Notes for Project Appraisal (Session 1 to 10)

Table of Contents
Introduction – Projects Appraisal and Finance .............................................................................3
What are some of the common elements in making of following? ............................................3
What is Project?.......................................................................................................................3
What is Project finance? ..........................................................................................................3
What is project Appraisal? .......................................................................................................3
Characteristics of project. ........................................................................................................3
Types of Project.......................................................................................................................4
Types of investment.................................................................................................................4
Project constraint and Iron Triangle. ........................................................................................5
Project Management – Knowledge Group and Process Group..................................................6
Feasibility Study Diagram .......................................................................................................7
GENERATION AND SCREENING OF PROJECT IDEAS........................................................9
Project Selection Process .........................................................................................................9
MARKET AND DEMAND ANALYSIS IDENTIFICATION OF TARGET MARKETS &
PROJECTION OF DEMAND USING PRIMARY AND SECONDARY DATA ...................... 11
Concept of Market & Demand Analysis................................................................................. 11
Key Steps in Market & Demand Analysis, and their Inter-relationships ................................. 11
Situational analysis and specification of objectives ................................................................ 11
Collection of secondary information ...................................................................................... 12
Conduct of market survey ...................................................................................................... 12
Steps in Sample Survey ......................................................................................................... 13
Characterization of the market ............................................................................................... 13
Demand forecasting ............................................................................................................... 13
Market planning .................................................................................................................... 14
Summary ............................................................................................................................... 15
TECHNICAL ANALYSIS ........................................................................................................ 16
Materials and inputs............................................................................................................... 16
Production technology ........................................................................................................... 17
Choice of technology ............................................................................................................. 17
Product Mix........................................................................................................................... 18
Plant capacity ........................................................................................................................ 18
Location and site ................................................................................................................... 19
 Machinery and equipment...................................................................................................... 19
FINANCIAL ANALYSIS ......................................................................................................... 21
Significance of financial analysis ........................................................................................... 21
Utility of financial and accounting statements ........................................................................ 22
SUMMARY .......................................................................................................................... 22
Introduction – Projects Appraisal and Finance

What are some of the common elements in making of following?

 The Great Pyramid of Giza
 Taj Mahal
 Saradar Sarovar Dam, Gujarat
 Delhi Metro
 GIFT City, Gandhinagar
 Tata Neno Plant, Sanand, Gujarat
 Airbus A380
 Statue of Unity
 International Space Station
 A Software Package
 COVID 19 Vaccine
What is Project?
“Unique process consisting of a set of coordinated and controlled activities with start and finish
dates, undertaken to achieve an objective conforming to specific requirements, including
constraints of time, cost, quality and resources”
The term project has a wider meaning. A project is accomplished by performing a set of
activities. For example, construction of a house is a project. The construction of a house consists
of many activities like digging of foundation pits, construction of foundation, construction of
walls, construction of roof, fixing of doors and windows, fixing of sanitary fitting, wiring etc.
Another aspect of project is the non-routine nature of activities. Each project is unique in the
sense that the activities of a project are unique and non-routine. A project consumes resources.
The resources required for completing a project are men, material, money and time. Thus, we
can define a project as an organized programme of pre-determined group of activities that are
non-routine in nature and that must be completed using the available resources within the given
time limit.
What is Project finance?
“A funding structure that relies on future cash flows from a specific development as the primary
source of repayment with that development’s assets, rights, and interests legally held as collateral
security”
What is project Appraisal?
Project Appraisal is a consistent process of reviewing a given project and evaluating its content
to approve or reject this project, through analyzing the problem or need to be addressed by the
project, generating solution options for solving the problem, selecting the most feasible option,
conducting a feasibility analysis of that option, creating the solution statement, and identifying
all people and organizations concerned with or affected by the project and its expected outcomes.
It is an attempt to justify the project through analysis, which is a way to determine project
feasibility and cost-effectiveness.

Characteristics of project.
(1) Objectives : A project has a set of objectives or a mission. Once the objectives are achieved
the project is treated as completed.
(2) Life cycle : A project has a life cycle. The life cycle consists of five stages i.e. conception
stage, definition stage, planning & organising stage, implementation stage and commissioning
stage.
(3) Uniqueness : Every project is unique and no two projects are similar. Setting up a cement
plant and construction of a highway are two different projects having unique features.
(4) Team Work : Project is a team work and it normally consists of diverse areas. There will be
personnel specialized in their respective areas and co-ordination among the diverse areas calls
for team work.
(5) Complexity : A project is a complex set of activities relating to diverse areas.
(6) Risk and uncertainty : Risk and uncertainty go hand in hand with project. A risk-free, it only
means that the element is not apparently visible on the surface and it will be hidden underneath.
(7) Customer specific nature : A project is always customer specific. It is the customer who
decides upon the product to be produced or services to be offered and hence it is the
responsibility of any organization to go for projects/services that are suited to customer needs.
(8) Change : Changes occur through out the life span of a project as a natural outcome of many
environmental factors. The changes may very from minor changes, which may have very little
impact on the project, to major changes which may have a big impact or even may change the
very nature of the project.
(9) Optimality : A project is always aimed at optimum utilization of resources for the overall
development of the economy.
(10) Sub-contracting : A high level of work in a project is done through contractors. The more
the complexity of the project, the more will be the extent of contracting.
(11) Unity in diversity : A project is a complex set of thousands of varieties. The varieties are in
terms of technology, equipment and materials, machinery and people, work, culture and others.

Types of Project

Types of investment
 Physical, monetary and intangible assets
 Strategic investment and tactical investment
 Mandatory Investments
 Replacement investments
  Expansion investments
 Diversification investments
 R & D investments
 Miscellaneous investments

Project constraint and Iron Triangle.

Scope: What work will be done as part of the project? What unique product, service, or result
does the customer or sponsor expect from the project?
Time: How long should it take to complete the project? What is the project’s schedule?
Cost: What should it cost to complete the project? What is the project’s budget? What resources
are needed?
Quality: How good does the quality of the products or services need to be? What do we need to
do to satisfy the customer?
From PMBOK Guide.
Project Management – Knowledge Group and Process Group
Feasibility Study Diagram

The role which project feasibility studies play in the development of nations cannot be
overemphasized. With repercussions on the social, economic, culture, and business sectors of
society, a project feasibility study is an essential medium of progress both as a means to initiate
profitable projects for sectoral enhancement and expansion and to evaluate actual project results.
As a consequence, feasibility studies pervade the entire life of projects, from the time the latter
was conceived by a proponent as an idea to the time they are actually implemented and
accomplished.
The project feasibility study is a thorough and systematic analysis of all factors that affect the
possibility of success of proposed undertaking. The data, facts, and other findings presented in
the study then become the basis for deciding whether the project is to be pursued, abandoned, or
revised. The project feasibility study is really a synthesis of separate studies usually dealing with
the market, technical, financial, socio-economic, and management aspects of the project.
While it is true that several undertakings in the past have become successful without the aid of a
study, this cannot be used as a basis for the occasional belief that project feasibility studies are
next to useless; nor is the failure of some carefully-studies projects a valid reason. The project
feasibility study, in the first place, does not claim to be an antidote to failure. Its primary purpose
is to enhance the probability of success of a specific undertaking. It is a result of the belief that a
carefully planned activity has better chances to succeed than an activity without a previous plan.
And to those who argue that studies are worthless in these times of great uncertainty, let it be
said that studies become even more important in evaluating multiple alternatives arising from
multiple possibilities. The project feasibility study is one of the best instruments to meet the
challenges of constant change.
GENERATION AND SCREENING OF PROJECT IDEAS

Project Selection Process

Identification of a new project is a complex problem. Project selection process starts with the
generation of project ideas. In order to select the most promising project, the entrepreneur needs
to generate a few ideas about the possible project one can undertake. The project ideas as a
process of identification of a project begins with an analytical survey of the economy (also
known as pre-investment surveys). The surveys and studies will give us ideas. The process of
project selection consists of following stages
 Idea generation
o SWOT analysis
o Clear articulation of objectives
o Fostering a conducive environment
 Corporate appraisal
o Marketing and distribution
o Production and operations
o Research and development
o Corporate resources and personnel
o Finance and accounting
 Tools for Identifying Investment Opportunities
o Porter model
o Life cycle approach
o Experience Curve
 Scouting for project ideas
o Analyse the performance of existing industries
o Examine the inputs and outputs of various industries
o Review imports and exports
o Study plan outlays and governmental guidelines
o Look at the suggestions of financial institutions and development agencies
o Investigate into local materials and resources
o Analyse economic and social trends
o Study new technological developments
o Draw clues from consumption abroad
o Explore the possibility of reviving sick units
o Identify unfulfilled psychological needs
o Attend trade fairs
o Stimulate creativity for generating new product ideas
 Preliminary screening
o Compatibility with the promoter
o Consistency with governmental priorities
o Availability of inputs
o Adequacy of market
o Reasonableness of cost
o Acceptability of risk level
 Project rating index
o The steps involved in determining the project rating index are as follows:
o Identify factors relevant for project rating
o Assign weights to these factors (the weights are supposed to reflect their relative
importance)
o Rate the project proposal on various factors, using a suitable rating scale
(Typically a 5-point scale or a 7-point scale is used for this purpose.)
o For each factor, multiply the factor rating with the factor weight to get the factor
score
o Add all the factor scores to get the overall project rating index
 Sources of positive Net Present Value.
o Economies of scale
o Product differentiation
o Cost advantage
o Marketing reach
o Technological edge
o Government policy
MARKET AND DEMAND ANALYSIS IDENTIFICATION OF TARGET MARKETS
& PROJECTION OF DEMAND USING PRIMARY AND SECONDARY DATA

Concept of Market & Demand Analysis

The exercise of project appraisal often begins with an estimation of the size of the market.
Before a detailed study of a project is undertaken, it is necessary to know, at least roughly, the
size of the market because the viability of the project depends critically on whether the
anticipated level of sales exceeds a certain volume. Many a project has been abandoned because
preliminary appraisal revealed a market of inadequate size.
 Market and demand analysis is carried out to identify the aggregate demand for a product
or service and the market share a project under consideration is expected deliver.
 Companies perform market demand analysis to comprehend how much consumer demand
exists in the market for a product or service.
 This analysis helps management conclude if they can successfully enter a market and
generate enough profits to grow their business operations.

Key Steps in Market & Demand Analysis, and their Inter-relationships

Situational analysis and specification of objectives

In order to get a “feel” of the relationship between the product and its market, the project analyst
may informally talk to customers, competitors, middlemen, and others in the industry. Wherever
possible, the analyst may look at the experience of the company to learn about the preferences
and purchasing power of customers, actions and strategies of competitors, and practices of the
middlemen.
Collection of secondary information
The information required for demand and market analysis is usually obtained partly from
secondary sources and partly through a market survey. In marketing research, a distinction is
usually made between primary information and secondary information. Primary information
refers to information which is collected for the first time to meet the specific purpose on hand;
secondary information, in contrast, is information which is in existence and which has been
gathered in some other context. Secondary information provides the base and the starting point
for market and demand analysis. It indicates what is known and often provides leads and cues for
further investigation.
Secondary information is information that has been gathered in some other context and is readily
available. It provides the base and the starting point for the market and demand analysis. It
indicates what is known and often provides leads and cues for gathering primary information
required for further analysis.
While secondary information is available economically and readily (provided the market analyst
is able to locate it), its reliability, accuracy, and relevance for the purpose under consideration
must be carefully examined. The market analyst should seek to know:
o Who gathered the information? What was the objective?
o When was the information gathered? When was it published?
o How representative was the period for which the information was gathered?
o How representative was the period for which the information was gathered?
o Have the terms in the study been carefully and unambiguously defined?
o What was the target population?
o How was the sample chosen?
o How representative was the sample?
o How satisfactory was the process of information gathering?
o What was the degree of sampling bias and non-response bias in the information
gathered?
o What was the degree of misrepresentation by respondents?

Conduct of market survey

Secondary information, though useful, often does not provide a comprehensive basis for market
and demand analysis. It needs to be supplemented with primary information gathered through a
market survey. The market survey may be a census survey or a sample survey; typically, it is the
latter.
The information sought in a market survey may relate to one or more of the following:
o Total demand & rate of its growth
o Demand in different segments of the market
o Income & price elasticity of demand
o Motives for buying
o Purchasing plans & intentions
o Satisfaction with existing products
o Unsatisfied needs
o Attitudes toward various products
o Distributive trade practices & preferences
o Socio-economic characteristics of buyers
Steps in Sample Survey

Characterization of the market

Based on the information gathered from secondary sources and through the market survey, the
market for the product/service may be described in terms of the following:
o Effective demand in the past & present
o Breakdown of demand
o Price
o Methods of distribution and sales promotion
o Consumers
o Supply and competition
o Government policy

Demand forecasting
After gathering information about various aspects of the market and demand from primary and
secondary sources, an attempt may be made to estimate future demand. Several methods are
available for demand forecasting
1. Qualitative Methods: These methods rely essentially on the judgment of experts to
translate qualitative information into quantitative estimates. The important qualitative
methods are :
o Jury of executive method
o Delphi method
2. Time-Series Projection Methods: These methods generate forecasts on the basis of an
analysis of the historical time series. The important time series projection methods are:
o Trend projection –method
o Exponential smoothing method
o Moving average method
3. Causal Methods: More analytical than the preceding methods, causal methods seek to
develop forecasts on the basis of cause-effect relationships specified in an explicit,
quantitative manner. The important causal methods are :
 o Chain ratio method
o Consumption level method
o End use method
o Leading indicator method
o Econometric method

1. Uncertainties in demand forecasting

Demand forecasts are subject to error and uncertainty which arise from three principal sources:
o Data about past and present market
o Methods of forecasting
o Environmental change

Remember no one has predicted COVID 19 and its impact on business.

