operate a project

Project Sponsor A person who is involved (often with others) in originating and structuring a
project and who will (usually) be a shareholder or owner of all or a part of the
facility or project. Sponsors are those who provide equity to the project

Financial Advisor The sponsor’s advisor on arranging finance for the project company

Project lenders Those who provide debt to project the project company. Eg banks and
bondholders

Lender advisors External advisors employed by project lenders

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Offtaker The purchaser of the project company’s [Link] customers

Project manager A person responsible for managing the entire project

1.7. Summary
PFM is a subject that encompasses all the functional areas necessary for an entity to meet its financial objectives.
The goal of a financial manager is to maximise shareholder wealth. To achieve this goal, financial managers need
to make long-term financial goals such as achieving high-expected rate of return and lower cost of capital. Short-
term financial objectives are also necessary, and these include profitability, liquidity and solvency. There are two
primary functions of a financial manager, which are making investing and financing decisions. Other functions
include ensuring profitability, positive cash flows and solvency. All functional areas and stakeholders should
appreciate the fundamental principles of financial management: Cost and benefit, risk and return and time vale of
money principles.

1.8. Revision questions

1.7.1 Identify the primary functions of a financial manager.
1.7.2 Why is profit maximisation, on its own, not an appropriate goal for finance managers?
1.7.3 Justify shareholder wealth maximisation as a sound financial management goal.
1.7.4 Distinguish between capital markets and money markets. Under what circumstances do financial managers
seek finance from these two markets respectively?
1.7.5 Discus the fundamental principles of financial management in an organisation.
1.7.6 Why are the concepts of risk and time value of money important in making investment and financing
decisions?
1.7.7 Who are the main parties in a project finance transaction?

Revision Questions

1.7.1 Identify the primary functions of a financial manager.

1.7.2 Why is profit maximisation, on its own, not an appropriate goal for
finance managers?

1.7.3 Justify shareholder wealth maximisation as a sound financial

management goal.

1.7.4 Distinguish between capital markets and money markets. Under what
circumstances do financial managers seek finance from these two markets
respectively?

1.7.5 Discus the fundamental principles of financial management in an

organisation.

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1.7.6 Why are the concepts of risk and time value of money important in
making investment and financing decisions?

1.7.7 Who are the main parties in a project finance transaction?

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Answers to Activities
Knowledge Check
1.1-False
Think point 1-good financial management is needed because it provides
• Essential information needed by those who manage, implement, and supervise projects, including
government oversight agencies and financing institutions.
• The comfort needed by the borrower country, lenders, and donor community that funds have been
used efficiently and for the purposes intended; and
• A deterrent to fraud and corruption, since it provides internal controls and the ability to quickly
identify unusual occurrences and deviations.
Think point 2 – Managers should not always only focus on long term financial goals because they might not get
or arrive at long term goals if short term goals are not being met.
Activity 1 According to the profit maximisation goal, Project Beta will be recommended since it has higher
profitability. This is not the right objective from the project finance point of view because it ignores
the time value of money, risk involved and is subject to manipulation. Additionally, assuming profit
is equal to cash flow, the R1400 received for Project Alpha at the end of year 1 could be invested
for 2 years and generate interest. The sooner you realise the cash flow the better.
Video 1 Financing decision areas
1. Investment Analysis
2. Working capital Management
3. Sources and Cost of Funds
4. Determination of capital structure
5. Dividend Policy
6. Analysis of risk and return

Case Study – To answer this case study, your answer should be related to the functions of a financial manager and
or project manager. Read paragraph 1.4.

Practical Application 1 – When answering this question consider the fundamental principles of financial
management principles. Read paragraph 1.5.

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Unit
2: Time Value of Money

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Unit Learning Outcomes

CONTENT LIST LEARNING OUTCOMES OF THIS UNIT:

2.1 Introduction • Introduces topic areas for the unit

2.2 Future Value of a single sum • Determine the future value of a lump sum investment made
today

2.3 Present Value of a single sum • Determine the present value of a single sum investment

2.4 Annuities • Calculate the present value and future of an annuity

2.5 Present value of uneven cash flows • Compute the present value of an uneven cash flow project

2.6 Future Value of uneven cash flows • Compute the future value of an uneven cash flow project
series

2.7 Loan Payment and Amortisation • Construct an amortisation schedule to show interest and

2.8 Summary • Summarises topic areas covered in the unit

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Prescribed and Recommended Textbooks/Readings

Prescribed Reading/Textbook
• Marx, J, C Swardt, M Pretorius, W Rosslyn-Smith (2017) Financial
Management in Southern Africa, Fifth Edition. Pearson South Africa.
(This is the latest edition of the textbook)

Recommended Readings
• Conradie, W.M. and Fourie, C.M.W. (2018) Basic Financial
Management. Third Edition. Cape Town: Juta and Company Ltd.
• Gitman, L.J and Zutter, C.J (2017) Principles of Managerial Finance.
Thirteenth Edition. Cape Town: Pearson Education.
• Flynn, D., Uliana, E., Wormald, M. and Dillon, J. (2019) Financial
Management. Ninth Edition. Cape Town. Juta and Company (Pty) Ltd.
• Venkataraman, R.R., and Pinto, J.K (2008) Cost and Value Management
in Projects. NJ: Wiley, pp. 344–345.
• Yescombe, E.R. (2014) Principles of Finance. Second Edition: British
Library: Elsevier.
• Marx, J; De Swardt, C; Pretorius, M. (2023) Financial Management in
Southern Africa. Sixth Edition.
• Zutter, C.J. (2021) Principles of Managerial Finance. Sixteenth Edition.
Pearson.
• Venkataraman, R.R. (2023) Cost and Value Management in Projects.
Second Edition.

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2.1. Introduction
To determine the attractiveness of their investments and projects financial managers, project sponsors and investors
are concerned with the positive returns that their investments or projects can generate. Therefore, the commitment
of funds today needs to be compensated otherwise investors and project sponsors become reluctant to take risks.
Because projects cash inflows become uncertain, some investors may opt to invest in risk free assets such as
government bonds. Return from such an investment is known as the pure time value of money. Because project
cash flows are uncertain, the timing of cash outflows and inflows become very important and has important economic
consequences, which financial managers explicitly recognise as the time value of money (TVM).

The time value of money is a concept, which states that money available now is worth more than the same amount
of money in future due to its earning capacity (R1 today is worth more than R1 next year) (Rahman, 2017). It is very
important for project managers to understand the time value of money. Projects of almost any size have cash flows
that occur in the future. Generally, the timing of these cash flows is far enough in the future that an adjustment of
these cash flows to their present values is important enough to be considered. This annual rate of return is referred
to as the discount rate, required return, cost of capital, and opportunity cost. These terms will be used
interchangeably.

Video 2.1

[Link]

After watching the video, explain the difference between simple interest and compound
interest...

2.2. Future Value of a Single Sum

Future Value (FV) is the amount that is calculated by increasing the present value or series of payments at the given
rate of interest (Rahman, 2017). The FV technique typically measures cash flows at the end of a project’s life. In
calculating the future value, compounding frequency can be annually, semi-annually, quarterly, monthly. Future
value problems can be solved using future value tables. Mathematically, you can solve the FV problems by applying
the following formula:

FVN = PV ( 1 + i)N
Where,
𝐹𝑉𝑁 = future value of the investment N periods from today
PV = present value of the investment
i = rate of interest per period (in decimal form)
N = number of compounding periods

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Example 2.1
Suppose you identify a two-year project that pays 14 percent per year. If the project requires R35 000 at initiation,
how much will you have at the end of the two years, assuming the interest is compounded
a) Annually b) semi-annually c) quarterly d) monthly
Solution

a) Annual compounding, b) Semi-annual compounding

N = 2 years and i =14% = 0.14, PV =35 000 N = 2 years x 2 = 4, i = 0.14/ 2 = 0.07
Substituting to the above formula Substituting to the above formula
FV = 35 000 (1 + 0.14)2 FV = 35 000 (1 + 0.07)4
= 35 000 x 1.142 = 35 000 x 1.074
= 35 000 x 1.2996 = 35 000 x 1.3108
= R45 486 = R45 877.86

c) Quarterly compounding d) Monthly compounding

N = 2 years x 4 = 8 and i = 0.14/ 4 =0.035 N = 2 years x 12 = 24 and i =0.14/12 = 0.0117
FV = 35 000 (1 + 0.035)8 FV = 35 000 (1 + 0.0117)24
= 35 000 x 1.0358 = 35 000 x 1.011724
= 35 000 x 1.3168 = 35 000 x 1.3210
= R46 088.32 = R46 234.55

Knowledge Check 2.1

An investment of R3 million earns semi-annually compounded rate of return of 8%. The
interest earned for the 5-year period is closest to:

A. R4 440 733

B. R1 440 733

C. R1 200 000

2.3. Present value of a single sum

The present value of a single sum is obtained by discounting the future value of a project cash flow back to the
present. In other words, it is a direct opposite of the future value computation. Mathematically, it is represented by
the formula:

𝟏
𝐏𝐕 = 𝐅𝐕 𝐱 [ ]
(𝟏 + 𝐢)𝐍

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1
The term is the discounting factor, used to multiply the future value. The discounting factor is obtained
(1+𝑖)𝑁

from the financial tables provided at the end of this guide. Thus
PV = FV x discounting factor

Example 2.2
Suppose JG Projects embarked on a project that promises to pay a lump sum of R100 000 in 3 years. What
amount should JG Projects commit today in order to realise the promised lump sum. The opportunity cost of
capital is assumed to be 10% per annum.

Solution
Using the present value tables.
Number of periods is 3 and discount factor at 10% = 0.7513
PV = FV x PVIF
= 100 000 x 0.7513 (Table 3)
= R75 130.00
Thus R75 130 should be committed today in order to get the promised lump sum of R100 000

Think Point 2.1

Given a discount rate of 9%, calculate the PV of a R1 000 000 cash flow that will be
received at the end of 5 years.

2.4. Annuities
Alsemgeest et al, (2014:124) define an annuity as a series of equal payments (cash outflows) or receipts (cash
inflows occurring over a specified time period. These payments or receipts are at regular intervals and might be
annually, quarterly, and monthly (Marx et al, 2017:137). Examples of annuities include bond payments, car loan
repayments, insurance premiums, mortgage payments. Project managers are concerned with periodic repayments
to amortise a debt service and accumulate cash to replace equipment or make other future capital investments.
As put forward by Marx et al (2017;137) there are basically two types of annuities- ordinary annuity (annuity at the
end of each period) and annuity due (annuity at the beginning of each period). The most common type of an annuity
is an ordinary annuity where the cash flows happen at the end of each period and will be discussed in this guide.

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2.4.1 Future Value of an Annuity

The future value of an annuity is the total amount of the payments and the accumulated (or compounded) interest
on those payments. To calculate the future value of an ordinary annuity, the periodic payment/receipt is multiplied
by the future value interest factor of an annuity (FVIFA). This factor is known as the multiplier and is provided for in
Table 2 of the Appendix. Mathematically, future value of an ordinary annuity is given by:

(𝟏 + 𝐢 )𝐍 − 𝟏
𝐅𝐕𝐀𝐍 = 𝐏𝐌𝐓 × [ ]
𝐢

Where, FVAN = the future value after N periods

PMT = Periodic payment/regular receipt
i = Interest rate per year
N = number of periods (year x periods per year)
The term in the bracket is future value interest factor of an annuity (FVIFA). Which can be represented by the
following formula
𝐅𝐕𝐀𝐍 = PMT x 𝐅𝐕𝐈𝐅𝐀𝐈,𝐍

Where
FVIFAI,N = Future value interest factor for an ordinary annuity that can be obtained from table 2

Example 2.3
The company XYZ wishes to replace one of its moulding machines, its financial manager proposed to deposit an
amount of R10 000 annually, at the end of each of the next 5 years, into a savings account paying 7% annual
interest. What is the future value of the total deposits at the end of 5 years?

Solution
FVAN = PMT x FVIFAI,N
From the annuity tables, FVIFA7%,5yrs
= 10 000 x 5.7507 (Table 2)
= R57 507.39

Activity 2.1
Suppose the company you work for will receive R50 000 at the end of every year for the
next 20 years. As soon as it receives the payments, the project manager invests them
at ABSA bank at an interest rate of 12% per annum compounded annually. How much
will be in the company’s bank account at the end of 20 years, assuming no withdrawals
are made?

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2.4.2 Present Value of an Annuity

This refers to the amount of money needed today to fund a series of future annuity payments. The future annuity
payments are discounted to time zero at a predetermined discounting rate. Present value of an annuity is
represented by the formula below;
𝟏 − ( 𝟏 + 𝒊)−𝑵
𝐏𝐕𝐀𝐍 = 𝐏𝐌𝐓 × [ ]
𝒊
Where,
PVAN = the present value of an ordinary annuity
PMT = periodic payment/ regular receipt
i = Interest rate per year
N = number of periods (year x periods per year)
The above formula can also be presented as.
𝐏𝐕𝐀𝐍 = 𝐏𝐌𝐓 x 𝐏𝐕𝐈𝐅𝐀𝐫,𝐍
Where
PVIFAr,N = present value interest factor of an ordinary annuity (Table 4)

Example 2.4
Giamanje Trades and Development, a small producer of plastic toys, is considering investing in a project that
promises to pay R150 000 per year for five years, with the first payment received one year from now. The required
rate of return is 12 percent per year. Determine the present value?.

Solution
PVAN = PMT x PVIFAr,N
= 150 000 x 3.6048
= R540 720

Think Point 2.2

Suppose you need an investment that will pay R1000 per month, for 4 years, at 15%
interest compounded monthly. Determine the present value of this annuity.

2.5. Present Value of Uneven Cash Flows

Thus far, we have restricted our attention to the present value of a lump sum or annuity. But in reality, many projects
offer unequal cash flows over the project life cycle. The uneven cash flows may also be referred to as a mixed
stream of cashflows that does not reflect any pattern (Marx et al, 2017:143). When we have unequal cash flows, we
must first find the present value of each individual cash flow and then sum the respective present values.

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Example 2.5
XYZ Company, a shoe manufacturer, has been offered an opportunity to accept a project that has the following
mixed stream of cash flows over the next 5 years:

Year 1 2 3 4 5
Cash flow R4 000 R8 000 R5 000 R4 000 R3 000

If the company must earn at least 9% on this project. What is the present value of this project?
Solution
Year Cash flow Discount Factor @ 9% Present Value
(Table 3)
1 4 000 0.9174 3 670
2 8 000 0.8417 6 734
3 5 000 0.7722 3 861
4 4 000 0.7084 2 834
5 3 000 0.6499 1 950
Present Value R19 049

2.6. Future Value of Uneven Cash Flows

To find the future value of uneven of cash flows is similar to the concept applied when determining the present
value of even cash flows. We first determine the future value of each cash flow at the specified future date and
then add all the individual future values to find the total future value.

Example 2.6
ABC Industries, a brick moulding company, expects to receive the following cash flows over the next 5 years from
one of its regular customers.
Year 1 2 3 4 5
Cash flow R11 500 R14 000 R12 900 R16 000 R18 000

If ABC expects rate of return of 15% on its investments, how much will it accumulate by the end of year 5 if it
immediately invests these cash flows when they are received?

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Solution (Using table 1 to get the FVIF)

Year Cash flow Number of years FVIF @ 15% Future value
earning interest
1 50 500 4 1.7490 88 150
2 54 000 3 1.5209 82 129
3 62 900 2 1.3225 83 185
4 86 000 1 1.1500 98 900
5 95 500 0 1.0000 95 500
Future Value 447 864
NB: The future value of the end of year 5 deposit is its present value because it earns interest for zero years and
(1 + 0.15)0 = 1

Practical Activity 2.1

Suppose your company has the following uneven cash flows at the end of each year for
6 years

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

-1000 -500 0 4000 3500 2000

a) Compute the present value of this 6-year uneven cash flow stream using a 10%
rate of return
b) Using a rate of return of 10%, compute the future value of the 6-year uneven
cash flow stream at the end of the sixth year

2.7. Loan Payment and Amortisation

According to Gitman (2017:189), loan amortisation refers to the computation of equal periodic loan payments. In
project financing, recourse loans need to be repaid over time. A simple way of amortising a loan is to have the
borrower pay the interest each period plus some fixed amount. Since loan amortisation is concerned with finding
the future payments, over the term of the loan, it uses the concept of present value of an annuity. Lenders use a
loan amortisation schedule to determine the equal payment amount and the allocation of each payment to interest
and principal.

From the previous illustrations in the unit you will recall that;
PVAN = PMT x PVIFAr,N
Isolating PMT on the left side of the equation gives us;

PVAN
PMT =
PVIFAr,N

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Where
PMT = annual equal instalment
PVAN = Is the initial amount borrowed
PVIFAr,N= the present value interest factor of annuity
r = is the rate of interest per annum
N = number of periods required to pay off the loan.

Example 3.1
Suppose Gugu Construction company has borrowed R200 000 from ABSA bank at an interest rate of 20% per
annum to be repaid over the next 5 years. Construct the amortisation schedule if equal payments are required at
the end of each year.

Solution
The instalments on the loan may be calculated as follows:

PVAN
PMT =
PVIFAi,N

PVIFAr,N Using Table 4: discount factor for 20% and 5 years, we get 2.9906

200 000
=
2.9906
= R66 876 (rounded off to the nearest rand
2Table 2.1 Loan Amortisation table
End of year Instalment Beginning Interest Paid Principal Paid End of year
balance principal
(1) (2) (3) = 0.2 x (2) (4) = (1) – (3) (5) = (2) – (4)
1 R66 876 R200 000 R40 000 R26 876 R173 124
2 R66 876 R173 124 R34 625 R32 251 R140 873
3 R66 876 R140 873 R28 175 R38 701 R102 172
4 R66 876 R102 172 R20 434 R46 442 R55 730
5 R66 876 R55 730 R11 146 R55 730 R0

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Case Study: Financial Freedom Through Investing

Many people spend their entire lives living pay check to pay check, not realising that they
could retire early or achieve the financial freedom and independence they have already
dreamed of. Many people have become millionaires through investing in real estate than
through any other means. Why is that? Well, think about all the ways you could generate
different streams of income in your life. You could write a book, start a business, create
an award-winning new mobile app, or pursue countless other ventures. However, all of
those ventures require significant skill, knowledge, experience, connections, and often,
start-up capital. One of the simplest ways to invest in real estate is to buy a property and
rent it out. Another way to invest in real estate, especially if you do not want to deal with
the hassle of finding and fixing up a property yourself, is to invest in a real estate
syndication (i.e. a group investment).

GoodEggInvestments, 2020, viewed 1 November 2020,

<[Link]

Question

How does the application of time value money leads to financial freedom?

2.8. Summary
• Time value of money is an important concept in project financing. Financiers are concerned with the rate
of return of their capital, which can also be referred to as cost of capital, opportunity cost or discount rate.
• Investors who are afraid of taking risks can invest their monies in risk free assets and earn a risk-free rate
also known as the pure time value of money.
• Interest rate can be compounded annually, semi-annually, quarterly, monthly, and even daily
• FV refers to the amount of money an investment will grow to over some period at some given interest rate
• PV is obtained by discounting the future value of a project cash flow back to the present.
• Annuity refers to a fixed amount of money that is paid or received at regular intervals, such as annually,
quarterly, or monthly
• To find the PV of series of unequal cash flows, first find the PV of each cash flow and then add individual
present values to get the total present value.
• To find the FV of series of unequal cash flows we first determine FV of each cash flow and then add all the
individual future values to find the total future value
• A series of constant cash flows that arrive or are paid at the end of each period is called an ordinary annuity
• Many loans are annuities. We use the present value of an annuity to determine the periodic payment.
• The process of providing for a loan to be paid off gradually is called loan amortisation.

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Revision Questions

2.9.1 Differentiate between time value of money and pure time vale of money.
2.9.2. Suppose your company needs R40 000 to buy sawing machine three
years from today. The financial manager is proposing putting money in
the savings account that can earn 12 percent per annum. How much
does the company have to deposit in the savings account today in order
to meet its goal assuming an interest is compounded: a) annually b)
semi-annually c) quarterly d) monthly?
2.9.3. TJK, a hypothetical SME deposits R20 000 annually at the end of each
year for the next five years in a savings account that pays an interest
rate of 10% per annum. What will the FV of its savings account be after
5 years?

2.9.4. Suppose your company wants to upgrade its IT department after five
years at an estimated cost of R100 000. The finance department is
considering depositing R15 000 at the end of each of the next five years
in a savings account that pays an interest rate of 10% per annum.
Advice whether the company will be able to meet its objective.

2.9.5 Mercury Ltd. recently completed a project for a client which yielded a
profit of R1 000 000. The company now has the opportunity to either
invest the proceeds from the project or to take on a new project. The
company can either undertake the development of new software for
which it can sign a contract now to sell it for R1 500 000 in 3 years’ time.
Alternatively, it can invest the proceeds in a money market account
where it can earn 15% interest per year. Advice the company whether
to invest the proceeds or develop a new software?

2.9.6. Suppose you are given the following two cash inflows from which to
choose.
Option A: Year-end receipts of R7 000 for each of the next four years
Option B: A single, lump-sum receipt of R3 000 at the end of four years
Which option would you choose if the discount rate of money were 6
percent, and why?

2.9.7. Find the present value of the following cash flows, each of which is
received at year-end for the next five years:

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Year 1 2 3 4 5

Cash R4 500 R8 000 R10 000 R5 000 R2 000

flows

If the opportunity cost of capital of money is 14% per year, what is the
present value of the stream of cash flows?

2.9.8 TPK borrowed a R220 000 from First National Bank (FNB) at an interest
rate of 12% per annum to be repaid over the next six years. Construct
an amortisation schedule if equal payments are required at the end of
each year.

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Answers to Activities

Video 2.1 Simple interest is when the interests received or paid is based solely on the amount that was initially
invested. Therefore, the interest earned or paid each period or year is the same.
Compound Interest is the kind of interest you would like to earn but definitely not the amount you
want to pay. The interest is based on the balance of the investment when it is calculated not the
initial investment

Knowledge Check 2.1 B is the correct answer calculated as follows:

FVN = PV ( 1 + i)N

PV = 3M, i = 0.08/2 = 0.04 N =5 years x 2 =10

FV = 3 000 000 (1 + 0.04)10

= 3 000 000 (1.04)10

= R4 440 733

Total interest earned = 4 440 723 – 3 000 000 = R1 440 733

Think point 2.1 PV = FV x PVIF

= 1000 000 x 0.6499 (from Table 3)
= R649 900

(1+i )N −1
Activity 2.1 FVAN = PMT × [ ] PMT = 50 000, i = 0.12 , N = 20
i

(1.12 )20 − 1
FVA = 50 000 × [ ] = R3 602 622
0.12

1−( 1+i)−N
Think point 4 PVAN = PMT × [ i
]

PMT =1 000; i = 0.15/12 = 0.0125; N= 4 years x 12 =48

1 − ( 1 + 0.0125)−48
= 1 000 × [ ]
0.0125

= 1 000 × 35.9315

= R35 932

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Practical Activity 2.1

a) Present Value of uneven cash flow (Using Table 3 to get the PVIF)

Year Cash flow PVIF @ 10% Present Value

1 -1 000 0.9091 -909
2 -500 0.8294 -415
3 0 0.7513 0
4 4 000 0.6830 2 732
5 3 500 0.6209 2 173
6 2 000 0.5645 1 129
Present Value 4 710

b) Future Value of Uneven Cash (Using table 1) to get the FVIF)

Year Cash flow Number of years FVIF @ 10% Future value

earning interest
1 -1 000 5 1.6105 -1 611
2 -500 4 1.4641 -732
3 0 3 1.3310 0
4 4 000 2 1.2100 4 840
5 3 500 1 1.1000 3 850
6 2 000 0 1 2 000
Future Value 8 347

Case study: Financial Freedom.

You should cover the following aspect in answering this question:
The practical application of time value of money will lead to financial freedom and independence. It
allows investors to make a more informed decision about what to do with their money. The TVM can
help you understand which option may be best based on interest, inflation, risk, and return. It can also
be used to help you understand how much money to save in an account if you have a certain goal in
mind, such as saving R20 000 in five years if the account earns 7% compound interest each year.
Without this knowledge, may people will be spending the most valuable years of their lives working
for money instead of money working for them.

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Unit
3: Capital Budgeting

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Unit Learning Outcomes

CONTENT LIST LEARNING OUTCOMES OF THIS UNIT:

3.1 Introduction • Define the capital budgeting decision within the broader
perspective of project financing

3.2 Motives of capital expenditure • Explain different motives of Capital Expenditure

3.3 Capital Budgeting Process • Explain the steps in the capital budgeting process its
relevance to project financing

3.4 Principles of Capital Budgeting • Describe the basic principles of capital budgeting

3.5 Classification of investment projects • Classify investment projects based on how they influence
the investment decision process

3.6 Profit versus Cash flow • Gain an insight into the differences between accounting
income and cash flows

3.7 Components of project cash flows • Calculate initial investment outlay, operating cash flows,
and terminal cash flows

3.8 Summary • Summarises topic areas covered in the unit

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Prescribed and Recommended Textbooks/Readings

Prescribed Reading/Textbook
• Marx, J, C Swardt, M Pretorius, W Rosslyn-Smith (2017) Financial
Management in Southern Africa, Fifth Edition. Pearson South Africa.
(This is the latest edition of the textbook)

Recommended Readings
• Conradie, W.M. and Fourie, C.M.W. (2018) Basic Financial
Management. Third Edition. Cape Town: Juta and Company Ltd.
• Gitman, L.J and Zutter, C.J (2017) Principles of Managerial Finance.
Thirteenth Edition. Cape Town: Pearson Education.
• Flynn, D., Uliana, E., Wormald, M. and Dillon, J. (2019) Financial
Management. Ninth Edition. Cape Town. Juta and Company (Pty) Ltd.
• Venkataraman, R.R., and Pinto, J.K (2008) Cost and Value Management
in Projects. NJ: Wiley, pp. 344–345.
• Yescombe, E.R. (2014) Principles of Finance. Second Edition: British
Library: Elsevier.
• Marx, J; De Swardt, C; Pretorius, M. (2023) Financial Management in
Southern Africa. Sixth Edition.
• Zutter, C.J. (2021) Principles of Managerial Finance. Sixteenth Edition.
Pearson.
• Venkataraman, R.R. (2023) Cost and Value Management in Projects.
Second Edition.

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3.1 Introduction
According to Marx et al (2017:267) capital budgeting is the process of evaluating and selecting long-term
investments that contribute towards the goal of increasing an entity’s value. Capital budgeting is referred to as
capital investment analysis. Chandra (2002:3) defines a capital investment as the current outlay of funds in
anticipation to a stream of benefits that extend well into the future.

Project Finance involves funding of large, complex, and expensive projects such as installations of power plants,
chemical processing plants, infrastructure for telecommunication and transport. These projects involve capital
expenditure described as an investment made by an entity that is expected to generate benefits over a period
exceeding one year. Since long-term investments require a large outlay of cash, the cash flows generated from the
investment are important. The capital budgeting decision is important, because a firm’s future success will often
depend on current investment decision (Flynn et al, 2019:407)

3.2 Motives of capital expenditure

According to Marx et al (2017:267) the primary motives for capital expenditure are expansion, replacement and
renewal which are further discussed in the following sections
• Expansion
One of the most common motives for capital expenditure is the need to expand the level of operations and this is
usually achieved through the acquisition of fixed assets. For example, a growing firm often needs to acquire new
fixed assets such as the purchase of property and plant facilities
• Replacement
Most assets have a limited lifetime and need to be replaced at some time in the future. Replacement projects often
occur when an asset reaches the end of its useful life or when it becomes old and inefficient. For Instance, broken,
obsolete or worn-out machinery needs to be replaced.
• Renewal
Renewal of existing assets may be a suitable alternative to replacement. Efficiency may be improved by replacing
or renewing existing pieces of machinery. Renewal may take the form of rebuilding or overhauling a machine or
production plant. For, example, an existing drill press could be renewed by replacing its motor and adding a numeric
control system, or a physical facility could be renewed by rewiring and adding air conditioning.
• Other purposes
Sometimes capital expenditures may be of a nature that they do not add new physical assets to an entity’s statement
of financial position. These expenditures include outlays for research and development, advertising campaigns,
improved safety measures and pollution control.

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Think Point 3.1

Is it advisable to replace an asset before it reaches the end of its useful life? Explain.

3.3 Capital Budgeting Process

To ensure that money invested will be to the entity’s best advantage, procedures must be developed to ensure that
the investment opportunities are properly analysed. Marx et al (2017:268) suggests the following five distinct but
interrelated steps to the capital budgeting process:
▪ Proposal generation: Capital expenditure proposals may be made by people at all levels within the entity.
These proposals usually move from the originator to a higher level in the entity. Relatively minor
expenditures may be reviewed at the next organisational level whilst major expenditure proposals are
usually reviewed at a higher level.
▪ Review and analysis: A review of the capital expenditure proposals is done to determine their
appropriateness to the entity’s overall objectives and plans. Their economic viability is also evaluated. The
techniques that may be used will be discussed in the next unit. The analysis is submitted to management.
▪ Decision making: The amount to be outlayed and the importance of the investment opportunity determine
the organisational level at which the decision is made. After studying the analysis at the appropriate level
of management, a decision is made whether to invest or not.
▪ Implementation: After approval for the proposal is obtained and funding is made available, the
implementation phase commences. Implementation is usually routine for minor outlays. For major
expenditures, greater control is necessary to ensure that what has been approved is actually acquired and
is at the budgeted cost.
▪ Control: The monitoring of costs during the operating phase of the project is important. Actual outcomes
in respect of costs and benefits are compared with those expected. When actual outcomes are below those
projected, remedial action may be required or at the worst-case scenario termination of the project may be
required.

Knowledge Check 3.1

Control as part of the capital budgeting process is least likely to include the:
A provision of future investment ideas.
B rescheduling and prioritising of projects.
C Indication of systematic errors.

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3.4 Principles of Capital Budgeting

Goel, (2015:51) detailed the following principle of capital budgeting.
▪ Decisions are based on cash flows and not on accounting concepts such as net income.
▪ The timing of cash flows is critical.
▪ Cash flows are based on opportunity costs. A comparison is made between the incremental cash flows
that occur with an investment and without the investment.
▪ Cash flows are analysed on an after-tax basis. Taxes have to be fully reflected in capital budgeting
decisions.
▪ The financing costs are ignored. Financing costs are already reflected in the required rate of return and
therefore including them again in the cash flows and in the discount, rate would lead to double counting.
▪ The capital budgeting cash flows are not the same as accounting net income.

Knowledge Check 3.2

Which of the following statements concerning capital budgeting principles is most accurate?
A. Cash flows should be based on opportunity costs.
B. Financing costs should be reflected in a project’s incremental cash flows.
C. The net income for a project is essential for making a correct capital budgeting decision.

