Unit 1: The Engineering Environment

• Learning outcomes

After studying this unit, you should be able to:

• Explain the numerous technical and financial aspects that comprise engineering.
• Explain the role and responsibilities of an engineer in the different phases of a
project.
• Explain the management process of a project.
• Explain financial data and use this concept to achieve the most economical and
feasible outcomes.
• Discuss the importance of project cash flow and the different techniques to process
financial data to achieve the most economical feasible outcomes.
• Describe the influence of inflation on project cash flow.
• Explain the use of the balance sheet, income statement and cash flow statement.

1. INTRODUCTION

In this study unit, we cover eight main topics and you should study them in conjunction with
various sections of your prescribed textbook as follows:

General premise chapter 1 pages 4-19

The Management Process for Engineering chapter 1 pages 6-9

Projects

Inflation: chapter 4 page pages 114-135 , 325-331

Development of project cash flow: chapter 8 page pages 270-298

Financial statements: chapter 13 page pages 456-481

1
This module is an introduction to engineering and financial management. Apart from other
subjects that constitute engineering management, this module covers different aspects of the
environment the engineer is operating in:
• The role engineers play in the management and decision-making processes of projects.
• The responsibility of engineers in the financial aspects of project management.
• The role engineers play in the selection between alternatives and the approval of design
changes.
• The role of the engineer in the approval process for a project to be accepted.
• The influence of economic entities, inflation and project risk, on the engineer`s environment.
• The management and control of project costs.
On completion of this unit, you will have a good comprehension of the work that engineers do in
performing analysis, synthesising and drawing conclusions on projects of all sizes. These
decisions involve elements of cash flow, time and interest rates.

One of the biggest challenges you will face as a civil engineer is to get involved in some difficult
and complex feasibility studies. One of the most difficult activities is to determine the activities and
the cost associated with each. Once the cash flow has been determined you will be able to
execute an engineering economic analysis. The engineering economic analysis is only the first
step to determine the most economical feasible alternative. Engineering Economics will only
indicate the most economical feasible alternative but there are numerous considerations that will
influence the final decision. It is not a foregone conclusion that the most economical feasible
alternative would be the preferred option. Engineers are therefore called upon at this stage to
participate in making a decision that will enable the firm to produce products economically and
therefore make a profit and create wealth.

The role and responsibilities of the engineer:

As mentioned above, one of the processes that is important for an engineer as part of the project
team is decision-making.

Step 1
Firstly, you need to identify the problem. Once the problem is identified, you can develop
alternative solutions.
NB: You must make sure that you identify all possible solutions otherwise you might overlook the
best solution.
Step 2
As soon as you have identified all possible alternatives, the next difficult activity is to determine the
cash flow over the whole project life. In order to achieve this, you will use the MARR value
(minimum acceptable interest rate) to calculate the following:
• Net Present Value

2
• Annual Equivalent
• Future Value
• Internal Rentability

For these calculations, you will employ one of the preferred tools with which we will provide you.

The following tools will be made available to you in study unit 2 and you will use them to execute
the relevant calculations:

• Financial calculator
• Discrete tables
• Formulae
• Excel

How you will apply the different techniques provided to you will depend on a number of different
factors as follows:
• Cash flows for revenue and service projects and the project lives will not necessarily be the
same
• Interest rates
• Inflation
• The interest rate if there is a loan involved
• Depreciation
• The value of the Minimum Attractive Rate of Return (MARR) to be used in your calculations
• Decision to determine the most economical revenue and service projects and the project
lives will not necessarily be the same

Because civil engineering projects are usually long-term projects, you need to take into
cognisance the influence of inflation on the cash flow. The total cost of civil engineering projects
can escalate dramatically because of inflation and therefore the civil engineer must be acutely
aware of this fact.

Engineers must make provision in the cash flow to compensate for possible risk events that might
happen. Be aware of the cost implications in case an anticipated risk does occur.

Financial management activities:

As engineers, you will be expected to participate in the following tasks as a member of the project
team:

3
 • Assist the financial manager to compile the budgets required to manage projects and the
company.
• Do break-even analysis to determine the risk of projects and processes.
• Use financial information as sources of information for management as well as the engineers
working on the project.
• Manage the project creep and control the cost to prevent the cost increasing out of control.
• Assist to determine the cost and safety of design alterations.
Reading

For more extensive explanations on the topics covered thus far, read chapter 1, pages 29-42.

Self-assessment

Complete the exercises given by using one of the three suggested methods:
• Excel
• Discrete tables
• Formulae

NB: Once you have completed an exercise using a method of your choice, use the other two
methods to verify your answer. This will give you the required practice to understand and master
the different methods of calculation.

Collaboration

Share your experiences of the theory and self-test exercises with your peers in your study group.

NB: Do not discuss the self-test exercises before you have tried them yourself.

Prescribed Textbook:

The following are details of the prescribed textbook. Note that it is complementary to the content
covered in the study units.

Fundamentals of Engineering Economics. 6th International Edition

Author: Chan S Park

Publisher: Pearson Education Limited

ISBN 0-13-030791-2

2. ENGINEERING ENVIRONMENT

Engineering is a creative profession with defined objectives. Engineering endeavours require the
planning, scheduling and execution of projects. Project management is the approach to manage
all of this creativity to achieve the explicit and implicit needs of stakeholders in a cost-effective
way.

4
Engineering activities are not an end in itself. Any person practising the profession of engineering,
is always involved from the low-risk, well-defined scientific environment, to the higher risk
economic environment. The role of the engineer is to apply the wealth of scientific knowledge to
produce products, services and structures for the benefit of mankind. An engineer must be able to
operate successfully in the physical, scientific, as well as the economic fields of the total
environment. It is the objective of engineering economy to supply the project team with a thorough
understanding of the reciprocal nature between the physical and the economic sectors and to be
able to quantify their decisions in economic terms. A design can demonstrate excellence in
technical achievements but if the end user cannot afford it, or there is no requirement, the whole
project will be one of futility.

A successful product or service must be technically well conceived and must also produce results
that are viewed favourably by the consuming public or the end user. Benefits associated with
products and services must exceed their costs in order to be considered valuable. This basic
principle is also true for any engineering project. Taking into account the vast sums of money
involved in the design and development of products and structures, a wrong or unsuccessful end
product can seriously damage the profitability and survival of a company. When we take
cognisance of the fact that 75% of the life cycle cost of a product or system is committed by
completion of the design and development phase, then the impact of the engineering decisions
taken during execution of the different activities in these phases should emphasise the importance
of the engineering economic analysis that has been done.

As the project moves through the different phases of the engineering process, the decisions an
engineer must take become more complex and the economic impact on the final end product
becomes more important. An engineer can therefore not be successful if decisions are taken on a
strictly technical basis. The ultimate value of products, which result from engineering, is measured
in economic terms. The objective of engineering is therefore to get the greatest end result per unit
of resource expenditure.

The engineer who aspires to be in a creative position in engineering will find proficiency in
economic analysis and financial management helpful. The large percentage of engineers who will
eventually be engaged in managerial activities will find such proficiency a necessity.