Given the uncertainties in demand forecasting, adequate efforts, along the following lines, may
be made to cope with uncertainties.
o Conduct analysis with data based on uniform and standard definitions.
o In identifying trends, coefficients, and relationships, ignore the abnormal or out-
of- the- ordinary observations.
o Critically evaluate the assumptions of the forecasting methods and choose a
method which is appropriate to the situation.
o Adjust the projections derived from quantitative analysis in the light of
unquantifiable, but significant, influences.
o Monitor the environment imaginatively to identify important changes.
o Consider likely alternative scenarios and their impact on market and competition.
o Conduct sensitivity analysis to assess the impact on the size of demand for
unfavourable and favourable variations of the determining factors from their most
likely levels.

Market planning
A marketing plan usually has the following components
1. Current marketing situation
 Where is your organisation now?
 Who are your customer groups? What are their needs and requirements? How
large and diverse are they?
 What kinds of products and services do you currently provide?
 How do you reach your customer groupings?
 Do you have any competition?
 What factor/s in your environment has an effect on your organisation?
2. Opportunity and issue analysis (S.W.O.T. analysis). This identifies key issues and
opportunities for your organisation and it comprises an analysis of your internal
operations
 Strengths
 Weaknesses
Also those external factors, which effect your organisation
 Opportunities
 Threats
 3. Objectives. Having identified the key issues affecting your organisation you can make
some decisions about future objectives. These guide the development of strategies and
action plans.
 Objectives should meet certain criteria e.g. financial, and marketing which will be
customer focused.
 They should be clearly stated, measurable and listed in order of importance
 They should be attainable and consistent with your organisation's culture.
4. Marketing strategy. This is the game plan that needs to be implemented to achieve the
objectives. It addresses the following:
 Whom are you now targeting?
 What do you want your position to be in terms of new product/service delivery?
 Do you want to change your organisation profile and will you need to rebrand
your organisation?
 Will you change the way you promote and advertise yourself?
 Will there be any changes in how you reach your customer groupings?
 Any changes in staff?
 Is there a need for more research?
5. Action program. This describes:
 What will be done
 When will it be done?
 Who will do it?
 How much will it cost?
6. Budget and controls.
 The Budget is essentially a cash flow statement and profit/loss statement to
support the marketing plan
 Control mechanisms and procedures should be established to monitor the progress
of the plan to determine if anything needs changing. It would include a
contingency plan in case something adverse should happen.

Summary
An estimation of the size of the market is the first step in project appraisal. In many cases, a
project has been abandoned because preliminary appraisal revealed a inadequate size of market.
The information required for market and demand analysis relate to effective demand in the past
and present, breakdown of demand, price, consumers, methods of distribution and sales
promotion, government policy and supply and competition. The information required for demand
and market analysis is generally obtained partly from secondary sources and partly through a
market survey. The important sources of national sample survey reports, plan reports, India year
book, statistical abstract of the Indian Union. Sometimes, secondary information does not
provide a comprehensive basis for demand and market analysis. It needs to be supplemented
with primary information gathered through a market survey. After collecting information about
various aspects of the market and demand from primary and secondary sources, it is essential to
make an estimate of future demand. The various methods of demand forecasting include trend
projection method, consumption level method, end use method, leading indicator method
econometric method. Given the uncertainties in demand forecasting adequate efforts are to be
made to cope with uncertainties.
TECHNICAL ANALYSIS
The success of an enterprise depends upon the entrepreneur doing the right thing at the right
time. Starting a new venture is a very challenging and rewarding task. A businessman has to take
numerous decisions, right from the conception of a business idea, upon the start of production.
Hence, the identification of the project to be undertaken, requires an analysis of the project in
depth. Therefore, a technical and financial analysis of the project has to be undertaken.
 Scope of an investment project
o Corporate objective and strategies
o Marketing concepts and available inputs
 Design of the functional and physical layout
o All activities to deliver inputs and outputs
o Define corresponding investment expenditure
o Cost during operational phase
o Plant site

Analysis of technical and engineering aspects is done continually when a project is being
examined and formulated. Other types of analyses are dependent and closely intertwined with
technical analysis. Technical analysis is concerned primarily with:
Materials and inputs
An important aspect of technical appraisal is concerned with defining the materials and inputs
required, specifying their properties in some detail, and setting up their supply programme. There
is an intimate relationship between the study of materials and inputs and other aspects of project
formulation, particularly those concerned with location, technology, and equipment.
Materials and inputs may be classified into four broad categories:
(i) raw materials,
 (ii) processed industrial materials and components,
(iii)auxiliary materials and factory supplies, and
(iv) utilities.

(i) Raw materials— Raw materials (processed and /or semiprocessed) may be classified into
four types: (i) agricultural products, (ii) mineral products, (iii) livestock and forest
products, and (iv) marine products.
(ii) Processed industrial materials and components— Processed industrial materials and
components (base metals, semi-processed materials, manufactured parts, components,
and sub-assembly represent an important input for a number of industries. In studying
them the following questions need to be answered: In the case of industrial materials,
what are their properties? What is the total requirement of the project? What quantity
would be available from domestic source? What quantity would be available from
foreign sources? How dependable are the supplies? What has been the past trend in
prices? What is the likely future behaviour of prices?
(iii)Auxiliary materials and factory supplies— In addition to the basic raw materials and
processed industrial materials and components, a manufacturing project requires
various auxiliary materials and factory supplies, like chemicals, additives, packaging
materials, paints, varnishes, oils, grease, cleaning materials, etc. The requirements of
such auxiliary materials and supplies should be taken into account in the feasibility
study.
(iv) Utilities— A broad assessment of utilizes (power, water, steam, fuel, etc.) may be made
at the time of input study though a detailed assessment can be made only after
formulating the project with respect to location, technology, and plant selection. Since
the successful operation of a project critically depends on adequate availability of
utilities the following points should be raised whiled conducting the input study:
What quantities are required? What are the sources of supply? What would be the
potential availability? What are the likely shortages/bottlenecks? What measures may
be taken to augment supplies.

Production technology
For manufacturing a product/service often two or more alternative technologies are available.
For example:
 Steel can be made either by the Bessemer process or the open hearth process.
 Cement can be made either by the dry process or the wet process.
 Soda can be made by the electrolysis method or the chemical method.
 Paper, using bagasse as the raw material, can be manufactured by the kraft process or the
soda process or the simon cusi process.
 Vinyl chloride can be manufactured by using one of the following reactions: acetylene on
hydrochloric acid or ethylene or chlorine.
Choice of technology
The choice of technology is influenced by a variety of considerations:
 Principal inputs— The choice of technology depends on the principal inputs available for
the project. In some cases, the raw materials available influences the technology chosen.
For example, the quality of limestones determines whether the wet or dry process should
be used for a cement plant. It may be emphasized that a technology based on indigenous
 inputs may be preferable to one based on imported inputs because of uncertainties
characterizing imports, particularly in a country like India.
 Investment outlay and production cost— The effect of alternative technologies of
investment outlay and production cost over a period of time should be carefully assessed.
 Use by other units— The technology adopted must be proven by successful use by other
units, preferably in India.
 Product mix— The technology chosen must be judged in terms of the total product-mix
generated by it, including saleable byproducts.
 Latest developments— The technology adopted must be based on latest development in
order to ensure that the likelihood of technological obsolescence in the near future, at
least, is minimized.
 Ease of absorption— The ease with which a particular technology can be absorbed can
influence the choice of technology. Sometimes a high-level technology may be beyond
the absorptive capacity of a developing country which may lack trained personnel to
handle that technology.

Product Mix
The choice of product mix is guided primarily by market requirements. In the production of most
of the items variations in size and quality are aimed the production of most of the items,
variations in size and quality are aimed at satisfying a broad range of customers. For example,
production of shoes to different customers. It may be noted that sometimes slight variations in
quality can enable a company to expand its market and enjoy higher profitability. For example, a
toilet soap manufacturing unit may by minor variation in raw material, packaging, and sales
promotion offer a high profit margin soap to consumers in upper-income brackets. While
planning the production facilities of the firm, some flexibility with respect to the product mix
must be sought. Such flexibility enables the firm to alter its product mix in response to changing
market conditions and enhances the power of the firm to survive and grow under different
situations. The degree of flexibility chosen may be based on a careful analysis of the additional
investment requirements for different degrees of flexibility.

Plant capacity
Plant capacity (also referred to as production as capacity) refers to the volume or number of units
that can be manufactured during a given period. Several factors have a bearing on the capacity
decision.
 Feasible normal capacity (FNC) :- Capacity attainable under normal working condition
 Nominal maximum capacity (NMC) :- capacity which technically attainable guaranteed
by plant supplier

Technological requirement— For many industrial projects, particularly in process type

industries, there is a certain minimum economic size determined by the technological factor. For
example, a cement plant should have a capacity of at least 300 tonnes per day in order to use the
rotary kiln method; otherwise, it has to employ the vertical shaft method which is suitable for
lower capacity.
Input constraints— In a developing country like India, there may be constraints on the
availability of certain inputs. Power supply may be limited; basic raw materials may be scarce;
foreign exchange available for imports may be inadequate. Constraints of these kinds should be
borne in mind while choosing the plant capacity.
Investment cost— When serious input constraints do not obtain, the relationship between
capacity and investment cost is an important consideration. Typically, the investment cost per
unit of capacity decreases as the plant capacity increases.
Market conditions— The anticipated market for the product/service has an important bearing on
plant capacity. If the market for the product is likely to be very strong, a plant of higher capacity
is preferable. If the market is likely to be uncertain, it might be advantageous to start with a
smaller capacity. If the market, starting from a small base, is expected to grow rapidly, the initial
capacity may be higher than the initial level of demand- further additions to capacity may be
affected with the growth of market.
Resources of the firm— The resources, both managerial and financial, available to a firm define
a limit on its capacity decision. Obviously, a firm cannot choose a scale of operations beyond its
financial resources and managerial capability.
Governmental policy— The capacity level may be constrained by governmental policy. Given
the level of additional capacity to be created in an industry, within the licensing framework of
the government the government may decide to distribute the additional capacity among several
firms.

Location and site

The choice of location and site follows an assessment of demand, size, and input requirement.
Though often used synonymously, the terms 'location' and 'site' should be distinguished.
Location refers to a fairly broad area like a city, an industrial zone, or a coastal area; site refers to
a specific piece of land where the project would be set up.
The choice of location is influenced by a variety of considerations:
 proximity to raw materials and markets
 availability of infrastructure
 labor situation
 governmental policies, and other factors.

Machinery and equipment

The requirement of machinery and equipment is dependent on production technology and plant
capacity. It is also influenced by the type of project. For a process-oriented industry, like a
petrochemical unit, machinery and equipment required should be such that the various stages
have to be matched well. The choice of machinery and equipment for a manufacturing industry is
somewhat wider as various machines can perform the same function with varying degrees of
accuracy. For example, the configuration of machines required for the manufacture of
refrigerators could take various forms. To determine the kinds of machinery and equipment
requirement for a manufacturing industry, the following procedure may be followed:
(i) Estimate the likely levels of production over time.
(ii) Define the various machining and other operations.
(iii)Calculate the machine hours required for each type of operation.
(iv) Select machinery and equipment required for each function.

The equipment required for the project may be classified into the following types:
(i) plant (process) equipment,
(ii) mechanical equipment,
(iii)electrical equipment,
(iv) instruments,
(v) controls,
 (vi) internal transportation system, and
(vii) other machinery and equipment.

In addition to the machinery and equipment, a list should be prepared of spare parts and tools
required. This may be divided into:
(i) spare parts and tools to be purchased with original equipment, and
(ii) spare parts and tools required for operational wear and tear.