3.5 Classification of investment projects

An entity may be required to choose from a number of different projects. The type of project being considered may
have an influence on the investment decision process. Marx et al (2017:290) distinguish between two types of
projects independent and mutually exclusive projects. Classification is relevant for evaluating project risk and
determining the ranking of projects. Projects may be classified in a number of different ways. Flynn, (2015:408)
classified the investment projects based on whether there are independent or mutually exclusive; divisible or
indivisible projects as discussed below.
3.5.1 Independent versus mutually exclusive.
• Independent projects are such that the acceptance of one does not affect the acceptance of another.
Projects A and B are independent if Project B may be accepted or rejected irrespective of whether Project
A was accepted or not. For example, a company may analyse two projects: a material cutting machine and
a new delivery truck. The firm may decide to accept both projects if certain economic criteria are met. There
is no competition between independent projects.
• Mutually exclusive projects are alternative investments that serve the same function. The acceptance of
one project in a group of mutually exclusive projects prevents all the other projects from the group from
being chosen. For example, if a firm has decided that it needs to invest in delivery vehicles, it may have
the option to invest in either one large delivery truck or two smaller trucks. If the company decides on the
larger truck, it will probably not need the two smaller trucks.

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3.5.2 Divisible or Indivisible projects

Divisible project may be split into a number of separate parts, each capable of being undertaken on its own. Divisible
projects usually have more simultaneous processes (activities that are carried out at the same time).
Indivisible project entails that the entire project must be undertaken and can no longer function if one part is removed.
Project managers often face problems with project divisibility. For example, the decision to build a toll bridge or a
tunnel.

Think Point 3.2

Explain any 2 benefits of divisible projects over Indivisible ones.

3.6 Profit versus Cash flow

Alsemgeest et al. (2014:195) are of the view that when the financial feasibility of an investment project is
investigated, the focus is on the project’s cash flows and not on the profit that results from investing in it. This is
because profits are determined on the basis of accounting standards and accounting policies, and the profit does
not necessarily represent its cash flow. For example, the profit after tax figure is determined after deducting
depreciation. However, deprecation is a non-cash expense. The profit figure thus contains items that are of a non-
cash nature. For capital budgeting purposes it is the project’s net cash flow, not its accounting income, that is
relevant. Therefore, when analysing a proposed capital budgeting project, disregard the project’s net income and
focus exclusively on its net cash flow (Ehrhardt and Brigham, 2016:425).

Practical Activity 3.1

Suppose you bought the last calculator in the store for R500 cash. You decide to sell it
to your friend for R600, but he/she can only pay you at the end of two months. How would
you differentiate between the profit and cash flows?

3.7 Components of Project Cash flows

Capital expenditures with conventional cash flow patterns usually consist of the following major cash flow
components as highlighted by (Marx et al, 2017:271):
• An initial investment.
• Operating cash flows expected each year.
• A terminal cash flows.

The initial investment is the cash outlay before the project starts. The operating cash flows are the incremental after-
tax operating cash flows that result from the project. The terminal cash flow is the after-tax non-operating cash flow
that is expected to occur in the final year of the project.

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Each of the major components can be explained assuming a replacement decision. The reason for this is that all
capital budgeting decisions can be viewed as replacement decisions. Expansion decisions can also be regarded as
replacement decisions, except that one would regard the cash flows from the old asset as zero. (Marx et al,
2017:272)

Think Point 3.3

What are unconventional cash flows?

3.7.1 Initial Investment

Assuming cash flows are conventional; the initial investment must therefore occur at time zero. The basic
components of the initial investment are the cost of the new asset, installation costs, the proceeds from the sale of
an old asset, any tax liability resulting from the sale of the old asset and the change in net working capital (Marx et
al, 2017:272). The basic format is displayed in Table 3.1:

3Table 3.1: Basic Format of Calculating the Initial Investment

Total cost of the new asset (xxx)
Purchase price (xxx)
Transport cost (xxx)
Installation costs (xxx)
After-tax proceeds from the sale of the old asset Xxxx
Proceeds from the sale of the old asset Xxx
Tax on the sale of the old asset (Profit –/Loss +) Xxx
Change in net working capital of the old asset Xxx
Change in net working capital of the new asset (xxx)
Initial investment (xxx)

When an old asset is replaced with a new one, the book value (carrying value) is first calculated using the following
formula.
Book value = Total cost of the asset – Accumulated depreciation
For simplicity and easy application, the capital assets will be depreciated using the straight-line method
whereby the cost of the asset is divided by the period in years of the expected useful life of the asset. If the asset
is expected to have a scrap value, this amount must first be subtracted from the cost of the asset before dividing
by the period in years of the expected useful life of the asset.

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Tax is calculated on the profit or loss on the sale of the asset. Removal costs can be deducted from the profit
before the tax is calculated. The tax on the sale of the asset is calculated as follows:
[(Selling price – Book value) – Removal cost] X Tax rate
If an old asset is sold for more than its book value, a taxable profit will result from the transaction thereby increasing
the amount of tax that the company needs to pay. The tax on the profit on the sale of the asset will represent a
cash outflow, thereby reducing the sales proceeds. If the asset is sold for less than its book value, then the
resultant loss will represent a tax benefit for the company and will increase the sales proceeds. The method
used to calculate the after- tax proceeds from the sale of an old asset is illustrated in the following example.

Example 3.1
Brigham Ltd is considering purchasing a machine to replace an old one. The price of the new machine is
R90 000. The cost to transport the machine to the factory is R11 000, and the installation cost is R9 000.
The purchase of the new machine will result in an increase in net working capital of R25 000. The old
machine was purchased 3 years ago at a cost of R50 000. The old equipment is depreciated on a straight-
line basis over a period of 5 years. In addition, the old machine required an increase in net working capital
of R12 000. Suppose the old machine is sold after 3 years for R35 000, and the removal cost of the
old machine is R5 000. Assume that the tax rate is 30%.

Required:
Calculate the initial investment for the replacement project.

Solution

Book value = Total cost of asset – Accumulated depreciation

= R50 000 – [(50 000 ÷ 5) X 3]
= R50 000 – R30 000
= R20 000

Tax on the sale of the asset = [(Selling price – Book value) – Removal cost] X Tax rate
= [(R35 000 – R20 000) – R5 000] x 30%
= R3 000

The sale of the old machine thus generates an operating cash flow of R27 000 calculated as follows:
Selling price – Removal costs – Tax on the sale of the asset
R35 000 – R5 000 – R3 000 = R27 000

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4Table 3.2: Calculating Initial Investment

Total cost of the new asset (110 000)
Purchase price (90 000)
Transport cost (11 000
Installation costs (9 000)
After-tax proceeds from the sale of the old asset 27 000
Proceeds from the sale of the old asset 30 000
Tax on the sale of the old asset (Profit –/Loss +) (3 000)
Change in net working capital of the old asset 12 000
Change in net working capital of the new asset (25 000)
Initial investment (96 000)

3.7.2 The operating cash flows

According to Marx, (2017:275) operating cash inflows are incremental cash flows expected to be generated during
the life of the proposed long-term investment. The term incremental means how much more (or less) cash will flow
into an entity as a result of the capital expenditure. It is advisable to evaluate all capital expenditures on an after-tax
basis Alsemgeest et al. (2014:205). The term cash inflow refers to an expected cash benefit. Since cash inflows are
required to pay for an entity’s operating expenses, it is the annual operating cash flows/net cash inflows (and not
accounting profit) that are appropriate (Marx, 2017:275). Accounting profit factors in non-cash items such as
depreciation when calculating accounting profit. Depreciation shelters income from taxation, and this has an impact
on cash flow. Therefore, depreciation must be added back when estimating a project’s operating cash flow (Ehrhardt
and Brigham, 2016:425). For the purpose of this module, depreciation is the only non-cash item that will be
considered.

Practical Activity 3.2

The estimated NOPAT of a capital project is expected to amount to R80 000 per annum.
The depreciation amounts to R15 000 per annum.
What is the cash flow for this capital project?

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[Link] Operating cash flows of a replacement project

Example 3.2 shows how the operating cash flows are calculated when a company expands its operations by
replacing an old machine with a new one. Brigham Ltd is purchasing a new machine to replace an old machine
(following on from Example 2.1). The Earnings before interest, taxes, and depreciation (EBITDA) over the next 5
years for both machines are shown below:

EBITDA (new machine) EBITDA) (old machine)

Year

1 R45 000 R28 000

2 R45 000 R26 000
3 R45 000 R24 000
4 R45 000 R22 000
5 R45 000 R20 000

Assume that the new machine has a useful life of 5 years and depreciation is calculated over 5 years using the
straight-line method. The annual operating cash flow for the new machine can now be calculated using the income
statement format.

EBITDA 45 000
Less: Depreciation (22 000) (R110 000 ÷ 5 years)

EBIT 23 000
Tax (30%) (6 900)
NOPAT 16 100
Add back Depreciation 22 000

Annual operating cash flow 38 100

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The calculation of the annual operating cash flows of the old machine is shown below:

5Table 3.3: After tax operating Cash flows

Year EBITDA Depreciation EBIT Tax (30%) NOPAT Annual after-tax

operating cash
flows

(1) (2) (3) = (1) - (2) (4) (5) = (3) - (4) (6) = (5) +( 2)
R R R R R R
1
R28 000 10 000 18 000 5 400 12 600 22 600
2 R26 000 10 000 16 000 4 800 11 200 21 200
3 R24 000 - R24 000 7 200 16 800 16 800
4 R22 000 - R22 000 6 600 15 400 15 400
5 R20 000 - R20 000 6 000 14 000 14 000

When the new machine was purchased, the old machine had 2 years remaining to reach its useful life. Hence no
depreciation was calculated for year 3, 4 and 5 because the machine will be fully depreciated. Based on the figures
obtained in the calculation of the operational cash flow for the new machine and the operating cash
flows of the old machine provided in the table above, the annual incremental cash flows are
calculated as shown below:

6Table 3.4: Annual Incremental cash flows

Operating cash flows Operating cash Annual incremental cash flows
Year
(new machine) flows (old machine)

(1) (2) (3) = (1) – (2)

R R R
1
38 100 22 600 15 500
2 38 100 21 200 16 900
3 38 100 16 800 21 300
4 38 100 15 400 22 700
5 38 100 14 000 24 100

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3.7.3 Terminal Cash flow

Marx et al (2017:276) defines terminal cash inflows as the cash flow that is expected to be generated once the
investment is terminated at the end of its life and the assets are liquidated. This terminal value is determined on an
after-tax basis. The following must be considered when determining the terminal value cash flow:

▪ the proceeds from the sale of assets

▪ any tax liability or loss for tax purposes
▪ the change in net working capital.

The net amount obtained from the sale of assets at the end of the investment’s life constitutes the proceeds from
the sale of new or old assets. The net amount should therefore include any removal costs. In instances in which
assets are replaced, proceeds from both the new asset(s) and the old asset(s) must be considered (Marx, 2017)

7Table 3. 5 Calculating the terminal cash flow of a replacement project.

After tax proceeds from the sale of new assets xxx

proceeds from the sale of new assets xxx
Tax on the sale of new assets (xxx)
After-tax proceeds from the sale of the old asset (xxxx)
Proceeds from the sale of the old asset xxx
Tax on the sale of the old asset (Profit –/Loss +) xxx
Change in net working capital of the old asset xxx
Change in net working capital of the new asset (xxx)
Terminal cash flow xxx

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Suppose 5 years later after the purchase, the new machine can be sold for R35 000 and the removal and clean-up
costs are R5 000. The old machine has no salvage value, but the same removal and clean- up costs of R5 000 for
the machine has to be paid. The incremental terminal cash flow for the replacement project (the difference between
the cash flows of the old and new machines) is as follows:
8Table 3.6: Solution
After tax proceeds from the sale of new assets 21 000
Proceeds from the sale of new assets (R35 000 – R5 000) 30 000
Tax on the sale of new assets (R30 000 x 30%) (9 000)
After-tax proceeds from the sale of the old asset 3 500
Proceeds from the sale of the old asset (5 000)
Tax on the sale of the old asset (Profit –/Loss +) 1 500
Change in net working capital of the new asset 25 000
Change in net working capital of the old asset (12 000)
Terminal cash flow 37 500

Although the old machine has no salvage value five years from now, the removal cost is incurred, resulting in a loss
of -R5000 from the termination of old machine. This loss results in a tax benefit of +R1 500
The total cash flow for Year 5 equals the operating cash flow plus the terminal cash flow.

Operating Cash flow R24 100

Terminal Cash Flow R37 500
Net Cash Flow (Year 5) R61 600

Video 3.1: Relevant Cash flows

[Link]
In calculating the expected cash flow for each year, the presenter calculated the net
operating profit after tax as EBIT × (1 – tax rate). Interest is not subtracted because:
A. it would be correct from an accounting point of view
B. is a financing cash flow, not an operating cash flow
C. is already included in calculating the cost of capital
D. is an investment cash flow
E. Not an operating cash flow

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Knowledge Check 3.2

Which of the following statements is most likely accurate?
A. In capital budgeting, only pre-tax cash flows should be considered.
B. The timing of cash flows is crucial to the capital budgeting process.
C. A nonconventional cash flow pattern is one that has an initial cash outflow followed by
a series of cash inflows

Capital Budgeting: Reliance Industries Ltd. (RIL)

The Reliance Group is India’s largest private sector enterprise, with businesses in the
energy and materials segment. Group’s annual revenues are over US$ 66 billion. The
flagship company, Reliance Industries Limited, is a Fortune Global 500 company and is
the largest private sector company in India. It started with textiles in the late seventies,
and then pursued a strategy of backward vertical integration—in polyester, fibre
intermediates, plastics, petrochemicals, petroleum refining and oil and gas exploration,
and production—to be fully integrated along the materials and energy value chain.
Reliance enjoys global leadership in its businesses, being the largest polyester yarn and
fibre producer in the world and among the top five to ten producers in the world in major
petrochemical products. After conducting a feasibility study that cost the company 2.5
million rupees, on 31 August 2020, Reliance bought assets of debt-strapped rival Future
Group for 247.1 billion rupees ($3.4 billion). The deal includes Future’s retail, wholesale,
logistics and warehousing units.

Reliance Industries Ltd , 2020, viewed 1 November 2020,

<[Link]
group-s-units-for-3-4-billion>

Question

1. What are sunk cost and identify sunk cost(s) mentioned in the case study.
2. What is the motive behind Reliance’s acquisition of its rival company?
3. State any two capital budgeting principles relevant to Reliance when acquiring
Retail, Wholesale Business, and the Logistics & Warehousing Business from
the Future Group

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3.8 Summary
▪ Capital budgeting can also be referred to as capital investments or capital expenditure
▪ The primary motives for capital expenditure are expansion, replacement, and renewal
▪ The capital budgeting process involve proposals generation, review and analysis be done, decisions taken,
and implementation and control be exercised.
▪ Projects can be classified according to whether they are independent, mutually exclusive, divisible or
indivisible.
▪ Independent projects mean the acceptance of one project does not exclude another from being
implemented. Mutually exclusive projects mean the acceptance of one project prevents all other projects
from being considered. Divisible project may be split into a number of separate parts, each capable of
being undertaken on its own while indivisible project requires the entire project to be undertaken
▪ Capital budgeting decisions are based on cash flows and on accounting concepts, such as net income.
▪ The initial investment takes the cost of the new asset, installation cost, proceeds from an old asset (if any),
tax liability and change in net working capital into account.
▪ The operating cash flow is the incremental change in EBIT multiplied by (1 – tax rate) plus the change in
depreciation on an after-tax basis.
▪ The terminal cash flow takes the proceeds from the sale of assets, any tax liability, and the possible
recovery of net working capital into account.

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Revision Questions

3.9.1 FIMCO Ltd wants to determine the initial investment of a capital

expenditure involving the replacement of an old asset. The machine will
cost R700 000 and installation costs amount to R60 000. The old machine
has a book value of R0 and can be sold for R1 000. No costs will be
incurred to remove the old machinery. The old machine required an
increase in net working capital of R100 000. The new capital expenditure
will result in an increase in the net working capital by R150 000. The firm
is subjected to a tax rate of 30%.
Required
Calculate the initial investment of the replacement project.

3.9.2 Garden Ltd has decided to invest in equipment that cost R80 000
(including R10 000 installation costs). The equipment is to be
depreciated on a straight-line basis over a five-year period. The
following are the expected incremental increases in net
operating profit (loss) after taxes (NOPAT) for the five-year life
of the investment:
Year 1 2 3 4 5

NOPAT R20 000 R10 000 R8 000 R6 000 (R5 000)

Required

Calculate the operation cash flow over the five-year period

3.9.3 Amino Ltd expects to sell equipment used in an investment project for
R4 000. The equipment, with a book value of R0, is sold at the end of
the life of the project. The company is subject to a 30% tax rate. Net
working capital worth R150 000 will be recovered.

Required

Calculate the terminal cash flow

3.9.4 Differentiate between independent and mutually exclusive projects

tabular form

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Answers to Activities

Think Point 3.1

Sometimes, yes. New technology may become available and may lead to significant cost reductions. High
maintenance costs may warrant making a replacement.

Knowledge Check 3.1

Option B is the correct answer. Rescheduling and prioritizing projects is part of the planning stage (Proposal
generation) of the capital budgeting process, not the control stage. The purpose of control is to explain any
differences between the actual and predicted results of a capital budgeting project. This process can aid in
indicating systematic errors, improve business operations, and provide concrete ideas for future investment
opportunities

Knowledge Check 3.2 Option A - Cash flows are based on opportunity costs. Financing costs are recognized in
the project’s required rate of return. Accounting net income, which includes non-cash expenses, is irrelevant;
incremental cash flows are essential for making correct capital budgeting decisions

Think Point 3.2

Less vulnerable to failures -Any problem in one part of the project can more easily be isolated or a part of the project
can even be cancelled without any consequences for the rest of the project. Divisibility also ensures more certainty
and manageability during the implementation of the project.

Practical Activity 3.1

If you sell the calculator to your friend now you will have a profit of R100 now. However, your cash flow situation
would be –R500 now and +R600 at the end of the two months, when your friend pays you.

Think point 3.3 - is a pattern in which an initial outflow is not followed by a series of inflows. This may be due
to a cash outflow over and above the initial investment during one of the years following the initial outflow.

Practical Activity 3.2

Cash flow = NOPAT + Depreciation = R80 000 + R15 000 =R95 000

Knowledge Check 3.3

The correct answer is B.

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Option A is incorrect because cash flows are analyzed on an after-tax basis; taxes have to be fully reflected in capital
budgeting decisions.

Option C is incorrect because a conventional cash flow pattern (not a nonconventional cash flow pattern) is one
which has an initial cash outflow followed by a series of cash inflows.

Case study 3.1

4. A sunk cost is cash outflow associated with the project that has already occurred and will not be affected by the
decision to purchase the asset. For example, a firm might pay R100 000 for a research study to determine
whether a new project should be accepted. R100,000 will be paid whether the firm decides to accept the project
or not, that is, it is incurred for conducting a feasibility analysis. Thus, the cost of the evaluation study is a sunk
cost. The only sunk cost mentioned in the case study is the amount of 2.5 million rupees
5. Since Reliance has acquired several business units from its rival, the motive could be of expansion and/
diversification purposes. Reliance will be able to increase its production capacity and operations by adding new
products, additional machines and so on. It could be that Reliance has decided to enter into new lines of business
either product wise or territory wise. Thus, the business has inevitably increased it fixed assets.
6. Sunk cost should not be included in the determination of cash flow and Decisions are based on cash flows and
not on accounting concepts such as net income

Video: Relevant cash flows

Option C is correct. Because the financing costs are ignored. Financing costs are already reflected in the required
rate of return (cost of capital) and therefore including them again in the cash flows and in the discount, rate would
lead to double counting.

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Unit
4: Investment Criteria

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Unit Learning Outcomes

CONTENT LIST LEARNING OUTCOMES OF THIS UNIT:

4.1. Introduction • Understand the importance of non-financial criteria on the

selection of investment projects

4.2. Non-Discounted versus • Distinguish between discounted and non-discounted cash flow
Discounted Cash flow methods methods

4.3. Payback Method • Calculate and interpret payback period of an Investment and
how it aids project financing decisions

4.4. Accounting Rate of Return • Calculate and interpret accounting rates of return of an
investment.

4.5. Net Present Value • Describe how the net present value contributes to increasing
shareholder wealth. Also how it is essential for project financing

4.6. Internal Rate of Return • Evaluate the acceptability of an investment project using IRR

4.7. Profitability Index • Understand PI for a given project and its relation to NPV

4.8. Summary • Summarises topic areas covered in the unit

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Prescribed and Recommended Textbooks/Readings

Prescribed Reading/Textbook
• Marx, J, C Swardt, M Pretorius, W Rosslyn-Smith (2017) Financial
Management in Southern Africa, Fifth Edition. Pearson South Africa.
(This is the latest edition of the textbook)

Recommended Readings
• Conradie, W.M. and Fourie, C.M.W. (2018) Basic Financial
Management. Third Edition. Cape Town: Juta and Company Ltd.
• Gitman, L.J and Zutter, C.J (2017) Principles of Managerial Finance.
Thirteenth Edition. Cape Town: Pearson Education.
• Flynn, D., Uliana, E., Wormald, M. and Dillon, J. (2019) Financial
Management. Ninth Edition. Cape Town. Juta and Company (Pty) Ltd.
• Venkataraman, R.R., and Pinto, J.K (2008) Cost and Value Management
in Projects. NJ: Wiley, pp. 344–345.
• Yescombe, E.R. (2014) Principles of Finance. Second Edition: British
Library: Elsevier.
• Marx, J; De Swardt, C; Pretorius, M. (2023) Financial Management in
Southern Africa. Sixth Edition.
• Zutter, C.J. (2021) Principles of Managerial Finance. Sixteenth Edition.
Pearson.
• Venkataraman, R.R. (2023) Cost and Value Management in Projects.
Second Edition.

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4.1 Introduction
Non-financial criteria seem to play a more important role in the evaluation of capital budgeting projects than in the
past. This came after some criticism on the growing emphasis and stress on financial aspects while neglecting the
non-monetary side. According to Batra and Verma (2018:80) the evaluation and appraisal process for investments
projects is found to be complex and goes beyond the quantitative factors. According to Mutairi et al, (2016) a project
usually generates externalities, in terms of costs and benefits that are not considered in financial forecasts. As
summarized by Batra and Verma (2018:80) the following non-financial aspects are to be taken into account when
selecting an investment project.
▪ Technical factors (resource availability), the focus is on technical factors such as availability of adequate
funds for the project, specialised personnel with requisite qualification and capability, implementation of
new production techniques, availability of required inputs/raw materials, infrastructural facilities to suit the
technical complexity of the project.
▪ Social factors (social benefits and responsibility), i.e., the project’s contribution to society in terms of
increasing employment, ensuring safety of public and employees and safeguarding interest of the country
as a whole. For example, you would not invest in new machinery that breaks health and safety regulations.
▪ Strategic alignment (intangible market related benefits and risks), i.e., how far the project fits with corporate
objectives and strategy, improves brand image, customer image, market share, competitive advantage of
the company in the market.
▪ Availability of suitable project location/site selection: Site selection involves measuring the needs of a new
project against the merits of potential locations. This indicates the practice of new facility location, keeping
in mind project requirements. A wrong or unsuitable project location may benefit of a financially lucrative
investment proposal.

Some companies conduct a SWOT analysis as part of their project appraisal. An analysis of this kind ensures that
the investment project is in line with the corporate objectives as well as strategic alignment (Batra and Verma
2018:80). Therefore, project success is not just related to completion of project’s scope of work but also focuses on
non-financial parameters primarily the achievement of business objectives in terms of project delivering desired
output, outcomes, and impacts. The financial techniques must be used only as a guide, or a baseline, and other
factors that may influence the uncertainty analysis must be considered.
Regarding government projects, Baker & English (2011:409) indicated that:
• Projects should be subject to cost-benefit analysis. If the subjection of all projects to CBA is too costly, the
focus could primarily be on the larger projects, while using a simplified methodology for smaller projects
• A government investment agency, with strong links to the Ministry of Finance, should prepare guidelines
for project development and analysis.
• The agency should review project proposals to ensure that they are adequately prepared and analysed
and should have the authority to reject projects that do not meet the established technical standards.

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• The Ministry of Finance should give the cabinet recommendations for which investment projects should be
realised within the available resource envelope.
• Ministries should compete for investment funds based on the net social value and political priority of their
investment proposals.

4.2 Non-Discounted versus Discounted Cash flow methods

If organisations have more than sufficient funds for all projects or all investment opportunities coming their way,
there would have been no need to conduct a project appraisal. However, in real life, financial resources are limited,
and it becomes imperative to appraise all projects from the viewpoint of their financial viability (Shrotriya, 2018:3).
A set of Non-Discounted Cash Flows and Discounted Cash Flow techniques are used.

Non discounted cash flow (NDCF) techniques of project appraisal are simple to understand. These techniques
involve calculations and are easy to apply in practice. The term non discounted, means that the time value of money
has not been considered i. e. the present value and the future value of money is being treated the same (Shrotriya,
2018:719). These are used primarily for the initial screening of investment alternatives in order to determine if any
further time and energy should be devoted in further evaluating the alternatives (Marx et al, 2017:283). Examples
include Payback and Accounting rate of return.

Discounted Cash flow (DCF) methods consider the time value of money. Marx et al (2017:286) acknowledges that
a rand today is worth more than a rand received at some future date because of the interest that could be earned.
We have laid the foundation of time value of money in the previous study units. The terms discount rate, opportunity
cost, cost of capital and required rate of return will be used interchangeably to refer to the minimum return investor
must receive in order to accept an investment project Examples of DCF techniques covered in module are
▪ Net present Value (NPV),
▪ Profitability Index (PI)
▪ Internal Rate of Return (IRR)

Think Point 4.1

What is the biggest limitation of evaluating projects using NDCF techniques?

4.3 Payback Period Method

The payback period (PBP) refers to the number of years required to recover the initial investment. It is determined
by calculating exactly how long it takes to recover the initial investment from net cash inflows (Marx et al, 2017:
292). No adjustment is made for the time value of money. When the cash flows are the same, for example, cash
flow in year 6 is treated in the same way as a cash inflow in year 1.

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According to Alsemgeest et al. (2014:167) the length of the maximum acceptable PBP is usually determined
by the management of the company. When comparing two or more projects, the decision-making criterion for
the PBP is to accept the project with a shorter payback period and reject those with longer PBP. This is
because PBP is a measure of liquidity.

Payback period is calculated as follows if the net cash flows are the same each year:

Payback Period = Initial investment

Net annual cash flow

Knowledge check 4.1

Payback period is recommended under the following circumstances except:

A. When the firm suffer from a liquidity crisis.

B. When firms which focus on short-term earnings rather than long-term growth
C. When the firm has uniform cashflows throughout the project life circle.

If the annual net cash inflow is not provided, it can be determined by adding back the depreciation to the
expected NOPAT. As indicated before, depreciation will be calculated using the straight-line method, is calculated
as follows:

Depreciation = Cost -Scrap Value

Expected useful life

Example 4.1
Polokwane Ltd obtained information in respect of two projects and it intends to select one of the projects.
The following details are available:

Project M Project N
Cash outlay
R600 000 R600 000
Useful life 6 years 4 years
Annual net cash flows over the project’s useful life R200 000 R280 000
Depreciation (straight-line method) R100 000 R150 000

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Required

Calculate the payback period of each project and recommend the project that should be chosen based on
the payback period.
Project M Project N

Investment Annual = R600 000 R600 000

net cash inflow R200 000 R280 000

3 years 2.14 years

=
Note:
0.14 X 12 months = 1.68 months
0.68 X 30 days = 20.4 days
Payback period = 3 years 2 years, 1 month and 21 days

The shorter the period the better, so project N should be selected because it can be paid back within a short period
of time 2 years, 1 month and 21 days as compared to 3 years

Example 4.2
Consider two projects whose annual net cash flows are not even. Assume that each project costs
R200 000. The net cash flows for each year are as follows:

Year Project B Project C

1 R20 000 R100 000
2 R40 000 R80 000
3 R60 000 R60 000
4 R80 000 R40 000
5 R100 000 R20 000

Required
Calculate the PBP of each project and recommend the project that should be selected based on the
payback method.

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Solution
Project B Project C
Investment (200 000) (200 000)
Year 1 (Cashflows) 20 000 100 000
(180 000) (100 000)
Year 2 (Cashflows) 40 000 80 000
(140 000) (20 000)
Year 3 (Cashflows) 60 000 50 000
(80 000)
Year 4 (Cashflows) 80 000

Project B Project C
The payback period is 4 years 2 years, 4 months and 24 days Note:
20 000 X 12 months 50 000
= 4.8 months
0.8 X 30 = 24 days

Project C should be chosen since the payback period (2 years, 4 months, and 24 days) which is less than that of
project B (4 years).

Think Point 4.2

Suppose you choose projects solely on the basis of payback period. Explain how the
break- even point of each project could lead to an incorrect decision, if the project with a
shorter payback period is chosen.

4.4 Accounting Rate of Return

The accounting rate of return (ARR) measures profitability by determining the average investment of a project to the
future annual net profit. In other words, ARR uses the average profit an investment will generate and expresses it
as a percentage of the average investment over the life of the project. Ross et al, (2013:277) regards ARR as an
attractive, but flawed approach that can be used in making capital budgeting decisions because it is not a true return
since it ignores the time value of money.
The accounting rate of return of an investment is calculated using the following formulae:

Accounting Rate of Return = Average Annual Profit x 100

Average Investment 1

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Average annual profit is calculated by adding the profits expected for each year of the project’s life and dividing it
by the project lifetime. The average investment is calculated by adding the initial investment to the residual/resale
value (i.e. the value at the end of the useful life) and then dividing it by 2. To determine whether this return is
acceptable, one should compare this percentage with the minimum required rate by the firm. If the firm has a target
ARR less than the percentage achieved, then the investment is acceptable. When comparing two or more projects,
the one to be selected has the higher ARR.

Example 4.3
As provided in Example 4.1 calculate the Accounting Rate of Return for each project and determine which of the
two is to be selected.
Project M Project N

ARR = Average annual profit X 100 Average annual profit X 100

Initial investment 1 Initial investment 1

= R100 000 X 100 R130 000 X 100

R600 000 1 R600 000 1

= 16.67% 21.67%

In calculating the average annual profit depreciation is deducted from the average annual net cash inflow (Project
M: R200 000 – R100 000 = R100 000). Using ARR, project N gives a higher rate of return and appears to be a
better investment.

Knowledge Check 4.2

Messie motors have just made an investment of R420 000, salvage value is R120 000,
expected useful life 6 years and annual cash flow of 145 000. The ARR for this
investment is closest to:
A. 35%
B. 28%
C. 20%

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Practical Activity 4.1

M Ltd. is planning to invest in a project. The initial investment required for the project is
R50 000. Its stream of expected earnings before interest, tax depreciation and
amortisation, (EBITDA) for five years is given below.

Year 1 2 3 4 5

EBITDA R12 000 R15 000 R18 000 R19 000 R20 000

Yearly interest is zero. Tax rate is 28%. Depreciation is charged on straight-line

basis. The salvage value is R5 000. Should the firm accept this project if the
minimum accounting rate of return required by the company is 20%

4.5 Net Present Value

The Net Present Value (NPV) is a common discounted cash flow technique that considers the time value of money
(Marx et al 2017: 286). It involves estimating a project’s future cash flows, discounting these cash flows at the
company’s required rate of return, and subtracting the cost of the investment from the present value (Flynn et al,
2015:410). This provides a refined picture of the cash streams of the projects and also guides the organisation on
the worth of the project.