The field of engineering economy and financial management is concerned with the systematic
evaluation of the benefits and costs of projects involving engineering design and analysis.
Engineering economy requires the application of technical and economic analysis, with the goal of
deciding which course of action best meets the technical performance criteria and uses scarce

5
capital in a prudent manner. The domain of such a decision-making activity ranges from the
engineer who uses advanced computer technology to design new products, structures, systems,
and services to the chief executive considering a major business venture that may transform the
company in the years ahead.

For a project to start, there should be inputs in terms of specifications and planning of the logistics.
Project resources would be finances, material and labour. Once the project is initiated, there
should be controls to ensure that the project is executed according to the project schedule and
specifications. The process diagram in figure 1.1 below illustrates a project process.

Project Controls
and Constraints
Project
Project Product
Input
Project
Process

Project
Resource
s

Figure 1.1: Project Process Diagram

You will remember that at the beginning of this study unit, I mentioned that as an engineer
involved in managing a project, you will need to develop alternative solutions to an identified
problem. An engineer as part of the project management team will participate in using
engineering economics to choose one alternative solution above another based on financial and
economic potential. Engineering economics is about the economic feasibility of projects in an
engineering environment. In study unit 2, you will learn how to calculate and use the four values,
namely net present value, annual equivalent, future value and the IRR to make decisions that will
have a great impact on the capital budget and the eventual profit of a company.
These values will be calculated on a before and after tax basis. The study unit will also
demonstrate how different project lives are accommodated during these calculations. We will
focus our illustration on the use of Excel, formulae and the discounting tables to do the
calculations.
2.1. The Management Process for Engineering Projects

The management of projects require inputs from various stakeholders. The engineer allocated to
the project plays a major role to manage it successfully. The different activities comprising the
project management process are:

6
• Integration management
➢ Develop project charter
➢ Project management plan
➢ Direct project execution
➢ Monitor and control execution
➢ Change control
➢ Close project or phase
• Scope management
➢ Requirements
➢ Scope definition
➢ Scope verification
➢ Scope change control
➢ Work breakdown system
• Time management.
➢ Activity definition and sequencing
➢ Resource estimation
➢ Duration estimation
➢ Schedule development and control
• Cost management
➢ Cost estimating and budgeting
➢ Cost control
• Quality management
➢ Quality planning, assurance and control
• Human resource management
➢ Identify skills required
➢ Determine number of personnel required
➢ Appoint personnel
➢ Compensation policy
➢ Grievance management
• Communications management
➢ Transparent policies
➢ Information
• Risk management
➢ Risk management planning
➢ Risk identification
➢ Risk monitor and control

7
 • Procurement management

2.2. The Decision-making Process

Rational decision-making is a complex process. Decision-making contains elements of the future

and everything is uncertain about the future therefore the basis of decision-making is estimates.
Techniques have been developed to assist the manager to make informed decisions. These
techniques can only assist up to a point where experience takes over. These techniques can also
only identify the economic feasibility of a project or alternative and does not take any intangibles
into account.
To ensure that the best solution is chosen, these tools are integrated into a decision-making
process.
The steps are as follows:
• Recognition and definition of problem or opportunity
In order to solve a problem, the problem must be identified along with the characteristics of its
desired solution. Problems that must be solved present themselves and require solutions.
Identifying opportunities are harder because it requires examination of the technical capabilities
available at the time and then seeking creative, additional applications of those capabilities or
creating new technology solutions that must be more cost-effective or have increased capabilities.
Projects can emanate from the following:
• An outcome of the strategic planning activities
• The result of an RFP received from a potential customer
• Long-term projects
• Proposals from individuals or departments within the company
• Proposals can be identified as part of a company`s normal operational or maintenance needs
Sometimes the required funds needed to finance all the acceptable projects are just not available
because of budget constraints. Management is then forced to go through a decision-making
process to prioritise and select those projects that will maximise the worth of the company.

• Defining the goal or objective

The goal or objective can be an overall goal of a person or a company. The following are some of
the goals a company might set for itself:
• increase sales
• profitability
• rate of return on the capital investment
• market share or recognised leader in the industry
• cost-effective solutions

8
 • minimise the transport cost over time

• Generation of solution alternatives

Once a problem or opportunity has been defined, solution alternatives must be identified.
Identifying these solutions requires the following:
• training
• creativity
• skill
• maturity
• experience inside a company

This phase is about generating alternatives and evaluating them. Make sure that all possible
alternatives are identified, even if some of them are obviously not practical solutions. While it
seems to be the safe strategy to identify as many alternatives as possible, the cost implications of
analysing a large number of alternatives must also be kept in mind. It would therefore be
appropriate to discard solutions that are obviously impractical.

• Development of cash flows and gathering of information for feasible alternatives

Once alternatives have been identified, the economic and technical feasibility of the alternatives
must be researched. In addition to the economic viability analysis, a risk analysis should be done
and the impact of these identified risks should be quantified and possible risk management
strategies should be proposed. Estimation of cash flow is regarded as the most challenging activity
as all of the cash flows take place in an uncertain future. However, techniques are available to
reduce the estimation errors, but it cannot be eliminated in totality.

• Selection of criteria to determine the best alternatives

To choose the best alternative, a criterion or set of criteria that would discriminate sufficiently,
constantly and unambiguously between alternatives is needed. The decision methodology is one
of comparison of alternatives. We are therefore dealing in relative terms and not in absolute value.
Examples of criteria can be:
• minimise the cost
• minimise the time to accomplish the goal or objective
• maximise profit
• maximise owner’s wealth
.
• Evaluation of alternatives

9
During the evaluation of alternatives, the focus should be on the differences between alternatives
and not the similarities. In addition to the economic feasibility analysis, non-economic and
intangible considerations should be taken into account. Although it is extremely difficult to achieve,
these factors should also be quantified in monetary terms.
At some point during the evaluation phase, the various elements should be brought together.
Constructing the interrelationships between all the relevant elements can be regarded as the
development of a business model. This model can then be used to do a break-even and sensitivity
analysis to strengthen the basis from which the manager can make a decision.
Alternatives or projects should also be evaluated against the strategic plan of the company. A
strategic plan can only be successfully implemented by choosing projects that will conform to the
strategic plan and by doing so develop the company towards the ultimate vision and mission of
management.

• Selection of the best alternative

Once the alternatives have been analysed economically, the optimal alternative must be selected.
Because non-economic intangibles and strategic considerations play a major role in this final
decision, management must now rely on experience and good judgment to make the final
decision.

• Implementation of the best alternative

Once the best alternative is selected and decided upon, the stakeholders will need to seek
approval for the project to be implemented. This is done through the presentation of a business
case to the decision-makers in a company.

Self-test exercise 1.1

This is a group exercise, you are therefore requested to complete this exercise in groups assigned
by your lecturer.

Scenario:
You are selected as part of a project management team for a factory, manufacturing wood
furniture that requires the development of a sawdust extractor.
Questions
Develop a solution for the project using the questions below as guidelines. Discuss how you would
go about determining a solution to the request using the following questions as guidelines.

1.1.1 Identify the project phases that will be applicable and the activities to be done in each phase.

10
1.1.2 Identify the economic factors that you would need to consider prior to making a decision as
to which design should be accepted.
1.1.3 Identify the role of the engineer in each phase.