Constraints in selecting machinery and equipment— In selecting the machinery and equipment,
certain constraints should be borne in mind:
(i) there may be a limited availability of power to set up an electricity intensive plant like,
for example, a large electric furnace;
(ii) there may be difficulty in transporting a heavy equipment to a remote location;
(iii)workers may not be able to operate, at least in the initial periods, certain sophisticated
equipment such as numerically controlled machines;
(iv) the import policy of the government may preclude the import of certain types of
machinery and equipment.
FINANCIAL ANALYSIS
Financial analysis is defined as the process of discovering economic facts about an enterprise
and/or a project on the basis of an interpretation of financial data. Financial analysis also seeks to
look at the capital cost, operations cost and operating revenue. The analysis decisively
establishes a relationship between the various factors of a project and helps in maneuvering the
project's activities. It also serves as a common measure of value for obtaining a clear-cut
understanding about the project from the financial point of view.

An analysis of several financial tools provide an important basis for valuing securities and
appraising managerial programmes. Financial analysis is vital in the interpretation of financial
statements. It can provide an insight into two important areas of management— return on
investment and soundness of the company's financial position.

Internal management accounts provide information which is valuable for the purpose of control.
The information is made available in the form of accounting data, which may be manifested as
financial and accounting statements. A financial analysis reveals where the company stands with
respect to profitability, liquidity, leverage and an efficient use of its assets. Financial reports
provide the framework within which business planning takes place. They are the key through
which an effective control of a business enterprise is exercised. It is the process of determining
the significant financial characteristics of a firm. It may be external or internal. Creditors,
stockholders and investment analysis perform the external analysis. The internal analysis is
performed by various departments of a firm.

Significance of financial analysis

Financial analysis primarily deals with the interpretation of the data incorporated in the proforma
financial statements of a project and the presentation of the data in a form in which it can be
utilized for a comparative appraisal of the projects. It is, in effect, concerned with the
development of the financial profile of the project. Its purpose is to find out whether the project
is attractive enough to secure funds needed for its various constituent activities and once having
secured the funds, whether the project will be able to generate enough economic values to
achieve the objectives for which it is sought to be implemented. It deals not only with the
financial aspects of a project but also with its operational aspects. As such, it is necessary to
undertake such an analysis not only in the case of industrial projects but also in the case of non-
industrial projects.

Analysis of financial statements has become very significant due to the widespread interest of
various parties in the financial results of a company. In recent years, the ownership of capital of
most public companies has become broad-based. A number of parties and bodies, including
creditors, potential suppliers, debenture-holders, credit institutions like banks, industrial finance
corporations, potential investors, employees, trade unions, important customers, economists,
investment analysts, taxation authorities and government have a stake in the financial results of a
company. Various people look at the financial statements from various angles. A number of
techniques have been developed to undertake analysis of financial statements in order to reach
conclusions about the financial health, profitability and efficiency of an enterprise and to
compare an enterprise with other similar undertakings. The technique of ratio analysis is the
most important tool of financial analysis. It helps in comparing the performance of various
companies and judge their financial soundness.

Utility of financial and accounting statements

Financial statements play a vital role in the internal financial control of an enterprise. These
should, therefore, the properly constructed, analyzed and interpreted by executives, bankers,
creditors and investors.

The entire future of a company hinges on the manager's ability to decide relevant financial data
with a view to planning profit ability moves. Learning to read financial statements is the first
essential element in any businessperson’s attempt to acquire financial management skills. The
change in the elitism of stock ownership to broad public ownership has necessitated a
concomitant change in the entire process of reporting corporate financial results. The role of
management in the matter of preparation of financial statements is to add understanding to these
statements, the fairness of which is to be viewed through the eye of the user, while that of the
accountant is to close the communication gap and of the auditor to add credibility to them. For
evolving a good economic information system, accounting innovations are of great economic
information system. Without these, communication with the financial community would be
difficult, the interest of present and future potential investors would not be served, the ability of
the company to raise additional capital would be impaired and the government's regulatory
measures and policies would not serve the best interest of society. Though a financial statement
reveals less than it conceals, it provides the indicators of the enterprise's performance during the
year.

Financial analysis seeks to spotlight the significant facts and relationships concerning managerial
performance, viz., corporate efficiency, financial strengths and weaknesses and creditworthiness
of the enterprise.

SUMMARY

Technical analysis is done continually when a project is being formulated. Technical analysis is
concerned with materials and inputs, production technology, choice of technology, product mix,
plant capacity, location, machinery and equipment, structure and civil works and project charts
and layouts. Financial analysis seeks to look at the operating cost, operating revenue and capital
cost. The purpose of financial analysis is to find out whether the project is attraction enough to
secure funds needed for its various constituent activities and once having secured the funds,
whether the project will be able to generate enough economic values to achieve the objectives for
which it is sought to be implemented. The future of a company depends on the manager’s ability
to decide relevant financial data with a view to profitability planning. A financial statement
reveals less than it conceals, it provides the indicators of the performance of the enterprise during
the year.
SOURCE: “Projects: Planning , Implementation , and Review”-Prasanna Chandra 8th Edition (10th
reprint-2018) Appendix C - contributed by Dr. T.V. Ramachandra of Indian Institute of Science.

Environmental Appraisal of Projects:

• Meaning of Environment and Pollution:
An ecosystem is a functional unit of nature where organisms interact with
each other and their surrounding. There are many external forces,
substances or conditions which can effect the living organism in one way
or the other. These factors which can effect living organisms are in toto
referred to as the environment.
Environment around us acts in many ways to benefit mankind some of
which are fixation of CO2 , release of Oxygen and pollination by various
biotic and abiotic agents.
Examples of biotic components include animals, plants, fungi, and
bacteria. Abiotic components are non-living components that influence an
ecosystem. Examples of abiotic factors are temperature, air currents, and
minerals.
Anthrosphere is that part of the environment made or modified by humans
and used for their activities like; factories , transport vehicles,
infrastructure etc.
Pollution is the introduction of harmful material into the environment.
Though environment degradation can occur naturally, advancement and
development taking place today in the anthrosphere , also causes
pollution, resulting in environmental degradation through depletion of
resources such as air , water and soil, destruction of ecosystems and the
extinction of wild life.
The largest areas of concern at present are the loss of rain forests, air
pollution, smog, ozone depletion, and damage to marine life.

1
 • Pollution created by Different Industries.
Industrial Activities release / emit harmful chemicals into the stratosphere
, into water bodies and which leach into the soil too over time. They also
are a source of noise pollution. The following list will give an idea as to
how in the name of progress humankind is causing great damage to the
environment:
Air Pollution-
 CFC ( chloroflurocarbons ) used in the refrigeration industry extensively
till relatively recently was the primary cause of ozone depletion allowing
harmful UV rays of the sun to adversely impact the biotic components of
the environment.
 Methyl-iso-cyanate(MIC) is a poisonous gas used in Pesticide Plants
leakage of which into the air can drastically and fatally reduce the quality
of air
 Sulphur dioxide released by the burning of fossil fuels particularly coal
and at times petrol and diesel by Power Plants
 Carbon monoxide , hydrocarbons , nitrous oxides – Automobile and
Transport industry
 Carbon particles, metallic dust, tars , resins, aerosols, solid oxides,
nitrates, and sulphates, Sulphur, nitrogen and oxygen compounds,
Halogens like chlorine , fluorine and radioactive substances are artificial
pollutants released into the air majorly by the following industries –
Metallurgical, chemical , synthetic rubber, cement plants , Petroleum
refineries , paper pulp, sugar , cotton mills
 Dust from agricultural processes, field burning , construction industry

Water Pollution –
(referred to as addition of an excess material or heat to water that is
harmful to humans animals and aquatic life.)
Major source of pollutants are:
 Domestic – homes and commercial establishments due to badly
maintained drainage and sewerage systems

2
  Industrial wastes and effluents- petro-chemical, fertilizer, tanneries, steel ,
distilleries, coal washeries, synthetic material , drugs, fibres, rubber ,
plastic . Methyl mercury from Japanese coastal industries caused fatal
“Minamata” disease to people who ate the contaminated sea food.
 Agricultural – fertilizers , sediments , animal wastes
 Shipping – oil, human waste
Radioactive Pollution –
Radiation from radioactive materials hazardous to health of all the living
forms.
 Atomic explosions and Atomic reactors are the source of large quantities
of radioactive material found in the ecosystem.

• Methods of preventing Pollution.

Preventing Air Pollution:

 Desirable and harmless air quality standards have to be established
 Adequate legislation to compel control of pollutants at source
 Source control disallowing emission of pollutants into the air
 Abatement rendering the emission harmless
 Utilization of positive cranck case ventilation valve and catalytic
converter by public to reduce exhaust emissions
 PUC Certification
 Industry to use electrostatic precipitators to reduce smoke and dust
 Using chemical methods like Differential solubility of gases in water by
using scrubbers and by filtration or absorption through activated carbon
 Use unleaded petrol , CNG ( Compressed Natural Gas), mixed fuel
containing methanol

3
Preventing Water Pollution:
 Stabilization of ecosystem-reducing waste input , harvesting and removal
of biomass , trapping of nutrients , fish management and aeration
 Reutilization and recycling of waste- to generate cheaper fuel gas and
electricity
 Physical removal of pollutants- absorption, electrodialysis , reverse
osmosis ( desalinate brackish water, purification of sewage effluents) and
ion exchange
 CSIR’s techniques – removal of ammonia, mercury , phenolics and
sodium salts for re use of water after decolourization.

Precautions against radioactive leakage

 The radioactive waste is normally disposed in landfilling by digging deep
pits in desert areas or sea bottom and capped by concrete to avoid
contamination.

 Environmental Regulations in India

 The Environment (Protection) Act was enacted in 1986 with the objective
of providing for the protection and improvement of the environment. It
empowers the Central Government to establish authorities [under section
3(3)] charged with the mandate of preventing environmental pollution in
all its forms and to tackle specific environmental problems that are
peculiar to different parts of the country. The Act was last amended in
1991. EIA was made statutory in 1994.
 The Water (Prevention and Control of Pollution) Act was enacted in 1974
to provide for the prevention and control of water pollution, and for the
maintaining or restoring of wholesomeness of water in the country. The
Act was amended in 1988. The Water (Prevention and Control of
Pollution) Cess Act was enacted in 1977, to provide for the levy and
collection of a cess on water consumed by persons operating and carrying
on certain types of industrial activities. This cess is collected with a view
to augment the resources of the Central Board and the State Boards for the
prevention and control of water

4
 pollution constituted under the Water (Prevention and Control of
Pollution) Act, 1974. The Act was last amended in 2003.
 The Air (Prevention and Control of Pollution) Act was enacted in 1981
and amended in 1987 to provide for the prevention, control and
abatement of air pollution in India.
 The Noise Pollution (Regulation and Control) Rules, 2000 under The
Environment (Protection) Act - The increasing ambient noise levels in
public places from various sources, inter-alia, industrial activity,
construction activity, generator sets, loud speakers, public address
systems, music systems, vehicular horns and other mechanical devices
have deleterious effects on human health and the psychological well
being of the people; it is considered necessary to regulate and control
noise producing and generating sources with the objective of maintaining
the ambient air quality standards in respect of noise;
Functions of the Central Pollution Control Board of India at the
National Level
 Advise the Central Government on any matter concerning prevention and
control of water and air pollution and improvement of the quality of air.
 Plan and cause to be executed a nation-wide program for the prevention,
control or abatement of water and air pollution;
 Co-ordinate the activities of the State Board and resolve disputes among
them;
 Provide technical assistance and guidance to the State Boards, carry out
and sponsor investigation and research relating to problems of water and
air pollution, and for their prevention, control or abatement;
 Plan and organise training of persons engaged in programme on the
prevention, control or abatement of water and air pollution;
 Organise through mass media, a comprehensive mass awareness
programme on the prevention, control or abatement of water and air
pollution;

5
  Collect, compile and publish technical and statistical data relating to water
and air pollution and the measures devised for their effective prevention,
control or abatement;
 Prepare manuals, codes and guidelines relating to treatment and disposal
of sewage and trade effluents as well as for stack gas cleaning devices,
stacks and ducts;
 Disseminate information in respect of matters relating to water and air
pollution and their prevention and control;
 Lay down, modify or annul, in consultation with the State Governments
concerned, the standards for stream or well, and lay down standards for
the quality of air; and
 Perform such other function as may be prescribed by the Government of
India.
 As per the policy decision of the Government of India, the CPCB has
delegated its powers and functions under the Water (Prevention and
Control of Pollution) Act, 1974, the Water (Prevention and Control of
Pollution) Cess Act, 1977 and the Air (Prevention and Control of
Pollution) Act, 1981 with respect to Union Territories to respective local
administrations.
 CPCB along with its counterparts State Pollution Control Boards
(SPCBs) are responsible for implementation of legislations relating to
prevention and control of environmental pollution.
Functions of the Central Board and State Boards for the Union
Territories
 Advise the Governments of Union Territories with respect to the
suitability of any premises or location for carrying on any industry which
is likely to pollute a stream or well or cause air pollution;
 Lay down standards for treatment of sewage and trade effluents and for
emissions from automobiles, industrial plants, and any other polluting
source;
 Evolve efficient methods for disposal of sewage and trade effluents on
land;develop reliable and economically viable methods of treatment of
sewage, trade effluent and air pollution control equipment;

6
  Identify any area or areas within Union Territories as air pollution
control area or areas to be notified under the Air (Prevention and Control
of Pollution) Act, 1981;
 Assess the quality of ambient water and air, and inspect wastewater
treatment installations, air pollution control equipment, industrial plants
or manufacturing process to evaluate their performance and to take steps
for the prevention, control and abatement of air and water pollution.