NPV = Sum of the present values of the cash inflows – initial investment

If the NPV is positive, then the project is considered acceptance. If the NPV is negative, the project is rejected since
it would not be profitable.

Video 4.1:
[Link]
criteria-for-evaluating-projects-uoCfz
Question
What are the three ingredients needed to evaluate project using the NPV criteria.

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Example 4.4

Mthunzi Ltd has a choice to make between two projects. The following details relate to these projects

Project A Project B
Investment required
R75 000 R80 000
Expected useful life 6 years 6 years
Scrap value R0 R0
Minimum required rate of return 12% 12%
Net cash inflows:
Year 1 R20 000 R22 000
Year 2 R22 000 R22 000
Year 3 R24 000 R22 000
Year 4 R26 000 R22 000
Year 5 R23 000 R22 000
Year 6 R21 000 R22 000

Required
Using the NPV investment criteria, determine which project Mthunzi Ltd should invest in?

Solution

Discount Factor
Year Net cash inflows @12% Present value
(see Table 3)
1 R20 000 0.8929 R17 858
2 R22 000 0.7972 R17 538
3 R24 000 0.7118 R17 083
4 R26 000 0.6355 R16 523
5 R23 000 0.5674 R13 050
6 R21 000 0.5066 R10 639
Total PV R92 691
Initial Investment (R75 000)
NPV (positive) R17 691

Project A
Note: For Project A, The Present value Table 3 must be used because of a mixed cash flow stream. For
Project B, Table 3 can also be used but the short cut method is to use Table 4 because operating cash flows are the
same each year i.e. an annuity).

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Project B
Year Cash flow Discount factor @ 12% Present Value

1-6 R22 000 4.1114 R90 451

Initial Investment (R80 000) 1 (R80 000)

NPV R10 451

Decision: Project A should be chosen since it has a higher (and positive) net present value and will add
greater value to the entity.

Think Point 4.3

What are the advantages of NPV over the non-discounted cash flow techniques?

Practical Application 4.2

If the company invests 1.2 million dollars in a new gaming system and a quarter of a
million dollars on the third year of its launch, how does the net present value look if the
company anticipates annual inflows of 0.9 million dollars each year for 5 years? The rate
of return is set at 10%.

4.6 Internal Rate of Return (IRR)

A project’s internal rate of return (or time-adjusted rate of return) may be described as the actual economic
return earned by a project over its life. Marx et al, (2017:288) defined IRR as the discount rate that equates the
present value of cash inflows with the initial investment associated with the project. The IRR is, in other words, the
discount rate that makes the NPV of an investment equal to zero. Based on the IRR rule, an investment is
acceptable if the IRR exceeds the required rate of return, otherwise the project should be rejected. However, IRR
and NPV sometimes give conflicting results. If projects are mutually exclusive and NPV and IRR give conflicting
result, the decision should be made based on NPV.

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Activity 4.1
Cost (Rm) IRR NPV
Project A 100 75% 0.59
Project B 100 20% 9.09
Project C 100 25% 8.18

Cost of capital is 10%

Question
Rank the above projects in order of priority.

4.6.1 Calculating the IRR for an annuity

Calculating the IRR for an annuity is much easier than it is for a mixed stream of cash inflows. According to Marx
et al, (2017:288) the following three steps are involved in determining the IRR for an annuity

Step 1 Calculate the Payback Period of the project (in years only).

Step 2 Use Table 4 (present value of a regular annuity) at the end of this module guide and find the two
discount factors that the figure calculated in step 1 would lie between.

Step 3 Use interpolation to determine the precise IRR.

Example 4.5
Use the figures from Example 4.3 to calculate the IRR for Project B.

Solution Project B

Step 1
Calculate the payback period of Project B.

Payback period = R80 000 ÷ R22 000 = 3.6364 years

Step 2

Using present value Table 4 (at the end of this module), we notice that (using the 6-year row) 3.6364 lies between
16% and 17%.

Step 3

First, we calculate the NPV at 16% and 17%. (Always remember that one NPV will be positive and the other
negative

By interpolation,

NPV+
IRR = r1 +
NPV+ + NPV−

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Where,

r1 = Lower Discount rate of that resulted in positive NPV

NPV+ = Positive NPV

NPV− = negative NPV

Year Net cash Discount Discount Present Present
inflow p.a. Factor 16% Factor 17% value value 17%
16%
1-6 R22 000 3.6847 3.5892 R81 063 R78 962
Initial Investment (R80 000) (R80 000)

NPV R1 063 (R1 038)

Using Interpolation to determine the exact IRR. The IRR is between 16% and 17

1 063
𝐼𝑅𝑅 = 16 +
1 063 + 1038

1 063
= 16 +
2 101

= 16 + 0.506

= 𝟏𝟔. 𝟓𝟏%

Knowledge Check 4.3

The firm’s the cut-off rate is 12 % and the IRR is calculated to be 30%. The management
should immediately accept the project because its IRR is 30%. (True/ False).

4.6.2 Calculating the IRR for a mixed stream of cash flows

When the net cash inflows are different over the lifetime of a project, the trial-and-error method for calculating IRR is
usually used. The following steps may be performed to calculate the IRR for a mixed stream of cash flows:

▪ Calculate the NPV at the cost of capital rate.

▪ Check if the NPV is positive or negative.
▪ If the NPV is positive, then pick another rate higher than the cost of capital rate. (If the NPV is
negative, pick a smaller rate.) The correct IRR is the one at which the NPV = 0 and lies
somewhere between two rates, with one rate indicating a positive NPV and the other rate
showing a negative NPV. (They should be consecutive rates e.g. 14% and 15%.)
▪ Use interpolation to calculate the exact rate.

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Example 4.6

Using the information in Example 4.3 and we can determine the Internal Rate of Return for Project A as follows
▪ Step 1: Calculate the NPV at the cost of capital rate (example 4.3)
▪ Step 2: Check if the NPV is positive or negative: We notice that the NPV is positive and far away
from zero.
▪ Step 3: Pick a rate that will give you a negative NPV

Step 2
We now pick a higher rate e.g. 19%. (Trial-and-error is used to obtain the higher rate.)

Discount Discount Present Present

Year Net cash
factor factor value value
inflows
19% 20% 19% 20%

1 R20 000 0.8403 0.8333 R16 806 R16 666

2 R22 000 0.7062 0.6944 R15 536 R15 277
3 R24 000 0.5934 0.5787 R14 242 R13 889
4 R26 000 0.4987 0.4823 R12 966 R12 540
5 R23 000 0.4190 0.4019 R9 637 R9 244
6 R21 000 0.3521 0.3349 R7 394 R7 033

Total PV R76 581 R74 649

Investment (75 000) (75 000)

NPV R1 581 (R351)

Using interpolation to find the exact IRR

1 581
IRR = 19 +
1 581 + 351

1 581
= 19 +
1 932

= 19 + 0.818

= 𝟏𝟗. 𝟖𝟐%

Decision: Using the calculations from Example 4.4 and Example 4.5
Project A should be chosen since it has a higher IRR

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Think Point 4.4

If a project has an IRR of 13.5% and the cost of capital is 11%, would you still recommend
that the investment be made? Explain.

4.7 Profitability Index

According to Marx et al, (2017: 287) the profitability index (PI) is also referred to as the benefit-cost ratio. The
difference between this technique and NPV is that PI measures the present value return per rand invested, whilst
the NPV approach provides the difference in Rands between the present value of the returns and the initial
investment. The PI is calculated by dividing the present value of cash inflows by the present value of cash
outflows (Initial Investment).

PI = Total present value of the net cash inflows

Initial investment

The criterion that is used in making a decision (accept or reject a project) when using PI is as follows:
▪ Projects with a PI of ≥ 1 are accepted as they will maintain or enhance the value of the firm.
▪ Projects with a PI of < 1 are rejected as they would decrease the value of the firm.

Example 4.6
Using Example 4.3 calculate the profitability index of Project A and Project B.
Solution
Project A Project B

Profitability Index = Present Value of Cash Flows = 92 691 90 451

Initial Investment 75 000 80 000

= 1.24 1.13

Both projects are acceptable as the PI’s are greater than 1. Ranking the projects on the basis of PI shows that
Project A is preferable because it returns R1.24 for each rand invested, while Project A returns R1.13.

Think Point 4.5

Do you think projects with positive NPV, automatically have PI of greater than 1? Why
or why not?

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Capital Budgeting: Non-Financial Criteria

Hector Gaming Company (HGC) is an educational gaming company specialising in
young children’s educational games. HGC has just completed their fourth year of
operation. The company is committed to launching 5 new monster truck versions each
April to take advantage of the summer season. HGC invited 2 finance professors to cover
capital budgeting, explaining how to calculate the NPV and IRR, and stated that these
should be used to screen potential projects and many other innovations that HGC bring
into the market each year. Based on their calculation, the 5 the launching of 5 new truck
were having negative NPV and very low IRR leading to the rejection of the project.
However, one professor advised the project should be accepted based on its contribution
to the organisation’s objectives and strategic plan. In the Q-and-A session, the ED
Wilson, the Hector Gaming Company’s CFO and the 2 government officials from the
Ministry of Finance office argued in favour of non-financial criteria in selecting and
ranking projects and vehemently rejected the NPV and IRR approach.

(Fundamental analysis, Palat, 2019, 233)

Question:

Give practical recommendations in favour of the CFO and the 2 government officials in
soliciting for non-financial criteria when selecting and ranking potential projects.

4.8 Summary
▪ The Non-financial criteria considered when selecting between projects include technical factors, social
factors, strategic alignment, site of the project, and this can be done by performing a SWOT analysis.
On the other hand, the Financial criteria includes the use of Non-Discounted Cash Flows (NDCF) and
Discounted Cash Flows (DCF) techniques.
▪ The Non-Discounted Cash Flow techniques comprise of the payback period and the Accounting Rate
of Return (ARR) which do not consider the time value of money.
▪ The ARR uses accounting figures and determines the rate of return based on the average profit after
tax divided by the average investment. While the payback period describes the number of years required
to recover the initial investment. The shorter the period the better.
These two approaches may be used for the initial evaluation of capital expenditure projects.
Projects that meet the requirements of these techniques may be evaluated further by means Discounted
Cash Flow techniques such as the NPV, IRR and PI.
▪ The NPV discounts the future operating cash flows to present value using a stated discounting factor
and subtracts the initial investment. For a project to be viable, the NPV must be greater than zero. If
both projects have positive NPV select the one with higher NPV.

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▪ The PI discounts the future operating cash flows to present value and divides the sum of the present
values by the initial investment. For a project to be viable, the PI must be greater than one
▪ The IRR is the discount rate the makes the NPV of the project equals to zero. And this can be obtained
using the trial-and-error method. For a project to be viable, the IRR must be greater than the initial cost
of capital.

4.9 Revision Questions

Revision Questions

An investment has the following cash flows, with no scrap value expected:

Year 0 1 2 3 4 5

Net (60 000) 10 12 28 20 30

Cash 000 000 000 000 000
flows

The cost of capital is 12%.

Required: Calculate the following:
4.8.1 Payback Period (expressed in years and months)
4.8.2 Net Present Value (NPV).
4.8.3 Profitability Index (PI)
4.8.4 Accounting Rate of Return (ARR). (Assume that the depreciation is R12
000 per year.
4.8.5 Must the investment be considered positively or negatively? Give
reasons for your answer.

4.9 The management of Rujeko & Sons Trading are considering two
mutually exclusive investment projects. The following data are
available for each project

Project Tim Project Tok

Cost of plant and equipment R90 000 R60 000

Salvage Value Nil Nil

The estimated cost of capital is 10% p.a.

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Expected profit/loss

Year 1 R25 000 R7 500

Year 2 (R17 500) R10 750

Year 3 R22 500 R14 750

Required: Calculate for each project

4.9.1 The Accounting Rate of Return.
4.9.2 The Payback Period
4.9.4 The Net Present Value
4.9.4 The Profitability Index
4.9.5 The Internal Rate of Return
4.9.6 Which project should be chosen and why?

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Answers to Activities

Think Point 4.1

The biggest limitation for NDCF techniques such as payback and ARR is that they ignore the time value of money.

Knowledge Check 4.1

Option C is the correct answer.

Think Point 4.2

Payback method ignores the cash flows after the break even. Suppose Project A is expected to reach its break-
even point after 3 years but has very little cash flows thereafter. Suppose Project B is expected to break even after
4 years but is expected to generate substantial cash flows thereafter. Using payback period, Project A may be
chosen, thereby forfeiting Project B’s cash flows, which occur after the break-even point

Knowledge Check 4.2

Option A is the correct answer, calculated as follows.

ARR = (Average annual profit /Average Investment) x 100

Average Annual Profit = Annual Cash flow (145 000) - Depreciation (50 000) =95 000

Average Investment = (420 000 + 120 000)/2 = 270 000

ARR = (95 000/270 00) x 100 =35.19%

Practical Activity 4.1

Years 1 2 3 4 5 Average
EBITDA 12 000 15 000 18 000 19 000 20 000 16 800
Depreciation -10 000 -10 000 -10 000 -10 000 -10 000 -10 000
EBIT 2 000 5 000 8 000 9 000 10 000 6 800
Interest 0 0 0 0 0 0
EBT 2 000 5 000 8 000 9 000 10 000 6 800
Tax @ 28% -560 -1 400 -2 240 -2 520 -2 800 -1 904
Net Income 1 440 3 600 5 760 6 480 7 200 4 896

Accounting Rate of Return = Average Annual Profit x 100

Average Investment 1

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= R4 896 x 100

(R50 000 + R5 000)/2 1

= R4 896 x 100

R27 500 1

= 17.80%

The company cannot accept this project, as its ARR is less than the minimum or standard rate of return 20%

Video 4.1
Ingredients needed to evaluate the projects using the NPV criteria are
• Time value of Money
• Incremental cash flows
• Cost of Capital

Think Point 4.3

The technique is logically consistent with the company’s goal of maximising shareholders’ wealth; considers the
time value of money; It provides theoretically correct decisions; It uses all the cash flows of the project and
discounts them correctly.

Practical Activity 4.2

Years

0 1 2 3 4 5

Cash Outflows -1 200 000 -250 000

Cash Inflows 900 000 900 000 900 000 900 000 900 000

Net Cash flows -1 200 000 900 000 900 000 650 000 900 000 900 000

Discount factor @ 10% 1 0.9091 0.8264 0.7513 0.6830 0.6209

Present Value -1 200 000 818 190 743 760 488 345 614 700 558 810

NPV $2 023 805

Activity 4.1

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The three projects have equal amount of investment, then it follows that the project should be ranked using the NPV
criteria. Project B has a higher NPV, therefore it is selected in preference of A and C. Project C has second highest
NPV then finally project A.

Ranking Project
1 Project B
2 Project C
3 Project A

Knowledge Check 4.3

False:

The problem with IRR it gives unrealistic returns. So, the answer will be False. An IRR of 30% assumes that a firm
has the opportunity to reinvest future cash flows at 30%. If past experience and the economy indicate that 30% is
an unrealistic rate for future reinvestments, an IRR of 30% is doubtful. An IRR of 30% is not practical. So, unless
the calculated IRR is a reasonable rate for reinvestment of future cash flows, it should not be used as a criteria to
accept or reject a project.

Think Point 4.4

Yes it can be accepted. Based on the IRR rule, an investment is acceptable if the IRR exceeds the required return.
It should be rejected otherwise.

Think Point 4.5

If the NPV of a project investment is greater than zero (0) then the present value of the future cash flows must be
bigger than the initial investment. Hence the NPV and PI do not offer conflicting results.

Case Study:
Private companies can reject profitable projects by using non-financial criteria due to the following strategic
reasons
• To capture larger market share
• To make it difficult for competitors to enter the market
• To develop an enabler product, which by its introduction will increase sales in more profitable products
• To develop core technology that will be used in next-generation products
• Strategic alignment (intangible market related benefits and risks)
• Firms may support projects to restore corporate image or enhance brand recognition

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Unit
5: Project Portfolio Management

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Unit Learning Outcomes

CONTENT LIST LEARNING OUTCOMES OF THIS UNIT:

5.1 Introduction • Define project portfolio management

5.2 Project Portfolio vs. Financial Portfolio • Differentiate between project portfolio and Financial
Portfolio

5.3 Benefits of Project portfolio Management • Discuss the benefits of project portfolio management

5.4 Practical challenges in executing PPM • Analyze the challenges in executing PPM

5.5 Portfolio selection and rebalancing • Describe the selection and rebalancing process of
portfolio formation

5.6 Expected return and Risk of a portfolio • Calculate and interpret the expected returns and standard
deviation of a portfolio

5.7 Efficient Frontier in Project Portfolio • Demonstrate an understanding of an efficient frontier for
Management optimum projects

5.8 Summary • Summarises topic areas covered in the unit

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Prescribed and Recommended Textbooks/Readings

Prescribed Reading/Textbook
• Marx, J, C Swardt, M Pretorius, W Rosslyn-Smith (2017) Financial
Management in Southern Africa, Fifth Edition. Pearson South Africa.
(This is the latest edition of the textbook)

Recommended Readings
• Conradie, W.M. and Fourie, C.M.W. (2018) Basic Financial
Management. Third Edition. Cape Town: Juta and Company Ltd.
• Gitman, L.J and Zutter, C.J (2017) Principles of Managerial Finance.
Thirteenth Edition. Cape Town: Pearson Education.
• Flynn, D., Uliana, E., Wormald, M. and Dillon, J. (2019) Financial
Management. Ninth Edition. Cape Town. Juta and Company (Pty) Ltd.
• Venkataraman, R.R., and Pinto, J.K (2008) Cost and Value Management
in Projects. NJ: Wiley, pp. 344–345.
• Yescombe, E.R. (2014) Principles of Finance. Second Edition: British
Library: Elsevier.
• Marx, J; De Swardt, C; Pretorius, M. (2023) Financial Management in
Southern Africa. Sixth Edition.
• Zutter, C.J. (2021) Principles of Managerial Finance. Sixteenth Edition.
Pearson.
• Venkataraman, R.R. (2023) Cost and Value Management in Projects.
Second Edition.

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5.1. Introduction

According to Schwalbe (2015:19) a portfolio is a collection of projects and programs that are grouped together to
facilitate effective management to meet strategic business objectives. Schwalbe (2015:19) defines project portfolio
management as an emerging business strategy in which organisations group and manage projects and programs
into a portfolio of investments. Rothman, (2016:129) consider project portfolio management as a strategy that moves
the selection and implementation of projects from a random process to one with structure and discipline. The aim is
to align projects with strategic goals and objectives for a more effective and efficient organisation.

Portfolio managers need to understand how projects fit into the bigger picture of the organisation, especially in terms
of corporate strategy, finances, and business risk. Project managers create portfolios based on financial and non-
financial investment criteria which has been discussed in the previous units. In other words, a project should be part
of a portfolio upon meeting specific organisational goals, such as ability to maximise the value of the portfolio or
making effective use of limited resources. Portfolio managers help their organisations make wise investment
decisions by helping them select and analyse projects from a strategic perspective.

Oltmann (2008) describes PPM as a funnel that connects strategic planning to the execution of projects, making the
strategic objectives executable

2Figure 5.1 PPM Connects Strategy with Execution

(Rothman, 2016:131)

The mouth of the funnel takes in all of the ideas for projects that the organisation might do. These ideas may come
from strategy, customer requests, regulatory requirements, or ideas from individual contributors. The purpose of the
funnel is to select only those projects that meet certain criteria and to say “no” to the others. The resulting collection
of projects is a focused, coordinated, and executable portfolio of projects that will achieve the goals of the
organisation.

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Think Point 5.1

What is the role of a project portfolio manager?

5.2. Project Portfolio vs. Financial Portfolio

There is relationship between project and financial portfolio. Kapoor, (2014:136) defined a financial portfolio as
group of financial assets such as stock, bond, cash equivalents and derivatives that are managed together to
stabilise the risk of non-performing securities. Theoretical concepts of selecting managing financial portfolios is now
being applied to the selection and execution of project portfolios. In other words, project portfolio management draws
many of its concepts from financial portfolio. For instance, companies do not approve and fund any project that is
proposed without first evaluating it and its contribution to and alignment with the corporation's strategic goals and
objectives.

However, the difference lies on how the portfolio is managed and the constituencies that make up that portfolio.
Bodie et al (stated that financial portfolios or investment portfolios are concerned about investments in financial
securities such as stock, bonds, derivatives, commodities, forex, and these do not meet a definition of a project.
Reilley & Brown, (2017:127) added that portfolio managers for these investment portfolios are concerned about
maximising returns for their clients by using different portfolio strategies such as active or passive strategies. In case
of South Africa, the securities that make up a financial portfolio are traded on security exchanges such Johannesburg
Securities Exchange (JSE).

In contrast, project portfolio management involves investments in projects that are meant for infrastructural
development such as power plant installations, road construction, shopping mall erection etc. Schwalbe, (2015:18)
highlighted the following outstanding examples as project portfolios:
a) An automotive company managing a project portfolio that includes all of the cars, trucks, and Sport Utility
Vehicle (SUVs) in its product line.
b) A government agency for children’s services grouping projects into a portfolio based on key strategies such
as improving health, providing education, skills development to help make decisions on the best way to
use available funds and resources

Think Point 5.2

Can mutually exclusive projects form a portfolio? Explain

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5.3. Benefits of Project Portfolio Management

Schwalbe (2015:16) outlines the following reasons for project portfolio management:

Video 5.1:
[Link]

What are the six (6) steps involved in executing a portfolio of projects?

• It assists in making better decisions e.g. increasing, decreasing, discontinuing, or changing specific projects
based on financial performance, risks, resource allocation or other factors that influence business value and
strategy.
• Enterprises can better tie their projects to meet strategic goals.
• It can also assist an enterprise do a better job of managing its human resources by hiring, training, and
retaining workers to support the projects in the portfolio.
• It provides the means of assessing the balance of the types of projects especially in terms of them being
high-risk or low risk.
• Provides for greater visibility to the enterprise’s total projects without focusing on just one project at a time

5.4. Practical Challenges in Executing PPM

According to Rajegopal, McGuin and Waller (2017:99) portfolio managers are faced with the following challenges
in executing the PPM.
• Insufficient information
Disparate project and resource registry and information gives management an insufficient basis for making decisions
because no one wants to be the one to kill a questionable project.
• Biased selection methods
Projects can be selected based on politics or emotions, and lack of strategic criteria in the project selection leads to
too many mediocre projects finding their way into the pipeline.
• Scarcity of resources
There is also a limitation on the number of resources within a business and how they are allocated across the
organisation’s project. This means that resources are too thinly spread across multiple initiatives resulting in
increase in delivery times and the final quality of the products tends to suffer, because the employees are scrambling
between multiple ventures, missing deadlines, and making mistakes that become harder to fix as the projects
progress from initiation to the close-out stages.

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• Too much red tape

Executing PPM naturally results in hierarchies. Hierarchies tend to breed bureaucracies that are overly rigid and
complex structures that tie the projects down thus choking off innovation that comes from the bottom up.
• Human Capital
Some projects may have human capital requirements. An example is an oil company that buys a supermarket. The
oil company does this to be better diversified. But the management skills the oil company brings forward do not
necessarily match the management needs of the supermarket. The time required for the oil company to learn how
to run a supermarket may result in lost market share for the store.

5.5. Portfolio Selection and Rebalancing

It has been discussed already in the previous study units that projects can be selected and approved based on
financial and non-financial criteria. Mikkola, (2016:427) defines a balanced portfolio as a desired combination of
projects that expose the organisation to minimal risk, while achieving the growth and profit objectives related with
the corporate strategy. Thus, project should be included in the portfolio if they maintain a strategy fit. Strategic fit
can be evaluated by looking at how tightly a project’s deliverables are tied to supporting the achievement of a
strategic objective as compared to the contribution of other projects in the portfolio. Portfolio rebalancing, therefore,
entails having a project portfolio mix with the greatest potential, to collectively support the organisation’s strategic
initiatives and achieve strategic objectives. The key activities within this process include:
▪ Adding new projects that have been selected and prioritised for authorisation.
▪ Identifying projects that are not authorised based on the review process.
▪ Eliminating projects to be suspended, reprioritised, or terminated based on the review process.
▪ High-risk projects may have to be balanced with low risk once to ensure that the overall exposure to risk
is acceptable.
▪ The innovation portfolio must fit and respond to the company’s strategic needs. Periodically good
projects may have to be delayed or aborted in favour of others in more strategically important parts of
the business.

Knowledge Check 5.1

Which of the following statements is least likely to be correct?
A. Strategic fit is a measure of how closely aligned a project is to meeting an organisation’s
strategic goals.
B. The goal of rebalancing is to minimise the level of risk and maximise the returns.
C. The primary benefit of rebalancing is that it restores the portfolio to its theoretically optimal
asset weighting.

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To select and rebalance the portfolio the following models are used
• Checklist Models
According to Larson, & Gray (2018:63) The most frequently used method in selecting projects is the checklist model.
This approach basically uses a list of questions to review potential projects and to determine their acceptance or
rejection. A justification of checklist models is that they allow great flexibility in selecting among many different types
of projects and are easily used across different divisions and locations. Major shortcomings of this approach are
that it fails to answer the relative importance or value of a potential project to the organisation and fails to allow for
comparison with other potential projects. To overcome these shortcomings experts, recommend the use of a multi-
weighted scoring model to select project.
• Multi-Weighted Scoring Models
The multi-weighted scoring models is the most important method that one can use to select a project. The model
utilises a weighted selection criterion to evaluate project proposals. This scoring models encompasses both
qualitative and/or quantitative criterion methods. To determine the attractiveness of the project, each criterion is
assigned specific weight. Scores are assigned to each criterion for the project, based on its importance to the project
being evaluated (Larson, & Gray, 2018:63).

The weights and scores are multiplied to get a total weighted score for the project. Using these multiple
screening criteria, projects can then be compared using the weighted score. Projects with higher weighted scores
are considered better and are first to be included into the portfolio.

3Figure 5.2: Project screening matrix

(Source: Larson, & Gray, 2018:63)

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Each project proposal is then evaluated by its relative contribution/value added to the selected criteria. Values of 0
to a high of 10 are assigned to each criterion for each project. This value represents the project’s fit to the specific
criterion. For example, project 1 appears to fit well with the strategy of the organisation since it is given a value of
8. Conversely, project 1 does nothing to support reducing defects (its value is 0). Finally, this model applies the
management weights to each criterion by importance using a value of 1 to 3. For example, ROI and strategic fit
have a weight of 3, while urgency and core competencies have weights of 2.

For example, project 5 has the highest value of 102

(2 × 1) + (3 × 10) + (2 × 5) + (2.5 × 10) + (1 × 0) + (1 × 8) + (3 × 9) = 102
and project 2 has the lowest value of 27. If the resources available create a cut-off threshold of 50 points, the priority
team would eliminate projects 2 and 4. (Note: Project 4 appears to have some urgency, but it is not classified as a
“must” project. Therefore, it is screened with all other proposals). Project 5 would receive first priority, project n
second, and so on.

Knowledge Check 5.2

Which of the following statements is most likely to be incorrect?
A. The least important criterion for selection is the project’s fit to the organisation strategy
B. Weighted scoring models result in bringing projects to closer alignment with strategic goals
C. When rebalancing a portfolio of projects, project managers need to evaluate each potential
in terms of what it adds to the project mix

5.6. Expected Return and Risk of a Portfolio

An analysis of asset’s risk and return is important because it affects the risk and return of the portfolio. The risk-
return trade-off for a portfolio is measured by the portfolio’s expected return and standard deviation, just as with
individual assets (Gitman et al, 2017:478). Expected return is a weighted average of the possible returns, where the
weight applied to a particular return equals the probability of that return occurring. The expected return of a portfolio
is the weighted average of the expected returns for each project in the portfolio and can be expressed as follows:
𝑚

𝐸(𝑅𝑃 ) = ∑ 𝑊𝑗 𝐸(𝑅𝑗 )
𝑗=1

Example 5.1
Suppose a project manager has R100 000 to invest in two independent projects, A and B. Project A requires
R75 000 and the expected returns of project A and B were calculated to be 5% and 8% respectively.

Required
Calculated the expected return of the portfolio.

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Solution
First calculate the weights of each project in the portfolio
Project A Project B
75 000 25 000
= 0.75 = 0.25
100 000 100 000

𝐸(𝑅𝑃 ) = 0.75 × 5% + 0.25 × 8%

= 3.75% + 2%
= 𝟓. 𝟕𝟓%

Note: the weights should always add up to 1. (0.75 + 0.25 = 1)

Now that we have calculated the expected return of the portfolio (E(RP), we need to calculate the risk of the portfolio.
The riskiness of the portfolio is measured by variance of returns from the expected return. Because the variance is
difficult to interpret, risk is often measured using standard deviation. In financial theory the risk for a two-operation
portfolio can be calculated using the following equation:

σp = √W 2 A × σ2 A + W 2 B × σ2 B + 2 × WA × WB × σA × σB × ρAB
Where
• σP is the standard deviation of the portfolio
• WA and WB are, respectively, the weights of Projects A and B in the asset portfolio
• σ2 A and σ2 B are the variances for returns of Projects A and B respectively.
• 𝜌𝐴𝐵 the correlation between the risk levels for Project A and for B.

Note the following is the relationship between correlation and covariance

𝐶𝑜𝑣𝐴,𝐵
𝜌𝐴,𝐵 =
𝜎𝐴 × 𝜎𝐵

Where
CovA,B is the covariance between A and B
σA and σB are the standard deviations of A and B respectively.

Example 5.2
Using the information provided in Example 5.1. The project manager assumed that the standard deviation for Project
A and B are 4% and 10%. The correlation between Project A and Project B is estimated to be +1.

Required
Calculate the risk of the portfolio as measured by standard deviation.

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Solution

σp = √W 2 A × σ2 A + W 2 B × σ2 B + 2 × WA × WB × σA × σB × ρAB

= √0.752 (0.042 ) × (0.252 )(0.1)2 + 2 × 0.75 × 0.25 × 0.04 × 0.1 × 1

= √0.0009 + 0.000625 + 0.0015

√0.003025

= 0.055

= 𝟓. 𝟓%

Think Point 5.3

All else held constant, a lower correlation between the assets in a portfolio most likely
results in higher:
A Diversification.
B Portfolio Risk
C Portfolio Return

A better way of understanding a project’s contribution is to look at how it increases diversity within a portfolio,
because diversity creates opportunity and reduces risk when projects are aggregated rather than managed in
isolation from one another. Whittingham, (2014) indicated that the purpose of a securities portfolio is defined by a
formal investment statement known as the Investment Policy Statement (IPS), which describes the goals of the
portfolio and how those goals will be met. The statement sets boundaries for the kinds of securities in which the
portfolio can invest as they relate to the achievement of the portfolio’s investment goals. In a similar fashion, project
portfolios should also be defined with reference to a specific purpose, expressed in goals and objectives or in an
over-arching vision statement. (Whittingham, 2014)

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Practical Activity 5.1

Maputo Development Bank has a portfolio of two projects for R4 million each. One
project has an expected return of 17% and a standard deviation of 25%. The other
project has an expected return of 9% and a standard deviation of 15%. It is determined
that the covariance between the two projects is 2%. Determine the expected return and
standard deviation of the portfolio.