2.3. The Business Case

Success of a project starts with a well-constructed business case. A business case is normally a
formal written document, but can also be a presentation, to motivate the acceptance and approval
of an action or project by the relevant decision-makers. A business case is a justification for a
proposed project or requirement on the basis of its expected commercial benefits at lowest risk.
Approval of a business case will then make it possible to include the project as part of the capital
budget. A carefully constructed business case covers all feasible approaches or alternatives to
solve a given problem or requirement and enables the decision-makers to make a well-informed
decision or select the option that would benefit the company most.
A carefully constructed business case should:
• Examine the benefits and risks involved when either accepting the proposal or the
consequences if it is not accepted and the do-nothing option is decided upon.
• Have a conclusion with a compelling argument why the proposal should be selected and
approved. This is essential because the benefits from accepting a proposal is not immediately
evident. Therefore, the business case document can highlight and point out the benefits
associated with the project or proposal.

2.3.1. Constructing a business case

This process consists of the following activities:

• Estimating, collecting, processing and analysing of data.

NB: Estimates must include determination of costs, revenue, ROI and risk (financial and
technical).
• Identifying resources, finance, technology, infrastructure, human resources and available
time.
• Identifying all the sources of data that will be required to support the business case, i.e.
financial sources, case studies, historical data, forecasts, demographic studies.
• Analysing to determine risk and economic feasibility.

2.3.2. The Business Case Document

A business case is divided into various sections as follows:
• The Executive Summary

11
The executive summary is a high level synopsis of the broader business case document. Some
stakeholders are not interested or do not have the time available to read the business case in its
entirety; they may only read the executive summary. Therefore, it is crucial to include all the
information that is essential for the reader to make a well-informed decision. Similar to an
academic article, the executive summary is the first heading of the document but is only written
after the completion of the business case.
The executive summary explains in condensed form and plain language the following:
• The problem the project or proposal is to solve.
• The resources required to complete the project successfully.
• The desired outcome.
• The predicted rate of return and when it should be expected to realise.

• Problem Statement
The problem statement is a straightforward articulation of the problem the project or proposal must
solve. It identifies the possible causes of the problems that are experienced, such as:
• reliability
• high cost
• unacceptable market performance
• new opportunity
• negative client feedback

• Analysis of the Situation

This section describes the situation behind the problem in more detail and possible causes that
brought the situation to this point where a solution must be developed.
This section also documents the consequences if nothing is done to address the problem.

• Solution options
This section identifies all potential solutions to the problem. Each alternative should be described
and discussed in sufficient detail for the reader to understand them and for the reader to associate
with the alternative proposals as possible solutions to the problem.
Most of the time there are multiple solutions to a problem in the engineering field and this section
should cover all of them.

• Project Description

• Describe the project charter and scope

• Identify and describe all stages of the project

12
 • Delivery period
• Timeline project budget
• Project milestones and measurable goals
• List of assumptions
• Availability of resources
• Identified risks and proposed mitigating strategies
• Financial projections and ROI
• Provision for cost escalations due to scope creep

• Cost-Benefit Analysis
This section integrates all the results from the economic feasibility study and the risk analysis for
all the possible alternatives or proposals of which the do-nothing option can or may be an
alternative.
The motivation for the recommended choice can be supported by data from similar projects, case
studies, charts and graphs. Graphs can illustrate points that are hard to extrapolate from text-
based data.
The cost-benefit analysis should include the projected financial benefit and a projection of when
the pay-off is expected.

• Recommendation
In this, the recommendation is made as to which is the best solution and how it is to be conducted.
The recommendation is a brief restatement of all the critically important aspects originating from
the analysis that support the chosen alternative.
Describe the circumstances under which the project should be undertaken such as:
• available human resources,
• risk, and
• available budget.
Limitations on resources should be made clear. The discussion of the key factors should refer the
reader to the relevant data in the analysis section.

The beginning of the implementation phase is the approval of the capital budget. Once the capital
budget has been approved a project manager would be appointed, if not already done at an earlier
stage in the decision process. The project manager now has the authority to convene a project
team and start committing the approved funds.

• Post implementation analysis and evaluation

13
After implementation of an alternative, the project must be monitored to determine if any changes
should be made to the scope, more funds be made available or maybe the most difficult decision
of all is to decide whether a project should continue.
Projects are also monitored to build a history of mistakes made, problems that were experienced
and the accuracy of the original estimates. This can then be used as a guide for the planning of
future projects.

Self-test exercise 1.2

Scenario
Your company received an RFP for the construction of a suspension bridge on the newly
developed N4 highway.
Questions
1.2.1. Develop the estimates and requirements necessary to make a proposal.
1.2.2. Identify the risks involved for your company and develop strategies to mitigate the impact of
such risks should they happen.
1.2.3. Develop the project plan and the foreseen activities.
1.2.4. Allocate responsibilities to the different stakeholders.

3. THE ROLE OF THE ENGINEER IN PROJECTS

The engineer plays a vital role in the development of items or structures as well as in the decision-
making process. Civil engineers play a major role in capital investment decisions based on their
analysis, synthesis and design efforts. All the activities have cost as a central theme. The
company does not want to use more capital than what was budgeted for the project and therefore
would like to ensure an acceptable rate of return on the investment.
The decision of how to invest capital will invariably change the future and it will hopefully change
the environment we are living in. Civil engineers usually operate as a member of a project team
and the output of this team will create a new environment that will comply with the future needs
and requirements of the country.
4. ENGINEERS IN THE CIVIL ENGINEERING FIELD
The following are different roles played by civil engineers in the civil engineering field:
• They play a major role in the feasibility studies of civil projects small and large.
• Must support the financial department in estimating the costs involved in a project.
• Should identify possible risks for the project and determine the possibility that such a risk can
occur.
• Should propose mitigating strategies to minimise the impact, financially and with regard to
safety, of a risk should it happen.
• They are responsible to sign off the final design and therefore declare it structurally sound.
• They are responsible for the quality control.

14
 • They approve design changes.

4.1. Advantages for civil engineers as part of the project team

• Civil engineers are creative by nature – they develop new structures or improve old
structures.
• Civil engineers can be involved in a wide field of different types of projects, i.e. consulting,
design, and project management.
• Signing off on a project gives a lot of satisfaction and pride.
• Civil engineers are not office bound and once a project is initiated, a lot of time is spent at the
site of the project.

4.2. Disadvantages for civil engineers as part of a project team

• The environment where a project is being undertaken can be uncomfortable.

• If a risk or disaster happens it is the responsibility of the civil engineer to determine the
reason for the event and arrange for remedial actions to be taken.
• Labour actions can delay the agreed delivery date and can have severe financial
implications.
• Shortages of the correct skilled labour can complicate the management of the project.
• A project can be delayed or terminated if the client experiences cash flow problems or goes
bankrupt.
• Approval of projects can be delayed or even cancelled because of the financial situation in
the country.

4.3. Activities where the engineer plays a very important role

• Execution of feasibility studies.

• Guidance on cost.
• Recommendation of the most feasible alternative.
• Approval of the final design.
• Test and evaluation schedules.
• Evaluation of design changes in terms of cost and safety.
• Supervision of execution of the project.
• Quality control to ensure compliance with specifications.
• Consulting.