• Environmental Impact Assessment for Projects

Introduction:
Formally Environmental Impact Assessment (EIA) and Strategic
Environmental Analysis (SEA) are structured approaches for obtaining
and evaluating environmental information prior to its use in decision
making in the development process.
 In recent years in most Capitalistic countries lenders are disinclined to ask
for guarantees in the form of the plant itself since the responsibility for
possible environmental damage derives from the ownership or actual
control of the Project.
 Due Diligence reports contain inter alia comments / opinions on the
Project’s vulnerability if harmful events were to occur and arrive at the
maximum possible loss( MPL) as regards the plant in that eventuality.
 Also safety aspects are studied by simulating various emergency
scenarios to assess the probability of catastrophic events and their impact
in terms of damage to structures and the surrounding environment.
Environment Impact Assessment (EIA) may need to be carried out if the
probability of such occurrence is high.
 Environment impact is any alteration of environmental conditions or
creation of a new set of environmental conditions- adverse or beneficial-
caused or induced by the Project under consideration.
 The impact depends on the nature ,scale, and location of the Project and it
includes the effect on the natural resource base ( quality of air, water,
noise , biological) and socio- economic components of the environment
management.

7
  Inter – alia EIA involves mainly:
 Identification of environmental components likely to be
impacted and the sources of impact
 Prediction of the extent of impact
 Evaluation of impacts to see whether they need to be
mitigated
 Mitigation
 Submission of action report

General procedure for EIA:

 Project screening
 Scoping
 Consideration of Alternatives
 Description of Project / Development Action
 Defining the Environmental baseline
 Main: Identification, Prediction, Evaluation, Mitigation
 Public Consultation and Participation
 EIS Presentation
 Review
 Decision making
 Monitoring
 Auditing
EIA methods:
 Adhoc: Suggests impacts on broad areas like on land, forests,
populations, water, wildlife etc. Does not address secondary impacts.
 Checklist : a list of attributes against which the impact of the project is
marked as ‘adverse”, ”beneficial” or “no effects”. Tends to be subjective
and provides little guidance indecision making process
 Matrix: Leopold’s matrix based on “project actions” in Columns and
“environmental components” in rows – the magnitude and

8
 importance of the impact decide the appropriateness of the cell it
would fall in with a positive sign for beneficial impacts and negative
sign for deleterious impacts. The Matrix total provides the total
environmental impact of the proposed project. Though this method
does touch on secondary impact it is non mathematical and hence
its application becomes arbitrary.
 Mathematical matrices: Peterson’s matrix involves 3 matrices - 1.impact
on physical components of the environment 2. Impact of the affected
components on human environment 3. The first two matrices are
multiplied to arrive at the “effect of actions on human environment”.
 Computer aided EIA: Use of air, water, noise models for prediction of
environmental parameters and with the help of Geographic Information
System (GIS) identify the impacted zones.
 Modeling: Mathematical models for assessment and simulation of
environment attributes like air quality, water quality, noise levels,
behaviour of biological systems for future prediction of impacts in
quantitative terms,
 EIA related legislation
The Environment (Protection) Act was enacted in 1986 with the objective
of providing for the protection and improvement of the environment. It
empowers the Central Government to establish authorities [under section
3(3)] charged with the mandate of preventing environmental pollution in
all its forms and to tackle specific environmental problems that are
peculiar to different parts of the country. The Act was last amended in
1991. EIA was made statutory in 1994.

EIA Notification 2006:

Projects seeking environment clearance have been divided into 2
categories- Category A-All major projects such as river valley, nuclear ,
thermal power, mining etc. require EIA study and clearance from Central
Govt.
Category B- Clearance is accorded by State Environmental Impact
Assessment Authority(SEIAA) on appraisal and recommendation by State
Level Expert Appraisal Committee( SEAC). Category B1 are those that
will require EIA study and B2 which do not require EIA study.

9
EIA Notification 2009:
o Proponent/Applicant has to make public terms of the environmental
clearance obtained and copies to be given to Panchayat, Local Bodies
o Self certification as to no further pollution load , waste generation, water
requirement
o In the absence of a duly constituted SEAC/SEIAA Category B project
will be treated as Category A
o In case of >50% production expansion Project holding of Public
constitution shall be essential
o Irrigation projects not involving submergence or inter state domain will
be treated as Category B project
o Clearance under Category A required for Biomass fueled Thermal Power
Plant> 50 MW
o Any project located within 10 km from Wildlife protected areas, critically
polluted areas , eco sensitive regions or interstate / international
boundaries will be treated as Category A

-------------------------
-
Social Cost Benefit Analysis (SCBA). SOURCE: “Projects: Planning ,
Implementation , and Review”-Prasanna Chandra 8 Edition (10th reprint-2018) Chapter 14.
th

• SCBA also called economic analysis is a methodology developed for

evaluating investment projects from the point of view of the society or
economy as a whole.

• The rationale for SCBA-

10
Focus is on social costs and benefits of the project as differentiated from
monetary costs and benefits:

 Market imperfections-rationing, minimum wages, foreign

exchange regulation

 Externalities-like infrastructure benefiting, environment pollution

harming neighbouring areas,

 Taxes and subsidies-cost/gain from private point of view, transfer

payments from social point of view

 Concern for savings-higher valuation is placed on savings (a it

leads to investment) and lower value on consumption

 Concern for redistribution-a rupee going to an economically

backward section is socially more valuable than going to an
affluent section

 Merit wants- adult education, balanced nutrition programmes are

more vauable in SCBA even though they are not sought by
conumers in the market place.

2
 • Different approaches to SCBA-

 UNIDO (UN Industrial Development Organization)

Approach

Stages:

 Calculation of Financial Profitability at market prices

 Obtain net benefit in terms of economic prices (efficiency or

shadow prices)

Shadow pricing - Basic issues:

- Choice of Numeraire: “net present consumption in the hands of the

people at the base level of consumption in the pvt sector in terms of constant
prices in domestic accounting currency”

- Concept of tradability-for a tradable good international price ( border

price) represents the “real” value of the good in terms of economic effeciency

-3 Sources of shadow prices-1.if impact on consumption: consumer

willingness to pay 2. if impact on production: cost of production 3. if impact is
on international trade : foreign exchange value

3
 - Taxes-when a project augments domestic production by other
producers taxes should be excluded; for fully traded goods taxes should be
ignored; when a project results in diversion of non traded inputs which are in
fixed supply from other producers or addition to non-traded consumer goods,
taxes should be included.

Shadow pricing - Specific resources:

- traded Inputs and outputs – border price translated in domestic

currencyat the market exchange rate

-non tradable inputs and outputs-a good is non-tradable if “cif” price >
domestic cost of production or “fob” price < its domestic cost of production

- externalities- product which is an incidental outcome, not traded in

market, beyond the control of the persons affected

- labour inputs-labour from other employments, induce new workers,

import of workers

- Capital inputs

- Foreign exchange

 Adjust for impact on savings and investment

- Change in savings income of group due to project X Marginal

propensity to save.

- value of a rupee saved is the present value of the additional

consumption stream produced when that rupee is invested.

4
  Adjust for impact on income distribution

- Identify Income gain/loss of Groups; Project, Other Pvt Business, Govt,

Workers, Consumers, External sector

 Adjust for impact on merit and demerit goods

- more and less than economic value respectively

 Little–Mirrlees (LM) Approach

 Similarities with UNIDO approach

-Calculating shadow prices

-Considering the factor of equity

-Using DCF analysis

 Differences with UNIDO approach

- L-M approach measures cost and benefits on international prices

(border prices).

- measures in terms of uncommitted social income instead of

consumption

- efficiency, savings and redistribution are dealt with together instead of

individually

 Methodology followed by Financial Institutions:

3 Aspects are Considered:

5
  Economic rate of Return – Border prices for all non labour inputs and
outputs

- “cif” prices for inputs and “fob” prices for outputs

- Social conversion factor is used for non tradable goods like electricity,
transportation , taking into account 3 components – tradable , labour and
residual.

- Step 1: Ascertain Social cost of Initial Outlay

- Step 2: Acertain Social cost of operations

- Step 3: Ascertain the stream of Costs and Benefits

- Step 4: Use the IRR formula to arrive at the value of “r” which will be
the ERR of the project.

 Effective rate of Protection:

(Value added at domestic prices – Value added at world prices)÷( Value added
at world prices).

 Domestic resource cost (DRC)

Reflects the domestic cost incurred per unit of foreign exchange saved or
earned.

If the domestic resource cost per USD saved is less than the present exchange
rate it is desirable to manufacture the product in the country rather than import
it.

DRC= A+B+C ÷ P- (Q+R+S+T) X Exchange rate where

6
A=10%charge on domestic capital

B=8%Depreciation on domestic capital assets other than land C=annual cost

of non traded inputs

P= Sales realizations at border prices

Q=10%charge on imported capital

R= 8%Depreciation on imported capital assets

S=annual cost of imported inputs

T= is the annual cost of domestically procured but tradable inputs

-------------------

7
Session 15- Structuring Projects:
How project structures create value
Project management typically revolves around three parameters – Quality, Resources, and
Time. A project structure can usually be successfully created by considering:

1. Project Goal

An answer to the question “What has to be done” is usually a good starting point when
setting a project goal. This question leads to the project structure plan. This plan consists
of work packages which represent enclosed work units that can be assigned to a personnel
resource. These work packages and their special relationships represent the project
structure.

2. Project Timeline and Order

A flowchart is a powerful tool to visualize the starting point, the endpoint, and the order
of work packages in a single chart.

3. Project Milestones

Milestones define certain phases of your project and the corresponding costs and results.
Milestones represent decisive steps during the project. They are set after a certain number
of work packages that belong together. This series of work packages leads to the
achievement of a sub-goal.

Definition Phase

The definition phase is where many projects go wrong. This can happen when no clear definition,
or when the definition is muddled due to the involvement of too many stakeholders. A successful
definition must involve the entire team at every step to facilitate acceptance and commitment to
the project.

Clear Goals

The project manager is responsible for the achievement of all project goals. These goals should
always be defined using the SMART paradigm (specific, measurable, ambitious, realistic, time-
bound). With nebulous goals, a project manager can be faced with a daily grind of keeping
everything organized. It will work decidedly to your advantage to clearly define goals before
the project begins.

Transparency About the Project Status

8
Your flowcharts, structure plan, and milestone plan are useful tools to help you stay on track.
As a project manager, you should be able to present a brief report about the status of the project
to your principal or stakeholders at each stage of the project. At such meetings, you should be
able to give overviews about the costs, the timeline, and the achieved milestones.

Risk Recognition

It’s the duty of the project manager to evaluate risks regularly. You should come into every
project with the knowledge that all projects come with a variety of risks. This is normal. Always
keep in mind that your project is a unique endeavor with strict goals concerning costs,
appointments, and performance. The sooner you identify these risks, the sooner you can address
negative developments.

Managing Project Disturbances

It’s not very likely that you have enough personal capacity to identify every single risk that may
occur. Instead, work to identify the big risks and develop specific strategies to avoid them. Even
if you’re no visionary, you should rely on your skill set, knowledge, and instincts in order to
react quickly and productively when something goes wrong.

Responsibility of the Project Manager

The Project Manager develops the Project Plan with the team and manages the team’s
performance of project tasks. The Project Manager is also responsible for securing acceptance
and approval of deliverables from the Project Sponsor and Stakeholders. The Project Manager
is responsible for communication, including status reporting, risk management, and escalation
of issues that cannot be resolved in the team—and generally ensuring the project is delivered
within budget, on schedule, and within scope.

Project managers of all projects must possess the following attributes along with the other
project-related responsibilities:

 Knowledge of technology in relation to project products

 Understanding Management concepts
 Interpersonal skills for clear communications that help get things done
 Ability to see the project as an open system and understand the external-internal
interactions

Project Success

Project success is a multi-dimensional construct that can mean different things to different
people. It is best expressed at the beginning of a project in terms of key and measurable criteria
upon which the relative success or failure of the project may be judged. For example, some
generally used success criteria include:

9
  Meeting key project objectives such as the business objectives of the sponsoring
organization, owner or user
 Eliciting satisfaction with the project management process, i.e., the deliverable is
complete, up to standard, is on time and within budget
 Reflecting general acceptance and satisfaction with the project’s deliverable on the
part of the project’s customer and the majority of the project’s community at some time
in the future.

