When applying for loan approval, very often the question investors are making is – why are banks actually looking for Feasibility Study? A Feasibility Study is actually some kind of broader and more detailed version of the Business Plan, but the goal is the same – making an assessment of the cost-effectiveness of investing in a project. A Feasibility Study is made for investing in projects of a slightly higher value (for those over EUR 100,000.00). Namely, by investing their available means to ensure the realization of investment project, the bank expects a certain yield in return because it has actually given up the consumption of these funds in the present time. Investor who use this borrowed money for the realization of its investment project, assume that its realization will benefit its company but they often forget the interest of the owners of the borrowed cash. It is not only about the price of money and the interest rate, that in banks business policy certainly has a significant share of the revenues. Earning on interest rate is actually the difference between an active and a passive interest rate, between the price of a capital which the bank took from its depositors and clients, and the price of capital that bank has placed on the market (investors). For comparison, you can specify the difference between the purchase and sales of exchange rates at the currency exchange. So, whatever the difference between the active and the passive part of the interest was, however, the bank has a need for a more accurate calculation of the economic feasibility of investing in a project, from the standpoint of financial efficiency. Namely, the bank does not want just to know how much they will earn from investing in a project, but of course and much more importantly, whether and within which time they will be able to return their investment. When a particular investor use 75%, 80% or even 100% of others assets (such as bank’s loans) for the realization of its project, it must be aware that the bank is the majority investor in its project and that regardless of the insurance instruments, this bank have a very important role in the project and certainly wants to literally dissect its business idea to the smallest detail. This dissection is actually a reflection of making a quality Feasibility Study or any other related profitability study of investment in a particular project. Of course, the quality, efficiency and assessment of the financial profitability of investing in a particular business venture is primarily important for the investor because it is the one who will repay the loan, but this will not be its only expense. The investor’s business costs will also be felt through obligations to employees, suppliers of services and goods, state and other stakeholders.
The financial efficiency of an investment project is determined in fact by looking at the net cash flow of the investment, taking into account the time preference of money and using different methods of financial decision making. Money today and money after five or ten years do not have the same value and methods to measure the financial efficiency of investment projects are actually trying to use mathematical expressions, to link the financial effects of the potential investment project with an invested amount. In other words, the projection of net cash flows that makes the difference between net cash receives and net cash expenditures in the project’s life, it is necessary to reduce to the net present value using the discount rate. After that, the obtained value is deducted from the investment value and if the result is positive the project is profitable to invest, and if it is negative it is not. The higher the net present value of the project is, the bigger is its profitability. The described method is called the method of the net present value, and is one of the three basic methods of dynamic economic analysis.
Furthermore, by accumulating net cash receives in the project’s life, we can also determine the period of return on investment. The moment in which the investment returns to zero is the one in which the accumulated net cash receives reach the invested amount. It is important to further explain the concept of project’s life. The lifetime of a project is the period of its observation, the period for which the future business venture is projected. For example, if an investor raises a loan with a repayment period of ten years, the company’s future operating should be taken into account for a minimum of ten years. In that case, all projections in the Feasibility Study shall be worked for a period of 10 years. Consequently, the profitability of a project is always concluded from the aspect of the observed period. The investment return period as a second important investment decision method determines the period in which the amount of the investment will be returned. Logically – the shorter is the period, the more efficient is the Project and vice versa. The period of return on investment is always determined on the basis of original or nominal net cash receives.
The third common method of financial decision-making is called the method of the internal rate of profitability (IRP). With this method, the previously described net cash flows are equated with the investment and it identifies the difference in discounted cash flows and investments as zeroes. The discount rate by which the cash receives are reduced to zero constitutes an internal rate of profitability. Whether the project is acceptable for an internal profitability rate or not, depends on how much the profitability rate is required. The required rate of profitability, namely, is the marginal rate of yield above which the company will accept projects, and below it will reject them. In most cases, the required profitability rate must be at least the amount of the loan interest rate. The internal rate of profitability should be higher than the project co-financing interest rate from external sources (loans).
Dynamic economic analysis is based on cash flow, while the base for static economic analysis is mainly a balance sheet and profit/loss statement (all of them are basic financial statements).
