Session 4: Economic Appraisal of DevelopmentOriented Rural Enterprises

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Building Development Oriented Rural Enterprises
Training and Project Development Workshop
Session 4 Economic Appraisal of
Development-Oriented Rural Enterprises
Workshop Presentation
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DOCUMENT OVERVIEW
INTRODUCTION NET PRESENT VALUE FOR
DOREs BREAKEVEN ANALYSIS GROUP WORK
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CONTENT OF THIS MODULE

• How can we be confident that a DORE we create
  wont need a subsidy to continue operating?
• How can we be confident that a DORE can pay for
  its own staff, training programmes, credit and so
  on?
• How can we make sure that DOREs are good uses of
  government, farmer and donor funds?

Problem

• We should make sure that we are making real,
  valuable businesses
• We should make sure that, given the probable
  size of the business, it can make a profit

Solution

• You will learn an economic method for working
  out the dollar value of a company (so we can
  avoid making companies with low or negative
  value)
• You will learn how to estimate breakeven
  level- the level of sales which the company must
  reach to avoid a loss

This Module
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DOCUMENT OVERVIEW
INTRODUCTION NET PRESENT VALUE FOR
DOREs BREAKEVEN ANALYSIS GROUP WORK
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A SIMPLE PUZZLE Ia

• How much money do you have to invest now to get
  100 dollars in one years time?

Question

• 90.91 ? 1.1 100 dollars
• Therefore, you must invest 90.91 now to get
  100 in one years time.

Calculation

• If the interest rate is 10, the present value
  of 100 in one years time is 90.91

Conclusion
Interest rate 10 p.a.
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A SIMPLE PUZZLE Ib

• How much money do you have to invest now to get
  150 dollars in one years time?

Question

• 136.36 ? 1.1 150 dollars
• Therefore, you must invest 90.91 now to get
  100 in one years time.

Calculation

• If the interest rate is 10, the present value
  of 150 in one years time is 136.36

Conclusion
Interest rate 10 p.a.
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A SIMPLE PUZZLE IIa

• What is the present value of 200 that you will
  receive in 2 years time?

Question

• (200/1.1)/1.1 165.29
• Therefore, 200 in 2 years time is worth 165.29
  now

Calculation

• If the interest rate is 10, the present value
  of 200 in two years time is 165.29

Conclusion
Interest rate 10 p.a.
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A SIMPLE PUZZLE IIb

• What is the present value of 300 that you will
  receive in 3 years time?

Question

• ((300/1.1)/1.1)/1.1) 225.39
• Therefore, 300 in 3 years time is worth 225.39
  now

Calculation

• If the interest rate is 10, the present value
  of 300 in three years time is 225.39

Conclusion
Interest rate 10 p.a.
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TABLE METHOD FOR PRESENT VALUE I
Interest rate 10 p.a.
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TABLE METHOD FOR PRESENT VALUE II
Put the number in the year you are going to
receive it
Put the interest rate (i), plus 1, raised to the
power of the year number (n), i.e. (1i)n
Divide the money received during the year by the
discount factor for the year
Interest rate 10 p.a.
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A SIMPLE PUZZLE IIIa

• What is the total present value if you have to
  pay 100 in 3 years time but receive 250 in 4
  years time?

Question

• - 100/(1.13) -100/1.331 -75.13
• 250/(1.14) 250/1.464 170.75
• 170.75 -75.13 95.62

Calculation

• The present value of -100 in 3 years time and
  250 in 4 years time is 95.62

Conclusion
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A SIMPLE PUZZLE IIIb

• What is the total present value if you have to
  pay 100 in 3 years time but receive 250 in 4
  years time?

Question

• - 100/(1.13) -100/1.331 -75.13
• 250/(1.14) 250/1.464 170.75
• 170.75 -75.13 95.62

Calculation

• The present value of -100 in 3 years time and
  250 in 4 years time is 95.62

Conclusion
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TABLE METHOD FOR PRESENT VALUE
Put negative numbers when you pay money, positive
when you receive it
You can add up the Present Values to find the
total value of all the payments and receipts
Interest rate 10 p.a.
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A (NOT SO) SIMPLE PUZZLE

• How much is 100 paid to you every year worth?

Question

• If interest rates are 10, 1000 paid into the
  bank would generate 100 every year

Calculation

• If the interest rate is 10, a perpetual payment
  of 100 per year is worth 1000
• The value of a perpetual payment is equal to the
  annual payment divided by the interest rate

Conclusion
Interest rate 10 p.a.
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A (NOT SO) SIMPLE PUZZLE II

• How much is 100 paid to you every year,
  starting in four years time, worth?