Structuring a PPP project" means allocating responsibilities, rights, and risks to each party to the
PPP contract. This allocation is defined in detail in the contract. Project structuring is typically
developed through an extended process, rather than by drafting a detailed contract straight away.
The first step is to develop the initial project concept into key commercial terms—that is, an
outline of the required outputs, the responsibilities and risks borne by each party, and how the
private party will be paid. The key commercial terms are typically detailed enough to enable
practitioners to appraise the proposed PPP, as described in Identifying PPP Projects, before
committing the resources needed to develop the draft PPP contract in detail.

Structuring PPP Projects

Structuring PPP Projects shows how PPP structuring—to the level of key commercial terms—
fits into the overall development process. Information from the feasibility study and economic
viability analysis is a key input to PPP structuring—for example, identifying the key technical
risks, and providing estimates for demand and users' willingness to pay for services. The PPP
structure then feeds into commercial viability, affordability and value for money analysis—
which may find that changes are needed to the proposed risk allocation. The aim is typically to
structure a PPP that will be

1
technically feasible, economically and commercially viable, fiscally responsible, and
provide value for money.

The starting point for PPP structuring is the project concept: that is, the project's physical
outline, the technology it is expected to use, the outputs it will provide, and the people it will
serve. These are often developed before deciding whether to implement the project as a PPP, as
described in Identifying PPP Projects.

The specification of output requirements in the PPP contracts is described in Designing PPP
Contracts. PPP project structuring focuses on identifying and allocating risks. This makes sense
since appropriate risk allocation is behind many of the PPP Value Drivers described in PPP
Value Drivers. Following this approach, the other elements of the PPP structure—such as the
allocation of responsibilities and the payment mechanism—stem from the risk allocation. For
example, construction risk may be allocated to the private party, on the basis that it is best
qualified to manage construction. This means that the private party should also be allocated the
responsibility and right to make all construction-related decisions. The mechanism for allocating
commercial risk to the private party may take the form of a user-pays payment mechanism.

This section follows the literature, starting with identifying and prioritizing project risks
(Identifying Risks) then describing how risks are allocated (Allocating Risks) then explaining
how the risk allocation relates to the other aspects of project structure (Translating Risk
Allocation into Contract Structure)..

There are four types of organizational structures, each of which has their own unique set of
influences on the management of the organization’s projects:

1. Functional
2. Project
3. Matrix
4. Composite

Functional

Most organizations are divided along functional lines, that is, each “division” is organized by
work type, such as engineering, production, or sales.

1
In the functional organizational structure, projects are initiated and executed by the divisional
managers, who assume the project manager duties in addition to their regular, functional, roles.
They are often given secondary titles such as “Coordinator of Project X.”

In this structure, project managers usually don’t have alot of authority to obtain resources or to
manage schedules and budgets. They must obtain approvals to utilize resources from other
departments, which can be a complex undertaking. This is because the functional organization
is designed to focus on the provision of the divisional services rather than project deliverables.

Project-Oriented

On the other end of the scale is the project-oriented organization. These companies do most of
their work on a project basis and are therefore structured around projects. This includes
construction contractors, architectural firms, and consultants.

Project managers are usually full time in the role, and for small projects they might
manage several projects at once.

In this structure project managers usually have a great deal of independence and authority.
They are able to draw on resources with little required approval.

New Developments in Organizational Management and PBOs

Stakeholders' interests (Clarke, 2004) and value creation (O'Sullivan, 2000; Blair, 2005) are two
major issues that affect the makeup of organizations and, by consequence, PBOs. Project
management literature has, for a long time, advocated a stakeholder perspective 1, but project
management continues to be practiced in a shareholder paradigm where financial measures are
the main or sole criterion driving the selection and prioritisation of projects (Dyson & Berry,
1998; Meredith & Mantel, 2005). In a shareholder perspective, strategic project decisions are
made based on strategic considerations that have often little to do with tangible benefits (Amram
& Kulatilaka, 1999; Rappaport, 2006). The recent movement towards a more strategic approach
to project management provides the opportunity to take into account these emerging

1
theories of corporate governance and organizational purpose. An integrated vision of projects
would directly link projects and programs to governance and strategy, whereas the continued
promotion of single project management practices reinforces the top- down mechanistic
shareholder approach and deny any value creation mission for project management, as shown in
Exhibit 2.

Exhibit 2: Shareholder and stakeholder value approaches

In line with recent value creation literature (De Wit & Meyer, 2004; Jaruzelski, Dehoff & Bordia,
2005; Jugdev & Thomas, 2002), well integrated PBOs would be expected to focus less on
financial investment and more on organizational effectiveness; they would display clear signs of
stakeholder and value creation perspectives, including innovativeness, empowerment and
stewardship, a wider set of success criteria and a drive towards sustainability over short-term
results and, overall, an increased focus on the link between expected benefits and results
(Dallago, 2002; Kim & Mauborgne, 2005; O'Sullivan, 2000).

Better integration in PBOs could be provided by a coherent project governance approach,

which could be summarised by addressing three major issues:

1. Vertical integration of projects across the project portfolio, to link it to the

corporate strategy.
2. Horizontal integration of projects across the product life-cycle, from formulation of the
business strategy to delivery of business benefits.
3. Integrative project governance structures to create and deliver value.

Vertical and Horizontal Integration

Corporate strategies can be considered as medium or long-term forecasts of the organization's

future position. Their implementation is usually a top-down process and regards the high level
direction of the corporation. In PBOs, portfolio management should not just be used to allocate
resources in the most efficient way, but foster vertical

1
integration between programs and projects to align with corporate strategy and effectively
create value for the business.

Business units, because they are close to the action, will best be able to deal with turbulent
environments by developing business strategies. In PBOs, the word ‘business unit’ may often
be synonymous with ‘programs’ and the advantage of a horizontally integrated project
management approach versus a product delivery project management approach should be
obvious.

As graphically displayed in Exhibit 3, in an organization that reveals a focus on single projects

and on a multi-project management approach that focuses on resource allocation and data
gathering; project managers would be expected to play a predominantly product delivery role.
On the other hand, a well integrated PBO will display strong interrelationships between its
projects and both its business and corporate strategies to create and realize value. In such an
organization project managers would be expected to be appointed in senior management roles,
or senior managers would be expected to view project management as an integrative process to
deliver value to the business. Exhibit 5 displays the main roles that key actors would be
expected to play in an integrated PBO.

Exhibit 3: Vertical and Horizontal Integration in PBOs

Integrated Governance

It is now well established that the growing popularity of program/portfolio management and the
emergence of PMOs as an organizational structure have prompted an accelerated movement
towards project-based organizational structures (Hodgson 2002; Jamieson & Morris, 2004;
Bredillet, 2004). Most organizations have implemented PMOs and portfolio management
structures based on traditional organizational structures (see Exhibit 1). In this model, PMOs are
playing a similar role to the quality department by

1
monitoring and controlling project performance and developing project management (PM)
competencies and methodologies (BIA, 2005, Hobbs & Aubry, 2005; PMI, 2004) some PMOs
are also playing the role of a finance department by allocating resources across the organization
(PMI, 2004); many practice authors (Crawford, 2001; EDS, 2004; Richards, 2001) also
advocate a project audit role for PMOs. This perspective simply mimics traditional
organizational structures, replacing management rhetoric with project rhetoric and will therefore
lose the dynamism and flexibility attributes that characterise project and program management
as demonstrated by recent research that a PMO's life expectancy is about 2 years (BIA, 2005,
Hobbs & Aubry, 2005).

Current turbulence in organizational environments may require the development of more

integrated models of PMOs where the role of the PMO would not only be to optimise the
effort, issue processes and procedures and gather project data, but strongly link the programs
and projects to the strategy as shown in the top part of Exhibit 4, thus exercising a true project
governance role, as defined by the OECD: “governance provides the structure through which
the objectives of the company are set, and the means of attaining those objectives and
monitoring performance are determined.” (OECD, 2004, p 13). This is a much broader view
than the simple monitoring approach taken by many PMOs.

One interesting model of organizational integration and governance is the EFQM Business
Excellence Model, introduced at the beginning of 1992, which has become the most widely used
organizational model in Europe and is steadily spreading across the world. The basic concept of
the model is that: “The ‘Results’ criteria cover what an organisation achieves. ‘Results’ are
caused by ‘Enablers’ and ‘Enablers’ are improved using feedback from ‘Results’.”
(http://www.efqm.org/Default.aspx?tabid=35

). Elements of this model, especially “Enablers”, “Results” and “Innovation and Learning”
arrows are represented in Exhibit 4.

Exhibit 4: The PMO as a Governance System in the PBO

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What is interesting is that, when this approach is taken in organizations the PMO often becomes
a vehicle towards an integrated PBO as witnessed in my own practice and that of many of my
clients and reported by Shelley Gaddie at the PMI North American Congress 2006 in her
presentation: “IT Portfolio Management Breakthroughs”.

X X X X

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SOURCE: “Project Finance in Theory and Practice”- Stefano Gatti and “Harvard Business
Essentials: Guide to Negotiation” - Harvard Business review Press- not for circulation.

Project Negotiation.

• Why and What do we need to negotiate:

 Project Agreements: Generally the Project Company outsources

every corporate and entrepreneurial function and through contracts for
supply of goods and services generically referred to as project
agreements, it procures everything it needs to develop and operate the
project. The system of project agreements is particularly extensive and
complex. They have to address certain peculiarities that make it possible
to apply project finance – this requirement is defined as the bankability
of the project agreements.

• Basic Rules to verify their bankability to emphasize in

Negotiation

 Reliable counterparty from industrial and financial stand point and

compliance transparency

 Price indexing clauses – pass through right

 Quality index

 Take or pay clause - Buyer has to take minimum quantity or pay amount
corresponding to minimum quantity - minimum set price.

 Pre-established indemnity clause for non performance and based on

overall damage to the project.

 Replace a non-performing supplier

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 Termination and withdrawal clause – by counterparty should be restricted
and in favour of project company in case of default by third parties

 Length of contract should cover the entire repayment period of the credit
agreement as lenders are exposed to without recourse credit risk.

 Warranty period

• Common Project Agreements

 Construction contracts (EPC – Engineering, Procurement and

Construction or Turn–key)

 Operations and Maintenance (O&M) Contract

 Raw Material Supply Agreement

 Refinancing Project Finance deals – restructuring, drawdown, payment

clawback

• Overview

 Basic types of negotiations

1. Distributive negotiation- zero sum game one’s gain is at

another’s expense – claiming value

2. Integrative negotiation- create greater value for eventual

distribution- creating and claiming value

 Four concepts-

1. BTNA-best alternative to a negotiated agreement–a plan B

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 2. The reserve price at which you plan to walk away

3. ZOPA- zone of possible agreement in which deal is feasible

4. Value creation through trades- One party assumes greater value

for something the other has and they trade both benefitting in value terms

• General aspects to note in the negotiation process

 Study the Project in detail

 Understand the bankability of the Project

 Determining authority /hierarchy levels in both the organization

 Understanding their background

 Defining Ground Rules

 Be confident, attentive, fair and flexible

 Create trust, avoid any conflict of interest

 Be prepared for multiparty /multiphase negotiations

• General aspects to note in the negotiation process

 Use concessions to continue negotiations

 Continual evaluation of stage of negotiation and revisit reparation

 For closing the deal

1. Indicate the close is near at hand

2. Be ready to stretch the final round

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 3. Discourage the other side from bringing new points on to the
table

4. Obtain and impart clarity of the terms agreed

• Who is an effective negotiator

 Aligns with organizational goals

 Prepares thoroughly

 Learns about the other party

 Mental dexterity to make quick assessments

 Indifferent to personal issues

 Ability to quickly spot potential barriers

 Knows how to form coalitions

 Has a reputation for reliability and creditworthiness

4
SESSION2 1-M ANAGING PRO JECT RIS K-

It is a well established fact that every project involves risk.

Moreover, it is
a practice to include a short summary of project risks in the project
appraisal report. There are certain projects for which economic benefits
can be quantified while for others, such quantification is not possible.
Firm risk stem from technological change in production process,
managerial inefficiency, availability of raw material, labour problems and
changes in consumer preferences. The financial risk considers the
difference between EBIT and EBT while business risk causes the
variations between revenue and EBIT. These are ways and means to
reduce the project risks. Risk can be categorized in the following
categories: Standalone risk, market risk and Portfolio risk.
Importance of Risk Analysis while taking Inve
whether or not the investment plans match with the financial goals of the

compare between investments with similar returns

Risk can arise due to a multitude of factors. Some of those are enlisted

Methods of Risk Evaluation The techniques of Risk Analysis have been

broadly classified into

Conventional Techniques
1) Payback: - It is the oldest and the most commonly used method wherein
the investment option with the least payback period is considered as the
most viable option. This option
however, completely ignores the present value of cash flows.

2) Risk Adjusted Discount Rate: - This method incorporates the risk

premium in the discount rate while evaluating the investment option. The
rationale behind this is simply that the higher the risk in the investment the
higher should be the return on the same. To keep the investors motivated it
is important to provide lucrative returns as well.