5.7. Efficient Frontier in Project Portfolio Management

The practice of managing a portfolio of projects was initially crafted after the concepts of financial portfolio
management by Harry Markowitz under his theory, Modern Portfolio Theory (MPT) (Markowitz, 1952). He indicated
that every possible asset combination can be plotted in risk-return space, and the collection of all such possible
portfolios defines a region in this space. The line along the upper edge of this region is known as the efficient frontier.
The combinations along this line represent portfolios for which there is lowest risk for a given level of return.
Conversely, for a given amount of risk, the portfolio lying on the efficient frontier represents the combination offering
the best possible return. Mathematically the efficient frontier is the intersection of the set of portfolios with minimum
variance and the set of portfolios with maximum return.

Knowledge Check 5.2

Which of the following statements is least likely to be correct?

A. systematic rebalancing improves portfolio’s risk-adjusted returns quite substantially

B. When rebalancing a portfolio each project is evaluated in terms of what it adds to the
project mix.
C. The purpose of rebalancing is to minimise risk and maximise returns

According to Bodie, Kane and Marcus (2017:271) to determine the optimum portfolio, project managers use
computers to feed relevant data into an optimisation program that reports investment proportions (weights),
expected returns, and standard deviations of the portfolios on the efficient frontier. Rational project managers will
choose a portfolio on the efficient frontier. Running a portfolio optimisation program will result in what is called the
Markowitz efficient frontier as depicted in Figure 5.3.

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4Figure 5.3: Markowitz Efficient Frontier, Bodie et al, 2017:97

The following comments can be presented:

• Portfolio A in Fig 5.3 dominates Portfolio C because it has an equal rate of expected return but substantially
less risk. Similarly, Portfolio B dominates Portfolio C because it has equal risk but a higher expected rate of
return.
• Portfolios to the right of the efficient frontier (interior portfolios) represent a feasible or attainable
opportunity set describing all possible portfolio combinations but are regarded as inefficient portfolios
• Portfolios to the left of the efficient frontier are not possible because they lie outside the attainable set.
• According to Markowitz, project managers can therefore choose a desired portfolio lying on the efficient
frontier

Think Point 4

How relevant is Morden Portfolio Theory (MPT) to Project Portfolio Management (PPM).

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Case Study: Challenges of Executing Project Portfolio Management

Like many financial institutions, the Navy Federal Credit Union struggled with adapting
IT technologies to better serve their over 5 million members. Navy Federal had no clear
method of prioritising projects. Project execution processes were ad hoc. Delivery
metrics were not being tracked. Doomed projects lingered, with no one willing to hit the
kill button. In 2010 things began to change. Navy Federal began developing a team of
project professionals who could advocate a standardised project delivery system as well
as strategic alignment practices. In 2014 the IT department opened its project
management office (PMO). The team had to work hard to avoid the perception that it
was a document engine or needless bureaucracy. “Throughout our journey, we’ve
certainly faced challenges in terms of buy-in and acceptance of portfolio of projects. All
of the projects (large and small) selected become part of a project portfolio meant to
balance the total risk for the organisation. Management of the project portfolio would
strive to ensure that only the most valuable projects are approved and managed across
the entire organisation. We had to highlight the demonstrated value that we brought in
terms of consistent, repeatable delivery of projects. While the initial push was to
standardise project management processes, the PMO realised that not all projects are
alike, and some may benefit from less traditional methods. “We’ve tailored our delivery
practices to introduce both agile and incremental delivery practices, and that’s helped us
improve our delivery within the portfolio.”

*Gantz, J., “Mission Accomplished,” PM Network 29 (12) (December 2015), pp. 30–37.

Question:

From the case study, discuss any three (3) practical challenges encountered by project
managers in executing a portfolio of projects

5.8. Summary
• A portfolio is a collection of projects and programs that are grouped together to facilitate effective
management to meet strategic business objectives.
• Project Portfolio Management as an emerging business strategy in which organisations group and manage
projects and programs as a portfolio of investments.
• There is a connection between project portfolio and financial portfolio. Project portfolio management draws
many of its concepts from financial portfolio.
• The benefits of project portfolio management include better decision making, meeting strategic goals, better
assessment of risk and return.

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• Challenges of executing project portfolio management include insufficient information, scarcity of

resources, biased selection method and too much red tape
• Two mostly used selection models are checklist model and multi weighted score model.
• Portfolio Balancing entails having a project portfolio mix with the greatest potential, to collectively support the
organisation’s strategic initiatives and achieve strategic objectives
• The expected return of a portfolio is the weighted average of the expected returns for each project in the
portfolio and can be expressed as follows:

𝐸(𝑅𝑃 ) = ∑ 𝑊𝑗 𝐸(𝑅𝑗 )
𝑗=1

• The riskiness of the portfolio is measured by variance of returns from the expected return. The standard
deviation for a two-asset portfolio is given by

σp = √W 2 A × σ2 A + W 2 B × σ2 B + 2 × WA × WB × σA × σB × ρAB

• The Modern Portfolio Theory is used to select optimum project portfolios that lie on the efficient frontier.
• Different weights or amounts of a portfolio held in various investment projects yield a curve of potential
combinations
• The efficient frontier is the graphical representation of a set of portfolios that maximise expected return for
each level of portfolio risk.
• Investors can maintain their rate of return while reducing the risk level of their portfolio by combining assets
or portfolios that have low-positive or negative correlation.
• The investment opportunity set that lie to the right of the Efficient frontier are said to be attainable yet
inefficient.
• Portfolios to the left of the efficient frontier are not possible because they lie outside the attainable ‘set.

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Revision Questions

5.9.1 Define project portfolio management

5.9.2 Distinguish between project portfolio and financial portfolio
5.9.3 Discuss how might project portfolio management improve and promote the
organisation’s chances of success
5.9.4 Discuss practical challenges faced by portfolio managers in attempting to execute
project portfolio management
5.9.5 Explain the key activities underpinning portfolio balancing exercise.
5.9.6 Draw a properly labelled graph of the Markowitz efficient frontier. Describe the efficient
frontier in exact terms.
5.9.7 Assume you were tasked to run a computer program to derive the efficient frontier for
your feasible set of projects. What information must you input to the program?
5.9.8 Jack Tobetsa, a portfolio manager for Giamanje Development Trades has the following
independent projects in the portfolio.
Project Name Invested Amount Expected return
Theta R300 000 15%
Gamma R100 000 12%
Delta R200 000 10%
Vega R400 000 9%

Required
Calculate the expected return of the portfolio to be anticipated by Jack Tobetsa.

5.9.9 Consider a portfolio consisting of equal holdings of two projects, Project short and
Project long. You have been provided with the following information
Project Name Expected Return Standard Deviation
Short 7.5% 2.5 %
Long 15% 5%

a) Calculate the mean and standard deviation of the return on the portfolio, given that
the correlation coefficient of the two projects is:
I. 1
II. 0
III. -1

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b) Comment on your results

5.10 Assume the information in the table below is used to screen projects; discuss which
model can be applied to screen projects. Given that the cut-off threshold is 80 points.
Which project (s) is/are the most attractive?
Criteria New Customer Supplier Success
Products Relations Relations Probability
Weights 10 6 7 5
Project A 5 3 3 3
Project B 3 4 5 4
Project C 3 4 3 2
Project D 2 2 5 3

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Answers to Activities
Think Point 5.1
Portfolio Manager create portfolios that meet specific organisational goals, such as maximising the portfolio value,
or making the best use of available resources. Portfolio managers assist in making wise decisions by selecting and
analysing projects from a strategic perspective.

Think Point 5.2

No, mutually exclusive projects are capital projects which compete directly with each other. For example, manager
can choose between investing in either project A or B, but not both. Hence project A and B cannot form a portfolio

Video 5.1
Steps involved are
1. Selection
2. Prioritisation
3. Kick-off
4. Management of time, cost, resources etc
5. Reporting
6. Communication

Knowledge Check 5.1

Correct answer is B. the goal of rebalancing is to reduce risk but NOT to maximise returns.

Knowledge Check 5.2

Correct answer is A. Project’s fit is the MOST important selection criteria not the least

Think Point 5.3

A is correct. An investor may achieve diversification by combining two assets that are not perfectly correlated. This
diversification increases as the correlation decreases.
B is incorrect. The portfolio risk would decrease, all else being equal, when the correlation between assets
decreases.
C is incorrect. The portfolio return does not change with lower correlation between assets, as long as the expected
returns of the individual assets are unchanged.

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Think Point 4
The MPT is a relevant to project portfolio management in such a way that projects, programmes, and operational
initiatives can be viewed as investments that must be aligned to organisational goals. The project portfolio mix can
be balanced in terms of risk exposure and investment returns. The projects can also be selected based on the risk
profile of the portfolio thus reducing the risk exposure to the organisation. The treatment of projects as investments,
managing groups of projects in portfolios and overseeing their execution and value to the organisation as a group
is at the core of PPM

Practical Activity 5.1

𝑚

Expected return of the portfolio = ∑ 𝑊𝐽 𝐸(𝑅𝐽 )

𝑗=1

E (Rp) = W1 x R1 x W2 x R2
E (Rp) = 0.5 x 17% x 0.5 x 9%
E (Rp) = 8.5 % + 4.5 %
E (Rp) = 13 %

Standard Deviation of the portfolio,

σP = √W1 2 × σ1 2 + W2 2 × σ2 2 + 2 × W1 × W2 × Cov1,2

= √0.52 (0.252 ) + 0.52 (0.152 ) + 2 × 0.5 × 0.5 × 0.02

= √0.015625 + 0.005625 + 0.01

= √0.03125
= 0.1768
= 17.68%

Case study:
Challenges in executing a project portfolio Management.
Alignment of Projects with Organisational Strategy
Strategic plans are written by one group of managers, projects selected by another group, and projects implemented
by another. These independent decisions by different groups of managers create a set of conditions leading to
conflict, confusion, and frequently an unsatisfied customer.

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Lack of resources
The number of small and large projects in a portfolio almost always exceeds the available resources (typically by a
factor of three to four times the available resources). This capacity overload inevitably leads to inefficient use of
scarce organisational resources.

Biased selection methods

Lack of a proper model to prioritise project is an area of concern. This means that projects can be selected based
on politics or emotions, and many mediocre projects can find their way into the portfolio.

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Unit
6: Financial Estimates and Projections

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Unit Learning Outcomes

CONTENT LIST LEARNING OUTCOMES OF THIS UNIT:

6.1 Introduction • Define financial estimates in the context of project financing.

6.2 Pro forma Financial statement • Explain the purpose of a pro forma financial statements

6.3 Pro-forma Income statement • Prepare pro forma income statements based on several
revenue and cost assumptions

6.4 Percentage of sales method • Use the percentage of sales method for forecasting.

6.5 Proforma Statement of Financial • Prepare a Proforma Statement of Financial Position

Position

6.6 Summary • Summarises topic areas covered in the unit

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Prescribed and Recommended Textbooks/Readings

Prescribed Reading/Textbook
• Marx, J, C Swardt, M Pretorius, W Rosslyn-Smith (2017) Financial
Management in Southern Africa, Fifth Edition. Pearson South Africa.
(This is the latest edition of the textbook)

Recommended Readings
• Conradie, W.M. and Fourie, C.M.W. (2018) Basic Financial
Management. Third Edition. Cape Town: Juta and Company Ltd.
• Gitman, L.J and Zutter, C.J (2017) Principles of Managerial Finance.
Thirteenth Edition. Cape Town: Pearson Education.
• Flynn, D., Uliana, E., Wormald, M. and Dillon, J. (2019) Financial
Management. Ninth Edition. Cape Town. Juta and Company (Pty) Ltd.
• Venkataraman, R.R., and Pinto, J.K (2008) Cost and Value Management
in Projects. NJ: Wiley, pp. 344–345.
• Yescombe, E.R. (2014) Principles of Finance. Second Edition: British
Library: Elsevier.
• Marx, J; De Swardt, C; Pretorius, M. (2023) Financial Management in
Southern Africa. Sixth Edition.
• Zutter, C.J. (2021) Principles of Managerial Finance. Sixteenth Edition.
Pearson.
• Venkataraman, R.R. (2023) Cost and Value Management in Projects.
Second Edition.

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6.1. Introduction
Financial planning is an important aspect of the firm’s operations. Gitman, (2017:108) describes financial planning
as a process that involves financial estimates that provide road maps for guiding, coordinating, and controlling the
firm’s actions to achieve its objectives. Successful financial planning begins with the sales forecast. From it,
production plans are developed that consider preparation times and include estimates of the required raw materials
(Gitman, 2017:109). Using the production plans, the firm can estimate direct labour requirements, factory overhead
outlays, and operating expenses. Once these estimates have been made, the firm’s pro forma financial statements
can be prepared. In developing a financial model for project financing, Ehrhardt & Brigham (2016:476) provide the
following as the basic elements that need to be estimated.
• Cost of the Project
• Estimates for sales
• Cost of production
• Sources of Financing
• Profitability Projections
• Operating expenses

Managers should be able to develop an explicit financial plan. Ross et al (2018:91cites the following basic
estimates of the firm’s financial policy:
1. The firm’s forecasted financial statements using the percentage of sales method. An accurate sales
forecast is critical to the firm’s well-being since it forms the basis for forecasting.
2. The firm’s needed investment in new assets: This will arise from the investment opportunities the firm
chooses to undertake, and it is the result of the firm’s capital budgeting decisions.
3. The degree of financial leverage the firm chooses to employ: This will determine the amount of borrowing
the firm will use to finance its investments in real assets. This is the firm’s capital structure policy.
4. The amount of cash the firm thinks is necessary and appropriate to pay shareholders: This is the firm’s
dividend policy.
5. The amount of liquidity and working capital the firm needs on an ongoing basis: This is the firm’s net
working capital decision.

Think Point 6.1

What are the key outputs a financial plan?

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6.2. Pro forma Financial statement

A pro forma financial statement includes forecasted income statements and balance sheets. Ross et al (2018:309)
clearly states that pro forma financial statements are a convenient and easily understood means of summarising
much of the relevant information for a project. The objective of pro forma financial statements is to assist investors
in analysing a company’s prospects, hence they are forward looking. The reliability of pro forma financial statements
in predicting future performance depends on the accuracy of managers’ assumptions in predicting the future.
According to Gitman, (2017:120) there two inputs required for preparing pro forma statements:
1. Financial statements for the preceding year
2. The sales forecast for the coming year.

6.3. Pro-forma Income statement

The purpose of pro forma Income Statement is to project the revenues and expenses of your business over a given
period – usually one year. Other terms for this are budgeted income statements or pro forma income statements.
There are three things that need to be predicted to forecast your income statement: the sales projection, the variable
cost projection, and the overhead projection.

6.3.1 Sales Forecast

The sales forecast is probably the most difficult part of the business to forecast. For established businesses, sales
forecasts generally begin with a review of sales during the past 5 to 10 years (Ehrhardt & Brigham, 2016:478).
Forecasting the future sales growth rate always begins with a look at past growth rate. The sales forecast will reflect
strategies and objectives of the firm. Sometimes, the percentage of sales method provides a starting point for
creating the sales forecast as illustrated in Table 6.1

MANAKE LTD
STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 2019
9Table :6.1 Pro Forma Statement of Comprehensive Income
R
Sales 5 000 000
Cost of Sales 3 500 000
Gross profit 1 500 000
Operating Expenses (700 000)
Profit before Tax 800 000
Income tax (30% pre-tax profit) (240 000)
Profit after tax 560 000

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Video 6.1:
[Link]
From the video, what are the basic assumption for building a pro forma income
statement?

Additional information
1. Sales for the year ended 31 December 2019 are expected to total R5 500 000.
2. Cost of sales and operating expenses are expected to represent the same percentage of sales for the year
ended 31 December 2019 as for the previous financial year.
3. An additional 100 000 shares are expected to be issued on 01 June 2018 at R3.50 each.
4. A final dividend of 50 cents per share is expected to be recommended on 31 December 2020 and the
dividends are payable during 2021.
5. An old vehicle (Cost price R300 000; Accumulated depreciation R200 000) is expected to be sold for R120
000 on 31 December 2020 and a new vehicle costing R400 000 will be purchased on the same date to
replace it. Depreciation for the year ended 31 December 2020 is expected to total R250 000 (and is
included in the operating expenses amount

Required

Prepare a Pro Forma Statement of Comprehensive Income for the year ended 31 December 2020

Solution

MANAKE LTD
PRO FORMA STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER
2020
R
Sales 5 500 000
Cost of sales (70%) (3 850 000)
Gross profit 1 650 000
Profit on disposal of asset (120 000 – 100 000) 20 000
Expenses (14%) (770 000)
Profit before tax 900 000
Income tax (30%) (270 000)
Profit after tax 630 000

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6.4. Percentage of sales method

According to Marx et al. (2017:116) one of the methods of drawing up a pro forma Statement of Comprehensive
Income is the percentage-of sales method. Once sales are forecasted, the various items from the financial
statements are expressed as a percentage of projected sales. The rationale for this approach is the tendency for
variable costs, current assets, and current liabilities to vary directly with sales. Obviously, this will not hold true for
all items in the financial statements, and certainly some independent estimates of individual items will be required.
Correia, Flynn, Uliana & Wormald (2019:684) suggest the following steps should be used when adopting the
Percentage-of-sales method to forecast working capital or external funding.

Step 1
Examine historical data to determine which items varied in proportion to sales in the past. This enables the forecaster
to determine which items can be safely estimated as a percentage of sales and which must be forecast using other
information.

Step 2
A forecast of sales must now be done. Since many items are linked to the sales forecast, it is important to estimate
sales as accurately as possible.

Step 3
The last step is to extrapolate the historical patterns to the newly estimated sales e.g. if inventories have historically
been 15% of sales and next year’s sales are forecast to be R1 000 000, then one would expect inventories to be
R150 000. See the example in table 6.2

Example
Prepare the Statement of Financial Position of Acetex Limited for the year ending 31 December 2020 using the
percentage of sales method.

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10Table 6.2: Pro Forma Statement of Financial Position

R
Assets
Non-Current Assets 222 000
Equipment 222 000

Current Assets 220 000

Inventories 70 000
Accounts receivable 90 000
Cash and cash equivalents 60 000
Total Assets 442 000

EQUITY AND LIABILITIES

Equity 330 000
Ordinary share capital 120 000
Retained earnings 210 000

Current Liabilities 112 000

Accounts Payables 112 000

TOTAL EQUITY AND LIABLITIES 442 000

Additional information
• Sales for 2019 were R500 000 and are forecasted to be R700 000 in 2020
• The percentage of sales is used to determine the following balances:
o Inventories
o Accounts receivable
o Cash and cash equivalents
o Accounts payable
• Profit after tax for 2020 is expected to be R30 000
• A dividend of R8 000 is expected to be paid out by 31 December 2020
• Any shortfall will be funded by short term external funding
• Equipment of R20 000 will be purchased in 2020
• Depreciation for 2020 is expected to be R24 000
• Ordinary share capital will remain unchanged

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Solution
Acetex Limited
Projected Statement of Financial Position as of 31 December 2020

R
Assets
Non-Current Assets 242 000
Equipment (222 000 + 20 000) 242 000

Current Assets 308 000

Inventories 0.14 x 700 000 98 000
Accounts receivable 0.18 x 700 000 126 000
Cash and cash equivalents (0.12 x 700 000) 84 000

Total Assets 550 000

Equity and Liabilities

Equity 352 000
Ordinary share Capital 120 000
Retained Earnings (210 000 + 30 000 – 8 000) 232 000
External Funding Needed** (EFN) 550 000 -508 800) 33 200
Current Liabilities 164 800
Accounts Payable (0.224 x 700 000) 156 800
Dividends payable 8 000

Total Equity and Liabilities 550 000

**Theamount of External Financing Needed (EFN) to ensure that the firm’s statement of financial position
balances. This becomes the balancing figure.

In the above example, management could have financed EFN by pursuing avenues that result to the increase of
equity and liabilities such as
• Paying a smaller dividend
• Issue stock
• Issue debt such as bonds or debentures or bank loans
• Decrease cash balance -- if not needed for operations

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Think Point 6.2

On the liability section of the statement of financial position, what is the rationale behind
accounts payable varying with sales?

6.5. Proforma Statement of Financial Position

According to Ross et al (2018:21) a Statement of Financial Position, also known as the Balance Sheet, presents the
financial position of an entity at a given date. It is comprised of three main components: Assets, liabilities, and equity.
It is a convenient means of organising and summarising what a firm owns (its assets), what a firm owes (its liabilities),
and the difference between the two (the firm’s equity) at a given point in time. A balance sheet can also be referred
to as a Statement of Financial Position. According to the basic accounting equation, the Statement of Financial
Position should balance. It can be deduced that the value of the firm’s assets is equal to the sum of its liabilities and
shareholders’ equity.

Assets = Equity + Liability

This is the balance sheet identity, or accounting equation, and it always holds because shareholders’ equity is
defined as the difference between assets and liabilities.

Knowledge Check6.1
A proforma balance sheet has the following elements
• Current Assets of R560 000
• Accounts payable of R140 000
• Long term debt of 500 000
• Equity is R330 000

The amount of fixed assets that makes the balance sheet to balance is closet to
A. R410 000
B. R970 000
C. R560 000

6.5.1 External Financing Needed (EFN)

After the firm has a sales forecast and an estimate of the required spending on assets, some amount of new
financing will often be necessary because projected total assets will exceed projected total liabilities and equity
(Marx et al 2017:122). EFN is also referred to as the ‘plug’ and is necessary to cover all of the projected capital

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spending to bring the balance sheet to balance. The plug is the designated source or sources. Asset growth requires
additional funds, so the firm may have to raise additional external capital if it has insufficient internal funds of external
financing needed to deal with any shortfall (or surplus) in financing and thereby bringing the balance sheet into
balance. The plug comes from external sources; hence the name EFN. The typical sources of external funds are
bank loans, new long-term bonds, new preferred stock, and newly issued common stock. The mix of the external
funds used should be consistent with the firm’s financial policies, especially its target debt ratio (Ehrhardt & Brigham,
2016:479)

Think Point 6.3

Can EFN be negative? Explain.

Since the Percentage of sales method is based on the that there is a direct relationship between the level of sales
and certain current assets, current liabilities or working capital. The term spontaneous is used to describe such
assets and liabilities. The calculation of the amount of external funds required can be calculated using the following
formula:

𝑆1 − 𝑆0 𝑆1 − 𝑆0
𝐸𝐹𝑁 = 𝐴𝑠 [ ] − 𝐿𝑠 [ ] − 𝑀𝑆1 (1 − 𝑑)
𝑆0 𝑆0

Where

EFN=External financing Needed

𝐴𝑠 = Total spontaneous assets, at 𝑆0
𝐿𝑠 = Total spontaneous liabilities, at 𝑆0
𝑆1 = Expected sales
𝑆0 = Existing sales
M = Net profit margin
d = Retention ratio

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Example 6.1
The following information has been extracted from the financial statements of landmark Manufacturing Company
in 2020.
Rm %
Sales 100 100%
Operating Cash 5 5%
Accounts Receivable 20 20%
Inventory 15 15%
40 40%
Accounts Payable -12 -12%
Accruals -3 -3%
Net working Capital 25 25%

Landmark is expecting sales of R150m in the year 2021 and wishes to forecast the external funding needed to
support the incremental growth in sales. The relationships shown above are expected to remain unchanged.
Required
a) Use the percentage of sales method, determine the EFN to support the growth in sales.
b) Assume that the after-tax net profit margin on sales is 5% and no dividend is declared, determine the
new EFN using the EFN equation.
Solution
By applying the percentage-of-sales method, each component is expected to increase spontaneously by 50%,
Current Forecast Change
Rm Rm Rm
Sales 100 150 50
Operating Cash 5 7.5 2.5
Accounts Receivable 20 30 10
Inventory 15 22.5 7.5
40 60 20
Accounts Payable -12 -18 -6
Accruals -3 -4.5 -1.5
Net working Capital 25 37.5 12.5
Therefore, R12.5 million is the external funding required to support the 50 million growth in sales.

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b)
𝑆1 − 𝑆0 𝑆1 − 𝑆0
𝐸𝐹𝑁 = 𝐴𝑠 [ ] − 𝐿𝑠 [ ] − 𝑀𝑆1 (1 − 𝑑)
𝑆0 𝑆0

150 − 100 150 − 100

𝐸𝐹𝑁 = 40 [ ] − 15 [ ] − 0.05 × 150(1 − 0)
100 100

= [40 × 0.5] − [15 × 0.5] − 7.5

= R5m

Activity 6.1
Gia Development Trades had a project from Service SETA that generated sales of R10m and
expects sales to increase to R15m next year. All assets and liabilities move spontaneously in
proportion to its sales. Gia had assets of R50m, liabilities of R30m and a net profit margin of
30%. The company maintains a retention ratio of 50%. Using the EFN equation, determine the
funding requirements for Gia Development Trades for the coming year

Practical Activity 6.1

Rudo Projects Ltd operates a number of factories in Limpopo Province. Turnover during 2020
totalled R200m. In planning the financing of future growth, Rudo has assumed that assets and
current liabilities will be a constant percentage of sales. This relationship has been evident in
the past. Rudo has an after-tax profit margin of 5% and a dividend payout ratio of 30 cents in
the rand. It is anticipated that turnover will increase by 10% during 2021. The Statement of
Financial Position for 2020 in millions of Rands is as follows

Statement of financial Position as of 30 June 2020

Rm
Plant & Equipment 80
Current Assets 100
Inventory 60
Accounts receivable 30
Cash & Cash Equivalent 10
Total Assets 180
Shareholder equity 70
Long term loan 60
Current Liabilities 50
Accounts Payables 30
Accruals 12
taxation 8
Total Equity & Liabilities 180

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Required
Using the Percentage of Sales method, determine the additional funding required in 2021,
assuming the long-term loan should be the balancing figure.

Case Study: Pick n Pay

During 2017 and 2018, the South African economy experienced low economic growth and Pick
n Pay have reduced its working capital. This had a positive impact on cash flow.

Pick n Pay in 2018 stated the following:

Inventory – Pick n Pay is contemplating to us the percentage of sales method to determine the
amount of funding required to support the growth of sales and inventory. For the past 10 years
there has been a steady increase of inventory. In 2018/2019 financial year inventory has
increased by 4.9% to R6.0 billion, including the impact of 78 net new company-owned stores
over the year and the short-term impact of greater levels of centralisation across the Group.
Removing the impact of new stores and inflation, like-for-like inventory is down 5.0% on last
year. This reflects consistent improvement in the Group’s forecast and replenishment
processes, and solid progress on its plan to reduce its stock holding of slow-moving products
through its range rationalisation programme.

Trade and other receivables – increased 5.5% on last year to R3.6 billion, with 46 net new
franchise stores added over the year, and an increase in the sales to franchisees through the
Group’s supply chain.
Pick n Pay, Intergrated Annual Report 2018, Viewed 01 November 2020,
<[Link]
[Link]>
Required
1. Identify the inventory drivers of Pick n Pay for the past 10 years
2. Discuss the steps Pick n Pay needs to follow when modelling their financial performance
3. Propose the limitations of the percentage of sales method as a means of determining future
funding

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6.6. Summary
• Financial planning as a process that involves financial estimates that provide road maps for guiding,
coordinating, and controlling the firm’s actions to achieve its objectives
• In a building a financial model the following needs to be estimated
o Cost of Project
o Estimates of sales
o cost of production
o Means of Financing
o Profitability Projections
o Operating expenses
• Pro forma financial statements are a convenient and easily understood means of summarising much of
the relevant information for a project.
• The objective of Pro Forma financial statements is to assist investors in analysing a company’s future
prospects, hence they are forward looking
• The purpose of Pro Forma Income Statement is to project the revenues and expenses of your business
over a given period of time – usually one year
• A pro forma income statement can be developed by calculating past percentage relationships between
certain cost and expense items and the firm’s sales and then applying these percentages to forecasts.
• The balance sheet identity, or equation, Assets = Equity + Liability means that assets are financed by
equity and debt
• EFN is the plug that brings the balance sheet in balance. Asset growth requires additional funds, so the
firm may have to raise additional external capital if it has insufficient internal funds.
• Percentage of sales method is simple method of drawing up a Pro Forma Statement of Comprehensive
and Pro forma Statement of Financial Position (balance sheet)

Revision Questions

6.7.1 Briefly explain the phrase financial estimates

6.7.2 Why do firms draw up pro forma financial statements
6.7.3 What are the key inputs of a pro forma income statement
6.7.4 The following information relates to Chanetsa Traders. The financial
year ends on 30 June each year.

Statement of Comprehensive income for the year ended 30 June 2020

Sales 960 000

Cost of sales (480 000)

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Gross Profit 480 000

Operating Incomes 48 000

Rent Income 48 000

Gross Income 528 000

Operating Expenses (365 040)

Salaries and wages 240 000

Repairs 7 200

Telephone 9 840

Stationary 3 840

Bad debts 7 200

Electricity and water 13 440

Insurance 16 800

Bank Charges 13 200

Depreciation 53 520

Operating profit before interest 162 960

Interest on fixed deposit 5 280

Interest on Loan (36 000)

Net Profit for the year 132 240

Additional information

1 The average monthly sales are expected to: a

o decrease by 5% in July 2020
o increase by R16 000 in August 2020
o increase by R24 000 in September 2020.
2 The rental is to be increased by 12% on 01 July 2020. The building has
been sub-let to a tenant since 01 January 2020.
3 The existing gross percentage on sales (gross margin ratio) is
maintained.

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4 The investment in fixed deposit was made on 01 November 2019 and

matures/expires on 31 October 2020
5 The loan was taken on 01 July 2019. The first loan repayment of R40
000 will be made on 01 July 2020. Interest is calculated at a fixed rate of
15% per annum.
6 The employees are entitled to an 8% increase in wages and salaries with
effect from 01 July 2020
7 No increases are expected for stationery and bad debts in the next 12
months.
8 Depreciation for the year ended 30 June 2021 is expected to be
R48 000.
9 All other expenses are expected to increase by 2% each month.
Required
Prepare a Pro forma Statement of Comprehensive Income for Chanetsa
Traders for the period 01 July 2020 to 30 September 2020.

6.7.5 The following information relates of AKM Limited. The financial year
ends on 31 December 2019.
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 2019
R
Assets
Non-Current Assets 600 000
Property, Plant and Equipment 1200 000
Accumulated Depreciation (660 000)
Financial Assets Investments 60 000

Current Assets 4 600 000

Inventories 280 000
Accounts receivable 1 080 000
Cash and cash equivalents 720 000

Total Assets 5 200 000

EQUITY AND LIABILITIES

Equity 1 640 000

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Ordinary share capital 940 000

Retained earnings 700 000
Non-Current Liabilities 360 000
Mortgage Bond 360 000
Current Liabilities 3 200 000
Accounts Payables 900 000
2 300 000

TOTAL EQUITY AND LIABLITIES 5 200 000

Additional information:

Operations for 2020 were projected using the following working assumptions:

• All sales are on credit and are expected to amount to R4 000 000
• The profit margin (net profit margin) is expected to be 10%.
• Equipment costing R200 000 is due to be purchased during June
2019.
• Depreciation is expected total R150 000 for the year.
• 10 000 shares at R10 each are expected to be purchased in Kodak
Limited.
• Inventories are expected to be 10% higher than in 2019.
• Accounts receivable are expected to amount to 20% of credit sales.
• A cash balance of R700 000 is desired.
• Dividends for the year are estimated at R260 000 and these will be
paid during 2020.
• Mortgage loan repayments amounting to R60 000 (excluding
interest) are expected to be made during 2020.
• Accounts payable are forecasted to be 5% of sales.
• The ordinary share capital balance is expected to remain
unchanged.
• Other current liabilities will remain the same during 2020
Required
Prepare the Pro Forma Statement of Financial Position as of 31 December

2020 from the information given below.