Self-test exercise 1.3

15
Scenario
The nature of the company`s business and the management culture can differ. This difference can
influence the relationship, tasks and scope between the financial manager and the engineers.
Questions
Arrange interviews with at least two financial managers and two engineers from different
companies and determine the following:
1.3.1. The type of business a company is operating in has its own nature and culture. How does
the nature and the culture the company is operating in influence the relationships, tasks and scope
between management and the engineers?
1.3.2. How does the nature and management culture in the different companies influence the
relationships, tasks and scope of management and the engineers?
1.3.3. How does the management style of the CEO in the company influence the relationships,
tasks and scope of management and the engineers?

5. SCOPE OF THE FINANCIAL MANAGER

Because the engineer is heavily involved in the financial aspects of a project, there should be a
good relationship between the engineer and the financial manager. It is therefore important for the
engineer to understand the role and responsibilities of the financial manager. If this is not the case,
then conflict can arise from misunderstandings to the detriment of the project.
Financial managers manage all the financial affairs of any company irrespective size or type of
business. The activities and responsibilities of a financial manager can be:
• Planning of financial requirements, i.e. the capital budget, cash flow, operating cash flow.
• Managing the capital structure of the company.
• Extending credit to customers.
• Evaluating capital intensive investments or projects.
• Raising the necessary funds to finance the operations of the company.
• Being involved in the development and implementation of corporate strategies to grow the
company and improving the competitiveness of the company.
• Managing cash flow in different currencies and protecting the company from risk that can
arise from international transactions.

5.1. Financial Management and Analysis

The subject matter of this unit is most likely what you will be doing for the biggest part of your
engineering career. Success in the engineering field is not measured on how well you can solve a
differential equation, design a widget or structure to meet a specification but on how well you
manage the engineering work to create a cost effective solution.

This unit covers the following aspects in the engineering environment:

16
 • Activities that form part of the financial management in relation to projects.
• Management of a portfolio of projects and how a change of the portfolio of projects would
influence the risk for the company.
• The influence of inflation on the cash flow of projects and the rate of return.
• The objectives of financial data and how they are used to manage the finances of a
company.

6. FINANCE AND COST MANAGEMENT

During the design phase of a project, the focus is mainly on two aspects, namely:

• The economic feasibility of the design. The question that must be answered is whether the
total cost of the project is affordable. There is always a deficit of available capital. If a
company overspends on a project it means that other projects that are planned might have to
be cancelled or delayed.

• The second objective of the design process is to design an item that is efficient in its output.
Efficiency and profitability goes hand in hand.

Figure 1.2 below illustrates graphically the two financial objectives of the design process.

Economic Feasibility: Economic Efficiency:

The solutions provided must not The most economical of the many
exceed monetary budget limits. technical solutions to a problem
should be chosen.

Figure 1.2: The two financial objectives of the design process

17
Figure 1.3 below illustrates the financial activities in the project management phase where
engineers are involved:

Definition of Requirement (Problems & Opportunities)

Client User Specification

Project Charter
Generate Alternatives

Project Scope
Estimate of Costs
Description & Information on Identified alternatives Allocation of Costs
Risk analysis

Feasibility study
Evaluate & Select Alternatives
Time Value of Money
Interest Rate (MARR)
Business Case Measure of Worth
Capital Budget Non-economic
considerations
Strategic plan of the
Recommendation and Initiating of Project Company
Financing the Project

Conceptual Design

Value Engineering

Detail Design Design Review Cost analysis

Test and Evaluation

Figure 1.3: The financial activities in the project management phase where engineers are
involved

6.1. Project cash flow

6.1.1. Life cycle costing

• A large portion of the cost of a system is committed on the basis of decisions made early in
the system life cycle. Therefore, the total cost in all phases of the life cycle must be
considered, but particularly during the early planning and conceptual design stages when
major decisions are made that significantly impact all subsequent activities. Life cycle cost
provides the opportunity to design for economic feasibility.

18
 • The recent combination of economic trends, rising inflation, cost growth and budget
limitations are creating an awareness of the importance of the total project cost as well as the
cost of ownership. Not only are the acquisition costs associated with new systems rising, but
the costs of operating and maintaining systems already in use are increasing all the time.

This can be attributed to:

• Cost growth due to engineering changes occurring throughout the design and development
phases (technical deficiencies, improvements and change of scope).
• Cost growth due to changing suppliers in the procurement of components or sub-systems.
• Cost growth due to production or construction changes (legal, efficiency, cost).
• Cost growth due to changes in the logistical support chain.
• Cost growth due to estimating inaccuracies and changes in cost estimating procedures.
• Cost growth due to unforeseen problems.
• Total system cost is not always visible or available.

Figure 1.4 below illustrates the hidden cost of a capital investment.

Acquisition cost

Production Maintenance cost

Distribution cost Operations Technical data cost

Cost Inventory cost

Training cost

Retirement& disposal cost

Figure 1.4: The hidden cost of a capital investment

Figure 1.4 highlights the fact that when you procure capital equipment, the total cost is not only the
initial investment. When a capital procurement is done, all the cost to be incurred during the life of
the item or project should be taken into account during the decision process.

19
If the life cycle cost is not taken into account, the company might find that somewhere in the future
it might experience a cash flow problem. The end result would be that other projects must be
delayed. This outcome can decrease the expected profit for the company.

Self-test exercise 1.4

Scenario
There is a proposal on the table to buy an executive jet to the value of R300 000 000.
Task
1.4.1. Write a business case to motivate the procurement of this aircraft.
1.4.2. Identify the data and information you will need to motivate this case.
6.1.2. Life cycle phase profile of a project

Figure 1.5 below illustrates the phases during the life cycle of a project.

Research, Design & Development Cost

Construction & Production Cost

Operation & Support Cost

Retirement & Disposal

Figure 1.5: The phases during the life cycle of a project

A general rule states that 80% of the cost endured over the lifetime of a project occurs at the
design and pre-production phase of the project. When production finally begins, most of the
money to be spent on a project has been committed as illustrated in figure 1.6. The role of the
engineer during the design and pre-production phase is of critical importance to ensure a
successful project.

20
 Life cycle costs committed

Life cycle costs spent

100%

80%

60%

40%

20%

Needs Detailed Decline

Definition design Retirement

Conceptual Design Production Operational use

Figure 1.6: The cash flow and committed capital during the life cycle of a project

6.2. Financial decisions in project management

• The process of making decisions in a project context has the same essential characteristics
as problem-solving in general.

• The project/programme manager wants to choose that course of action which is most
effective in attaining the set goals for the project or programme.

• The project/programme manager is confronted with different decisions as follows:

✓ The estimation of costs as well as the accuracy and cost to obtain the costs. Some
costs are expensive to acquire and the more accurate the estimate must be, the
more expensive it will be.

✓ The allocation of overheads on a fair basis.

✓ Decisions under certainty or uncertainty.

✓ Decisions made for one period or a sequence of interrelated decisions over

several time periods (dynamic decision problem).

✓ Decisions where the opposition is nature.

✓ Decisions where the opposition is a thinking person.

21
 ✓ Control and contingency management.

✓ Abstraction: Real-world problems can be too complex to solve. The decision-

maker must abstract from the empirical situation those factors which he
considers to be most relevant to the problem at hand.

✓ Model building: Ideally the model simplifies the natural phenomenon of its
complexities and duplicates the essential behaviour of the natural phenomenon
with a few variables, simply related.