3) Certainty Equivalent: - Under this method a certainty equivalent is

calculated which is further used to convert the risking, uncertain future cash

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flows into cash flows with certainty. Certainty equivalent= Certain Cash flow
Risky Cash flow This risk adjustment factor has negative relationship with
risk. If the risk is higher a lower value is used for risk adjustment and vice
versa.

Statistical Techniques

1) Probability Distribution Approach: - In this method the chances of

occurrence of various activities is considered in order to calculate the NPV.
Once the probabilities are assigned NPV of future cash flows are
computed. 2) Variance: - A study of dispersion of cash flows is done in
order to estimate the risk associated with the investment option. The
standard deviation of NPV will be higher when cash flows are perfectly
correlated.

Sensitivity Analysis

This method shows the sensitivity of NPV or IRR with respect to any
variable that is used to determine the cash flow of the project. Analyzing
the change in NPV or IRR due to a change in one of the variable is called
Sensitivity Analysis. The forecasts change in different economic conditions
therefore it is done in different economic conditions mainly Optimistic,
Pessimistic and Expected.
ANALYSIS OF PROJECT RISKS
It is the normal practice to include a short summary of project risks in
each appraisal report. The purpose of this chapter is to provide a
summary of project risks in order to help ensure uniformity and
consistency in appraisal reports. Section-1 relates to projects for which
economic benefits can be quantified and section-2 deals with projects for
which such quantification is not possible.
Projects with quantified benefits
The economic internal rate of return (EIRR) is the measure most often
used to indicate the economic viability of financed projects. Calculation of
the EIRR requires a set of assumptions regarding the conditions faced by
the project which in the judgement of the appraisal mission are most
likely to prevail during its life. However, since bank financed projects
normally have a very long life, the conditions faced by the project may
change for a variety of reasons. Sensitivity analysis is, therefore, carried
out to determine the effects of possible changes in the values of key
variables (costs, yields, and price of inputs and outputs) on the project's
EIRR.
The number of risks facing a project could be large, and it is neither
possible nor desirable to identify all possible risks associated with a
project. The risks discussed in the appraisal report should essentially be

6
those which entail major economic consequences. These should be
identified from the sensitivity analysis and described in descending order
of importance with regard to their impact on the EIRR.
Particular attention should be paid to risks that would substantially
reduce the project's EIRR or render the project uneconomic by reducing
its EIRR below the opportunity cost of capital. In this context, both the
base-case EIRR and the sensitivity indicators are relevant. If the base
case EIRR is high, the discussion of project risks should generally
include risks to which the project is highly sensitive. For example, the
EIRR of most projects is highly sensitive to changes in project output,
which may in turn depend on a number of factors. A discussion of the
safeguards employed to minimize the risk of the outputs falling substantially
below the level expected should therefore be included. For
example, in an irrigation project, apart from the availability of water,
output may depend on the supply of other inputs, provision of extension
services, effectiveness of water management by farmer's groups, and
availability of adequate infrastructure and storage facilities. Measures
taken to ensure adequate and timely availability of each should be briefly
explained.
Risks are obviously greater in projects for which the base-case EIRR is
only marginally higher than the opportunity cost of capital. These larger
risks are even greater if the EIRR is highly sensitive to changes in key
variables since even a small reduction in the EIRR would render the
project unviable. Even when the EIRR is relatively insensitive to changes
in key variables, combinations of adverse changes might easily affect the
project's viability. Thus, in such cases, the remedial action proposed or
adopted should be fully explained.
If the project output is traded internationally, one risk may be future
changes in the price of the output, particularly if the share of a project or
the country's output is small relative to the world market. In such cases,
a review of world demand and supply forecasts for the good in question
should be included.
By their very nature, certain types of projects such as gas and oil
exploration involve very high risks. For such projects, it is necessary to
supplement the sensitivity analysis with a probability analysis. The latter
provides a range of possible outcomes in terms of a probability
distribution and based on that project related decision could be made
more intelligently. But the analysis is more complex and requires more
information about events affecting the project. Due to the considerable
work involved,, probability analysis of risks is usually undertaken only
for project carrying a high degree of risk or for large projects where
miscalculations could lead to a major loss to the economy. For such
projects, the nature of the risks involved and the measures taken or
recommended to minimize the risks, together with the results of the

7
analyses, should be discussed in the appraisal report.

8
SESSION 22- HOW RISK M ANAG EMENT CREAT ES VAL UE IN
PROJ ECT FINANCE
How risk management creates value in project finance?
Risk Management: - Risk Management is continuing process to identify, analyse and
evaluate and treat loss exposures and monitors risk control and financial resources to mitigate
the adverse effects of loss.
In financial world, Risk management is the process of identification, analysing and
acceptance of uncertainty in Investment decisions.
The outcome of the business activities are uncertain and they have some element of risk. So,
risk management is of great importance in project finance, because risk management
strategies can prepare businesses to address unpredictable scenarios .Handling unexpected
financial situations leads businesses to maintain high financial status in marketplace.
What risks are there in project finance?
 Unsound business Investment.
 Taking on Projects that are not cost – effective.
 Paying too much for materials to complete business projects.

In the money related world, risk management is the procedure of recognizable proof,
examination and acknowledgment or relief of vulnerability in speculation choices. Basically,
risk management happens when a financial specialist or reserve supervisor examines and
endeavours to measure the potential for misfortunes in a venture, for example, an ethical
danger, and afterward makes the suitable move (or inaction) given the store's speculation
destinations and hazard resilience.
Risk management happens everywhere in the domain of money. It happens when a speculator
purchases U.S. Treasury securities over corporate securities, when a fund manager fences his
money presentation with cash subordinates, and when a bank plays out a credit keep an eye
on a person before giving an individual credit extension. Stockbrokers utilize budgetary
instruments like options and futures, and cash supervisors use methodologies like portfolio
enhancement, resource designation and position measuring to relieve or effectively oversee
risk.
Insufficient risk management can bring about serious ramifications for organizations, people,
and the economy. For instance, the subprime contract emergency in 2007 that helped trigger
the Great Recession originated from awful hazard the executives choices, for example,
moneylenders who stretched out home loans to people with helpless credit; venture firms
who purchased, bundled, and exchanged these home loans; and assets that put unreasonably
in the repackaged, yet at the same time risky, mortgage backed securities (MBS).

 An assortment of strategies exist to find out risk; one of the most widely recognized is
standard deviation, a factual proportion of scattering around a focal propensity.
 Beta, otherwise called market risk, is a proportion of the unpredictability, or efficient
hazard, of an individual stock in contrast with the whole market.

9
  Alpha is a proportion of abundance return; cash chiefs who utilize dynamic
methodologies to beat the market are dependent upon alpha risk.

We will in general consider "risk" in predominantly negative terms. In any case, in the
speculation world, risk is fundamental and indivisible from alluring execution.
A typical meaning of investment risk is a deviation from a normal result. We can
communicate this deviation in supreme terms or comparative with something different,
similar to a market benchmark.
While that deviation might be positive or negative, venture experts by and large acknowledge
the possibility that such deviation infers some level of the proposed result for your
speculations. Hence to accomplish more significant yields one hopes to acknowledge the
more risk. It is likewise a for the most part acknowledged thought that expanded risk comes
as expanded instability. While investment experts continuously look for, and sometimes
discover, approaches to lessen such unpredictability, there is no unmistakable understanding
among them on how this is ideal to be finished.
How much unpredictability a financial specialist ought to acknowledge relies altogether upon
the individual speculator's capacity to bear risk, or on account of a venture proficient, how
much resilience their venture targets permit. One of the most regularly utilized supreme risk
measurements is standard deviation, a factual proportion of scattering around a focal
propensity. You look at the average return of an investment and then find its average standard
deviation over the same time period. Ordinary conveyances (the natural chime molded bend)
direct that the normal return of the speculation is probably going to be one standard deviation
from the normal 67% of the time and two standard deviations from the normal deviation 95%
of the time. This assists speculators with assessing risk numerically. On the off chance that
they accept, that they can endure the risk, financially and emotionally, they invest.
The possible responses can be given to risks are either Avoidance, Mitigation or Acceptance.
Risk management adds value in project finance by empowering a business with necessary
tools so that it can adequately identify and deal with risks.

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0
 SESSION 23-FI NANCI NG PROJ ECT SY NDICAT ION, ISL AMIC
FINANCE, LEVERAG E LE ASES
PROJECT FINANCING IN INDIA
For years now the Indian financial institutions have been the life line of credit for the Indian
corporate. This has been mainly because of their strong financial muscle and the various
concessions they received from the Central Government for their role. In India, special
financial institutions have been developed to provide finance to the upliftment of industrial
activities in all regions so as to sustain an equitable industrial growth in the county. Financial
assistance is being extended to the industrial enterprises by the financial institutions and
development banks on confessional terms of finance as per their bye laws in the state.
MEANING AND IMPORTANCE OF PROJECT FINANCE Project finance refers to the
financing of long-term infrastructure, industrial projects and public services based upon a
non-recourse or limited recourse financial structure where project debt and equity used to
finance the project are paid back from the cash flow generated by the project. Project finance
is used by private sector companies as a means of funding major projects off balance sheet.
At the heart of the project finance transaction is the concession company, a special purpose
Vehicle (SPV) which consists of the consortium shareholders who may be investors or have
other interests in the project (such as contractor or operator). The SPV is created as an
independent legal entity which enters into contractual agreements with a number of other
parties necessary in the project finance deals. The attractiveness of project finance is the
ability to fund projected in the off balance sheet with limited or non-recourse to the equity
investors i.e. if a project fails, the project lenders recourse is to ownership of the actual
project and they are unable to pursue the equity investors for debt. For this reason lenders
focus on the projects cash flow as the main source for repaying project debt. Importance of
Project finance Project financing is being used throughout the world across a wide range of
industries and sectors. This funding technique is growing in popularity as governments seek
to involve the private sector in the funding and operation of public infrastructure. Private
sector investment and management of public sector assets is being openly encouraged by
governments and multilateral agencies who recognize that private sector companies are better
equipped and more efficient than government in developing and managing major public
services. Project finance is used extensively in the following sectors. x Oil and gas x Mining
x Electricity Generation x Water x Telecommunications x Road and highways x Railways
and Metro systems x Public services
MEANS OF FINANCE AND SOURCES OF PROJECT IN INDIA The long-term sources of
finance used for meeting the cost of project are referred to as the means of finance. To meet
the cost of project, the following sources of finance may be available : x Equity Capital x
Preference Capital x Debentures x Rupees term loans x Foreign currency term loans x Euro
issues x Deferred credit x Bill rediscounting scheme x Suppliers line of credit x Seed capital
assistance x Government subsidies x Sales tax deferment and exemption x Unsecured loans
and deposits x Lease and hire purchase finance x Public Deposit x Bank Credit

EQUITY:
Equity capital represents ownership capital as equity shareholder collectively own the
company. They enjoy the rewards and bear the risks of ownership.
Rights of equity shareholders
 Right to income
 Right to control

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1
 Right to liquidation
 Pre-emptive right

PREFERENCE CAPITAL:
Preference capital represents a hybrid form of financing- it partakes some characteristics of
equity and some of debentures.
 The preference dividends are payable only out of distributable profit. (non- obligatory)
 The dividend rate is usually fixed
 The claim of preference shareholders is prior to equity shareholders
 Preference shareholders do not enjoy right to vote

INTERNAL ACCRUALS:
The internal accrual of a firm consists of depreciation charges and retained earnings.
Depreciation represents the allocation of capital expenditure to various period over which the
capital expenditure is expected to benefit the firm.

DEBT:
DEBENTURES (OR BONDS):
Debentures are instruments for raising debt finance. Debentures holders are the creditors of
the company. It contains a contract for the repayment of debt and the interest thereon at a
specified rate.
 Deep discount bonds
 Convertible debentures
 Floating rate bonds
 Indexed bonds

TERM LOANS
Term loans, also referred as to term finance, represent a source of debt finance which is
generally repayable in less than 10 years. They are typically employed to finance acquisition
of fixed assets and working capital margins

MISCELLANEOUS SOURCES
 Deferred credit
 Lease and hire purchase finance
 Unsecured loans and deposits
 Commercial paper
 Short term loans from financial institutions

Syndicated Loan
Loan syndication is a means of project finance which is been offered by various lenders is
known as “syndicate” who work together to provide financial resources to a single borrower.
Syndicated Loan involve a fixed amount of funds, a credit line, or a combination of two.
Need for financing a project through syndicated funds arise when a project requires a large
amount of funds and is difficult for a single lender to fund the project alone or when a project
need a lender with expertise in a specific asset class. Syndication of loan allow banks to
diverse risk and take part in opportunities that may be too large for an individual capital base.