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Answers to Activities
Think Point 6.1
Key outputs include a number of operating budgets, the cash budget, and pro forma financial statements
Video 6.1
Basic Assumptions
▪ Sales growth rate
▪ Relationships of income statement elements to sales
▪ Interest is based on debt balance and interest rates
▪ Taxes are based on tax rates and taxable amount

Think Point 6.2

Yes EFN can be negative and it means that there is excess financing, and this can be reduced by:
• Paying a larger dividend (reduce equity and liabilities)
• Repurchase stock (reduce equity and liabilities)
• Pay down debt (reduce equity and liabilities)
• Increase cash balance (increase assets)
• Buy more fixed assets and/or increase sales

Knowledge Check 6.1

Option A is the correct answer, calculated as follows
Assets = Equity + Liability

Fixed assets +R 560 000 = R330 000 + R140 000 + R500 000

Fixed assets =R970 000 -R560 000

=R410 000

Think Point 6.3 The reason is that we expect to place more orders with our suppliers as sales volume
increases, so payables will change “spontaneously
Activity 6.1

15 − 10 15 − 10
𝐸𝐹𝑁 = 50 [ ] − 30 [ ] − 0.3(15)(1 − 0.5)
10 10
= 25 − 15 − 2.25

= R7.75m

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Practical Activity 6.1

Sales 200 220

Proforma Statement of financial Position Current Forecast Change
2020 % sales 2021 Rm
Plant & Equipment 80 40% 88 8
Current Assets 100 110 10
Inventory 60 30% 66 6
Accounts Receivable 30 15% 33 3
Cash & Cash Equivalent 10 5% 11 1
Total Assets 180 198 18

Shareholder equity 70 77.7 7.7

Long term loan 60 65.3
Current Liabilities 50 55 5
Accounts Payables 30 15% 33 3
Accruals 12 6% 13.2 1.2
taxation 8 4% 8.8 0.8
Total Equity & Liabilities 180 198 12.7
EFN 5.3
Workings
Sales 10% 200 1+growth 220
Earnings after tax 5% 10 11
Dividends 30% -3 -3.3
Retained Earnings 7 7.7

Therefore, the additional funding required in 2021 is R5 300 000.

Case study: Pick n Pay

1) Drivers of inventory are attributed to the provisioning of new stores and inflation in the country.
2) Refer to paragraph 6.4
3) Limitation of Percentage of Sales Method
• Current liabilities may not increase spontaneously in proportion to sales
• Some current liabilities may increase differently to others
• The effect of inflation is usually not taken into account
• The anticipated increase in sales may differ from fixed asset requirements
• Current assets may not increase in proportion to sales

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Unit
7: Break Even Analysis

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Unit Learning Outcomes

CONTENT LIST LEARNING OUTCOMES OF THIS UNIT:

7.1. Introduction • Understand what is meant by break even analysis

7.2. Importance of Break-Even Analysis • Identify the importance of Break-Even Analysis

7.3. Marginal Income Statement • Understand the concept of marginal income and an example
thereof.

7.4. Break even quantity • Calculate the break-even point

7.5. Break even sales • Calculate the break- even value using the marginal income
ratio method.

7.6. Marginal Income Statement • Prepare a marginal income statement that will provide the
necessary information required for Break-even analysis

7.7. Sales and target profit • Calculate the sales required to attain a targeted net profit

7.8. Margin of safety • Calculate the margin of safety

7.9. Limiting Assumptions of Break-Even • List the limiting assumptions of Break-even analysis
Analysis

7.10. Summary • Summarises topic areas covered in the unit

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Prescribed and Recommended Textbooks/Readings

Prescribed Reading/Textbook
• Marx, J, C Swardt, M Pretorius, W Rosslyn-Smith (2017) Financial
Management in Southern Africa, Fifth Edition. Pearson South Africa.
(This is the latest edition of the textbook)

Recommended Readings
• Conradie, W.M. and Fourie, C.M.W. (2018) Basic Financial
Management. Third Edition. Cape Town: Juta and Company Ltd.
• Gitman, L.J and Zutter, C.J (2017) Principles of Managerial Finance.
Thirteenth Edition. Cape Town: Pearson Education.
• Flynn, D., Uliana, E., Wormald, M. and Dillon, J. (2019) Financial
Management. Ninth Edition. Cape Town. Juta and Company (Pty) Ltd.
• Venkataraman, R.R., and Pinto, J.K (2008) Cost and Value Management
in Projects. NJ: Wiley, pp. 344–345.
• Yescombe, E.R. (2014) Principles of Finance. Second Edition: British
Library: Elsevier.
• Marx, J; De Swardt, C; Pretorius, M. (2023) Financial Management in
Southern Africa. Sixth Edition.
• Zutter, C.J. (2021) Principles of Managerial Finance. Sixteenth Edition.
Pearson.
• Venkataraman, R.R. (2023) Cost and Value Management in Projects.
Second Edition.

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7.1. Introduction
As a project manager, you need to ascertain the impact on a project if the sales decline or costs increase. According
to Drury, (2018:112) managers are usually interested in knowing how much should be produced and sold at a
minimum to ensure that the project does not lose funds. This requires conducting a break-even analysis. The
minimum quantity that must be produced and sold to avoid a loss is called break-even point. The break-even point
represents the level of operations at which the revenues of an entity are equal to its total costs. In other words, the
entity has neither a profit nor a loss from operations. Expressed in other terms it is the point at which operating profit
is equal to zero. There are various ways of calculating the break-even point. For this module we will use the
contribution margin model and marginal income ratio to determine the break-even point. The break-even point can
be calculated in terms of units and revenues (Rand value).

7.2. Importance of Break-Even Analysis

According to Burke (2016:71) break-even analysis allows the project manager to determine how profit varies with
changes in sales volumes and costs. It puts management in a better position to cope with various short-term
planning decisions. Break-even analysis can be used by project managers to show the effect on the cost structure
of the project by looking at the amount of funds allocated to the project under different scenarios if sufficient to cover
costs of operation. If the activity is operated below this level, the project will incur losses.

Burke (2006: 72) adds that the break-even analysis may be used to aid decision-making where two mutually
exclusive projects have different cost structures. Consider a project to install a heating system for an office block.
Project A has high installation costs and low maintenance costs. Project B has a low installation cost, but
maintenance costs are high. A break-even analysis will show which system is more cost effective for a specific
period of time.

Knowledge Check 7.1

The level of activity at which funds allocated to the project are just sufficient to cover
costs of operation is referred to as:
A. Balance Sheet
B. Break Even point
C. Profitability

7.3. Marginal Income Statement

According to Drury, (2018:189) break-even analysis is based on the marginal income approach. Marginal Income
approach is an income statement in which all variable expenses are deducted from sales to arrive at margin income
or contribution margin, from which all fixed expenses are then subtracted to arrive at the net profit or net loss for the
period. The traditional Statement of Comprehensive Income that we use in financial accounting does not distinguish

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between fixed costs and variable costs. The marginal approach to drawing up a Statement of Comprehensive
Income is one where fixed and variable costs are available and is most suitable for break-even analysis. Using this
approach all expenses are classified as fixed or variable.

The following is an example of a traditional Statement of Comprehensive Income and a Marginal Statement of
Comprehensive Income Table 7.1 Traditional Statement of Comprehensive Income Format
Traditional Statement of Comprehensive Income R
Sales (XXXX)
Cost of sales (XXX)
Gross profit (XXX)
Operating expenses: (XXX)
Marketing costs XXX
Administration costs XXX
Net profit XXX

11Table 7.2 Marginal Statement of comprehensive Income Format

Marginal Statement of Comprehensive Income R

Sales XXXX

Variable costs: (XXX)

Production XXX

Marketing XXX

Administration XXX

Marginal income XXX

Fixed expenses: (XXX)

Production XXX

Marketing XXX

Administration XXX

Net profit XXX

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Consider the following example in illustrating the break-even analysis.

Example 7.1
The following is a budgeted marginal Statement of Comprehensive Income for Thulani Ltd for project Z.
Marginal Statement of Comprehensive Income for July 2020 R
Sales (40 000 units X R40 per unit) 1 600 000
Variable costs (40 000 units X R30 per unit) (1 200 000)
Marginal income (R10 per unit) 400 000
Fixed costs (200 000)
Net profit/loss 200 000

• Marginal income
Marginal income is the excess of sales over the variable costs (Niemand et al., 2004: 390). It refers to the amount
of money available to cover fixed costs. If the fixed costs are greater than marginal income, then a loss will result.
The following formulae are used to calculate marginal income and Net profit
• Marginal Income = Sales − Variable Cost
• Net Profit = Marginal Income − Fixed cost

Example 7.2
The Statement of Comprehensive Income for project Z can also be presented as follows:
Marginal Statement of Comprehensive Income for July 2020 R
Sales (1 unit X R40) 40
Variable costs (1 unit X R30 per unit) (30)
Marginal income (R10 per unit) 10
Fixed costs (20)
Net profit/loss (10)

Activity 7.1
The following data is for Cellular Connection (Pty) Ltd for June 2020

Selling price R20

Variable Cost 25% of the selling price
Fixed cost R15 000
Expected sales 2 000 units

Required
Draw up Cellular Connection’s Marginal Statement of Comprehensive Income for
June 2020

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7.4. Break Even Quantity (BEQ)

Breakeven quantity is the number of incremental units that the project needs to sell to cover the cost or investment
of the project. If the company does not sell the equivalent of the BEQ as a result of the investment, then it is losing
money thus it will not recoup its costs. If the company sells more than the BEQ then it has not only made its money
back but is making additional profit as well.

• Calculation of break-even point (using the marginal income method)

The volume of sales at which marginal income is equal to fixed costs is referred to as the break-even point, t this is
also referred to as the point of no profit and no loss. The break-even quantity is the minimum quantity that must be
sold to ensure that the fixed costs of the project are covered.

Break-even quantity can be calculated using the marginal income method as follows:

Total fixed costs

Break even quantity =
Marginal income per unit

Example 7.4

Using the figures from example 2, break-even quantity may be calculated as follows:

Total fixed costs

Break even quantity =
Marginal income per unit

R200 000
=
R10

= 𝟐𝟎 𝟎𝟎𝟎 𝐮𝐧𝐢𝐭𝐬

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Video 7.1 Break-Even Analysis

[Link]
Write down the formulas that are used to calculate total contribution and contribution per unit.

7.5. Break even sales

The break-even value (i.e. break-even point in Rands) is calculated as follows:

Break even value = Break-even quantity X Selling price per unit

Example 7.5
Using the figures from example 3, break-even value may be calculated as follows:

Break even value = Break-even quantity X Selling price per unit

= 20 000 X R40

= R800 000

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Both Break even sales and quantity may be represented graphically as shown on Fig 7.1 below.

Sales

Total Cost

Break Even Point

Variable Cost
Rands

Fixed Cost

Volume

5Figure 7.1: Break Even Point, Drury, 2018:753

The area between total fixed cost and total cost represents the variable cost. No profit or loss will be made at the
breakeven point as only total costs are covered. The firm will earn a profit above the breakeven point and will suffer
a loss if sales are below the breakeven point.

Activity 7.1
A firm manufactures one product. The price of the product is R19 000 per unit (fixed).
For the year 2015 the firm functioned at full capacity and 1 000 units were
manufactured. The firm’s total fixed costs amounted to R10 000 000 and the total
variable cost amounted to R14 000 000. Calculate the breakeven point in units and rand
value

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7.6. Marginal Income Statement

To reach break-even point during July 2020 Thulani Ltd needs to sell 20 000 units from project Z. This can be proven
as follows:
Example 7.6
Marginal Statement of Comprehensive Income for July 2020 R
Sales (20 000 units X R40 per unit) 800 000
Variable costs (20 000 units X R30 per unit) (600 000)
Marginal income (R10 per unit) 200 000
Fixed costs (200 000)
Net profit/loss 0

Practical Activity 7.1

FPT Enterprises sales for March 2020 was R200 000. Operating profit was R20 000.
Variable costs are usually 60% of sales. Suppose sales dropped by 15% in April to
R170 000. Would it be correct to say that operating profit will decline by 15% to R17
000? Motivate your answer.

• Calculating break-even value using the marginal income ratio

Variable costs and marginal income may be expressed as a percentage of sales. The marginal income ratio
indicates the amount by which each additional rand of sales will contribute toward profit. For instance, a marginal
income ratio of 50% indicates that for every additional R1 of sales, 50 cents will be contributed toward profit, once
the break-even point has been exceeded.
Using the figures from example 7.6 (Thulani Ltd), this can be illustrated as follows:
Total (R) Per unit (R) %
Sales (40 000 units) R1 600 000 40 100
Variable cost (R1 200 000) 30 75
Marginal income 400 000 10 25

Marginal income ratio is the percentage of marginal income to sales.

Marginal income ratio may be expressed as follows:

Marginal Income per unit

Marginal Income ratio = × 100
Selling Price per unit

Fixed Cost
Break even sales =
Marginal income ratio

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Example 7.7
The marginal income ratio for Thulani Ltd is:

Marginal income per unit 100

Marginal income ratio = ×
Selling Price per unit 1

R10 100
= ×
R40 1

= 25%

Fixed Cost
Break even sales =
Marginal income ratio
R1 200 000
=
25%

= R4 800 000

In order to break even, Thulani Ltd must sale R4 800 000 worth of stock.

7.7. Sales and target profit

Cost-profit-volume analysis may be used to determine the sales required to attain a targeted net profit.
This can be done in one of two ways. The first is as follows:

Fixed cost + Target profit

Target sales volume =
Marginal income per unit

Target sales value = Target sales volume × Selling per unit

Example 7.8
If Thulani Ltd targets a net profit of R40 000 from the sale of component Z, the sales required will be as follows:

Fixed cost + Target profit

Target sales volume =
Marginal income per unit

R200 000 + R40 000

=
R10

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= 𝟐𝟒 𝟎𝟎𝟎 𝐮𝐧𝐢𝐭𝐬

Therefore, Thulani Ltd requires to sell 24 000 units of component Z to achieve a target level of profit of R40 000

Target sales value = Target sales volume × Selling per unit

= 24 000 units x R40

= R960 000

The second way of calculating the required sales for a targeted net profit is as follows:

Fixed cost + Target profit

Target sales value =
Marginal income ratio

Example 7.9

The sales required by Salsa Ltd to realise a profit of R40 000 is:

Fixed cost + Target profit

Target sales value =
Marginal income ratio

R200 000 + R40 000

=
25%

R200 000 + R40 000

=
0,25

= R960 000

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7.8. Margin of Safety

Cloete et al. (2014:59) state that the margin of safety gives an indication of how close an entity is operating to the
break-even point. It shows by how much sales can decrease before the break-even point is reached or before losses
are incurred. If the margin of safety is low, even a small decrease in sales revenue may result in an operating loss.
The margin of safety may be expressed in value, units or as a percentage:

Margin of safety = Budgeted sales units – Break-even sales units

(in terms of units)

Margin of safety = Budgeted sales value– Break-even sales value

(in terms of value)

Budgeted sales – Break−even sales 100

Margin of safety = ×
Budgeted sales 1
(as a percentage)

Example 7.10
If sales are R125 000 (10 000 units), the unit selling price is R12,50, and the sales at break-even point are R100
000 (8 000 units), the margin of safety is calculated as follows:
Margin of safety = Budgeted sales units – Break-even sales units

(in terms of units) = 10 000 – 8 000

= 2 000 units

This means that present sales may decrease by 2 000 units before an operating loss result.

Margin of safety = Budgeted sales – Break-even sales

(in terms of value) = R125 000 – R100 000

= R25 000

This means that present sales may decrease by R25 000 before an operating loss result.

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Budgeted sales – Break−even sales 100

Margin of safety = ×
Budgeted sales 1

R125 000 – R100 000 100

(as a percentage = ×
R125 000 1

= 20%

OR

Budgeted sales – Break−even sales 100

Margin of safety = ×
Budgeted sales 1

10 000 – 8 000 100

(as a percentage = ×
10 000 1

= 20%

This means that present sales may decrease by 20% before an operating loss result.

Think Point 7.1

Why is that that if volume decrease by more than the margin of safety, the business
will incur losses?

Practical Activity 7.2

Ford Motor company purchased a new piece of machinery to expand the production
output of its top-of-the-line car model. The machine’s costs will increase the operating
expenses to R1 000 000 per year, and the sales output will likewise augment. The
company had R3 015 000 as fixed costs. After the machine was purchased, the
company achieved a sales revenue of R4 200 000. Determine the company’s margin
of safety in percentage and comment.

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7.9. Limiting Assumptions of Break-Even Analysis

Cloete et al. (2014:83) identify the following assumptions associated with CVP analysis that need to be taken
into consideration, since they affect the reliability for planning and decision-making:
▪ The price of the product will remain unchanged as the level of activity changes, within the relevant
range.
▪ Within the relevant range, costs are linear and can be accurately separated into fixed or variable costs.
▪ All variable costs will vary with only either production level or sales level.
▪ In entities that sell various products, the sales mix is constant.
▪ There are no inventories i.e. the number of units produced equals the number of units sold.

7.10. Summary
Each project involves costs for maintaining and operating the project, and so the cost implications of a project must
be assessed well before the project's approval. One of the important dimensions of new project evaluation should
be to determine the operating level of activities which justify the costs incurred. This can be done by performing a
break-even analysis.

Revision Questions

Complete the following sentences with the most appropriate answers.

i. The difference between sales and variable costs is called ____________.

ii. Break-even point is reached when ____________ is equal to ____________.

iii. The ____________is the amount by which the actual level of sales exceeds the
break-even point.

iv. The break-even quantity will ____________ if there is an increase in fixed costs.

v. One of the key assumptions underlying break-even analysis is that costs are
classified as either ____________ or ____________.

7.11.1 Thulani Ltd plans to manufacture a new product and the following information is
applicable:

Estimated sales for the year 20.20 7 000 units at R40 each
Estimated costs for the year 20.20

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Direct material R12 per unit

Direct labour R2 per unit
Factory overheads (all fixed) R24 000 per annum
Selling costs 30% of sales
Administrative costs (all fixed) R32 000 per annum

Required
[Link] Calculate the break-even quantity.
[Link] Calculate the break-even value.
[Link] Calculate the break-even value using the marginal income ratio.
[Link] Calculate the selling price per unit if the profit per unit is R2.
7.11.2. AIM Ltd supplies component J to furniture manufacturers. The marketing
manager is of the opinion that if the selling price of component J is reduced,
sales could increase by 25%. The following information is available:

Present Proposed
Selling price per unit R6 R5
Sales volume 100 000 units 25% more
Variable costs R400 000 Same unit variable cost
Fixed costs R140 000 R140 000
Net profit R60 000 ?

Required
[Link] Calculate the expected total marginal income and profit or loss on the marketing
manager’s proposal.
[Link] Calculate the number of sales units required under the proposed price to make a
profit of R60 000.
[Link] Calculate the sales value required under the proposed price to make a net profit of
R60 000.
7.11.3. Yusoff CC manufactures one product. The following details relating to the product
applies:

Direct materials cost per unit R20

Direct labour cost per unit R30
Variable overheads per unit R22
Total fixed costs R36 000
Selling price per unit R82

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Number of units sold 6 000

Required
[Link] Calculate the marginal income ratio.
[Link] Calculate the break-even quantity and break-even value.
[Link] Calculate the margin of safety, expressed as:
[Link].1 Value
[Link].2 Units

7.11.4 Read the following extract and answer the questions that follow.
Nordics Enterprises operate in the leisure and entertainment industry and one of its
activities is to promote concerts at locations throughout Europe. The company is
examining the viability of a concert in Stockholm. Estimated fixed costs are R60 000.
These include the fees paid to performers, the hire of the venue and advertising
costs. Variable costs consist of the cost of a pre-packed buffet which will be provided
by a firm of caterers at a price, which is currently being negotiated, but it is likely to
be in the region of R10 per ticket sold. The proposed price for the sale of a ticket is
R20.

The management of Nordic have requested the following information:

[Link] The number of tickets that must be sold to break-even.
[Link] How many tickets must be sold to earn R30 000 target profit.
[Link] What profit would result if 8 000 tickets were sold
[Link] Selling price to be charged to give a profit of R30 000 on sales of 8 000 tickets,
fixed costs of R60 000 and variable costs of R10 per ticket
[Link] Based on the original scenario, how many additional tickets must be sold to cover
the extra cost of television advertising of R8 000

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Answers to Activities

Knowledge Check 7.1

Option B is the correct answer.
Because project managers can identify the break-even level, which is that level of activity at which funds allocated
to the project are just sufficient to cover costs of operation. If the activity is operated below this level, the project
will incur losses.

Activity 7.1
Cellular Connection
Marginal Statement of Comprehensive Income for June 2020 R
Sales (2000 units X R20) 40 000
Variable costs (2000 units X 5 per unit) (10 000)
Marginal income (R15 per unit) 30 000
Fixed costs (15 000)
Net profit 15 000

Practical Activity 7.1

Statement of Comprehensive Income
May 2020 April 2020
Sales 200 000 Sales 170 000
Variable Cost (60%) (120 000) Variable Cost (60%) (102 000)
Contribution Margin 80 000 Contribution Margin 68 000
Fixed Cost (60 000) Fixed Cost (60 000)
Operating Profit 20 000 Operating Profit 8 000

The answer is no. From the calculations above it is clear that operating profit will drop by R12 000 to R8 000 (and
not drop to R17 000). Since fixed costs remained unchanged, the R12 000 decrease in contribution margin (resulting
from the 15% decrease in sales) reduced the operating profit by the same amount. This illustrates the point that
fixed costs behave differently from variable costs.

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Activity 7.2
Total fixed costs
Break even 142uantity =
Marginal income per unit
R10 000 000
=
R19 000 − 14 000
R10 000 000
=
R5 000
2000 units
Break even rand value = Break even quantinty × selling price
= 2000 × 19 000
= 38 000 000

Think Points 7.1

The margin of safety determines the level by which sales can drop before a business incur losses. In other words,
the margin of safety is the cushion by which actual or budgeted sales may be decreased without resulting in any
loss. So, if the volume decrease is greater than the Margin of safety, it means that the business is operating below
the break-even point thus incurring losses.

Practical Activity 7.2

Budgeted sales – Break−even sales 100
Margin of Safety (%) = ×
Budgeted sales 1
Marginal income per unit 100
Marginal income ratio = = ×
Selling Price per unit 1
4 200 000 − 1000 000
= × 100
4 200 000
= 76.19%
Fixed Cost
Break even sales =
Marginal income ratio
𝑅3 015 000
=
76.19%

= R3 957 212

4 200 000 − R3 957 212

Margin of Safety = × 100
R4 200 000

242 788
= × 100
4 200 000

= 𝟓. 𝟕𝟖%

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This means that present sales may decrease by 5.78% before an operating loss result
Video 7.1 Total contribution =Total revenue -Total variable cost
Contribution Margin = Selling price per unit – Variable cost per unit.

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Unit
8: Project Cost Management
Components and Planning Tasks

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Unit Learning Outcomes

CONTENT LIST LEARNING OUTCOMES OF THIS UNIT:

8.1. Introduction • Definition of project cost management, this should ensure that it
also covers the benefits associated with managing costs in a
project environment.

8.2. Period versus product cost • Distinguish between product cost and service costs

8.3. Variable and Fixed cost • Understand the difference between variable and fixed costs

8.4. Direct and Indirect cost • Understand the difference between direct and Indirect cost

8.5. Recurring and Non-Recurring • Understand the difference between recurring and non-recurring
costs costs

8.6. Overhead cost • Understand overhead cost and its application to manufacturing
projects

8.7. Establishing a Budget • Understand the establishment of budgets and the various
inputs, tools, techniques, and Outputs of a project budget

8.8. Advantages and Disadvantages of • Explain the advantages and disadvantages of using budgets
Budgets

8.9. Summary • Summarises topic areas covered in the unit

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Prescribed and Recommended Textbooks/Readings

Prescribed Reading/Textbook
• Marx, J, C Swardt, M Pretorius, W Rosslyn-Smith (2017) Financial
Management in Southern Africa, Fifth Edition. Pearson South Africa.
(This is the latest edition of the textbook)

Recommended Readings
• Conradie, W.M. and Fourie, C.M.W. (2018) Basic Financial
Management. Third Edition. Cape Town: Juta and Company Ltd.
• Gitman, L.J and Zutter, C.J (2017) Principles of Managerial Finance.
Thirteenth Edition. Cape Town: Pearson Education.
• Flynn, D., Uliana, E., Wormald, M. and Dillon, J. (2019) Financial
Management. Ninth Edition. Cape Town. Juta and Company (Pty) Ltd.
• Venkataraman, R.R., and Pinto, J.K (2008) Cost and Value Management
in Projects. NJ: Wiley, pp. 344–345.
• Yescombe, E.R. (2014) Principles of Finance. Second Edition: British
Library: Elsevier.
• Marx, J; De Swardt, C; Pretorius, M. (2023) Financial Management in
Southern Africa. Sixth Edition.
• Zutter, C.J. (2021) Principles of Managerial Finance. Sixteenth Edition.
Pearson.
• Venkataraman, R.R. (2023) Cost and Value Management in Projects.
Second Edition.

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8.1. Introduction
PMBOK®, (2017:155) defined Project Cost Management (PCM) as the processes of estimating, budgeting,
financing, managing, and controlling costs so the project can be completed within the approved budget. Cost
management allows a business to predict coming expenses in order to reduce the chances of it going over budget.
Projected costs are calculated during the planning phase of a project and must be approved before work begins. As
the project plan is executed, expenses are documented and tracked so things stay within the cost management
plan. Once the project is completed, predicted costs vs. actual costs are compared, providing benchmarks for future
cost management plans and project budgets.

Project cost management involves three processes (PMBOK®, 2013:157):

• Cost estimating – developing an approximate schedule of the costs for the resources needed to complete
project activities.
• Cost budgeting – aggregating the estimated costs of individual activities or work packages to establish a
cost baseline for measuring performance.
• Cost control – influencing the factors that create cost variances and controlling changes to the project
budge

Estimate Determine Control

Cost Budget Cost

Figure 8.1 Project Cost Flow, PMBOK®, 2013:157

The first two processes form part of the planning category (preceding implementation), and the third into the
monitoring category, which unfolds with implementation. According to Venkataraman and Pinto, (2008:51) project
costs estimations are important for the following reasons:
• They provide a standard against which actual expenditures incurred during a project can be compared
and serve as the basis for cost control.
• They are the chief means for assessing project feasibility. A comparison of the cost estimates with the
estimates of revenues will enable the project organisation to determine if the project is worthwhile to
undertake.
• Along with project returns, they facilitate decisions relating to project financing and funding.
• They provide the mechanism for managing cash flows during the project.
• They give the project manager a framework for allocating scarce resources as the project progresses.
• They provide the mechanism for revising project activity duration.

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Research has shown that even in relatively routine projects initial cost estimates are often completely off target from
the outcome.

Think Point 8.1

What could be the reasons leading to project overruns or cost estimates rendered off
target.

8.2. Period versus product costs

The key difference between product costs and period costs is that product costs are only incurred if products are
acquired or produced, and period costs are associated with the passage of time. Thus, a business that has no
production or inventory purchasing activities will incur no product costs but will still incur period costs. (Noreen,
Brewer and Garrison, 2019:39).

Noreen et al, (2019:40) indicated that product costs are initially recorded within the inventory asset, and for such
reason they are sometimes referred to as inventoriable costs. Once the related goods are sold, these capitalised
costs are charged to expense. This accounting is used to match the revenue from a product sale with the associated
cost of goods sold, so that the entire effect of a sale transaction appears within one reporting period’s income
statement. The examples of product costs are direct materials, direct labour, and allocated factory overhead whilst
of period costs are general and administrative expenses, such as rent, office depreciation, office supplies, and
utilities.

Period costs are sometimes broken out into additional subcategories for selling activities and administrative
activities. Administrative activities are the purest form of period costs, since they must be incurred on an ongoing
basis, irrespective of the sales level of a business. Selling costs can vary somewhat with product sales levels,
especially if sales commissions are a large part of this expenditure whereas product costs are sometimes broken
out into the variable and fixed subcategories. This additional information is needed when calculating the break-even
sales level of a business. It is also useful for determining the minimum price at which a product can be sold while
still generating a profit (Noreen et al, 2019:40)

8.3. Variable and Fixed cost

Variable costs are costs that change in proportion to changes in the volume of activity e.g. raw material cost to
produce a product has a variable cost behaviour pattern because an increase in the number of units produced will
increase the total raw materials cost. Fixed costs are costs that remain the same in total Rand amount as the level
of activity varies. Fixed costs usually relate to facilities that provide capacity for the firm to carry out its activities,
such as the cost of providing building, machinery, equipment and vehicles. Fixed costs are quantified for a specified
level of activity.

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According to Marshall et al. (2017:427), examples of variable and fixed costs include:
12Table 8.1 Variable versus Fixed Costs
Variable costs Fixed costs
Direct materials Advertising
Direct labour Supervisor’s salary
Shipping costs Property taxes
Sales commission Sales manager’s salary
Warranty costs Factory rent

Think Point 8.2

In classifying project cost, some costs are regarded as expedited costs or crash costs.
Explain what are expedited cost and give one example.

8.4. Direct and Indirect cost

8.4.1 Direct Cost
According to Noreen, Brewer and Garrison (2019:46) direct costs can be specifically and exclusively identified with
a particular cost object. Direct expenses are entailed by operations carried out to produce a particular output in
which the project specialises. For example, a hardware development project, direct costs will include raw materials
for shaping finished goods (e.g., steel, plastic, etc.), direct labour (i.e., human resources and hours necessary to
manufacture the product), and production equipment. They can also be specifically identified with an activity or
project. The trend is to assign as much costs as possible to direct costs since direct costs can be budgeted,
monitored, and controlled more effectively than indirect costs.

Direct costs for a project may include the following:

13Table 8.2 Project management costs

Direct management costs Project office running costs. Includes salaries for the project manager, project
engineer, planner, accountant, secretary and QA.

Direct labour costs The costs of personnel who are directly involved in the project, or the costs of
materials directly used for project work. People working on an activity e.g.
boilermakers, welders, fitters, computer programmers, etc.

Direct material costs Materials, consumables, components which are used for completing an activity and
an allowance for scrap and wastage.

Direct equipment costs Refers to machinery, plant, and tools.

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Direct expenses Include bought-in services that are specific to the project e.g. plant hire, surveyor,
designer, and subcontractor fees.