6.2.1. The creation of wealth as a corporate objective

The objective of every company or business is to make a profit or stated otherwise, creating
wealth. After the net profit has been determined, business management must decide on the
dividend to be declared.

Investors always have and will in the future be caring about stock returns. A confluence of factors
and circumstances lead to a growing predominance of pursuing the wealth of shareholders in
terms of the following:

• Projects are becoming larger, more complex, more expensive, and more capital intensive.
The need for capital resources worldwide is increasing and stakeholders are coerced into
partnerships and cooperation. This leads to the globalisation and deregulation of capital
markets.
• To facilitate the timely movement of capital where it is needed, capital and exchange controls
are being either phased out or regulations slackened.
• Due to the rapid advances in the information technology field, investors are more
sophisticated about trends in the financial markets and have a better understanding of the
associated risks and rewards of investing in the stock market.
• The securities market became more liquid because of large constitutional investors, and
more uncommitted funds available for investment.
• The regulations governing the investment in the capital market have been improved.
• Due to more uncommitted funds and the aging of the population, there is an expansion of
institutional investments.

As these developments took shape and started to have an effect on the capital markets, a new
generation of investors emerged. These investors are pursuing maximum value and they have the

22
financial means and supporting technology to achieve it effectively. The message to corporate
management is clear:

“Capital has attained a high degree of mobility and this capital will be invested where the
rate of return, at a risk, is acceptable”.

The implication of this development is that it is not only required for a company to be competitive
in the commercial markets, but they must also be competitive in capital markets. If this is not the
case, companies will be penalised by the capital markets by demanding higher rates of return on
their investments and therefore higher cost of capital for the company and this higher cost of
capital can put the company at a disadvantage with its competitors. The choice would therefore be
either to improve the financial standing of the company, risk a takeover from another competitor or
worst of all the company can go bankrupt.

All management must understand, for their company to survive and grow, they must be
competitive in terms of operating costs (labour, material administration) and that survival also
requires competitive capital costs. An optimal capital structure is therefore essential for success.

The forces within the financial markets will force the management of companies to take
cognisance of their capital budgeting maturity makeup. A lack in understanding the capabilities
and internal facilities required to strive towards an optimum capital structure, will surely lead to the
demise of the company.

6.2.2. Maximising profit

A general belief is that the responsibility of the management of a company is to maximise profit. If
maximising profit is the objective of the company, then it would imply that management would take
only those actions that would contribute to the company`s overall profit. Only alternatives or
projects that are expected to result in the highest monetary return would be accepted.
Companies and investors in equity shares generally measure the financial success of a company
in terms of its earnings per share. The earnings per share is calculated by dividing the total
earnings available to the company`s stockholders by the number of common stock outstanding (in
possession of investors).
Profit maximisation would ignore the advantages of the optimum portfolio of projects achieved by
portfolio management.

6.2.3. Risk management

Profit maximisation ignores risk as a consideration by investors. There is a trade-off between
return on an investment and the accompanied risk. The higher the risk the higher the expected

23
return by investors would be. Risk can significantly influence the value of an investment. Return
and risk is the key determinants of the share price, and the share price determines the wealth of
the investor.

6.2.4. Maximising shareholder wealth

The goal of management would be to maximise the wealth of the owners of the company. When
considering each financial decision in terms of its effect on the share price of the company`s stock,
the management should accept only those actions that are expected to increase share prices.

Self-test exercise 1.5

Scenario
A company is planning a development project but they will have to go to the capital market for the
necessary funds. There is no consensus what financial instrument should be used. The options
are:
• Loans.
• Common shares.
• Bonds.
• Retained earnings.

Questions
1.5.1. How would each one of these financial instruments, if incorporated into the capital
structure of the company, influence the perceived risk by investors?
1.5.2. If the debt/equity ratio is increasing over time, how would the increased risk influence the
required rate of return by potential investors?
1.5.3. Identify the considerations to be taken into account, to make a recommendation.

7. CONSIDERATIONS FOR CAPITAL BUDGET DECISIONS

Study the section on Capital budget decisions in conjunction with chapter 15 page 806 of your
prescribed textbook.

When capital budgets are developed, the risk associated with each project should be considered.
The risk associated with each project will eventually determine the collective risk of the company.
Although the risk of a project is high, it does not disqualify it from being accepted. What is
important is the correlation of its rate of return in relation to the other projects. Provision can be
made for the risk inherent in the project by increasing the cash flow or using an adjusted MARR
value.

24
7.1. Types of risk

The following are various types of risks associated with managing projects in a portfolio of
projects:
• Stand-alone Risk
The risk of the project disregarding the fact that it is part of a portfolio of projects within the
company. Stand-alone risk is quantified by calculating the variability of the project`s expected
returns.
• Corporate or with-in firm risk
The project`s risk to the corporation, considering that the project represents only one of the
company`s projects. Corporate risk is measured by the project`s impact on the uncertainty of the
company`s future earnings.
• Market or Beta Risk
Riskiness of the project within the company`s portfolio of projects to a well-diversified stockholder.
Market risk is measured by the project`s effect on the firm`s Beta coefficient.

7.2. Diversification and Corporate Risk

It is not a perfect correlation if the return of both projects do not correlate perfectly as illustrated in
figure 1.7 below.

Return Project A
Return Project B

Correlation not perfect Correlation perfect

Return Project A

Return Project B
No relation between the returns of the projects.

Figure 1.7: Different correlations of project rates of returns

25
A correlation coefficient of +1 indicates perfect positive correlation between the variables.
A correlation coefficient of -1 indicates perfect negative correlation between the variables.
A correlation coefficient of 0 indicates no correlation between the variables.
A correlation coefficient between >0 and +1 indicates positive but not perfect correlation between
the variables.
A correlation coefficient between 0 and -1 indicates negative but not perfect correlation between
the variables.

NB: Companies with well diversified portfolios of projects should therefore only be concerned with
the market risk as quantified by the Beta coefficient of the portfolio and not the risk of single
projects.

7.3. Incorporation of Risk into the Capital Budget

The following two methods are used to incorporate risk into a capital budget:
• The certainty equivalent approach
• The risk-adjusted discount rate (MARR value)

The corporate cost of capital provides the starting point for estimating the risk-adjusted discount
rate.
If all projects had the same risk and debt capacity, then all projects would be evaluated at the
corporate cost of capital.
Larger firms have several divisions that vary in risk, and even projects within a division can have
risk differences.

The first step in developing a project`s cost of capital calls for adjusting the corporate cost of
capital to reflect divisional risk and debt capacity.
Each project is then assigned to a risk category on the basis of its own risk relative to its division`s
average risk. Adjustments should also be made for differences in debt capacity as illustrated in
figure 1.8 below.

26
 High Risk Division A
k = 23%

Division A Average Risk Division A

Average WACC = 20% k = 20%

Low Risk Division A

k = 17%

High Risk Division B

k = 20%

Corporate WACC Division B Average Risk Division B

k = 15% Average WACC = 17% k = 17%

Low Risk Division B

k = 14%

High Risk Division C

k = 15%

Division C Average Risk Division C

Average WACC = 12% k = 12%

Low Risk Division C

k = 9%

Figure 1.8: A company with three divisions with different risks

The management of this company analysed the variance of the three divisions. The experience of
management decided that the MARR value should be 15%. If a division is now regarded as more

27
risky than what the company would normally accept, then the MARR value will be increased to, for
example, division B. To compensate for the risk associated with division B, the MARR value is
increased to 17%.