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2
 Understanding Syndication in Project Finance
By financing through syndication, there is an underwriter, known as the arranger, the agent,
or a lead lender. The arranger may put up correspondingly bigger share of loan and it may
perform other duties such as dispersing cash flows among other syndicate members and other
administrative work.
The main objective of syndicated lending is to distribute the risk of a borrower default among
multiple lenders. Because syndicated funds are much larger than regular lending and the risk
of one borrower defaulting could increase the risk of a single lender.
Project finance syndication could be made on a best-efforts basis, which means that if there
are no enough investors, the amount that a borrower receives is lower than actually
forecasted.

ISLAMIC FINANCE:
Islamic Finance represents financial activities which are consistent with the principles of
Sharia (Islamic Law). Sharia Law prohibits unethical, immoral, speculative activities as well
as well as interest uncertainty and gambling. Islamic Finance encourages entrepreneurship,
mutual cooperation, generosity and spirit of partnership which connects the real capital owner
with the real economic activities that may actually contribute to the wellbeing of the society
through commerce, manufacturing, construction, etc.
There is a high demand from the Muslim community for Sharia compliant alternatives to
conventional financing. The Sharia lays down rules and guidelines to promote fair dealing
and business ethics based on universal principles. These principles consider the needs that
contribute to the healthy society. The Islamic Bank uses the funds that are provided by its
depositors to purchase a house and the borrower then pays a rental for the use of that house of
the lifetime of loan plus an amount which repays the loan over its lifetime and the bank then
pays a share of its profits to its depositors. The two key aspects of Islamic finance are – Asset
base and Risk sharing.

Islamic finance is growing rapidly but it remains concentrated in the number of jurisdictions.
The rapid growth shows strong interest of Muslim population who previously have been
underserved. Some of the advanced economies are using this system as a growing
opportunity to tap the large pool of savings. Islamic finance has the advantage of being asset
backed which makes it less risky than the conventional finance.
Islamic finance faces are facing some challenges like: -
 It is being constrained by geography and business lines
 Lack of standardisation
 Lack of integration of business law of the different business segments of the industry

The above challenges can be dealt by: -

 Implementing standards and codes which would widen the system in a more consistent
manner nationally and internationally.
 Sharia compliant Money markets must be developed to help Islamic banks in maintaining
liquidity in a more efficient and an effective way. It will also help the bank in investing in
growth enhancing projects.
 Institutional reforms must take place in the areas of Tax policy, Legal reforms and capital
market development.
LEVERAGE LEASES:
In a leveraged lease, the lessor invests some money from his pocket to purchase the asset and
arranges for the rest of the money required from a lender in the market. The leveraged lease is

1
3
a lease in which three parties are involved: Lessor, Lessee, and the Lender. Here, the lender is
the third party but enjoys the benefit of the interest in the asset acquired.
In this type of arrangement, the lender will have a secured interest in the asset since he is
investing money to acquire the asset. When the assets are taken on lease, the lesser will be
obliged to make the payments to the lender of the leased asset. The lease agreement is
actually assigned to the lender of the leased asset in this type of arrangement. The leveraged
lease is also a tax advantage for the lessor since the lessor takes a loan from the lender to
purchase the asset while the payment from the lessee will directly go to the lender. Thus, they
are saving tax in this entire process. This type of arrangement is mostly seen while
purchasing high-value assets.

Characteristics of Leveraged Lease are given below:

1. The lender holds the asset since it carries the payment obligation.
2. The lessor will be free from the obligation of the payments to the lender the payment
is directly done to the lender by the lessee but in case of default, the lessor will be
obliged to pay the dues.
3. The small portion of the fund is arranged by the lessor and the majority portion of the
fund which is required to obtain the asset is borrowed by the lender.
4. The lender will have more rights in regard to the sale or resale of the asset in
comparison to the lessor.
5. One of the typical characteristics of this type of lease is that the lender can check the
financial position of the lessee that whether the lessee will be in a position to pay the
rentals or not and if not the lenders will opt for recourse loan payment where the
lessor will be obliged to make the payments.

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4
 SESSION 24-FI NANCI NG PROJ ECT VARIOUS DEBT
INST RUM ENT S AND INNO VAT IVE ST RUCT URES

A debt instrument is a fixed source of the income for the lender (giver) as the asset allows the
lender to earn a fixed interest with a right to getting the principal back while the issuer (taker)
can use it to raise funds at a cost. Debt acts as a legal obligation on the issuer part to repay the
borrowed sum along with interest to the lender on a timely basis. A debt instrument can be in
both paper and electronic form. Bonds, debentures, leases, certificates of deposit, bills of
exchange and promissory notes are some examples of debt instruments.

Type of Different Debt Instruments

government in exchange for a predetermined fixed interest rate. Bonds are mainly issued by
the central bank, government or large companies. Bonds also ensure payment of fixed interest
rates to the lenders of the money by the issuer of the bond. On maturity of the bond, the
principal amount is paid back. Bonds essentially work the way loans do.

commonly sold by banks, financial institutions, and credit unions. All-India Financial
Institutions can issue certificates of deposit which have been permitted by RBI to raise short-
term resources within the limit fixed by RBI. The CD be held until maturity by the lender, at
which time the money may be withdrawn together with the accrued interest.

issued in the form of a promissory note. It is highly rated corporate borrowers/ to diversify
their sources of short-term borrowings and to provide an additional instrument to investors. It
is redeemable at par to the holder at maturity. As per RBI rules, only corporates who get an
investment grade rating can issue CPs. It is issued at a discount to face value by the
borrowers.

are issued by the company to raise medium and long term funds.
They are the part of the capital structure of the company, reflect on the balance sheet but are
not included with the share capital. It is a certificate of agreement of loans which is given
under the company's stamp and where debenture holder will get a fixed return and the
principal amount whenever the debenture matures.

for a set period of time (generally min 1yr.), thereby earning him a higher rate of interest in
return. Fixed deposits also give you a higher rate of interest than a savings bank account in
general. Fixed deposit is considered most secure form of investment in India.

Which One to opt?

The company faces a dilemma, which debt instrument to opt to raise the money so that the
company can get a maximum return with minimum risk. The company can choose either of

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5
the instruments depending upon the situation and can also choose the combination of
instruments to attain the optimum efficiency. For example: There is a company named ABC
ltd. This company wants to acquire another company, whose name is XYZ ltd. XYZ ltd. has
a total net worth of Rs. 20 Crores and ABC ltd. has the funds of Rs. 5 Crores available with
them. Now ABC ltd. need to arrange the rest Rs. 15 crores. In this case they will be left with
the different alternatives to raise funds in the form of various debt instruments and will be
attaining different risk and reward situations with the respective debt instruments.

1) If ABC ltd. goes with the debenture, then it doesn’t need to keep a collateral for raising the
money, since debentures are unsecured but it needs to pay higher interest rate to the lender.
On the other hand, the lender will be enjoying higher interest rate but they will also be facing
the high risk factor.

2) If ABC ltd. goes with the bonds, then it needs to keep a collateral for raising the money as
bonds are secured. Also, they will be paying moderate rate of interest to the lender. On the
other hand, the lender will be enjoying moderate risk-return situation.

3) Commercial papers are used generally for short term borrowings. Commercial paper is a
very good option for ABC ltd. if the company wants to resell the business in a short span of
time. Commercial papers are matured within the short span of time, generally within less than
270 days.

In this scenario, ABC ltd. can choose any of these alternatives or a combination of them to
achieve the required objective. The company needs to decide whether they want to retain full
control of the business, they are comfortable with the regular monthly payments, they have a
good credit history, they have a collateral or not before going to raise funds from debt
instruments.

There are several advantages when we go for debt instruments. We don’t lose control as the
lenders don’t interfere in the management of the business. The decision making lies with us
and our agreement with the lenders, once we pay the loan. Also, the interest that we pay on
the debt is tax deductible, so we get an extra advantage that ultimately reduces our obligation.
Also, we can easily plan our budgets for the payments as we know the principal and interest
well in advance
On the other hand, we need to have a good credit history to receive the debt. We also
have the obligation of timely interest payments. We need to have a collateral for the secured
debt instruments. After analyzing all these factors, we can go for the best debt instruments
depending upon the resources available with the company.

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6
SESSION 25-FI NANCI NG PROJ ECT EQ UAT OR PRINCI PLES,
SECURIT IZING PROJECT LOANS

Financing Project Equator Principles

The Equator Principles is a risk management framework which is adopted by the Financial
Institutions for determining, assessing and managing environmental and social risk in projects
and is intended to provide a minimum standard for due diligence and monitoring to support
responsible risk decision making.
The EP’s are applied globally to all the sectors and to four financial products-
1. Project finance Advisory Services
2. Project Finance
3. Project-related corporate loans
4. Bridge Loans
Current Scenario-
 105 equator Principles Financial Institutions in 38 countries have officially adopted
the EP’s which covers the majority of International Project finance debt within
developed and emerging markets.
 EP Financial Institutions formulate their own environmental and social guidelines to
comply with Equator Principles framework, which in turn confirms compliance with
the underlying IFC Performance standards and World Bank Group EHS Guidelines.
 While the EPs are not intended to be applied retroactively, EPFIs apply them to the
expansion or upgrade of an existing project where changes in scale or scope may
create significant environmental and social risks and impacts, or significantly change
the nature or degree of an existing impact.

Outcomes of EP-
 Increased the attention and focus on Social/Community Standards and responsibility.
including robust standards for indigenous peoples, labour standards, and consultation
with locally affected communities within the Project Finance market.
 They have promoted Convergence around Common environmental and social
Standards.
 They have also helped Spur the Development of Responsible environmental and
social management practices in the financial sector and banking industry.
 Supported member banks in developing their own Environmental and Social risk
Management Systems.

Securitizing Project Loans

Securitization is a process of transformation of non-tradable assets into tradable Securities. It
is a Structured finance process that distributes risk by aggregating debt instruments in a pool
and issues new securities backed by the pool.

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When a bank or financial institution is in need of additional capital to finance a new facility,
to raise the fund, instead of selling the assets, the financial institution decides to sell the
portion of the loan to a Trustee named as Special Purpose Vehicle (SPV) and collect the fund
up front and remove the loan asset from the balance sheet of the institution. SPV holds the
asset as collateral in balance sheet and issues bonds to the investors. It uses the proceeds from
those bond sales to pay the originator for the assets.

Step1: Borrower Obtains loan from the Financial Institution/ Bank with the help of Mortgage
Broker.
Step2: Lenders/ Financial institution sells the loan assets to Issuer and provide the service
between the borrower and the issuer.
Step3: The Issuer sells the securities as bonds to the investor, Underwriter assists the sale,
Rating agency rates the securities, Credit enhancement agencies provide the credit
enhancement on securities.
Step4: Service will collect the monthly payments from borrowers and remits to SPV.
The roles and responsibilities of various components involved in the securitization structure
are explained below:
 Borrower – An Individual or organization which obtains loan and pays the monthly
payments.
 Mortgage Broker - Acts as a facilitator between a borrower and the lender.
 Issuer - A bankruptcy-remote Special Purpose Entity (SPE) formed to facilitate a
securitization and to issue securities to investors.
 Lender - An entity (banks or non-banks) that underwrites and funds loans that are
eventually sold to the SPE for inclusion in the securitization.
 Servicer - The entity responsible for collecting loan payments and for remitting these
payments. The servicer is obligated to maximize the payments from the borrowers to
the issuer and is responsible for handling delinquent loans and foreclosures.
 Trustee - A third party appointed to represent the investors' interests in a
securitization. The trustee ensures that the securitization operates as set forth in the
securitization documents.

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  Securitization Documents - The documents create the securitization and specify how
it operates. One of the securitization documents is Pooling and Servicing Agreement
(PSA).
 Underwriter - Administers the issuance of the securities to investors.
 Credit Enhancement Provider - Securitization transactions may include credit
enhancement provided by an independent third party in the form of letters of credit or
guarantees.

Features of Securitization
 Marketability
 Merchantable Quality
 Wide distribution
 Homogeneity
 Commoditization
 Integration and Differentiation

Types of Securitisable Assets

 Mortgage-Backed Securities (MBS)
 Assets-Backed Securities (ABS)
 Collateralized Debt Obligations (CDO)

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SESSION 26-RIS K AN ALYSIS IN CAP ITAL INVESTMEN T
DECISIONS
Risk Analysis in Capital Investment Decision • Risk in a project means
variability in cash flows. Primarily risk is two types – financial risk and
business risk. But other types of risks like investment risk, portfolio risk are also
there. Tools generally used to calculate risk are range, mean, absolute deviation,
variance, semi variance and coefficient of variation. Certainty equivalent
method and risk adjusted discounting rate method is used to incorporate risks in
an investment appraisal. Sensitivity analysis, simulation approach and decision
tree analysis are applied as advanced technique in risk analysis. Application of
Portfolio Theories in Investment Risk Appraisal • When a firm holds many
projects then it can be viewed as a portfolio. Financial portfolio models like
Markowitz’s single index model can be applied for minimization of risk. A best
portfolio has lesser risk at a given return or higher return at a given risk than
other portfolios. By applying these models organization can identify portfolios
which are above the Capital Market Line. CAPM model can be used in capital
budgeting also to identify rate of discount for projects.