In addition to the dynamic, quality Feasibility Study must also contain a static economic analysis. A static analysis is called because it considers certain indicators of the business only on a particular day, usually at 31.12. (in Croatia also end of the business year). The static analysis of the project, therefore, determines the static indicators, which are the most common indicators of liquidity, indebtedness, activity, cost-effectiveness and profitability. The first (beginning) and last (end) year of the project lifetime is observed, and the goal of each entrepreneur is to achieve a progression of results. This means that the company is progressing and not stagnating or backward which would be the worst possible solution. This analysis, as well as all other analyses, is based on the projection or assessment of future business operation in a given period, and is also very important for external sources of financing or banks that are placing their free resources. The projection of future business operation is carried out through an estimate of the achievement of revenues, expenditures and financial results. Projections of balance sheet, profit and loss account, cash flow, depreciation and calculation of credit liabilities constitutes an economic-financial analysis which is also a very important element of every quality Feasibility Study. The assessment of future business venture therefore has its footing in the financial-market and economic-financial analysis and must be as realistic as it needs to be. In addition to these, the most important segments of the quality Feasibility Study must also include market analysis. Market analysis is also a very important element of every quality Feasibility Study and must be professionally and well processed.
The Feasibility Study should also include the following analysis – project sensitivity analysis, SWOT analysis and risk analysis. By sensitive analysis we examine its elasticity in case of changing market conditions. In other words, we observe what will happen if cash flow does not go how we planned. In concrete cases, a cash flow is charged with two or more risky assumptions, after which the initial projection of the cash flow looks somewhat different. It examines the degree of resistance to the possible occurrence of negative impacts of a greater number of critical parameters and delivers a rating of elasticity of the project. SWOT analysis is a strategic instrument that dynamically confronting the strengths/weaknesses of enterprises with the opportunities/dangers of the environment, in order to identify the chances/risks for the enterprise’s existence. SWOT analysis (the acronym of strength, weaknesses, opportunities and threats), is a diagnostic and prognostic instrument that enables planning measures to reinforce strength and decompose weak places, the starting point in the strategic management process and the first step in defining the existing position of the company. Risk assessment is an integral part of the risk management process. It is a process of recognizing, quantifying and sorting the risks that are extremely important because of the quality of implementation and achievement of the project’s objectives. Risk assessment consists of two sub-processes: analysis and risk evaluation. Risk analysis represents the identification and eventual grouping of any particular risk that may negatively affect the implementation of the project. The risks can be grouped into the following categories: administrative, legal, ecological, organisational, social and any other relevant to the specific project. In each group you can identify the copyrighted risk. It’s necessary to evaluate to what stage of project implementation the risk is affected. The risk treatment shall be determined to minimise it. The method of dealing with some potential risks can be incorporated into the project/Business Plan, some of them can be treated according to the needs at the moment of their occurrence, and some are so weak that can be ignored. Detection and quantification of potential risks of a project are certainly essential for a bank that lends its money. In addition to the element mentioned so far, each high-quality Feasibility Study also include introduction and summary of investment, information about the entrepreneur, detailed description of the business venture, evaluation of possibilities after the investment, description of the project location, a description of the protection of environment and technical-technological elements of the investment structure. A very important element is the projection of employment’s positions and salaries. The dynamics of the realization of the investment is also considered, and at the end of the day the final assessment of the project can be positive (investment is profitable and recommended) or negative (investment is not profitable and is not recommended). The final assessment actually extracts the most important from all the processed parts of the Study, with the aim of making a definitive decision that the external sources of funding are interested in.
A Feasibility Study often has a range of more than 100 pages, on which there is also a series of tables, images and graphical representations. It is a professional elaborate that must be well prepared and developed. All elements of the Feasibility Study must be linked, and the slightest change of any of financial parameter affects the other parameters and changes the complete structure and the results obtained by the analyses carried out in the Study. Since it is an elaboration that will persuade investors and banks to invest their money in the project, the development of Study should be entrusted to the qualified and professional person. It is recommended to choose a person with as much experience as possible for such elaborates, because regardless of the education and professional competencies that are implied, only experience comes with excellent results. Finally, the idea is not at all cost (and by force) to prove that a project is profitable if it is not realistic; on the contrary – the idea is realistic Study to assume future business events (after investing). To conclude, the banks are looking for a Feasibility Study with a very good reason, and with that they are not protecting only themselves but also the investor himself, because he will be the one to spend the coming years encouraging growth and development of his company.