Division C is regarded as a low risk and therefore the MARR value is reduced to 9%.

Self-test exercise1.6
ScenarioThe management of a company fixed the MARR at 12%.
Questions
1.6.1. If taxes are increased, how would management change the MARR?
1.6.2. If there are a large number of projects to choose from, how would management change the
MARR?
1.6.3. If there are a small number of projects to choose from, how would management change the
MARR?
1.6.4. If the perceived risk of a project is high, how would management change the MARR?
1.6.5. If the perceived risk of a project is low, how would management change the MARR?
1.6.6. If management wants to give one or more of the projects a better chance to be accepted,
what MARR would they allocate to those projects?
1.6.7. Motivate your answer to each one of the six scenarios.

7.4. Risk in a Project Portfolio Context

Risk in an investment or project means that the future returns are uncertain. The uncertainty of
future possible returns is measured by the variance and the standard deviation.

The principle of diversification is that highly diversified portfolios will have negligible unsystematic
or diversifiable risk. Unsystematic risk disappears in diversified portfolios and only systematic risk
remains. Figure1.9 illustrates what happens to the risk of a portfolio of projects. The more projects
with a correlation of less than 1 are added, the risk of the portfolio decreases. The risk can only be
decreased until it equals the risk for the market the company is operating in.

An asset or project as part of a portfolio is less risky than the stand-alone risk of the project. The
fact that a specific project is risky in terms of its variability in future income, is not that important.
What is important is the impact of the project’s inclusion on the rate of return and the risk of the
portfolio.

The risk of a portfolio can be reduced by introducing projects whose returns are not highly
correlated with one another. This principle forms the basis of portfolio theory. Portfolio theory

28
states that by combining projects whose returns are not correlated with one another, we can
determine combinations of projects that provide the least risk for each possible expected portfolio
return.

Diversification is based on the premises that introducing projects that are uncorrelated will reduce
the total risk of a portfolio. The risk seems to decline until a point is reached where it stays almost
constant. Returns on projects in general, are almost always positively correlated (0 < r < 1).
Projects that are perfectly negative correlated are hard to find.

We refer to risk that declines as we add projects as diversifiable risk (unsystematic risk). The risk
that cannot be diversified is referred to as non-diversifiable risk (systematic risk), as illustrated in
figure 1.9 below.

Portfolio Risk

Diversifiable risk (unsystematic risk)

Non-diversifiable risk (systematic risk)

Number of Projects

Figure 1.9: The risk of a portfolio of projects when diversifiable risk is added to the
portfolio

8. DEVELOPMENT OF PROJECT CASH FLOW

Study this section in conjunction with chapter 10 page 512 of your prescribed textbook.

Figure 1.5 illustrates the different phases of a project as follows:

• Research, Design and Development Cost

• Construction and Production Cost
• Operation and Support Cost
• Retirement and Disposal
Each one of these phases has got its own unique activities. The first challenge is to identify the
relevant activities that are required for the project execution. The second challenge is to determine
the cost of each activity. The total cost and revenue is then determined for each period of time.
The MARR value can then be used to determine the net present value, the annual equivalent, and
the future value or the internal rentability. The most economic feasible alternative can now be

29
identified. The management can then decide if there are any other considerations that would
disqualify the project from being accepted.

Self-test exercise 1.7

This is a group exercise, you are therefore requested to complete this exercise in groups.

Scenario

Budget Airline is a newly established airline that will be operating from Lanseria Airport, north of
Johannesburg. The airline standardises on the Boeing 737-800.

Your company management seeks confirmation if they should procure another Boeing 737-
800.The period allocated for this study period is 5 years.

Background description of Budget Airline

The management of Budget Airline decided that their policy would be to standardise the type of
aircraft in their fleet. The strategic analysis highlighted the fact that the best option for Budget
Airline would be to buy the aircraft. This procurement project will be a cash transaction at a cost of
R300 000 000.

Landing cost is only applicable on incoming aircraft for each airport. No additional cost is
applicable on aircraft departing except for catering, baggage handling and refuelling. Landing cost
is determined by the weight of the aircraft.

The catering cost is estimated at R100 per passenger.

The maintenance cost for a Boeing 737-800 is estimated at R30 000 every 470 hours of flying
time. The refuelling cost for the airline is payable to the Airport Company and is R10-60 per litre,
including sales tax. It can be assumed that all departing aircraft from all airports will refuel to full
fuel capacity.

The management of Budget Airline estimates that during the first year the aircraft will operate at
70% of full capacity. It is also estimated that the growth rate for Budget Airline can be 3% per year.

The routes to be serviced by this additional Boeing is:

• Durban, two return flights per week
• Cape Town, four return flights per week
The duration times for these flights are:

• From Johannesburg to Cape Town the flight is 2 hours.

• From Johannesburg to Durban the flight is 1 hour.

30
Description of costs

Airport cost per aircraft:

Landing cost: R9 000 per landing

Staircases: Two staircases needed at R350 per staircase applicable for each landing of the aircraft

Catering R100/passenger
Baggage handling R50/passenger

Description of different financial entities:

• The average inflation for the duration of the study period is estimated at 6% per year.
• Fixed cost: Aircraft crew: R1 800 000 per year.
• Market value of aircraft decreases by 10% per year.
• Market growth rate is estimated at 3% per year.
• The average price for a one-way ticket on the Johannesburg–Cape Town route is R1 300.
• The average price for a one-way ticket on the Johannesburg–Durban route is R900.

The management of Budget Airline is of the opinion that the available data is the best estimates
available at this stage of the project. However, the management is uncomfortable with certain of
the estimated economic values. There is also no consensus about which variables are the
important ones to affect the economic feasibility of the project.

The management of Budget Airline requested an investigation into the matter.

Question

Develop the cash flow for the project over a period of four years

NB There is no loan involved.

9. INFLATION AND ITS EFFECT ON INVESTMENT

Study this section in conjunction with chapter 11 page 564 of your prescribed textbook.

The project cash flow that was determined in Self-test exercise 1.7 is in actual rand. That means
all the activities are priced in the value of the rand today. Engineering projects normally are spread
over fairly long periods of time. The cost of an activity somewhere in the future, say two years from
now, will escalate because of inflation. This means that once the cost of activities has been
determined, they must be adjusted to compensate for inflation.

31
9.1. Inflation rate

The inflation rate (f) is the annual percentage of increase in prices of goods and services.
−
9.2. The average annual inflation rate ( f )
Because engineering projects take place over long periods of time it would be cumbersome to
use a different inflation rate for each year. To overcome this problem and make the calculations
easier, the average inflation rate is used. Figure 1.10 illustrates a project over a period of four
years and the inflation rate is different for each year (f1 to f4).

Year 1 2 3 4
Inflation per period f1 f2 f3 f4

−
f
Figure 1.10: Different inflation rates over four years

From the information in figure 1.10, the average inflation rate can be calculated.
−
(1+f1)(1+f2)(1+f3)(1+f4) = (1+ f ) 4
−
f Is the average inflation to be used in the calculation.