8.4.2 Indirect costs

These are costs that cannot be directly assigned to an activity or project but are needed to keep the company
operational. Tracking and allocating indirect costs to specific projects is considerably more difficult than allocating
direct costs (Venkataraman and Pinto, 2018:57). For example, a hardware project, indirect costs include renting a
facility, paying wages to administrative employees, use technology for communication between various business
units, and travel to different cities to sign contracts with suppliers.

14Table 8.2 Indirect Cost

Indirect Refer to senior managers, the estimating department, sales and marketing, accounts, IT,
management costs general office staff, secretarial, administration, and the personnel department.

Indirect labour Refer to reception, maintenance, security, and cleaners.

costs

Indirect materials Include stationery, cleaning materials, and maintenance parts.

Indirect equipment Includes computers, photocopiers, and fax machines.

Indirect expenses Include training, insurance, depreciation, rent, and taxes.

8.5. Recurring and Non-Recurring costs

Recurring costs refer to any expense that is known, anticipated, and occurs at regular intervals. Nonrecurring costs
are one-of-a-kind expenses that occur at irregular intervals and thus are sometimes difficult to plan for or anticipate
from a budgeting perspective (Rad, 2012:124)

The examples of recurring costs include those for resurfacing a highway. Annual expenses for maintenance and
operation are also recurring expenses. Recurring costs, such as labour and materials, are repeatedly incurred
throughout the project life cycle. The examples of nonrecurring costs include the cost of installing a new machine
(including any facility modifications required), the cost of augmenting equipment based on older technology to
restore its usefulness, emergency maintenance expenses, and the disposal or close-down costs associated with
ending operations. They are typically incurred at the beginning or at the end of the project, such as market research
and labour training (Rad, 2012:124)
.

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8.6. Overhead cost

Overhead costs are ongoing business expenses that support your business but do not generate revenue. Overhead
expenses are indirect costs, meaning they are not related to specific business activities that generate money (Drury,
2018:262). The costs can vary depending on your industry and whether you are an online or brick-and-mortar
business. There are three types of overhead costs: fixed, variable, and semi-variable.

8.6.1 Fixed overhead costs

Fixed overhead costs are the same amount every month. These overhead costs do not fluctuate with business
activity. These costs are more time-dependent than volume- or revenue-dependent. The office rental for the
company costs R400 000 per year. If the company accomplishes either R1 million in volume or R500 million in
volume the office rent is the same, it is fixed. These fixed costs may increase though when volume has increased
so substantially that an addition is necessary. This may be the case with added office space or an additional
company officer or accountant. It is difficult for a contractor to reduce its fixed overhead in an effort to increase its
profit margin (Holm, 2019:72)

Knowledge Check 8.1

Which of the following statements is most likely to be incorrect?
A. Indirect costs are those costs that are directly attributable to the project, such as
salaries, travel, and buying or renting equipment for the explicit use of the project.
B. Indirect costs include portions of the salary of supervisory personnel.
C. Overhead cost items include the cost of preparing unsuccessful proposals, general
marketing and public relations, and ongoing innovative ventures of the organisation

8.6.2 Variable overhead costs

According to Holm, (2019:72) variable overhead costs are affected by business activity. When you have increased
business activity, these overhead costs will likely increase, too. And, when you have decreased business activity,
variable overhead expenses decrease and are sometimes eliminated. Variable overhead costs include shipping,
legal expenses, materials, office supplies, equipment maintenance, advertising, and consulting services.

8.6.3 Semi-variable overhead costs

Semi-variable overhead costs are present no matter what, but the cost will slightly fluctuate. These overhead costs
might have a base rate that you must always pay, and a variable rate determined by usage. Semi-variable overhead
expenses include some utilities, vehicle usage, hourly wages with overtime, and salespeople’s salaries and
commissions.

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Activity 8.1
Discuss how project managers can reduce maintenance of costs of their project
assets.

An overhead cost for one company might be a direct production cost for another. For example, a marketing agency
will likely list rent as an overhead cost, while a production facility will likely list rent as a direct cost. Some types of
expenses might be both direct and indirect costs for your business, depending on the situation. For example, wages
paid to a seamstress at a dress shop might be a direct cost because her work increases your business’s revenue.
However, wages paid to an in-house accountant are an overhead cost (Holm, 2019:76)

Think Point 8.3

Discuss the sources of project costs.

8.7. Establishing a Budget

A Project Budget is the total amount of authorised financial resources allocated for the particular purpose(s) of the
sponsored project for a specific period of time. It is the primary financial document that constitutes the necessary
funds for implementing the project and producing the deliverables. The project budget gives a detailed statement of
all the direct and overhead costs required to carry out the project goals and objectives.

Once the project cost of each activity has been identified, project managers need to calculate your overall project
costs by estimating and totalling the individual activity costs. It is important to come up with detailed estimates for
all the project costs. Once this is compiled, you add up the cost estimates into a budget plan. This process of
subtotalling costs by category or activity is called cost aggregation (Watt, 2018). This process is performed once or
at predefined points in the project. According to PMBOK®, 2014:164), determining the cost budget involve the
following inputs, tools & techniques, and Outputs

Determining the Budget

Input Tools and Techniques Output

Project Documents Expert Judgement Cost Baseline
Business Documents Cost Aggregation Funding Requirements
Agreements Data Analysis Project docs Updates
Project Management Plan Meetings Cost Management Plan
Financing
Historical Info Review

6Figure 8.2 Budgeting Flow, PMBOK®, 2014:164

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Although there are several types of project costs, the cost baseline is usually limited to direct costs (such as labour,
materials, equipment) that are under the control of the project manager; other indirect costs can be added to project
costs separately. Overhead costs are typically added later by accounting processes (Larson, & Gray 2018:489)

Video 8.1:

[Link]
What is the link between cost estimation, determining budget and controlling costs?

8.8. Advantages and disadvantages of Budgets

Advantages of budgets
Van Rensburg et al. (2017:251) provide the following advantages:
• Management’s plans are communicated to all stakeholders by means of budgets.
• Budgets force managers to plan.
• It is through budgeting that resources are allocated to areas of the organisation where they can be used
most effectively.
• Budgeting helps to ensure that employees in the different departments work towards the same goal.
• Budgets provide goals and objectives that may be used as benchmarks for evaluating performance.
Els et al. (2016:371) add the following advantages:
• Budgets facilitate the establishment of standards if the standard costing system is being used.
• The occurrence of cost variations identifies weaknesses in the organisation for which remedial measures
can be developed.

Disadvantages of Budgets
Despite the advantages of budgets, Van Rensburg et al. (2017:251) have identified the following disadvantages:
• Most items within a budget are by definition allowances or plugs. Budgets are the least accurate estimate
type and should carry substantial contingencies.
• Budgets are sometimes perceived as pressure devices imposed by management, thus resulting in poor
labour relations.
• Departmental conflicts are bound to arise over resource allocation.
• Wastage of money may arise if managers adopt the view of spending all that has been allocated or lose
what is unspent.
• Responsibility may become a problem when some costs are under the influence of more than one person
e.g. water.
• Managers may overestimate costs to avoid being blamed in the future for overspending.

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Els et al. (2016:371) add the following disadvantages:

• The usefulness of budgets depends on the accuracy of its forecast, but it is not possible for all forecasts to
be 100% accurate.
• The degree of willingness and co-operations among all members of management involved in the system
determines its success.
For most people the advantages of budgets and budget control outweigh their disadvantages.

Practical Activity 8.1

What is the link between project cost estimation and planning? Explain your
reasoning.

8.9. Summary
Project costs can be classified into direct cost, indirect costs, variable cost, fixed costs, recurring costs, none
recurring cost and sometimes overheads. While there are various approaches to classifying project costs, it should
be emphasised that many of these costs belong to multiple classifications; for example, labour costs can be regarded
as direct, recurring, or variable cost. Cost estimation and project budgeting are interconnected and cannot work in
isolation.

Revision Questions

8.10.1 Classify the following costs as direct or indirect. Place a tick in the
appropriate column.

No Cost Direct Cost Indirect Cost

[Link] Fabric used in the manufacture

of shirts

[Link] Grease for the factory machines

[Link] Depreciation of factory

machinery

[Link] Cleaning materials

[Link] Salary of the supervisor

[Link] Wood used in making tables

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[Link] Wages of the person who

operates the machine that
makes the shoes

[Link] Rent of the factory

8.10.2 Briefly explain any three sources of project cost

8.10.3 Explain the advantages and disadvantage of using project budgets

8.10.4 Clearly explain the difference between recurring and non-recurring

cost and give examples of each.

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Answers to Activities
Think Point 8.1
The most significant reasons could be
▪ Low initial cost estimates
▪ Unanticipated technical difficulties
▪ Lack of or poor scope definition
▪ Specification changes
▪ External factors
Knowledge Check 8.1
Correct answer is A. Because this statement explains Direct costs Not Indirect costs

Think Point 8.2

Expedited costs or crash costs are unplanned costs incurred as a result of steps taken to accelerate project
completion. For example, costs associated with using additional overtime or hiring additional workers specifically to
hasten project completion can be regarded as expedited costs.

Activity 8.1
Maintenance cost can be is minimised by selecting high-quality materials, equipment, and piping, and by
implementing proactive and systematic preventive maintenance program. Plant environmental and monitoring costs
are reduced by using environmentally safe, low-cost concentrate disposal methods and by automation of most plant
performance monitoring functions.

Think Point 8.3

These may include Labour Cost, Material Cost, Facility costs, travelling costs.

Video 8.1
The link between the three is that the first two (cost estimation and determining budget form part of the planning
category (preceding implementation), and the third one (controlling cost) fall into the monitoring category, which
unfolds with implementation.

Practical Activity 8.1

Your answer could be:
Cost estimation and project budgeting are inextricably linked. For example, identifying the various human and
material resources needed for a project and developing accurate cost estimates for them are essential parts of
developing a comprehensive, time-phased project budget, as well as for subsequent project monitoring and cost
control. Without reasonable cost estimation, project budgets are essentially useless, and without accurate
budgeting, cost estimation is a wasted exercise.

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Unit
9: Financing the Project

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Unit Learning Outcomes

CONTENT LIST LEARNING OUTCOMES OF THIS UNIT:

9.1 Introduction • Distinguish between project finance and financing the project

9.2 Principles of Project Financing • Outline the principles of Project financing

9.3 Short term financing • Discuss the sources of short-term financing

9.4 Long term financing • Discuss the sources of long-term financing

9.5 Cost of Financing • Determine the cost of financing a project

9.6 Problems in obtaining finance • Identify problems that may be experienced in obtaining finance.

9.7 Summary • Summarises topic areas covered in the unit

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Prescribed and Recommended Textbooks/Readings

Prescribed Textbook
• Marx, J, C Swardt, M Pretorius, W Rosslyn-Smith (2017). Financial
Management in Southern Africa, Fifth Edition. Pearson South Africa. (This
is the latest edition of the textbook)

Recommended Readings
• Conradie, W.M. and Fourie, C.M.W. (2018) Basic Financial Management.
Third Edition. Cape Town: Juta and Company Ltd.
• Gitman, L.J and Zutter, C.J (2017) Principles of Managerial Finance.
Thirteenth Edition. Cape Town: Pearson Education.
• Flynn, D., Uliana, E., Wormald, M. and Dillon, J. (2019) Financial
Management. Ninth Edition. Cape Town. Juta and Company (Pty) Ltd.
• Venkataraman, R.R., and Pinto, J.K (2008) Cost and Value Management
in Projects. NJ: Wiley, pp. 344–345.
• Yescombe, E.R, (2014) Principles of Finance. Second Edition: British
Library: Elsevier.
• Marx, J; De Swardt, C; Pretorius, M. (2023) Financial Management in
Southern Africa. Sixth Edition.
• Zutter, C.J. (2021) Principles of Managerial Finance. Sixteenth Edition.
Pearson.
• Venkataraman, R.R. (2023) Cost and Value Management in Projects.
Second Edition.

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9.1. Introduction
Finance is necessary for all projects. A project cannot progress without financial resources. Turner and Simister
(2004:547) state that the nature and amount of financing required during different phases of the project vary greatly.
In most projects the rate of expenditure changes significantly as the project moves from the appraisal stage, where
mainly human expertise and analytical skills are used, to the design stage, then to manufacture and finally to the
operational phase. In project financing, it is the future cash flows that becomes the basis for acquiring resources to
invest in the project. The project finance team has the responsibility to package this cash flow in a manner that
meets the needs of the project and at the same time is attractive to potential organisations and individuals willing to
provide resources to the project for investment. To achieve this objective effectively, a thorough knowledge of the
various means of finance is essential. Hence, Project finance” is not the same as “financing projects,” because
projects may be financed in many different ways.

Project Finance
Project Finance is the provision of funds for a single purpose facility (or facilities) that generate cash flow to repay
the debt. Debt is serviced by the project’s assets and cash flows not by the assets or general credit worthiness of
the project’s sponsor (Davis, 2018:19). Project Finance involves a corporate sponsor investing in and owning a
single purpose, industrial asset through a legally independent entity financed with non-recourse debt. The funding
for project finance is large, complex, and meant for expensive installations such as power plants, chemical
processing plants, infrastructure for telecommunication and transport. Because the investment does not appear on
the company’s balance sheet, it is referred to as off-balance sheet financing. If the project fails, the lender has no
recourse to recover the investment.

Financing Project
According to Venkataraman and Pinto, (2018:36) financing the project means to guarantee that the amount of
money needed to run the project is available. This means that the project sponsor, in order to know how much
money is needed, needs to be able to calculate the amount of the cost and benefits associated with the investment.
He or she then needs to adapt the time scale of the money needed, to finally know how much and when the money
is required. Hence project finance differs from financing the project through a corporate loan, for example which is
primarily lent against a company’s balance sheet and projections extrapolating from its past cash flow and profit
record, and assumes that the company will remain in business for an indefinite period and so can keep renewing
(“rolling over”) its loans (Yescombe, 2014).

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Knowledge Check 9.1

Which of the following statements is most likely to be true
A. Under financing the projects, the borrowed amount must be repaid, regardless of
project success or failure.
B. Project finance is used to finance simple structures and assets
C. Loans offer lenders recourse to the assets of borrowers in case of default

9.2. Principles of Project Financing

According to Yescombe, (2014: 22) the following are the important principles of project financing

a) Project financing and structure are driven by cash flow. This means that lenders rely on the future cash
flow projected to be generated by the project for interest and debt repayment (debt service), rather than
the value of its assets or analysis of historical financial results
b) Project structures should allocate risks to those parties most capable of controlling or bearing such risk
because project finance involve no-recourse or limited-recourse and the main security for lenders is the
project company’s contracts, licenses
c) Project financiers accept term risk and avoid principal risk. The financiers need to have evidence of
borrower’s ability to pay because they face additional risks from highly leveraged projects.
d) The money required to finance a project is the single largest component of project cost
e) Projects financed by the parent organisation; a financial package is typically not put forth until design work
is completed because the design package is considered part of the investment appraisal process.
f) Projects that involve non-recourse financing, design work often does not begin until financing is obtained
g) Financial planning begins at the feasibility stage and involve financiers to eliminate high risk options and
pave the way for project funding.

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Case study: Project Financing

In the last several years the South African Project Finance market has been defined by
the Renewable Energy IPP Procurement Programme (REIPP) which has successfully
closed three rounds of projects on a project financing basis, with over US$10 billion of
investment facilitated. In addition to REIPP, certain large infrastructure projects have
been closed, such as the Gautrain light rail project, certain liquid fuel and liquid
petroleum gas (LPG) import terminals and mining-derived projects. Looking forward,
project finance activity in the market is expected to focus on further renewables projects
(subject to policy planning), thermal projects procured on a similar basis being both coal
and liquefied natural gas (LNG), to power and increasingly captive power and water
projects, as credit worthy off-takers increasingly look to private sector solutions for
services traditionally provided by utilities.

Another main focus of the project finance market is investment "from" or "through" South
Africa into the rest of the African continent, particularly in the areas of renewables, gas
fired power, off grid power, oil and gas infrastructure projects (such as pipelines and
refineries) and transportation infrastructure projects (such as toll roads and ports).

Alexandra Clüver, Alexandra Felekis, Jonathan Veeran and Garyn Rapson, Webber
Wentzel, Project finance in South Africa: overview, 2020, Viewed 1 November 2020,
<[Link]
2513?transitionType=Default&contextData>
Question
What types of projects make use of project financing in your jurisdiction? What have
been the most significant project finance deals in the past 3 years?

9.3. Short term financing

Short-term financing includes debts/obligations where repayment must be made within one year. From a cost point
of view, it is advisable to finance current assets needs with short-term funds. Conradie and Fourie (2013:98)
elaborate on various forms of short-term financing] including the following;
• Trade credit
• Accruals
• Bank overdraft

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9.3.1 Trade credit

Trade credit mainly takes the form of suppliers’ credit. Payment is not made when the goods or services are
purchased. The enterprise is only expected to pay after 30, 60 or 90 days, depending on the credit terms granted.
In order to encourage prompt payment, suppliers often offer a cash rebate/discount for early payment. Prospective
lenders and suppliers of trade credit are interested in the average payment period because it provides insight into
the firm’s bill-paying patterns.

9.3.2 Accruals
Accruals refer to liabilities for services provided to the enterprise for which payment has not yet been made. Wages
and taxes are common examples. Employees are actually providing short-term financing for the enterprise by
waiting for a week or month to be paid rather than being paid daily. Accrued tax also represents a form of financing.
The extent of financing from accrued taxes is determined by the amount of tax payable and the frequency of
payment. Since accruals have no associated cost, they are a valuable source of finance.

9.3.3 Bank overdraft

Banks provide this facility for enterprises to make payments from a cheque account in excess of the balance in the
account. It provides a means to bridge the gap between cash receipts and cash payments. Overdraft limits are
usually reviewed annually. Interest that is charged on an overdraft is negotiable and is linked to the risk profile of
the borrower. Banks charge interest daily on the outstanding balance owing. This implies that interest is only charged
on the portion of the overdraft limit that is used. Some banks even charge a fixed monthly overdraft facility fee.

9.3.4 Other short-term methods

According to Gitman, (2012:658) two other commonly used means of obtaining short-term financing are pledging
accounts receivable and factoring accounts receivable.
• A pledge of accounts receivable is often used to secure a short-term loan. Because accounts receivable
are normally quite liquid, they are an attractive form of short-term-loan collateral.
• Factoring accounts receivable involves selling them outright, at a discount, to a financial institution. A factor
is a financial institution that specialises in purchasing accounts receivable from businesses. Although it is
not the same as obtaining a short-term loan, factoring accounts receivable is similar to borrowing with
accounts receivable as collateral.

9.4. Long term financing

Various means of long-term finance are available to meet the costs of the project. Long-term financing is necessary
if the assets financed normally have a high capital cost that cannot be recovered over a short term without pushing
up the cost that must be charged for the project's end product (Yescombe, 2014:288). So, loans for power projects
often run for nearly 20 years, and for infrastructure projects even longer. Compared to power and infrastructure
project, Oil, gas, and minerals projects usually have a shorter term because the reserves extracted deplete more
quickly, and telecommunication projects also have a shorter term because the technology involved has a relatively

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short life. These include share capital, debentures, mortgage bonds, Bank loan, Venture Capital, lease Financing,
subsides and grants.

9.4.1 Share capital

Share capital can also be called equity. Md Lasa, Ahmad, & Takim, (2015:2) described equity as a long-term capital
provided by an investor in exchange for shares representing ownership in the company or project. The demand for
equity hinders small contractors from participating in project finance since their balance sheet is insufficiently strong
to sustain such investment. Shares can be broadly categorised as preference and ordinary shares.

Preference shares: Preference shares and ordinary shares are main classes of shares in a public company.
Preference shares provide holders of them with a fixed percentage dividend. These shareholders have preferential
rights to dividends over other shareholders and in respect of claims in the event of liquidation. Dividends are declared
if sufficient profits are available.

Ordinary shares only qualify for dividends once preference shareholders have been paid. The share in the profit
varies and depends on the availability of profits and the amount of dividend approved. It is possible for a company
to buy back its own shares.

9.4.2 Bond
A bond is tradeable debt instrument. According to Yescombe (2014:66) a bond issued by a Project Company is
basically similar to a loan from the borrower's point of view, but it is aimed mainly at the nonbanking market and
takes the form of a tradable debt instrument. The issuer (i.e., the Project Company) agrees to repay to the bond
holder the amount of the bond plus interest on fixed future instalment dates. Buyers of project finance bonds are
investors who require a good long-term fixed-rate return without taking equity risk, in particular insurance companies
and pension funds.

Think Point 9.1

Explain in detail what is meant by the term debenture.

9.4.3 Lease Finance

The distinguishing feature of a lease is that one party (the lessee) obtains the use of an asset in exchange for a
computed lease payment, whereas the legal ownership of the asset remains with the other party (lessor). Yescombe,
(2014:75) states that the lessee pays lease rentals instead of interest and principal payments (debt service) on a
loan. Other things being equal (e.g. assuming the implied interest rate for the financing included in the lease rental
payments is the same as the loan interest rate), payments under a lease or a loan should be the same. It is in this

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context that leasing of equipment to the project company is a way of raising finance. Lease payments, similarly, to
interest payments, are known in advance hence the degree of risk associated with future cash flows (lease or interest
payments) is the same. Furthermore, lease payments, just as interest payments, are a tax-deductible business
expense, making the after-tax cost of leasing relevant. Leasing is common in aircraft, vehicles, plant and machinery,
computers, and other office equipment. More recently, it has been touted as a means of bringing private finance
into public sector projects, e.g. transport and health care sectors.

9.4.4 Mortgage bond

When land and buildings are purchased and are financed by borrowing, a special loan called a mortgage bond is
taken. If it is taken with a bank, the bank will register a bond over the land and buildings (fixed property). If the
property is sold before the bond is settled, the bank has a preferential claim to the proceeds. If the conditions of the
bond are violated (e.g. through non-payment of the loan), the bank has the right to sell the property and use the
proceeds to settle the amount owing to it. The rest of the proceeds goes to the owner of the property.

9.4.5 Venture Capital

Project finance may also come from sources such as venture capital. Sarwate (2004:111) states that venture capital
is ideal for promoters who have good projects but lack margin money. Venture capital is not a loan but is profit-
sharing on a mutually agreed basis for a period. Those who provide venture capital are known as venture capitalists
(VCs). They typically are formal business entities that maintain strong oversight over the firms they invest in and
that have clearly defined exit strategies.

9.4.6 Bank Loan

Commercial banks provide long-term loans to project companies. In developed countries projects are normally
financed by local banks or foreign banks with branch or subsidiary operations in the country concerned. Sponsors
may arrange a bank loan as an insurance policy in case the bond issue falls through or put together a bank loan
with the intention of refinancing it rapidly with a bond. In general, bonds are suitable for developed markets and
"standard" projects. The greater flexibility of bank loans tends to make them more suitable for the construction and
early operation phases of a project, projects where there are likely to be changes in the Offtaker's or end-user's
requirements, more complex projects, or projects in more difficult markets (Yescombe, 2014:95).

9.4.7 Subsidy and Grants

Public-sector debt is sometimes provided to projects as a kind of subsidy, often on a subordinated basis. Such
financing is subordinated to senior debt and repayment in will come in second place to the senior lenders.
Alternatively public-sector grants may be provided to the Project Company-these may be without any obligation for
repayment (so long as the money is in fact used for the project) or may be repaid if the project reaches an agreed
level of success (e.g., as reflected in its cash flow). Where there is no obligation for repayment, or repayment is
highly contingent in nature, such grants may be considered by commercial lenders as equity rather than debt
(Yescombe, 2014:46).

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Think Point 9.2

What is a Subordinated debt?

Video 9.1: Project Financing

[Link]
What is the significance of Debt Service Coverage Ratio to project sponsors?

9.5. Cost of Financing

The cost of financing represents the firm’s cost of capital and is the minimum rate of return that a project must earn
to increase firm value (Gitman, 2014:358). As indicated above most project companies finance their operations from
a combination of equity and debt. In order to calculate the cost of capital, the weighted average of the costs of
different sources of finance must be determined. As financing is raised to fund future projects, the appropriate cost
is that of future funding. This is fully described as the weighted average cost of capital (WACC).

9.5.1 Cost of Equity

Project sponsors (investors) who develop and lead the project through their investment in the project company
requires a return on their investment known as the required return or the cost of equity (Yescombe,2014:535). The
cost of equity is the dividends paid to shareholders plus any estimate of the equity’s capital growth (Venkataraman
and Pinto, (2008:158). To calculate the cost of equity, two generally recognised methods for determining the
required return on equity are the Dividend Discount Model or Gordon Growth Model and the Capital Asset Pricing
Model (CAPM).

[Link] Dividend Discount Model (DDM) - Gordon Growth Model

According to Correia, Flynn, Uliana & Wormald (2019:356) the value of ordinary equity is determined by the present
value of future dividends. The idea is that if the value obtained from the DDM is higher than what the shares are
currently trading at, then the stock is undervalued. The DDM is an interesting way to estimate the cost of equity
capital. Since is the return that shareholders require, it can be interpreted as the project company’s cost of equity
capital. Dividend payments are not tax deductible and are only paid after debt obligations are satisfied.

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Example 9.1
To illustrate how we estimate 𝑅𝐸 , suppose a company paid a dividend of R0.20 per share last year and the share
price is currently R5, and the expected growth is 8% p.a. Using the dividend growth model, the expected dividend
for the coming year is
𝐷1 = 𝐷0 × (1 + 𝑔)

=𝑅0.20 × (1 + 0.08)

= R0.22

Given this, the cost of equity, 𝑅𝐸 is:

𝐷1 𝐷0 (1+𝑔)
𝑅𝐸 = 𝑃0
+g or 𝑃0
+𝑔

𝑅0.22
= + 0.08
𝑅5

= 12.32%

Where

𝑅𝐸 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦

𝐷0 = 𝐿𝑎𝑠𝑡 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑖𝑑

𝐷1 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

𝑃0 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑠ℎ𝑎𝑟𝑒

𝑔 = 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒

Knowledge Check 9.2

Lexton paid a dividend of R0.12 per share and the dividend per share is expected to
grow at 7% indefinitely. The company’s share price is R2.30. The company’s cost of
equity is closest to
A. 12.58%
B. 16.94%
C. 16.10%

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[Link] The Capital Asset Pricing Model (CAPM)

CAPM allows investors to determine the required rate of return on a share, based on the risk associated with that
share. The CAPM is a model for pricing an individual security or portfolio. For individual securities, we make use of
the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market
must price individual securities in relation to their security risk class. The expected return on a risky investment
depends on three things:
R E = R F + β(R M − R F )
Where,
• 𝑅𝐹 = 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒
• 𝛽 = Beta coefficient, systematic (market) risk of equity
• 𝑅𝑀 − 𝑅𝐹 = market risk premium

Example 9.2
Suppose a company has a beta factor of 1.1, a market returns of 13% and a risk-free return of 9%. Given this, the
cost of equity, 𝑅𝐸 is closest to
Solution
R E = R F + β(R M − R F )
= 9% + 1.1(13% − 9%)
= 9% + 4.4%
= 13.4%

Activity 9.1
Lexton Ltd has an equity beta of 1.50. The market risk premium in South Africa is
expected to be 5% and the yield on government bonds is currently 7.5%. Lexton has
issued bonds and its R100 par-value bond is currently trading at R94.50. The coupon
rate is 8%. The maturity date is in five years’ time and the corporate tax rate is 28%.
Determine the cost of Equity.

9.5.2 Cost of Preference Shares

Preference shares have some debt characteristics. Specifically, the dividend payable is usually a fixed amount,
the same way as interest on a typical debenture is fixed. The cost of issuing new shares is called Floatation cost.
Flotation cost reduces the value of preferences & increases cost of preferences shares. Tax effect has no effect
on preference shares.
Expected Dividend rate
Value of Preference Shares (Vp ) = × Issue Price
Required rate

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The cost of preference shares is given by

D
RP =
VP − Flotation Cost
Where
R P = Cost of preference shares
D = Dividend
𝑉p = Value of preference shares

Example 9.3
ABC Ltd wishes to issue 12% preference shares at an issue price of R1 each. If the current market rate for
preference shares in the same class has risen to 14%. The company has a marginal tax rate of 28% and will be
required to pay flotation costs of 5 cents per share issued. Determine the component cost of preference shares.

Solution
Expected Dividend rate
Value of Preference Shares (Vp ) = × Issue Price
Required rate
12
VP = × R1
14
= 85.72 cents
12
𝑅𝑝 =
85.71 − 5
12
=
80.71
= 14.87%

Knowledge Check 9.3

Suppose a company, Vector Limited (Ltd) paid a dividend of R0.9 on the current market
price and its preference share of R12. The company has a marginal tax rate of 28%
and will be required. Determine the cost of preference shares.
A. 6.5%
B. 5.40%
C. 7.5%

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9.5.3 Cost of debt

The level of debt that can be raised for a project is based primarily on the projected ability to pay interest and repay
loan principal instalments as they fall due (Yescombe, 2014:322). The funding cost from the company’s debt holders
is called the cost of debt. The interest payments paid to bond and loan holders are tax deductible for the company,
so the after-tax cost of debt is lower than the before cost debt.
After tax cost of debt is given by
𝑅𝐷 = YTM (1 – T),
Where
𝑅𝐷 = After tax cost of debt
YTM = Yield To Maturity of a bond or Before tax cost of debt
T = Tax rate

Example 9.4
A project company issued a bond with the following is extracted
Face value = R1 000
Current market price = R1 030
Coupon rate = 11%
Time to maturity = 4 years
YTM = 10.05%
Tax rate = 28%
Given the above information, the after- tax cost will be
R D = YTM (1 – T),
= 10.05 x (1 – 0.28)
= 7.24%

Think Point 9.3

Describe debt financing.

9.5.4 Weighted Average Cost of Capital (WACC)

[Link] al, (2019:405) described WACC as a firm’s blended cost of capital across all sources, including common
shares, preferred shares, and debt. The cost of each type of capital is weighted by its percentage of total capital
and they are added together. According to Heerkens, (2011) WACC and related principles are widely viewed as
vital to profit making companies. But it is equally important to public-sector entities and project companies that
pursue projects on the basis of cost-effectiveness. If the expected financial return of a project is less than the cost
to finance it, the organisation actually loses money. When the economic return exceeds the cost of financing, the

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project is considered financially justified, and will result in that project having a positive net present value (Pinto,
2009). It is this WACC that is used to discount cash flows of capital projects in determining their financial feasibility.
In order to calculate a company’s WACC, we need to determine the weights to allocate to each cost of finance. The
question that is ever asked is how do we decide on the weights of debt and equity to calculate WACC? This
represents a firm’s capital structure. The assumption is that there is an optimal or target capital structure that will
maximise the value of a company and reduce its cost of capital (Marx et al, 2017). Typically, a capital structure that
comprises of debt and equity is used in project financing with high ratio of debt to equity of about 70% -90%
(Yescombe 2014:22).

Example 9.5
Assume a company has cost of equity of 12.30% and after-tax cost of debt of 7.38%. What is the weighted-
average cost of capital (WACC) if the target debt–equity ratio is 25%.