Question

• 100 every year is worth 100/.01 1000
• The present value of 1000 in 4 years time is
  1000/1.14 683.01

Calculation

• 100 per year, starting in 4 years time, is
  worth 683.01

Conclusion
Interest rate 10 p.a.
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PUTTING IT ALL TOGETHER PUZZLE

• What is the present value if I
• Pay 200 Baht 1 year from now and 100 Baht 3
  years from now
• Receive 250 Baht in year 2 and 200 Baht in year
  4
• Receive 100 Baht every year from year 5 onwards

Question

• -200/(1.11) -200/1.10 -181.8
• 250/(1.12) 250/1.21 206.6
• -100/(1.13) 100/1.33 -75.1
• 200/(1.14) 200/1.46 136.6
• (100/(0.1))/1.15 1000/1.61 620.0
• -181.8 206.6 -75.1 136.6 620.0 707.2

Calculation
Interest rate 10 p.a.

• The present value of the payments and receipts
  in years 1 to 4 and the perpetuity is 707.2 Baht

Conclusion
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TABLE METHOD
Money you will receive every year after year 4
you put here
The interest rate 0.1, divided by the discount
factor (1.15)
You can add the total values just like normal
Interest rate 10 p.a.
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APPLICATION VALUING A BUSINESS

• Some tribal women are considering setting up a
  handicraft business
• They will manufacture and sell traditional bags
  that they have made themselves

Situation

• The women can make and sell 500 units in the
  first year, 1,000 units in the second year, and
  1,500 units per year every year after that
• The sale price of a unit is 75 baht
• The cost of a unit is 25 baht per unit including
  materials, labour, packaging and distribution
• There will be a startup cost of B200,000
• The discount rate should be 20

Costs Benefits

• Should the women set up the business?

Problem
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METHOD (I) CALCULATE BENEFIT
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METHOD (II) CALCULATE PRESENT VALUE
Continuing profit divided by discount rate
Profit after investment
Divide by 20
The handicraft business will be worth B1,486.
Because it has a negative NPV, it will not be a
good investment. Costs need to be decreased or
revenues increased to make NPV positive
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CALCULATE NPV (3)
ESTIMATING DISCOUNT RATE
Discount Rate (Interest Rate)
Capital User

• 5
• 7
• 8
• 11
• 13
• 15
• 17.5-20
• 25

• Central government
• Local government
• Utility company
• Food or construction company
• Software company
• Small software company
• Farmers group
• Individual farmer

Increased Risk, Increased Expected Rate Of Return
The discount rate is the rate of return that the
owners of the enterprise will expect and require
in order to compensate them for the risks the
enterprise takes- the higher risk, the higher the
expected rate of return
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DOCUMENT OVERVIEW
INTRODUCTION NET PRESENT VALUE FOR
DOREs BREAKEVEN ANALYSIS GROUP WORK
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ANOTHER SIMPLE PUZZLE I (this one really is
simple, honest)

• Running my business coffee shop costs me 1000
  per year
• I make 50 cents profit every time I sell a cup
  of coffee
• How many cups of coffee do I need to sell to
  break even (make neither a loss nor a profit)?

Question

• -1000 (2000 cups 50 cents profit) 0
• Therefore, I have to sell 2000 cups of coffee to
  break even

Calculation

• The breakeven level is the level of sales,
  which, given the profit per sale, will cover the
  running costs of the business

Conclusion
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ANOTHER SIMPLE PUZZLE II (this one is too)

• Running my business coffee shop costs me 2000
  per year
• The ingredients for a cup of coffee cost 50
  cents and I sell the cup of coffee for 1
• How many cups of coffee do I need to sell to
  break even (make neither a loss nor a profit)?

Question

• -2000 (4000 cups 50 cents profit per cup)
  0
• Therefore, I have to sell 4000 cups of coffee to
  break even

Calculation

• The breakeven level is the level of sales,
  which, given the difference between the input
  cost and sale price per unit, will cover the
  running costs of the business

Conclusion
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MAKING IT REALISTIC

• Include the following costs
• Labour and salaries
• Rental costs
• Fuel and utilities
• A charge for all the fixed assets owned by the
  business (buildings, vehicles, processing
  facilities, working capital etc) equal to 15 of
  total value
• Interest repayments

Fixed Costs

• For input cost use price paid to buy stock
• Usually purchase price from farmer
• Remember to adjust for shrinkage- 1 kilo of
  farmers produce often makes less than 1 kilo of
  saleable produce, e.g. if there is processing or
  losses between the field and the factory

Input Cost

• Use average price paid by customer
• Ensure price reflects value of postharvest
  process, packing, handling, etc