Engineering projects usually take place over long periods of time. To construct a bridge or power
station usually takes place over a period of several years. It is therefore more convenient to
only use the average inflation rate instead of using an inflation rate for each period or year.

9.3. The Influence of the inflation rate on the cash flow

Figure 1.11 below illustrates this influence over a period of two years.

0 Y1 Y2

f = 9% f = 8%

Price t = 0 Price end t = Y2

Worth t = 0 Worth end t = Y2

Figure 1.11: Influence of inflation on a price over a period of two years

Price (end t = Y2) = Price(t = 0)(1+0.09)(1+0.08)

Pr ice (end t = y 2)
Price (at t = 0) =
(1 + 0.09)(1 + 0.08)

Worth ( t = 0)
Worth (end t=Y2) =
(1 + 0.09)(1 + 0.08)

32
Worth (at t = 0) = Worth (end t=Y2)(1+0.09)(1+0.08)

9.4. Effect of inflation on interest rate

The market interest rate (i) represents the opportunity to earn as reflected by the actual rates of
interest available in finance and business. The interest rates quoted in the marketplace include the
effects of the earning power and the purchasing of money.

The inflation-free interest rate (i`) represents the earning power of money with the effects of
inflation removed (real or constant-rand interest rate).

9.5. Cash flows in actual or constant rand

• Actual rand represent the out-of-pocket rand received or disbursed at any point in time.
• Constant rand represent the hypothetical purchasing power of future receipts and
disbursements in terms of the purchasing power of rand at some base year.
• The conversion of actual rand at a particular point in time to constant rand (based on
purchasing power n years earlier) at the same point in time is:

Actual Rands
Cons tan t Rands = n
 −

1 + f
 
9.6. Actual rand cash flow changed to constant rand cash flow and constant inflation rate
per period

This process is illustrated in figure 1.12 below.

0 Y1 Y2 Yn

f = 5% f = 5% f = 5%

Actual Rand 1 000 1 000 1 000

1000 1000 1000

(1 + 0.05)
1
(1 + 0.05) 2
(1 + 0.05)n

Constant Rand 952 907 X

Figure1.12: Conversion of cash flow in actual rand to constant rand and constant inflation
rate

33
9.7. Constant rand cash flow changed to actual rand cash flow and constant Inflation rate
per period

This process is illustrated in figure 1.13 below.

0 Y1 Y2 Yn

f = 5% f = 5% f = 5%

Constant Rand 952 907 X

952(1 + 0.05) 907(1 + 0.05) X (1+ 0.05)

2 n

Actual Rand 1000 1000 1000

Figure 1.13: Changing of constant rand cash flow to actual rand cash flow and constant
inflation rate per period

9.8. Actual rand cash flow changed to constant rand cash flow and varying inflation rate
per period

This process is illustrated in figure 1.14 below.

0 Y1 Y2 Y3

f = 5% f = 6% f = 7%

Actual Rand 1 000 1 000 1 000

1000 1000 1000

(1 + 0.05)
1
(1 + 0.05)(1 + 0.06) (1 + 0.05)((1 + 0.6)(1 + 0.07)
Constant Rand 952 898 839

Figure.1.14: Changing of actual rand cash flow to constant rand cash flow and varying
inflation rate per period

9.9. Constant rand cash flow changed to actual rand cash flow and varying inflation rate
per period

This process is illustrated in figure 1.15 below.

34
 0 Y1 Y2 Y3

f = 5% f = 6% f = 7%

Constant Rand 952 898 839

952(1 + 0.05) 898(1 + 0.05)(1 + 0.06) 839(1 + 0.05)(1 + 0.06)(1 + 0.07)

Actual Rand 1000 1000 1000

Figure 1.15: Changing constant rand cash flow to actual rand cash flow and varying
inflation rate per period

9.10. Relationship between i, i`, f

• The inflation rate f is required to transform cash flow from one domain to the same
point in time in the other domain.
• In the Actual Rand Domain, the market interest rate is used to calculate
equivalence (NPV, FV, AE, IRR).
• When computing equivalences in the Constant Rand Domain, the inflation-free rate
(i`) must be used. If analysis in either the Actual Rand or the Constant Rand
Domains is to be consistent, the equivalent amount at the base year in either domain
must be equal.
NPV(Actual Rand Domain) = NPV(Constant Rand Domain)
• Relationship between i, i`, f

1+ i
i`= −1
1+ f
Alternatively:

− −
i = i `+ f + i ` f
9.11. Different methods to calculate in another domain

Example: Let us look at an instance where you receive the operating cost of a machine and this
cost includes inflation. To determine if the machine became less cost-effective over the relevant
period, you must remove the inflation from the cash flow. The cash flow is now in constant rand. If
the constant rand in each period is still increasing, it means the machine became less cost-

35
effective. If the cash flow in constant rand is decreasing every period, it means that the machine
became more cost-effective over time.

There are three methods to calculate either the NPV, the AE or the FV as follows:

Method 1:

NPV option to calculate the AE in the Constant Rand Domain.

Cash flow in Actual Rand Domain.

11500

1500 1500 1500 i =11% f = 6%

0 1 2 3 4Years

NPV(Actual Rand domain) =1500(P/A,11,4)+10000(P/F,11,4)

=+11241

1+ i
i`= − 1 i`= 1 + 0.11 − 1 = 0.0471 = 4.71%
1+ f 1 + 0.06

Note:
NPV(Actual Rand Domain) =NPV(Constant Rand Domain)

A`(Constant Rand Domain)=P(A/P,4.71,4)=11241(A/P,4.71,4)

=3148.8 per year

Method 2:

Change cash flow option to calculate the AE in the constant Rand domain.

Cash flow in Actual Rand Domain.

11500

1500 1500 1500 i =11% f = 6%

0 1 2 3 4Years

1500 1500 1500 1500

(1 + 0.06) 1
(1 + 0.06) 2
(1 + 0.06)3
(1 + 0.06)4 Constant rand

Constant rand=1415 =1335 =1259 =9109

NPV = 1415(P/F,4.71,1)+1335(P/F,4.71,2)+1259(P/F,4.71,3)+9109(P/F,4.71,4)

=11241(Same as for method 1)

i` = Interest inflation free

36
A`(Constant Rand Domain)=P(A/P,4.71,4)=11241(A/P,4.71,4)

=3148.8 per year

Method 3:

FV option to calculate the AE in the Constant Rand domain.

Cash flow in Actual Rand Domain.

11500

1500 1500 1500 i =11% f = 6%

0 1 2 3 4 Years
FV(Actual Rand domain) =1500(F/A,11,4)+10000

=+17064.55

 FV ( Actual Rand domain) 

FV `(Cons tan t Rand domain) 

 (1 + 0.06)4


17604.55
= =13944.45
(1 + 0.06)4
1+ i
i `= − 1 i`= 1 + 0.11 − 1 = 0.0471 = 4.71%
1+ f 1 + 0.06

FV` =A`(F/A,4.71,4)=13944.45

A`=3148.8

9.12. Effect of inflation on the cash flow of a project

Depreciation is calculated on some base year (total initial investment at t=0) and the value of the
depreciation per year is not affected by the inflation rate. Depreciation is only calculated on the
initial investment. The influence of the annual depreciation that can be claimed to lower the
taxable income, is therefore diminishing because of the inflationary effects on the cash flow.