Solution

To calculate the weights given debt to equity ratio, the following formula is used

X
WD =
1+X

Where

WD = weight of debt

X = is the debt to equity ratio

0.25 0.25
WD = = = 20%
1 + 0.25 1.25

WE = 100% − 20% = 80%

Components Weight Cost Contribution

Debt 0.2 7.38% 1.48%
Equity 0.8 12.30% 9.84%
WACC 11.32%

Think Point 9.4

What is the target weight of equity if the company has target debt ratio of 60%

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Practical Activity 9.1

Codman Ltd provides carpentry services to South African furniture companies. The
company’s capital structure is presented below

Capital Employed R000

Long-term debt - debentures 13 244
Preference shares 1 892
Ordinary share capital 22 704
37,840
The debentures which have a par value of R100 are currently priced at R112 and are
redeemable in five years’ time and the. The coupon rate is 10% per year and can yield
7.07%. The preference shares, which had an issue price of R100, are currently priced
at R118 and the preference shares offer a fixed dividend rate of 12% per year. The
preference shares are non-redeemable. The company’s equity beta is 1.3 and 10-year
Treasury bonds are currently yielding 8%. The market premium is estimated to be 5%.
The company’s book value capital structure is expected to reflect the target capital
structure in the future.

Required
What is the firm’s weighted-average cost of capital (WACC)?

9.6. Problems in Obtaining Project Finance

According to Ehlers, (2014:15) project companies are faced with the following funding challenges:
• Lack of investable projects. Often, projects are not properly designed to support the much-needed
financial package,
• In some emerging markets, both the banking sector and long-term investors, such as pension funds or
insurance companies, are still at early stages of development. They do not always possess the financial
capacity to supply large amounts of funds required for projects financing.
• Project cash flows are mostly in local currency, international financiers face currency risks. As hedging
long-term currency risks is not feasible, international financing often comes in foreign currencies. But the
resulting currency mismatches represent significant risks – both for the viability of a project as well as for
the financial system as a whole.
• Infrastructure projects are relatively more likely to require debt restructurings in unforeseen events and this
restructuring of bonds, is complex and time consuming.
• Limited involvement of financial institutions in offering financing, and a complex loan application process

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• Political risk: Available financing options critically depend on the legal structure of the project and
government have the power to renegotiate contracts, and sometimes are tempted to do so. And this political
interference greatly increases the perception of risks for private investors.
• Report published by the Basel Committee on Banking Supervision requires an increase in the quantity of
capital to be held by banks, making non-recourse lending difficult.
• The perception of credit rating agencies may be influential to a foreign investor’s assessment of risk in this
regard. If, for example, as a result of a weaker institutional framework assessed by credit rating agencies,
the measures that the South African government will take in situations of financial distress (such as direct
intervention to control foreign exchange markets) are uncertain, investors may require assurance that a
foreign currency loan obligation is capable of being serviced in a timely manner.

9.7. Summary
There are both short- and long-term sources of financing a project. Short term of financing includes Accruals, Trade
credit, bank overdraft, factoring and pledging of accounts receivables. Long tern sources include equity, mortgage
loan, grants, subsidies, leasing, bonds, and venture capital. Since project finance involve large and complex
projects, long term sources are usually used. The cost associated with borrowing money depends on the particular
form of capital borrowed. For instance, cost of equity the cost of equity is the dividends paid to shareholders plus
any estimate of the equity’s capital growth. The cost of equity is usually calculated using the Capital Asset Pricing
Model (CAPM) or the Dividend Discount Model (DDM). The cost of debt is the cost of debt financing, or the interest
paid on the money borrowed which has a tax benefit. The cost of capital is the average cost of various forms of
finance used by the project organisation; specifically, it is the weighted average of the cost of the different types of
capital borrowed. Project companies are faced with several challenges in when attempting to get funding including
political and currency risk.

Revision Questions

9.8.1 Discuss the various sources of financing a project.

9.8.2 Explain any three problems faced by project companies when
attempting to obtain finance.
9.8.3 Outline the basic principles of financing the project.
9.8.4 Many project companies choose to meet financing requirements
through the use of a combination of equity and debt. Provide reasons
for the choice of a combination of these sources of finance, rather than
the use of only equity or only debt.
9.8.5 Lexton Ltd, a project company based in Limpopo has an equity beta of
1.10. The market risk premium in South Africa is expected to be 5% and
the yield on government bonds is currently 7.5%. Lexton has issued

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bonds and its R100 par-value bond is currently trading at R94.50. The
coupon rate is 8%. The maturity date is in five years’ time the YTM is
9.43% and the corporate tax rate is 28%. Interest is payable annually in
arrears. The company has just paid the coupon interest for the current
year.
Required:
a) What is Lexton’s cost of equity, based on CAPM?
b) What is the after-tax cost of debt?
c) Lexton paid a dividend of R0.12 per share and the dividend per
share is expected to grow at 7% indefinitely. The company’s share
price is R2.30. What is the company’s cost of equity if we use the
dividend growth model?
d) What is the weighted-average cost of capital (WACC) if the target
debt-equity ratio is 50%? (Use cost of equity as per CAPM)

9.8.6 BCX Ltd, is a project company operating in the IT industry and has a
beta of 1.3. The market (equity) premium is estimated at 4% and the
risk-free rate (yield on government bonds) is 7%. The company can
raise debt finance at an interest rate of 9.4% per year. The corporate
tax rate is 28%. The target debt-equity ratio is 33.33%. Determine the
company’s cost of financing?

9.8.7 How are projects financed? What sources of funding are typically
available?

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Answers to Activities

Knowledge Check 9.1

The correct answer is B. Project finance is used to finance complex structures and Not simple ones.

Case study:
Project Financing
The answer will vary depending on your research, but the type of project should be large and complex structures
that meet the definition of project finance.

Think Point 9.1

A debenture is an unsecured bond, for which no specific pledge of property (referred to as collateral) is made in
case the firm does not fulfil its promise. This means that the bondholder depends on the success of the borrower to
make the promised payment. An investor who purchases a debenture is lending money to the issuer, and the
debenture represents the issuer’s contractual promise to pay interest and repay principal according to specified
terms.

Think Point 9.2

Debt whose debt service comes after amounts due to senior lenders, but before distributions of dividends to investor
have been paid.

Video Activity 9.1

Debt Service Coverage Ratio (DSCR) of say greater than 1 provides comfort to the lender to receive timely payments
as the project is generating sufficient cash flows to service the debt obligation. In contrast a DSCR of less than 1
shows that the borrower will have difficulties to meet interest payments and principal settlement due to insufficient
cash flows.
Knowledge Check 9.2 Option A is the correct answer calculated as follows:
𝐷0 (1 + 𝑔)
𝑅𝐸 = +𝑔
𝑃0

0.12(1 + 0.07)
= + 0.07
R2.30

0.1284
= + 0.07
R2.30

= 0.0558 + 0.07

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= 0.1258

= 12.58%

Activity 9.1

R E = R F + β(R M − R F )
= 7.5% + 1.5(5%)
= 7.5% + 7.5%
= 15%

Knowledge Check 9.3

Option C is the correct answer. Tax has no effect on preference shares.
D
RP =
VP − Flotation Cost

R0.9
=
R12 − 0

= 0.075
= 7.5%

Think Point 9.3

Debt financing refers to money borrowed from a number of sources, including banks. This debt involves periodic
repayments of the debt and interest, based on agreed-upon schedules. The money borrowed through this type of
financing arrangement has to be repaid first, before the repayment of other types of finances. This type of debt is
also sometimes known as senior debt.

Think Point 9.4

Total Debt
Debt Ratio =
Total Assets
So, a debt ratio of 60 means that 60% of total assets are financed by debt and the remainder is financed by
equity. Therefore, weight of equity becomes 40%

Practical Activity 9.1

After tax cost of debentures
R D = YTM(1 − T)
= 7.07(1 − 0.28)
= 5.09%

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Cost of preference shares

𝐷
𝑅𝑝 =
𝑉𝑝 − 𝐹𝑙𝑜𝑡𝑎𝑡𝑖𝑜𝑛 𝐶𝑜𝑠𝑡
12
=
118 − 0
= 10.17%
Cost of Equity
𝑅𝐸 = 𝑅𝐹 + 𝛽(𝑅𝑀 − 𝑅𝐹 )
= 8% + 1.30(5%)
= 14.5%
Components Target Capital Target Weights Cost Contribution
Structure
Debt 13 244 0.35 5.09% 1.78%
Preference Shares 1 892 0.05 10.17% 0.51%
Equity 22 704 0.60 14.50% 8.70%
37 840 1
WACC 10.99%

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Answers to Revision Questions

Unit 1
1.7.1 Primary functions of a financial manager are:
• Making investment decisions
• Making financing decisions
1.7.2 To explain why profit maximisation is not an appropriate goal read to paragraph 1.3.
1.7.3 Justification of why maximise shareholder wealth is a sound financial management goal.
Shareholder wealth maximisation represents forward-looking goal centred on increasing the wealth of the
owners of the firm. If the manager looks at past performance as an indicator of future performance the firm
will not grow. This goal takes into account the risk and return (cash flows) objectives, which are the key
determinants of share price, which represents wealth of the owners in the firm. Therefore, managers should
pursue only those decisions that are expected to increase share price.
1.7.4 Difference between Capital and Money market
Capital markets are generally distinguished from money markets on the basis of the term of the investment.
Money markets provide short term funding while capital markets provide permanent or long-term funding.
Most companies experience cyclical or seasonal fluctuations that result in their financing requirements not
being constant over the year. As a result, they are likely to have a large element of financing from capital
markets and enter the money market when additional funding is required for short-term seasonal or cyclical
fluctuations. For example, a company may finance its investment in property, plant and equipment with long-
term debentures or equity and may finance the investment in inventory for the summer season by obtaining
a short-term loan.

1.7.5 To discuss the principle of financial management, read paragraph 1.5.

1.7.6 Importance of Risk and Time value of money
Time Value of Money
The time value of money is one of the most important principles of finance. Value is affected by the size, risk
and timing of cash flows. A dollar in hand today is worth more than a dollar promised at some time in the
future. This is because cash flows received sooner can be reinvested to provide greater future returns. For
example, if Project X results in R1m in a year’s time and Project Y results in a cash flow of R1m in two
years’ time, then we have to value these two amounts differently. The reason is that the R1m to be received
at the end of year 1 can be reinvested for one year so that it grows to a larger amount at the end of year 2.
Risk
Investors prefer investments with low risk. Risk is the probability that the actual result of a decision may
deviate from the planned outcome resulting in a financial loss. Often, we measure risk in terms of volatility of
returns. High levels of volatility mean high risk and investors will require a higher return from projects with a
higher level of risk. Thus, there is a risk-return trade-off between the two.

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1.7.7 Project finance generally structured on a limited or non-recourse basis. The parties to a project financing will
be the:
• Project Company, generally a special purpose vehicle created for the purpose of the specific project.
• Lead sponsor and/or shareholder, potentially private equity or another additional investor.
• The off taker.
• Construction and operation contractors.
• Lenders and financiers.
• For government-procured projects, the relevant department or government entity

Unit 2
2.9.1

Pure time value of money Time value of money

Is a measure of risk-free rate, which is the reward for Refers to the fact that a dollar in hand today is worth
merely waiting for your money, without taking any more than a dollar promised at some time in the
risk. Eg, investment in government bonds future. This is because you could earn interest while
you waited; so a dollar today would grow to more
than a dollar later

2.9.2 The question is asking for the calculation of the present value using different discounting frequencies. We
use the following formula
𝟏
𝐏𝐕 = 𝐅𝐕 × [ ]
(𝟏 + 𝐢)𝐍

a) Annual Discounting c) Semi -Annual discounting

FV= 40 000; i =0.12; N = 3 years FV =40 000; i = 0.12/2 =0.06; N = 3 years x 2 = 6

1 1
PV = 40 000 x [ ] PV = 40 000 x [ ]
(1 + 0.12)3 (1 + 0.06)6

1 1
= 40 000 x [ ] = 40 000 x [ ]
(1.12)3 (1.06)6

= 40 000 x 0.7118 = 40 000 x 0.7050

= R28 471 = R28 198

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d) Quarterly Discounting e) Monthly Discounting

FV =40 000; i = 0.12/4 =0.03; N = 3 years x 4=12 FV =40 000; i = 0.12/12 =0.01; N = 3 years x 12=36
1 1
PV = 40 000 x [ ] PV = 40 000 x [ ]
(1 + 0.03)12 (1 + 0.01)36

1 1
= 40 000 x [ ] = 40 000 x [ ]
(1.03)12 (1.01)36

= 40 000 x 0.7014 = 40 000 x 0.6989

= R28 055 = R27 957

2.9.3 This is question is asking for the future value of an ordinary annuity, the following formula can be used

FVAN = PMT x FVIFAI,N ,PMT = 20 000; N = 5 Years; i = 10%

= 20 000 x 6.1051 (from Table 2)

= R122 102

2.9.4 To advice the company, you must first calculate the future value of an ordinary annuity and compare it with
the R100 000

FVAN = PMT x FVIFAI,N,PMT = 15 000; N = 5 Years; i = 10%

= 15 000 x 6.1051

= R91 577

The company will not be able to meet its objective. To meet its objective, it must shop for other financial
institutions that offer higher rate of return. Alternatively, it must increase its annual payments.

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2.9.5 To advice the company one has to compare the proceeds from different alternatives at the end of 3 years.

Investing the money in the money market account yields,

FVN = PV ( 1 + i)N

FV = 100 000( 1 + 0.15)3

= 1000 000 x 1.5209

= R1 520 875

Since the proceeds (R1 520 875) from investing in the money market account are greater than the proceeds from
developing a new software by R20 875 it is advisable that the company should consider putting money in the money
market account.

2.9.6 To be able to make the comparison, calculate the future value of an ordinary annuity then compare it with
the lump sum at the end of 4 years

FVAN = PMT x FVIFAI,N,PMT = 7 000; N = 4 Years; i = 6%

= 7 000 x 4.3746 (From Table 2)

= R30 622

Receiving R7 000 per year for 4 years is a better option than single lump sum of R30 000 at the end of 4 years

2.9.7 Present value of uneven cash flows (Use Table 3)

Year Cash flow PVIF @ 14% Present Value

1 4 500 0.8772 3 947
2 8 000 0.7695 6 156
3 10 000 0.6750 6 750
4 5 000 0.5921 2 961
5 2 000 0.5194 1 039
Present Value 20 853

2.9.8 Loan Amortisation schedule

PVAN
PMT =
PVIFAi,N

PVIFAi,N Using Table 4: discount factor for 12% and 6 years, we get 4.1114
220 000
=
4.1114
= R53 510 (rounded off to the nearest rand
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End of year Instalment Beginning Interest Paid Principal Paid End of year
balance principal
(1) (2) (3) = 0.12 x (2) (4) = (1) – (3) (5) = (2) – (4)
1 R53 510 R220 000 R26 400 R27 110 R192 890
2 R53 510 R192 890 R23 147 R30 363 R162 527
3 R53 510 R162 527 R19 503 R34 007 R128 520
4 R53 510 R128 520 R15 423 R38 087 R90 433
5 R53 510 R90 433 R10 852 R42 658 R47 775
6 R53 510 R47 775 R5 733 R47 777 0
Rounding off error of R2

Unit 3

3.9.1
Total cost of the new asset (760 000)
Purchase price (700 000)
Installation cost (60 000)
After-tax proceeds from the sale of the old asset 700
Proceeds from the sale of the old asset 1 000
Tax on the sale of the old asset (Profit –/Loss +) (300)
Change in net working capital of the old asset 100 000
Change in net working capital of the new asset (150 000)
Initial investment (809 300)

3.9.2 Depreciation = R80 000 ÷ 5 years = R16 000 per year

Year NOPAT Depreciation Operating cash
flows
R R R
1 20 000 + 16 000 = 36 000
2 10 000 + 16 000 = 26 000
3 8 000 + 16 000 = 24 000
4 6 000 + 16 000 = 22 000
5 (5 000) + 16 000 = 11 000

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3.9.3
After tax proceeds from the sale of new assets 2 800
proceeds from the sale of new assets 4 000
Tax on the sale of new assets (R4 000 x 30%) (1 200)
After-tax proceeds from the sale of the old asset 0
Proceeds from the sale of the old asset 0
Tax on the sale of the old asset (Profit –/Loss +) 0
Change in net working capital of the new asset 150 000
Change in net working capital of the old asset 0
Terminal cash flow 152 800

3.9.4 To differentiate between independent and mutually exclusive project, read paragraph 3.5

Unit 4
4.8.1 Payback period

Investment (60 000)

Year 1 10 000
(50 000)
Year 2 12 000
(38 000)
Year 3 28 000
(10 000)
Year 4 20 000
3 years 6 months
Calculations 10 000
𝑥 12
20 000
0.5 x12 =6 months

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4.8.2 Net Present Value

NPV

Year Cash flow Discount Factor Present

12% Value

1 10 000 0.8929 R8 929

2 12 000 0.7972 R9 566

3 28 000 0.7118 R19 930

4 20 000 0.6355 R12 710

5 30 000 0.5674 R17 022

Total PV R68 157

Investment (R60 000)

NPV R8 157

4.8.3 Profitability Index

Profitability Index = Present Value of Cash Flows = 68 157

Initial Investment 60 000

= 1.14

4.8.4 Accounting Rate of Return

ARR

ARR = Average annual profit X 100

Initial investment 1

= R8 000 X 100

R30 000 1

= 26.67%

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Workings

Year Net cash Depreciation Profit (Loss)

inflows
1 R10 000 R12 000 (2 000)
2 R12 000 R12 000 0
3 R28 000 R12 000 16 000
4 R20 000 R12 000 8 000
5 R30 000 R12 000 18 000
Average annual profit (R40 000 ÷ 5) R8 000

4.8.5 The investment should be considered positively because:

• The payback period is only 3 years and 6 months,
• The net present value (R8 157) is positive.
• The profitability index (1.14) is greater than 1.
• The accounting rate of return (26.67%) is higher than the cost of capital (12%).

4.9.1

Project Tim Project Tok

Year Profit/Loss Depreciation Cash Flow Year Profit/Loss Depreciation Cash Flow
1 R25 000 30 000 55 000 1 R7 500 20 000 27 500
2 (R17 500) 30 000 12 500 2 R10 750 20 000 30 750
3 R22 500 30 000 52 500 3 R14 750 20 000 34 750

Project Tim Project Tok

ARR = Average annual profit X 100 Average annual profit X 100

Initial investment 1 Initial investment 1

= R10 000 X 100 R11 000 X 100

R45 000 1 R30 000 1

= 22.22% 36.70%

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4.9.2 Payback Period

Project Tim Project Tok

Investment (90 000) (60 000)
Year 1 55 000 27 500
(35 000) (32 500)
Year 2 12 500 30 750
(22 500) (1 750)
Year 3 52 500 34 750
2years 5 months 4 days 2 years 18 days
Calculations 22 500 1 750
𝑥 12 𝑥 12
52 500 34 750
0.429 x12 =5.143 months 0.05 x 12 = 0.604
5.143 -5 =0.143 0 months
0.143 x 30 =4.29 0.604 x 30 =18.129
4 days 18 days

4.9.3 Net Present Value (NPV)

Project Tim Project Tok

Year Cas flow Discount Present Cash Flow Discount Present

Factor 10% Value Factor 10% Value

1 55 000 0.9091 50 001 27 500 0.9091 25 000

2 12 500 0.8264 10 330 30 750 0.8264 25 412

3 52 500 0.7513 39 443 34 750 0.7513 26 108

Total PV 99 774 76 520

Investment (90 000) (60 000)

NPV R9 774 R16 520

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4.9.4 Profitability Index

Project Tim Project Tok

Profitability Index = Present Value of Cash Flows = 99 774 76 520

Initial Investment 90 000 60 000

= 1.11 1.28

4.9.5 IRR for Project Tim

Discount Discount Present Present

Year Net cash
factor factor value value
inflows
16% 17% 16% 17%

1 55 000 0.8621 0.8547 R47 416 R47 009

2 12 500 0.7432 0.7305 R9 290 R9 131
3 52 500 0.6407 0.6244 R33 637 R32 781
Total PV R90 343 R88 921
Investment (90 000) (90 000)

NPV R343 (R1 079)

Using interpolation to find the exact IRR

343
IRR = 16 +
343 + 1079
343
= 16 +
1422

= 16 + 0.241

= 𝟏𝟔. 𝟐𝟒%

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Project Tok

Discount Discount Present Present

Year Net cash
factor factor value value
inflows
24% 25% 24% 25%

1 27 500 0.8065 0.8000 R22 179 R22 000

2 30 750 0.6504 0.6400 R20 000 R19 680
3 34 750 0.5245 0.5120 R18 226 R17 792
Total PV R60 405 R59 472
Investment (60 000) (90 000)

NPV R405 (R528)

Using interpolation to find the exact IRR

405
IRR = 24 +
405 + 528
405
= 24 +
933

= 24 + 0.434

= 𝟐𝟒. 𝟒𝟑%

4.9.6 In all the investment appraisals, Project Tok has the better returns. Project Tok also has a superior
NPV than Project Tim. Using the IRR, Project Tok’s cost of capital can go up to 24% before it can be
rejected.

Unit 5

5.9.1 To define project portfolio management, read paragraph 5.1.

5.9.2 When attempting to distinguish between project portfolio and financial portfolio, refer to paragraph
5.2.
5.9.3 For the discussion on how might project portfolio management improve and promote the
organisation’s chances of success, read to paragraph 5.3.
5.9.4 To answer this question on challenges faced by portfolio managers in attempting to execute project
portfolio management read paragraph 5.4.
5.9.5 For the key activities relating to portfolio rebalancing, read paragraph 5.5.

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5.9.6 To draw the Markowitz efficient frontier, you need expected returns and standard deviation of each
assets, read paragraph 5.7
5.9.7 Information required to put into the program include, expected return, standard deviation, co-variance
between returns, Beta and Risk-free rate
5.9.8 To get the expected return of the portfolio, we first need to calculate the weights and apply the formula

𝐸(𝑅𝑃 ) = ∑ 𝑊𝑗 𝐸(𝑅𝑗 )
𝑗=1

Project Name Invested Amount Weights (W) Expected return E(P) W x E(R)

Theta R300 000 0.3 15% 4.5%

Gamma R100 000 0.1 12% 1.2%

Delta R200 000 0.2 10% 2%

Vega R400 000 0.4 9% 3.6%

Total 1 000 000 1 11.3%

Therefore, the expected return of the portfolio is 11.3%

5.9.9 Equal holding means there is 50% weighting in project Short and Long

Expected mean of the portfolio

m

E(R P ) = ∑ Wj E(R j )
j=1

E(R P ) = 0.5 × 7.5 + 0.5 × 15

= 4.25 + 7.5
= 11.75%
standard deviation of the return on the portfolio, given that the correlation coefficient of the two projects is:

σp = √W 2 A × σ2 A + W 2 B × σ2 B + 2 × WA × WB × σA × σB × ρAB

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I. 𝜌𝐴𝐵 = 1

σp = √W 2 A × σ2 A + W 2 B × σ2 B + 2 × WA × WB × σA × σB × ρAB

= √0.52 (0.0252 ) + (0.52 )(0.05)2 + 2 × 0.5 × 0.5 × 0.025 × 0.05 × 1

= √0.000156 + 0.000625 + 0.000625

√0.0001406

= 0.0375

= 3.75%

II. 𝜌𝐴𝐵 = 0

= √0.52 (0.0252 ) + (0.52 )(0.05)2 + 2 × 0.5 × 0.5 × 0.025 × 0.05 × 0

= √0.000156 + 0.000625 + 0

√0.000781

= 0.0279

= 2.79%

III. 𝜌𝐴𝐵 = −1

= √0.52 (0.0252 ) + (0.52 )(0.05)2 + 2 × 0.5 × 0.5 × 0.025 × 0.05 × (−1)

= √0.000156 + 0.000625 − 0.000625

√0.000156

= 0.0125

= 1.25%

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b) Comments
Given the calculated standard deviations, it can be interpreted that where the returns for the two
projects are perfectly positively correlated ( 𝜌𝐴𝐵 =1) the standard deviation of the portfolio is, in fact,
the weighted average of the individual standard deviations. This means that portfolio managers get
no real benefit from combining two projects that are perfectly correlated; they are like one project
already because their returns move together, thus the risk is very high (3.75%). When the correlation
coefficient is 0, the returns from these two projects have no predictive relationship and the risk
measured by standard deviation is lower (2.79%) than first scenario showing a benefit of
diversification. This combination of two projects that are completely negatively correlated (-1) provides
the maximum benefits of diversification and the risk is very minimum. In other cases, perfectly
negatively correlation completely eliminates the risk of the portfolio.

5.10) Mult-weighted Scoring model

The multi-weighted scoring models is the most important method that one use to select a project. The model
utilises a weighted selection criterion to evaluate project proposals. This scoring models encompasses both
qualitative and/or quantitative criterion methods. To determine the attractiveness of the project, each criterion
is assigned specific weight. After scores are assigned to each criterion for the project, based on its
importance to the project being evaluated. As seen from the table below, project B is most attractive since
it has the highest value of 109 [(3 x10) +(4 x 6) + (5 x 7) + (4 x 5) =109]. A threshold of 80 points helps project
priority team to accept or reject a project. A threshold of 80 points will make project A, B and C acceptable
while project D will be rejected since it is below the minimum cut off threshold.

N.P C.R S.R S.P Weighted Total

10 6 7 5
Project A 5 3 3 3 104
Project B 3 4 5 4 109
Project C 3 4 3 2 85
Project D 2 2 5 3 82

Unit 6
6.6.1 Financial estimate is the term used in financial planning in which the managers make use of projections
that provide road maps for guiding, coordinating, and controlling the firm’s actions to achieve its
objectives.
6.6.2 Proforma financial statements are important because:
▪ They assist investors in analysing a company’s future prospects
▪ Allows companies to get a mutual understanding of the important marks based on the current data
▪ Pro forma profit and loss statements can also be used to calculate the financial ratios.

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▪ For some companies, the pro forma profit and loss statements provide a clear and accurate view of
its performance given the nature of their business.
▪ Further, with such financial report, you can develop a marketing strategy that will suit your business
model
6.6.3 The key inputs of pro forma statements are:
• Financial statements for the preceding year
• The sales forecast for the coming year.
6.6.4 Po forma Statement of Comprehensive Income
Chanetsa Traders

Statement of Comprehensive income for the year ended 30 June 2020

July August September

R R R
Sales 76 000 96 000 104 000
Cost of sales (38 000) (48 000) (52 000)
Gross Profit 38 000 48 000 52 000
Operating Incomes 8 960 8 960 8 960
Rent Income 8 960 8 960 8 960
Gross Income 46 960 56 960 60 960

Operating Expenses (31 660) (31 763) (31 867)

Salaries and wages 21 600 21 600 21 600
Repairs 612 624 636
Telephone 836 853 870
Stationary 320 320 320
Bad debts 600 600 600
Electricity and water 1 142 1 165 1 188
Insurance 1 428 1 457 1 486
Bank Charges 1 122 1 144 1 167
Depreciation 4000 4 000 4 000

Operating profit before interest 15 300 25 197 29 093

Interest on fixed deposit 660 660 660
Interest on Loan (2 500) 2 500 (2 500)
Net Profit for the year 13 460 23 357 27 253

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Workings

1. Sales

July: R960 000 ÷ 12 = R80 000; R80 000 – R4 000 = R76 000

August: R80 000 + R16 000 = R96 000

September: R80 000 + R24 000 = R104 000

2. Cost of sales

Gross margin = R480 000 ÷ R960 000 X 100 = 50%

Cost of sales as a percentage of sales will therefore be 50% (100 – 50% gross margin)

Cost of sales for each month = 50% of sales

July: R76 000 X 50% = R38 000; Aug: R96 000 X 50% = R48 000;

Sep R104 000 X 50% = R52 000

3. Rent income
R48 000 ÷ 6 months = R8 000 per month.

R8 000 + R960 = R8 960 (Increase is 12%)

4. Salaries and wages

R240 000 ÷ 12 = R20 000

R20 000 + R1 600 = R21 600 per month (Increase is 8%)

Stationery and bad debts

Stationery: R3 840 ÷ 12 = R320 per month

Bad debts: R7 200 ÷ 12 = R600 per month

5. Depreciation
R48 000 ÷ 12 = R4 000

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6. Other expenses
July August September
Repairs R600 + R12 = R612 R612 + R12 = R624 R624 + R12 = R636
Telephone R820 + R16 = R836 R836 + R17 = R853 R853 + R17 = R870
Electricity and water R1 120 + R22 R1 142 + R23 R1 165 + R23
= R1 142 = R1 165 = R1 188
Insurance R1 400 + R28 R1 428 + R29 R1 457 + R29
= R1 428 = R1 457 = R1 486
Bank charges R1 100 + R22 R1 122 + R22 R1 144 + R23
= R1 122 = R1 144 = R1 167

6.6.5 Pro forma statement of financial position

AKM LIMITED
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 2020
R
ASSETS
Non-current assets 750 000
Property, Plant and Equipment (1 200 000 + 200 000) 1 400 000
Accumulated depreciation (660 000 + 150 000) (810 000)
Financial assets: Investments (60 000 + 100 000) 160 000
Current assets 4 580 000
Inventories 3 080 000
Accounts receivable (20% of sales) 800 000
Cash and cash equivalents 700 000
Total assets 5 330 000

EQUITY AND LIABILITIES

Equity 1 780 000
Ordinary share capital (940 000) 940 000
Retained income (700 000 + 400 000 – 260 000) 840 000
External Funding Needed** (EFN) 490 000
Non-current liabilities 300 000
Mortgage bond (360 000 – 60 000) 300 000
Current liabilities 2 760 000
Accounts payable (5% of sales) 200 000

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Other current liabilities 2 300 000

Dividends payable 260 000
Total equity and liabilities 5 330 000

**Balancing Figure

Unit 7

i. Marginal income/contribution
ii. Marginal income; fixed costs
iii. Margin of safety
iv Increase
v Variable; fixed

Total (R) Per Unit (R) Percentage (%)

Sales (7 000 units) 280 000 40 100
Variable Cost (R84 000 + R14 000 + R84 000) (182 000) (26) 65
Marginal Income 98 000 14 35

7.1.1 Break-Even point in Units = Fixed Cost

Marginal Income per unit

= R56 000

R14

= 4 000 units

7.1.2 Break even value = Break even quantity x selling price

= 4 000 x R40
= R160 000

7.1.3 Break even value = Fixed Cost

Marginal income ratio

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= R56 000
35%

= R160 000

7.1.4 Let the selling price per unit be represented by P

Sales = Variable costs + Fixed costs + Net profit
7 000P = R14(7 000) + 0.3P(7 000) + R56 000 + R2(7 000)
7 000P = R98 000 + 2 100P + R56 000 + R14 000
7000P -2100P = R168 000
4 900P = R168 000
P = R168 000
4900
= R34.29

7.2.1 Expected profit or loss Total ®

Sales (125 000 X R5) 625 000
Variable cost (125 000 X R4) (500 000)
Marginal income (125 000 X R1) 125 000
Fixed Cost (140 000)
Net Loss (15 000)

7.2.2 Sales volume required to achieve a profit of R60 000

Target sales profit = Fixed Cost + Target profit
Marginal income per unit
= R140 000 + R60 000
R1
= 200 000 units

7.2.3 Sales Value = 200 000 x R5

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= R1 000 000

7.3.1 Total (R) Per unit (R)

Sales (6 000 units) 492 000 82
Variable cost (R20 + R30 + R22) X 6 000 (432 000) (72)
Marginal income 60 000 10
Fixed costs (36 000)
Net Profit 24 000

7.3.2 Break even in units = Fixed Cost

Marginal Income per unit

= R36 000
R10

= 3 600 units

Break even in sales = Break even in units x Selling Price

= 3 600 x R82
= R295 200

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[Link] Margin of safety in terms of Value = Budgeted sales – Break even sales
= R492 000 – R295 200
= R196 800

[Link] Margin of safety in terms of Units = Budgeted sales units – Break-even sales units
= 6 000–3 600
= 2 400 units

7.4.1 Break-even Point

Break-Even point in Units = Fixed Cost

Contribution per unit

= R600 000
(R20 - R10)

= 6 000 Units

7.4.2 Target sales Profit

Target sales Profit = Fixed Cost + Target Profit

Contribution per unit

= R600 000 +R30 000

(R20 - R10)

= 9 000 Units
7.4.3 Profit
Sales (R20 x 8 000) R160 000
Variable Cost (R10 x 8 000) (R80 000)
Contribution Margin R80 000
Fixed Cost (R60 000)
Profit R20 00

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7.4.4 Selling Price

Contribution Margin = Target profit + Fixed cost
= R30 000 + R60 000
= R90 000

(SP -VC) *Units = Contribution margin

(SP – R10) *8 000 = R90 000
8 000SP – R80 000 = R90 000
8 000SP = R90 000 + R80 000
8 000SP = R170 000
SP = R170 000/8 000
= R21.25

7.4.5 Additional fixed cost

Break even on additional fixed cost = Additional fixed cost

Contribution margin per unit

= R8 000
R10

= 800 units

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Unit 8

8.10.1

No Cost Direct Cost Indirect Cost

[Link] Fabric used in the manufacture of shirts ✓

[Link] Grease for the factory machines ✓

[Link] Depreciation of factory machinery ✓

[Link] Cleaning materials ✓

[Link] Salary of the supervisor ✓

[Link] Wood used in making tables ✓

[Link] Wages of the person who operates the ✓

machine that makes the shoes

[Link] Rent of the factory ✓

8.10.2 Sources of project costs

Cost of labour—This involves hiring costs and wages for the various human resources associated with the project.
Given that a project requires a variety of personnel with varying skill levels, labour cost estimation is not an easy
task. It must factor in salaries or hourly rates, pension and health benefits, other overhead, and an estimate of time
involvement.
Cost of materials—This is the cost of raw materials, supplies, and other equipment needed to complete project
tasks. The actual costs incurred for materials depend on the nature of the project; for example, material costs for
software development projects can be quite small, whereas in construction projects they are very large.
Cost of equipment and facilities—Many ‘‘off-site’’ projects, such as mining or construction of large buildings,
require project team members to rent facilities and equipment. In these cases, the rental costs are legitimate costs
that can be charged against the project.
Other relevant sources of project costs can include travel costs of team members, as well as costs associated with
subcontractors or consultants.