Sale Price
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MAKING IT REALISTIC CHAK-WARDAK EXAMPLE
STEP ONE Work out 15 of total capital invested
in business
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MAKING IT REALISTIC CHAK-WARDAK EXAMPLE
STEP TWO Work out the annual fixed costs of the
business
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MAKING IT REALISTIC CHAK-WARDAK EXAMPLE
STEP THREE Work out profit per unit
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MAKING IT REALISTIC CHAK-WARDAK EXAMPLE
STEP FOUR Work out break-even point
The Chak-Wardak business has annual fixed costs
of 558,000. It purchases apples for the
equivalent of 275 per ton and sells them at an
average of 500 per ton. Therefore its break-even
volume, V, is
558,000
V
2480 MT
500-275
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MAKING IT REALISTIC CHAK-WARDAK EXAMPLE
STEP FIVE DRAW A CHART (BECAUSE PEOPLE LIKE
CHARTS)
2. Plot the breakeven point here
Annual Profit
3. Connect the two points with a straight line
1. Plot the fixed cost here
Volumes
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INTERPRETING THE BREAKEVEN ANALYSIS

• Check the amount needed to break even and
  determine if that total amount be purchased
• If the business buying crops, is that amount
  even produced in the area?
• Will the business compete with other buyers like
  local traders. If it needs to buy 80-90 of the
  production, is it realistic to expect other
  buyers to buy only 10-20?

Availability

• Check the capacity of the business to determine
  if it can handle the amount of produce that will
  move through the business
• Use the purchase price from farmer but remember
  to adjust for shrinkage- 1 kilo of farmers
  produce often makes less than 1 kilo of saleable
  produce, e.g. if there is processing
• Ensure that the cost of the business (e.g. number
  of staff, number of trucks, fuel costs, etc) can
  support the business at breakeven

Capacity Cost Base

• Use average price paid by customer
• Ensure price reflects value of postharvest
  process, packing, handling, etc

Sale Price
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DOCUMENT OVERVIEW
A GUIDED TOUR OF A DOREs COSTS NET PRESENT VALUE
FOR DOREs BREAKEVEN ANALYSIS GROUP WORK
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GROUP WORK DESCRIPTION

• Go into your small groups
• You will be given a case study about a DORE
  asking you to do an NPV estimate and a breakeven
  analysis
• Solve the case study
• Prepare a presentation of the case study for the
  plenary session

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Thank you
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SIMPLE PRESENT VALUE FORMULA
FORMULA 1
Let n be a number of years, x be an amount in
Baht, and i be an interest rate expressed as a
decimal. Then the present value of x given n
years into the future is
x
( 1i )n
EXAMPLE 1
What is the value of 250 dollars in 2 years time
if the interest rate is 5? Then n2, i .05, x
250
x
250
250
227.3
Present value



( 10.05)2
1.21
( 1i )n
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FORMULA FOR PERPETUAL PAYMENT
FORMULA 2
Let x be an amount in Baht, and i be an interest
rate expressed as a decimal. Then the value of x
paid every year is
x
i
EXAMPLE 2
What is the value of 200 Baht paid every year if
the interest rate is 12? Then i .12, x 200
x
200
1666.667
Value


.12
i
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FORMULA FOR FUTURE PERPETUAL PAYMENT
FORMULA 3
Let n be a number of years, x be an amount in
Baht, and i be an interest rate expressed as a
decimal. Then the present value of x paid every
year, starting n years into the future, is
x
i
( 1i )n
EXAMPLE 3
What is the value of 500 Baht paid every year,
starting in 3 years time, if the interest rate
is 15? Then i .15, x 500 and n 3
x
200
1333.33
Present value


876.69

i
.15
1.521
( 1i )n
( 1.15)3
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FORMULA FOR BREAKEVEN
FORMULA 4
Let F be the fixed costs of a business, V be the
number of units sold and P be the profit per
sale. Then the breakeven level is the value of V
such that
F - (P V) 0
Therefore by simple re-arrangement, the formula
for breakeven level, V, is
0 F
F
V

P
P
EXAMPLE 4
If a business has fixed costs of 15,000 per
year, and it makes 30 of profit per sale, how
many units does it have to sell to break even?
Then F 15,000. P 300, and we find V as follows
15,000
V
500
30
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FORMULA FOR BREAKEVEN, VERSION 2
FORMULA 5
Let F be the fixed costs of a business, V be the
number of units sold, i be the input cost per
unit and p be the sale price per unit. Then the
breakeven level is the value of V such that
F - ((r-i) V) 0
Therefore by simple re-arrangement, the formula
for breakeven level, V, is
0 F
F
V

p-i
p-i
EXAMPLE 5
If a business has fixed costs of 25,000 per
year, and it buys stock at 10 per unit and sells
at 15 per unit, how many units does it have to
sell to break even? Then F 25,000, p15 and
i10, and we find V as follows
25,000
V
5000
15-10