What will happen to the cash flow of an investment when inflation is present?

Sales and manufacturing costs are assumed to increase annually by the inflation rate of that
period. Depreciation will remain unchanged because it is linked to the value of the initial
investment. Taxes and profits will be higher.

Table 1.1 below illustrates how the value of revenue, material and labour changes over a period of
four years because of the 5% inflation rate.

37
Table 1.1: Changing of the value of revenue, material and labour over a period of four years
because of the 5% inflation rate

Inflation (%) t 1 2 3 4

Revenues 5% F (1 + f ) 100 000 105 000 110 250 115 762

n

Expenses

Material 5% F (1 + f ) 20 000 21 000 22 050 23 152

n

Labour 5% F (1 + f ) 12 000 12 600 13 230 13 891

n

• If the cash flow in the cash flow statement is in actual rand domain then the market-related i
(MARR) (including inflation) must be used to calculate the NPV.

• If the cash flow in the cash flow statement is in constant rand domain then the i` (MARR)
(excluding inflation) must be used to calculate the NPV.

• If different inflation rates are applicable, then each item`s cost will be determined by its
applicable inflation rate.

• It is essential to adjust future cash flows for inflation, otherwise a bias exists against
investing in long-term assets.

• In cases where the cash flows have been adjusted to include inflation, the market-related
discount rate should be used. These calculations are now being done in the actual rand
domain.

In cases where the cash flows are in constant rand (excluding inflation in real terms), the discount
rate excluding inflation should be used. These calculations are now done in the constant rand
domain.

1+ i
i`= −1
1+ f

i = Market-related discount rate (Including inflation)

i` = Discount rate in real terms (Excluding inflation)

f = Inflation rate

Example: i = 15% f = 8.5%

Calculation of NPV in Constant Rand Domain:

38
 1 + 0.15
i`= − 1 = 0.06 = 6%
1 + 0.085

Table 1.2 below illustrates the calculation of the NPV in constant rand.

Table 1.2: The calculation of the NPV in constant rand

Year 0 1 2 3 4

Cash flow at -1 800 000 480 000 875 000 700 000 350 000
current prices

No inflation
added to cash
flow

i` = 6%

PV of cash flow -1 800 000 452 830 778 747 587 733 277233

NPV(CRD) 296 968

Calculation of NPV in Actual Rand Domain

Table 1.3 below illustrates the calculation of the NPV in actual rand (Inflation is added each year.)

Table 1.3: Calculation of the NPV in actual rand (Inflation is added each year.)

Year 0 1 2 3 4

Cash flow at -1 800 000 480 000 875 000 700 000 350 000
current prices

Inflation 1.0000 1.085 1.1722 1.2773 1.3859

adjustment

Nominal cash -1 800 000 520 800 1 030 072 894 102 485 051
flow(including
inflation)

i= 15%

PV of cash flow -1 800 000 452 870 778 882 587 887 277 329

NPV 296 968

9.13. Rate of return analysis under inflation

39
• The rate of return (i`) is calculated in the constant rand domain. If this i`≥MARR, the project
would be economically viable. If i` has been calculated, the market-related MARR can be
calculated from:

− −
i = i `+ f + i ` f
• The rate of return (i) is calculated in the actual rand domain. If this i ≥ MARR, the project
would be economically viable. If i has been calculated, the inflation-free MARR can be
calculated from:

1+ i
i`= −1
1+ f

• Inflation is the general increase in the level of prices of products and services. One of the
most common measures of inflation is the change in the consumer price index (CPI), which
reflects the prices of consumer products. An alternative measure of inflation is the producer
price index (PPI), which reflects the prices of producer products.

• Inflation can affect the value of a firm through its influence on the interest rate movement.
Investors require higher rates of return during periods of higher inflation. The cost of
resources also increases and so does the price of consumer goods.

Self-test exercise 1.8

Scenario
The production manager in your company is of the opinion that one of the machines is not
operating at optimum cost.
Question
1.8.1 You are requested to investigate the matter. The operating cost of the machine is displayed
in the following table:

Year 1 2 3 4 5 6

Actual operating cost per year(R) 20 000 21 000 22 500 24 750 27 720 31 323

% inflation rate for each year 0 7 8 9 10 11

1.8.2 Did this machine become more inefficient and more expensive over the 6 years?

40
10. FINANCIAL STATEMENTS

Study this this section in conjunction with chapter 2 page 44-61 of your prescribed textbook.

Financial statements are written records that confirm the business activities and the financial
status of a company. Financial statements must be audited once a year (at the end of the financial
year) and in the case of listed companies on a Stock Exchange, they must be published in daily
newspapers and to the shareholders. Financial statements include:

• Balance sheet
• Income statement
• Cash flow statement

Investors and financial analysts rely on these financial data to assist them to evaluate the present
standing of the company and to make some extrapolations of what the future holds for the
company. It therefore determines the stock price if listed on the JSE and informs investors as to
the feasibility of investments in this specific company.

10.1. The balance sheet

The balance sheet provides information of a company`s assets, liabilities, and stockholder
equity. The balance sheet confirms the status at a specific time during the financial year and is
not tied to the end of the financial year although there must be a balance sheet available at the
end of the financial (fiscal) year. The balance sheet statement reports the status of the assets,
liabilities and stockholders` equity. Assets appear on the balance sheet in order of liquidity. Cash
would therefore be at the top of the list because it is the most liquid asset. Liabilities appear in
order of priority to be paid. The most urgent liability to be paid will appear at the top of the list of
liabilities. The stockholders` equity comprises owner contributions (shares) and retained earnings.
The date the balance has been created must always be visible on the document.

An example of a balance sheet can be found in your prescribed textbook chapter 9, page 310.
A requirement of a balance sheet is:
Assets = (Liabilities + Owner`s equity)

• Shareholders’ equity
Owners‘ contributions is the amount of money that would be returned to shareholders if all assets
were liquidated and all debt was paid.

41
 • Retained earnings
Retained earnings is the percentage of net earnings that is retained if management is planning
investments or to mitigate a risk that they anticipate. Retained earnings therefore will decrease the
money available to pay dividends to its shareholders.

10.2. Income statement

Income statements cover a fixed financial period. This can be annually or even quarterly. The
income statement covers the financial performance of a company over a specific financial period.
The income statement covers primarily revenue and expenses. The income statement indicates
whether a company made a loss or profit during a fiscal year.

An example of an income statement can be found in your prescribed textbook chapter 9, page
308.

10.3. The cash flow statement

The cash flow statement demonstrates whether a company is generating enough cash to pay its
debt obligations, fund the operating expenses and the anticipated investments. The cash flow
statement provides information regarding how the company generated the cash it received and
how the company applied that cash during the fiscal year.

An example of a cash flow statement can be found in your prescribed textbook chapter 9, page
308.

Self-test exercise 1.9

Answer the following questions from your prescribed textbook chapter 2 page 73:

Problems 2.1, 2.2 and 2.3

Reflection on study unit 1

1.1. Describe what you have learnt from study unit 1.

1.2. How does this concur with your experience in your working environment?

1.3. What can you take from this unit to develop your capabilities?

1.4. What contributions do you think you will now be able to make in your work
area? Think of lessons you acquired that you were not aware of before going
through this unit.

42