8.10.3 For the advantages and disadvantage of using project budgets, read paragraph 8.8.
8.10.4 To differentiate between recurring and non-recurring cost, you need to read paragraph 8.5.

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Unit 9
9.8.1 The various sources of financing a project, read paragraph 9.4.
9.8.2 The problems faced by project companies when attempting to obtain finance, you need to read paragraph
9.6.
9.8.3 The basic principles of financing the project are covered in paragraph 9.2.
9.8.4 One of the financial manager's most important functions is the raising of finance for projects which have
been accepted by the business on the basis of the principles of capital investment decision-making. The
most intuitive reason for seeking a combination of alternative sources of finance is availability of funds.
Sponsors may simply not have finance available to meet the requirements and other sources are therefore
investigated.
A profitable business can achieve benefits for owners by borrowing, as a result of leverage. The principle
of leverage relies on the fact that the business achieves a return on assets which is greater than the cost
of finance due to lenders. The lenders, who do not share in the profits, receive their contractual interest.
Any returns which can be generated above the interest payment accrue to the owners. Owners thus lever
the return on equity upwards, achieving a return on equity which is greater than the return on assets.

The use of debt, due to the fixed nature of interest, increases the volatility of earnings as well as the
probability of bankruptcy. Interest results in a tax deduction and this is a further reason for using debt
finance. However, the mix of equity and debt financing is also affected by the level of business risk. A utility
such as Eskom will tend to use more debt whilst a biotech company will tend to use more equity finance.
9.8.5 Calculations
a) The cost of equity using the CAPM will be as follows

𝑅𝐸 = 𝑅𝐹 + 𝛽(𝑅𝑀 − 𝑅𝐹 )

= 7.5% + 1.1 × 5%

= 7.5% + 5.5%

= 13%

b) After tax cost of debt

𝑅𝐷 = 𝑌𝑇𝑀 (1 − 𝑇)

= 9.43 × (1 − 0.28)
= 6.79%

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c) Dividend growth model

𝐷0 (1 + 𝑔)
𝑅𝐸 = +𝑔
𝑃0

𝑅0.12 (1 + 0.07)
= + 0.07
𝑅2.30
0.1284
= + 0.07
2.30

= 12.58%

d) WACC
Debt to Equity ratio = 0.5
Weight of Debt = 0.5/(1 + 0.5) = 33.33%
Weight of Equity = 1- 0.3333 = 66.67%
Proportion Cost Contribution
Debt 0.3333 6.79% 2.26%
Equity 0.6667 13% 8.67%
1
WACC 10.93%

Note: If debt-equity is X, then the debt ratio is X/(1+X)

9.8.6 Cost of financing is similar to the cost of capital.

𝑅𝐸 = 𝑅𝐹 + 𝛽(𝑅𝑀 − 𝑅𝐹 )
𝑅𝐹 = 7%
𝛽 = 1.3
(𝑅𝑀 − 𝑅𝐹 ) = 4%

𝑅𝐸 = 7% + 1.3 (4%)
= 12.2%
Cost of debt
𝑅𝐷 = 𝑌𝑇𝑀(1 − 𝑇)
= 9.4 (1 − 0.28)
= 6.77%
Debt to equity = 33.33%
Weights of Debt = 0.3333/(1 + 0.3333) = 0.25
Weights of equity = 1 – 0.25 = 0.75

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Proportion Cost Contribution

Debt 0.25 6.67% 1.67%
Equity 0.75 12.2% 9.15%
1
WACC 10.82%

9.8.7 Infrastructure and energy projects are typically financed using a combination of debt and equity financing
on a limited or non-recourse basis with the debt portion coming from the large South African banks,
sometimes combined with pension funds, or international development finance institutions (often depending
on the currency of the off-take). For rand-based projects (such as energy projects for which the off-taker is
the South African state-owned utility Eskom), South African banks will usually be the lead (and often only)
financiers, using a combination of:

• Senior term loan funding.

• (Occasionally) mezzanine funding (provided by commercial banks or smaller investment
institutions).
• Additional revolving or shorter-term facilities, such as debt service reserve or VAT facilities.

Equity contributions, in particular by historically disadvantaged South African participants are often funded by the
likes of the Development Bank of Southern Africa (DBSA) or the Industrial Development Corporation (IDC) as well
as commercial banks, either as loans or preference share funding to the relevant equity participant, reliant on
dividend streams for repayment, or alternatively as deeply subordinated debt into the project companies
themselves.

In some instances, municipal or other projects developed by state-owned entities are funded by bond issuances
denominated in rand. Project bonds are otherwise currently uncommon in the South African market.

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Reference List
• Marx, J, C Swardt, M Pretorius, W Rosslyn-Smith (2017). Financial Management in Southern Africa. 5th
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• Schwalbe, K. (2019) Introduction to Project Management. 3rd Edition. Boston: Course Technology
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• Venkataraman, R.R., and Pinto, J.K (2018) Cost and Value Management in Projects. NJ: Wiley, pp.
344–345.
• Yescombe, E.R, (2014) Principles of Finance. 2nd Edition: British Library: Elsevier.

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Square.
• Rajegopal, S., McGuin, P and Waller, J. (2007) Project Portfolio Management. 1ST Edition. New York.
Palgrave Macmillan
• Reilley F. K & Brown K.C (2012) Investment Analysis and Portfolio Management. 10th Edition. South
Western. Cengage Learning
• Ross, S.A., Westerfield, R.W., Jordan, B.D (2013) Fundamentals of Corporate Finance. 10th Edition.
United Kingdom: McGraw-Hill Limited.
• Rothman, J (2016) Manage Your Project Portfolio: Increase Your Capacity and Finish More Projects. 2nd
Edition.
• Sarwate, D.M. (2004) Entrepreneurship Development and Project Management. 1st Edition. Pune:
Everest Publishing House
• Schwalbe, K. (2015) Introduction to Project Management. 2nd Edition. Boston: Course Technology
Cengage Learning. pp 15-17; 60
• Turner, J.R. and Simister, S. (2004) Project Management: A Comprehensive Handbook. 1st Edition. New
Dehli: Gower Publishing Limited

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• Van Rensburg, M., Boyce, L., Evangelou, O., Govender, B., Koortzen, P.J., Shaku, M.D. and Ziemerink,
J.E.E. (2017) Cost and Management Accounting. 3rd Edition. Pretoria: Van Schaik Publishers
• Venkataraman, R.R., and Pinto, J.K (2018) Cost and Value Management in Projects. NJ: Wiley, pp. 344–
345.
• Watt, A (2018) Project Management BCcampus Open Education.
• Yescombe, E.R, (2014) Principles of Project Finance. 2nd Edition: British Library: Elsevier
• [Link]
• [Link]
• [Link]
portfolio-management-defined/
• [Link]
financial-economics/29748
• [Link]
• ht[Link]
cost/tps://[Link]/training/basics-project-cost-management
• [Link]

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APPENDICES

𝐓𝐀𝐁𝐋𝐄 𝟏:
𝑵
𝐅𝐮𝐭𝐮𝐫𝐞 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐑𝟏: 𝐅𝐕𝐈𝐅(𝐢,𝐍) = (𝟏 + 𝒊)
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19%
1 1.0100 1.0200 1.0300 1.0400 1.0500 1.0600 1.0700 1.0800 1.0900 1.1000 1.1100 1.1200 1.1300 1.1400 1.1500 1.1600 1.1700 1.1800 1.1900
2 1.0201 1.0404 1.0609 1.0816 1.1025 1.1236 1.1449 1.1664 1.1881 1.2100 1.2321 1.2544 1.2769 1.2996 1.3225 1.3456 1.3689 1.3924 1.4161
3 1.0303 1.0612 1.0927 1.1249 1.1576 1.1910 1.2250 1.2597 1.2950 1.3310 1.3676 1.4049 1.4429 1.4815 1.5209 1.5609 1.6016 1.6430 1.6852
4 1.0406 1.0824 1.1255 1.1699 1.2155 1.2625 1.3108 1.3605 1.4116 1.4641 1.5181 1.5735 1.6305 1.6890 1.7490 1.8106 1.8739 1.9388 2.0053
5 1.0510 1.1041 1.1593 1.2167 1.2763 1.3382 1.4026 1.4693 1.5386 1.6105 1.6851 1.7623 1.8424 1.9254 2.0114 2.1003 2.1924 2.2878 2.3864

6 1.0615 1.1262 1.1941 1.2653 1.3401 1.4185 1.5007 1.5869 1.6771 1.7716 1.8704 1.9738 2.0820 2.1950 2.3131 2.4364 2.5652 2.6996 2.8398
7 1.0721 1.1487 1.2299 1.3159 1.4071 1.5036 1.6058 1.7138 1.8280 1.9487 2.0762 2.2107 2.3526 2.5023 2.6600 2.8262 3.0012 3.1855 3.3793
8 1.0829 1.1717 1.2668 1.3686 1.4775 1.5938 1.7182 1.8509 1.9926 2.1436 2.3045 2.4760 2.6584 2.8526 3.0590 3.2784 3.5115 3.7589 4.0214
9 1.0937 1.1951 1.3048 1.4233 1.5513 1.6895 1.8385 1.9990 2.1719 2.3579 2.5580 2.7731 3.0040 3.2519 3.5179 3.8030 4.1084 4.4355 4.7854
10 1.1046 1.2190 1.3439 1.4802 1.6289 1.7908 1.9672 2.1589 2.3674 2.5937 2.8394 3.1058 3.3946 3.7072 4.0456 4.4114 4.8068 5.2338 5.6947

11 1.1157 1.2434 1.3842 1.5395 1.7103 1.8983 2.1049 2.3316 2.5804 2.8531 3.1518 3.4785 3.8359 4.2262 4.6524 5.1173 5.6240 6.1759 6.7767
12 1.1268 1.2682 1.4258 1.6010 1.7959 2.0122 2.2522 2.5182 2.8127 3.1384 3.4985 3.8960 4.3345 4.8179 5.3503 5.9360 6.5801 7.2876 8.0642
13 1.1381 1.2936 1.4685 1.6651 1.8856 2.1329 2.4098 2.7196 3.0658 3.4523 3.8833 4.3635 4.8980 5.4924 6.1528 6.8858 7.6987 8.5994 9.5964
14 1.1495 1.3195 1.5126 1.7317 1.9799 2.2609 2.5785 2.9372 3.3417 3.7975 4.3104 4.8871 5.5348 6.2613 7.0757 7.9875 9.0075 10.1472 11.4198
15 1.1610 1.3459 1.5580 1.8009 2.0789 2.3966 2.7590 3.1722 3.6425 4.1772 4.7846 5.4736 6.2543 7.1379 8.1371 9.2655 10.5387 11.9737 13.5895

16 1.1726 1.3728 1.6047 1.8730 2.1829 2.5404 2.9522 3.4259 3.9703 4.5950 5.3109 6.1304 7.0673 8.1372 9.3576 10.7480 12.3303 14.1290 16.1715
17 1.1843 1.4002 1.6528 1.9479 2.2920 2.6928 3.1588 3.7000 4.3276 5.0545 5.8951 6.8660 7.9861 9.2765 10.7613 12.4677 14.4265 16.6722 19.2441
18 1.1961 1.4282 1.7024 2.0258 2.4066 2.8543 3.3799 3.9960 4.7171 5.5599 6.5436 7.6900 9.0243 10.5752 12.3755 14.4625 16.8790 19.6733 22.9005
19 1.2081 1.4568 1.7535 2.1068 2.5270 3.0256 3.6165 4.3157 5.1417 6.1159 7.2633 8.6128 10.1974 12.0557 14.2318 16.7765 19.7484 23.2144 27.2516

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20 1.2202 1.4859 1.8061 2.1911 2.6533 3.2071 3.8697 4.6610 5.6044 6.7275 8.0623 9.6463 11.5231 13.7435 16.3665 19.4608 23.1056 27.3930 32.4294

21 1.2324 1.5157 1.8603 2.2788 2.7860 3.3996 4.1406 5.0338 6.1088 7.4002 8.9492 10.8038 13.0211 15.6676 18.8215 22.5745 27.0336 32.3238 38.5910
22 1.2447 1.5460 1.9161 2.3699 2.9253 3.6035 4.4304 5.4365 6.6586 8.1403 9.9336 12.1003 14.7138 17.8610 21.6447 26.1864 31.6293 38.1421 45.9233
23 1.2572 1.5769 1.9736 2.4647 3.0715 3.8197 4.7405 5.8715 7.2579 8.9543 11.0263 13.5523 16.6266 20.3616 24.8915 30.3762 37.0062 45.0076 54.6487
24 1.2697 1.6084 2.0328 2.5633 3.2251 4.0489 5.0724 6.3412 7.9111 9.8497 12.2392 15.1786 18.7881 23.2122 28.6252 35.2364 43.2973 53.1090 65.0320
25 1.2824 1.6406 2.0938 2.6658 3.3864 4.2919 5.4274 6.8485 8.6231 10.8347 13.5855 17.0001 21.2305 26.4619 32.9190 40.8742 50.6578 62.6686 77.3881

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𝐓𝐀𝐁𝐋𝐄 𝟐
𝑵
𝑵
(𝟏 + 𝒊)𝑵 − 𝟏
𝐅𝐮𝐭𝐮𝐫𝐞 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐫𝐞𝐠𝐮𝐥𝐚𝐫 𝐚𝐧𝐧𝐮𝐢𝐭𝐲 𝐨𝐟 𝐑𝟏 𝐩𝐞𝐫 𝐩𝐞𝐫𝐢𝐨𝐝 𝐟𝐨𝐫 𝐩𝐞𝐫𝐢𝐨𝐝: 𝑭𝑽𝑰𝑭𝑨(𝒊,𝑵) = ∑(𝟏 + 𝒊) = [ ]
𝒊
𝒊=𝟏

No of 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%

Periods
1 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
2 2.0100 2.0200 2.0300 2.0400 2.0500 2.0600 2.0700 2.0800 2.0900 2.1000 2.1100 2.1200 2.1300 2.1400 2.1500
3 3.0301 3.0604 3.0909 3.1216 3.1525 3.1836 3.2149 3.2464 3.2781 3.3100 3.3421 3.3744 3.4069 3.4396 3.4725
4 4.0604 4.1216 4.1836 4.2465 4.3101 4.3746 4.4399 4.5061 4.5731 4.6410 4.7097 4.7793 4.8498 4.9211 4.9934
5 5.1010 5.2040 5.3091 5.4163 5.5256 5.6371 5.7507 5.8666 5.9847 6.1051 6.2278 6.3528 6.4803 6.6101 6.7424

6 6.1520 6.3081 6.4684 6.6330 6.8019 6.9753 7.1533 7.3359 7.5233 7.7156 7.9129 8.1152 8.3227 8.5355 8.7537
7 7.2135 7.4343 7.6625 7.8983 8.1420 8.3938 8.6540 8.9228 9.2004 9.4872 9.7833 10.0890 10.4047 10.7305 11.0668
8 8.2857 8.5830 8.8923 9.2142 9.5491 9.8975 10.2598 10.6366 11.0285 11.4359 11.8594 12.2997 12.7573 13.2328 13.7268
9 9.3685 9.7546 10.1591 10.5828 11.0266 11.4913 11.9780 12.4876 13.0210 13.5795 14.1640 14.7757 15.4157 16.0853 16.7858
10 10.4622 10.9497 11.4639 12.0061 12.5779 13.1808 13.8164 14.4866 15.1929 15.9374 16.7220 17.5487 18.4197 19.3373 20.3037

11 11.5668 12.1687 12.8078 13.4864 14.2068 14.9716 15.7836 16.6455 17.5603 18.5312 19.5614 20.6546 21.8143 23.0445 24.3493
12 12.6825 13.4121 14.1920 15.0258 15.9171 16.8699 17.8885 18.9771 20.1407 21.3843 22.7132 24.1331 25.6502 27.2707 29.0017
13 13.8093 14.6803 15.6178 16.6268 17.7130 18.8821 20.1406 21.4953 22.9534 24.5227 26.2116 28.0291 29.9847 32.0887 34.3519
14 14.9474 15.9739 17.0863 18.2919 19.5986 21.0151 22.5505 24.2149 26.0192 27.9750 30.0949 32.3926 34.8827 37.5811 40.5047
15 16.0969 17.2934 18.5989 20.0236 21.5786 23.2760 25.1290 27.1521 29.3609 31.7725 34.4054 37.2797 40.4175 43.8424 47.5804

16 17.2579 18.6393 20.1569 21.8245 23.6575 25.6725 27.8881 30.3243 33.0034 35.9497 39.1899 42.7533 46.6717 50.9804 55.7175
17 18.4304 20.0121 21.7616 23.6975 25.8404 28.2129 30.8402 33.7502 36.9737 40.5447 44.5008 48.8837 53.7391 59.1176 65.0751
18 19.6147 21.4123 23.4144 25.6454 28.1324 30.9057 33.9990 37.4502 41.3013 45.5992 50.3959 55.7497 61.7251 68.3941 75.8364

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19 20.8109 22.8406 25.1169 27.6712 30.5390 33.7600 37.3790 41.4463 46.0185 51.1591 56.9395 63.4397 70.7494 78.9692 88.2118
20 22.0190 24.2974 26.8704 29.7781 33.0660 36.7856 40.9955 45.7620 51.1601 57.2750 64.2028 72.0524 80.9468 91.0249 102.4436

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𝐓𝐚𝐛𝐥𝐞 𝟑
𝟏
𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐑𝟏: 𝐏𝐕𝐅𝐀(𝐢,𝐍) =
(𝟏 + 𝐢)𝐍
Number 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
of Periods
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333
2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264 0.8116 0.7972 0.7831 0.7695 0.7561 0.7432 0.7305 0.7182 0.7062 0.6944
3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513 0.7312 0.7118 0.6931 0.6750 0.6575 0.6407 0.6244 0.6086 0.5934 0.5787
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830 0.6587 0.6355 0.6133 0.5921 0.5718 0.5523 0.5337 0.5158 0.4987 0.4823
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209 0.5935 0.5674 0.5428 0.5194 0.4972 0.4761 0.4561 0.4371 0.4190 0.4019

6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645 0.5346 0.5066 0.4803 0.4556 0.4323 0.4104 0.3898 0.3704 0.3521 0.3349
7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835 0.5470 0.5132 0.4817 0.4523 0.4251 0.3996 0.3759 0.3538 0.3332 0.3139 0.2959 0.2791
8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820 0.5403 0.5019 0.4665 0.4339 0.4039 0.3762 0.3506 0.3269 0.3050 0.2848 0.2660 0.2487 0.2326
9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241 0.3909 0.3606 0.3329 0.3075 0.2843 0.2630 0.2434 0.2255 0.2090 0.1938
10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855 0.3522 0.3220 0.2946 0.2697 0.2472 0.2267 0.2080 0.1911 0.1756 0.1615

11 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3875 0.3505 0.3173 0.2875 0.2607 0.2366 0.2149 0.1954 0.1778 0.1619 0.1476 0.1346
12 0.8874 0.7885 0.7014 0.6246 0.5568 0.4970 0.4440 0.3971 0.3555 0.3186 0.2858 0.2567 0.2307 0.2076 0.1869 0.1685 0.1520 0.1372 0.1240 0.1122
13 0.8787 0.7730 0.6810 0.6006 0.5303 0.4688 0.4150 0.3677 0.3262 0.2897 0.2575 0.2292 0.2042 0.1821 0.1625 0.1452 0.1299 0.1163 0.1042 0.0935
14 0.8700 0.7579 0.6611 0.5775 0.5051 0.4423 0.3878 0.3405 0.2992 0.2633 0.2320 0.2046 0.1807 0.1597 0.1413 0.1252 0.1110 0.0985 0.0876 0.0779
15 0.8613 0.7430 0.6419 0.5553 0.4810 0.4173 0.3624 0.3152 0.2745 0.2394 0.2090 0.1827 0.1599 0.1401 0.1229 0.1079 0.0949 0.0835 0.0736 0.0649

16 0.8528 0.7284 0.6232 0.5339 0.4581 0.3936 0.3387 0.2919 0.2519 0.2176 0.1883 0.1631 0.1415 0.1229 0.1069 0.0930 0.0811 0.0708 0.0618 0.0541
17 0.8444 0.7142 0.6050 0.5134 0.4363 0.3714 0.3166 0.2703 0.2311 0.1978 0.1696 0.1456 0.1252 0.1078 0.0929 0.0802 0.0693 0.0600 0.0520 0.0451
18 0.8360 0.7002 0.5874 0.4936 0.4155 0.3503 0.2959 0.2502 0.2120 0.1799 0.1528 0.1300 0.1108 0.0946 0.0808 0.0691 0.0592 0.0508 0.0437 0.0376
19 0.8277 0.6864 0.5703 0.4746 0.3957 0.3305 0.2765 0.2317 0.1945 0.1635 0.1377 0.1161 0.0981 0.0829 0.0703 0.0596 0.0506 0.0431 0.0367 0.0313
20 0.8195 0.6730 0.5537 0.4564 0.3769 0.3118 0.2584 0.2145 0.1784 0.1486 0.1240 0.1037 0.0868 0.0728 0.0611 0.0514 0.0433 0.0365 0.0308 0.0261

25 0.7798 0.6095 0.4776 0.3751 0.2953 0.2330 0.1842 0.1460 0.1160 0.0923 0.0736 0.0588 0.0471 0.0378 0.0304 0.0245 0.0197 0.0160 0.0129 0.0105
30 0.7419 0.5521 0.4120 0.3083 0.2314 0.1741 0.1314 0.0994 0.0754 0.0573 0.0437 0.0334 0.0256 0.0196 0.0151 0.0116 0.0090 0.0070 0.0054 0.0042
40 0.6717 0.4529 0.3066 0.2083 0.1420 0.0972 0.0668 0.0460 0.0318 0.0221 0.0154 0.0107 0.0075 0.0053 0.0037 0.0026 0.0019 0.0013 0.0010 0.0007
50 0.6080 0.3715 0.2281 0.1407 0.0872 0.0543 0.0339 0.0213 0.0134 0.0085 0.0054 0.0035 0.0022 0.0014 0.0009 0.0006 0.0004 0.0003 0.0002 0.0001

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𝑵
𝟏 𝟏 − (𝟏 + 𝒊)−𝑵
𝐓𝐀𝐁𝐋𝐄 𝟒: 𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐫𝐞𝐠𝐮𝐥𝐚𝐫 𝐚𝐧𝐧𝐮𝐢𝐭𝐲 𝐨𝐟 𝐑𝟏 𝐩𝐞𝐫 𝐩𝐞𝐫𝐢𝐨𝐝 𝐟𝐨𝐫 𝐩𝐞𝐫𝐢𝐨𝐝: 𝑷𝑽𝑰𝑭𝑨(𝒊,𝑵) = ∑ = [ ]
(𝟏 + 𝒊)𝑵 𝒊
𝒊=𝟏

Number
of Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333
2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.8080 1.7833 1.7591 1.7355 1.7125 1.6901 1.6681 1.6467 1.6257 1.6052 1.5852 1.5656 1.5465 1.5278
3 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730 2.6243 2.5771 2.5313 2.4869 2.4437 2.4018 2.3612 2.3216 2.2832 2.2459 2.2096 2.1743 2.1399 2.1065
4 3.9020 3.8077 3.7171 3.6299 3.5460 3.4651 3.3872 3.3121 3.2397 3.1699 3.1024 3.0373 2.9745 2.9137 2.8550 2.7982 2.7432 2.6901 2.6386 2.5887
5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908 3.6959 3.6048 3.5172 3.4331 3.3522 3.2743 3.1993 3.1272 3.0576 2.9906

6 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173 4.7665 4.6229 4.4859 4.3553 4.2305 4.1114 3.9975 3.8887 3.7845 3.6847 3.5892 3.4976 3.4098 3.3255
7 6.7282 6.4720 6.2303 6.0021 5.7864 5.5824 5.3893 5.2064 5.0330 4.8684 4.7122 4.5638 4.4226 4.2883 4.1604 4.0386 3.9224 3.8115 3.7057 3.6046
8 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098 5.9713 5.7466 5.5348 5.3349 5.1461 4.9676 4.7988 4.6389 4.4873 4.3436 4.2072 4.0776 3.9544 3.8372
9 8.5660 8.1622 7.7861 7.4353 7.1078 6.8017 6.5152 6.2469 5.9952 5.7590 5.5370 5.3282 5.1317 4.9464 4.7716 4.6065 4.4506 4.3038 4.1633 4.0310
10 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601 7.0236 6.7101 6.4177 6.1446 5.8892 5.6502 5.4262 5.2161 5.0188 4.8332 4.6586 4.4941 4.3389 4.1925

11 10.3676 9.7868 9.2526 8.7605 8.3064 7.8869 7.4987 7.1390 6.8052 6.4951 6.2065 5.9377 5.6869 5.4527 5.2337 5.0286 4.8364 4.6560 4.4865 4.3271
12 11.2551 10.5753 9.9540 9.3851 8.8633 8.3838 7.9427 7.5361 7.1607 6.8137 6.4924 6.1944 5.9176 5.6603 5.4206 5.1971 4.9884 4.7932 4.6105 4.4392
13 12.1337 11.3484 10.6350 9.9856 9.3936 8.8527 8.3577 7.9038 7.4869 7.1034 6.7499 6.4235 6.1218 5.8424 5.5831 5.3423 5.1183 4.9095 4.7147 4.5327
14 13.0037 12.1062 11.2961 10.5631 9.8986 9.2950 8.7455 8.2442 7.7862 7.3667 6.9819 6.6282 6.3025 6.0021 5.7245 5.4675 5.2293 5.0081 4.8023 4.6106
15 13.8651 12.8493 11.9379 11.1184 10.3797 9.7122 9.1079 8.5595 8.0607 7.6061 7.1909 6.8109 6.4624 6.1422 5.8474 5.5755 5.3242 5.0916 4.8759 4.6755

16 14.7179 13.5777 12.5611 11.6523 10.8378 10.1059 9.4466 8.8514 8.3126 7.8237 7.3792 6.9740 6.6039 6.2651 5.9542 5.6685 5.4053 5.1624 4.9377 4.7296
17 15.5623 14.2919 13.1661 12.1657 11.2741 10.4773 9.7632 9.1216 8.5436 8.0216 7.5488 7.1196 6.7291 6.3729 6.0472 5.7487 5.4746 5.2223 4.9897 4.7746
18 16.3983 14.9920 13.7535 12.6593 11.6896 10.8276 10.0591 9.3719 8.7556 8.2014 7.7016 7.2497 6.8399 6.4674 6.1280 5.8178 5.5339 5.2732 5.0333 4.8122
19 17.2260 15.6785 14.3238 13.1339 12.0853 11.1581 10.3356 9.6036 8.9501 8.3649 7.8393 7.3658 6.9380 6.5504 6.1982 5.8775 5.5845 5.3162 5.0700 4.8435
20 18.0456 16.3514 14.8775 13.5903 12.4622 11.4699 10.5940 9.8181 9.1285 8.5136 7.9633 7.4694 7.0248 6.6231 6.2593 5.9288 5.6278 5.3527 5.1009 4.8696

25 22.0232 19.5235 17.4131 15.6221 14.0939 12.7834 11.6536 10.6748 9.8226 9.0770 8.4217 7.8431 7.3300 6.8729 6.4641 6.0971 5.7662 5.4669 5.1951 4.9476
30 25.8077 22.3965 19.6004 17.2920 15.3725 13.7648 12.4090 11.2578 10.2737 9.4269 8.6938 8.0552 7.4957 7.0027 6.5660 6.1772 5.8294 5.5168 5.2347 4.9789
40 32.8347 27.3555 23.1148 19.7928 17.1591 15.0463 13.3317 11.9246 10.7574 9.7791 8.9511 8.2438 7.6344 7.1050 6.6418 6.2335 5.8713 5.5482 5.2582 4.9966
50 39.1961 31.4236 25.7298 21.4822 18.2559 15.7619 13.8007 12.2335 10.9617 9.9148 9.0417 8.3045 7.6752 7.1327 6.6605 6.2463 5.8801 5.5541 5.2623 4.9995

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MANCOSA – Bachelor of Commerce in Project Management