Risk Analysis in Capital Investment Decisions

Risk refers to the level of uncertainty or possible financial loss that might occur
due to an investment decision. Of all the decisions that a business has to make,
the most challenging of them all is choosing alternative capital investment
options. It is imperative for a business to explore options before making an
investment decision in order to maximize its gains and mitigate the risk
associated with it. Risk can be categorized in the following categories:
Standalone risk, market risk and Portfolio risk.

whether or not the investment plans match with the financial goals of the

compare between investments with similar returns

Risk can arise due to a multitude of factors. Some of those are

Methods of Risk Evaluation The techniques of Risk Analysis have been broadly

Conventional Techniques

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0
1) Payback: - It is the oldest and the most commonly used method wherein the
investment option with the least payback period is considered as the most viable
option. This option
however, completely ignores the present value of cash flows.

2) Risk Adjusted Discount Rate: - This method incorporates the risk premium in
the discount rate while evaluating the investment option. The rationale behind
this is simply that the higher the risk in the investment the higher should be the
return on the same. To keep the investors motivated it is important to provide
lucrative returns as well.

3) Certainty Equivalent: - Under this method a certainty equivalent is calculated

which is further used to convert the risking, uncertain future cash flows into
cash flows with certainty. Certainty equivalent= Certain Cash flow
Risky Cash flow This risk adjustment factor has negative relationship with risk.
If the risk is higher a lower value is used for risk adjustment and vice versa.

Statistical Techniques

1) Probability Distribution Approach: - In this method the chances of

occurrence of various activities is considered in order to calculate the NPV.
Once the probabilities are assigned NPV of future cash flows are computed. 2)
Variance: - A study of dispersion of cash flows is done in order to estimate the
risk associated with the investment option. The standard deviation of NPV will
be higher when cash flows are perfectly correlated.

Sensitivity Analysis

This method shows the sensitivity of NPV or IRR with respect to any variable
that is used to determine the cash flow of the project. Analyzing the change in
NPV or IRR due to a change in one of the variable is called Sensitivity
Analysis. The forecasts change in different economic conditions therefore it is
done in different economic conditions mainly Optimistic, Pessimistic and
Expected.

2
1
 Risk Analysis

Measures of Risk

 Range

 Standard deviation

 Coefficient of variation

 Semi - variance

Range:

The range of distribution is the difference between highest and lowest value.

Standard deviation:

Risk refers to dispersion of a variable. It is measured by the variance or standard

deviation. The variance of a probability distribution is the sum of the squares of the

deviation of of actual returns from the expected return, weighted by associated

probabilities.

Standard deviation is the square root of variance.

Standard deviation = Variance

n
 R  R
1 2

n 1 
2
Variance    t
t 1

Coefficient of variation:

The coefficient of variation (CV) is a measure of relative variability. It is the ratio of the

standard deviation to the mean (average).

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Semi-variance:

There is problem with standard deviation is that it considers all positive as well as

negative deviations, from the expected value in the same value. Since investors are

only concerned with negative deviations so here in this situation, semi-variance seems

to be more suitable measures of risk.

The semi-variance is calculated in the same way as that of variance but in this case

only deviations less than expected return are considered for the purpose of calculation

and all deviations above expected returns are ignored.

Sensitivity Analysis:

Due to uncertain future, we may like to know the viability of project when some variable

like sales or investment deviates from its expected value. In other words, we can say we

want to do ‘what-if’ analysis or sensitivity analysis.

Merits:

It shows how robust or vulnerable a project is to changes in values of underlying

variables.

It is institutively very appealing as it articulates the concerns that project evaluation

normally have.

It suggests where future work may be done.

Demerits:

Typically in sensitivity analysis only one variable is changed at a time while in real

situation, many variables might tend to move together.

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It does not provide the probability of change

Illustration

Jawahar Industries has identified that the following factors, with their respective

expected values, have a bearing on the NPV of their new project.

Initial investment 10,000

Cost of capital 11 %

Quantity manufactured and sold annually 1,000

Price per unit 20

Variable cost per unit 15

Fixed costs 1,000

Depreciation 1,000

Tax rate 20 %

Life of the project 7 years

Net salvage value Nil

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 Assume that the following underlying variables can take the values as shown below:

Underlying variable Pessimistic Optimistic

Quantity manufactured and sold 700 1,400

Price per unit 18 23

Variable cost per unit 16 14

(a) Calculate the sensitivity of net present value to variations in (a) quantity

manufactured and sold, (b) price per unit, and (c) variable cost per unit.

(a) Sensitivity of NPV with respect to quantity manufactured and sold:

Pessimistic Expected Optimistic

Initial investment 10,000 10,000 10,000

Sale revenue 14,000 20,000 28,000

Variable costs 10,500 15,000 21,000

Fixed costs 1,000 1,000 1,000

Depreciation 1,000 1,000 1,000

Profit before tax 1,500 3,000 5,000

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 Tax 300 600 1,000

Profit after tax 1,200 2,400 4,000

Net cash flow 2,200 3,400 5,000

NPV at

PVIFA(11%,7years)

= 4.712 366 6,021 13,560

(b) Sensitivity of NPV with respect to variations in unit price.

Pessimistic Expected Optimistic

Initial investment 10,000 10,000 10,000

Sale revenue 18,000 20,000 23,000

Variable costs 15,000 15,000 15,000

Fixed costs 1,000 1,000 1,000

Depreciation 1,000 1,000 1,000

Profit before tax 1,000 3,000 6,000

Tax 200 600 1,200

Profit after tax 800 2,400 4,800

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 Net cash flow 1,800 3,400 5,800

NPV at

PVIFA(11%,7years)

= 4.712 - 1,518 6,021 17,330

(c) Sensitivity of NPV with respect to variations in unit variable cost.

Pessimistic Expected Optimistic

Initial investment 10,000 10,000 10,000

Sale revenue 20,000 20,000 20,000

Variable costs 16,000 15,000 14,000

Fixed costs 1,000 1,000 1,000

Depreciation 1,000 1,000 1,000

Profit before tax 2,000 3,000 4,000

Tax 400 600 800

Profit after tax 1,600 2,400 3,200

Net cash flow 2,600 3,400 4,200

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NPV at

PVIFA(11%,7years)

= 4.712 2,251 6,021 9,790

Scenario Analysis

In sensitivity analysis, normally only one variable is varied at a time. In scenario

analysis, several variables are varied simultaneously. Most commonly, three scenarios

are considered; normal, pessimistic and optimistic scenario.

Procedure

1. Select the factor around which scenarios will be built.

2. Estimate values of each of the variables for each Scenario

3. Calculate NPV / IRR under each scenario

NET PRESENT VALUE FOR THREE SCENARIOS

(RS. IN MILLION)

SCENARIO 1 SCENARIO 2 SCENARIO 3

INITIAL INVESTMENT 200 200 200

UNIT SELLING PRICE (In Rs.) 25 15 40

DEMAND (IN UNITS) 20 40 10

REVENUES 500 600 400

VARIABLE COSTS 240 480 120

FIXED COSTS 50 50 50

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 DEPRECIATION 20 20 20

PRE-TAX PROFIT 190 50 210

TAX @ 50% 95 25 105

PROFIT AFTER TAX 95 25 105

ANNUAL CASH FLOW 115 45 125

PROJECT LIFE 10 YEARS 10 YEARS 10 YEARS

SALVAGE VALUE 0 0 0

NET PRESENT VALUE (AT A DISCOUNT 377.2 25.9 427.4

RATE OF 15 PERCENT)

Decision Trees for Sequential Investment Decisions

• Investment expenditures are not an isolated period commitments, but as links in

a chain of present and future commitments.

• An analytical technique to handle the sequential decisions is to employ decision

trees.

Steps in Decision Tree Approach

• Define investment

• Identify decision alternatives

• Draw a decision tree

• decision points

• chance events

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 • Analyse data

Usefulness of Decision Tree Approach

• Clarity: It clearly brings out the implicit assumptions and calculations for all to

see, question and revise.

• Graphic visualization: It allows a decision maker to visualise assumptions and

alternatives in graphic form, which is usually much easier to understand than the

more abstract, analytical form.

Illustration:

Magna Oil is wondering whether to drill oil in a certain basin. The cost of drilling a 500

metre well is Rs.20 million. The probability of getting oil at that depth is 0.6. If oil is

struck, the present value of oil obtained will be Rs.30 million. If the well turns out to be

dry, Magna can drill another 500 metres at a cost of Rs.25 million. If it does so, the

probability of striking oil at 1000 metres is 0.5 and the present value of oil obtained will

be Rs.55 million.

Draw the decision tree. What is the optimal strategy for Magna Oil.

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Solution:

Conventional Techniques of Risk Analysis

• Payback

• Risk-adjusted discount rate

• Certainty equivalent

Payback:

• This method, as applied in practice, is more an attempt to allow for risk in capital

budgeting decision rather than a method to measure profitability.

• The merit of payback

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 • Its simplicity.

• Focusing attention on the near term future and thereby emphasising the

liquidity of the firm through recovery of capital.

• Favouring short term projects over what may be riskier, longer term

projects.

• Even as a method for allowing risks of time nature, it ignores the time value of

cash flows.

Risk-Adjusted Discount Rate

• Risk-adjusted discount rate, will allow for both time preference and risk

preference and will be a sum of the risk-free rate and the risk-premium rate

reflecting the investor’s attitude towards risk.

NPV =  NCFt
n

t =0 (1  k )

• Under CAPM, the risk-premium is the difference between the market rate of

return and the risk-free rate multiplied by the beta of the project.

k = kf + kr

Merits:

- It is simple and can be easily understood.

- It has a great deal of intuitive appeal for risk-averse businessman.

- It incorporates an attitude (risk-aversion) towards uncertainty.

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Demerits:

- There is no easy way of deriving a risk-adjusted discount rate. CAPM provides a

basis of calculating the risk-adjusted discount rate.

- It does not make any risk adjustment in the numerator for the cash flows that are

forecast over the future years.

- It is based on the assumption that investors are risk-averse. Though it is

generally true, yet there exists a category of risk seekers who do not demand

premium for assuming risks; they are willing to pay a premium to take risks.

Certainty-Equivalent

• Reduce the forecasts of cash flows to some conservative levels.The certainty-

equivalent coefficient assumes a value between 0 and 1, and varies inversely

with risk. Decision-maker subjectively or objectively establishes the coefficients.

n
 t NCFt
NPV =  (1  k )t
t =0 f

• The certainty—equivalent coefficient can be determined as a relationship

between the certain cash flows and the risky cash flows.

NCF* Certain net cash flow

t  t
=
NCFt Risky net cash flow

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 Example:

The expected cash flows of a project are given below:

Year Cash Flow

0 (50,000)
1 10,000
2 30,000
3 20,000
4 20,000
5 10,000

What is the net present value of the project under certainty equivalent method, if
the risk-free rate of return is 8 percent and the certainty equivalent factor behaves
as per the equation: t = 1 – 0.08t

Solution:

Certainty Certainty Discoun

Equivalent Equivalen t Factor Presen
Year Cash Factor: αt =1 - t value at 8% t
Flow 0.08t Value
0 -50000 1 -50000 1 -50000
1 10000 0.92 9200 0.926 8519
2 30000 0.84 25200 0.857 21596
3 20000 0.76 15200 0.794 12069
4 20000 0.68 13600 0.735 9996
5 10000 0.6 6000 0.681 4086

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 NPV = 6266

3
 Multiple Projects & Constraints
When investment projects are considered separately, any of discounted cash flow

criteria (NPV, IRR, B/C ratio etc.) may be applied for determining the correct decision

for acceptance or rejection of the project. But capital investment decisions can’t be

taken in isolation or individually. The reason is pre-conditions for viewing the projects

separately like project independence, lack of capital rationing and project indivisibility

are rarely. Under constraints, the rational criterion of project evaluation (NPV, IRR, etc)

may not lead to correct decisions.

Constraints
 Project dependence
 Capital rationing
 Project indivisibility

Project dependence

Project A and B are said to be economically independent if acceptance or rejection of

one does not affect the cash flow of other or does not affect acceptance or rejection of

other. (Ex. Investment in power press and investment in computer installation are

independent). While on other hand projects A and B are economically dependent if the

acceptance or rejection of any one changes the cash flow stream of the other or affects

the acceptance or rejection of the other. If selection of Project A would lead to the

decision of opting out from project B or vice versa, both of these projects A and B are

considered as mutual exclusive projects where selection of one project would result in

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rejection of the other because purpose of both projects would be same but might be in

different way. For example semi-automatic plant versus automatic plant.

Capital rationing

Capital rationing exists when capital available is insufficient to undertake all projects

which are else acceptable. Capital rationing may arise because of internal limitation or

external constraints. Internal capital rationing is caused by management decision to set

a limit on capital expenditure outlays whereas external capital rationing arise out of

firm’s inability to raise sufficient fund at a given cost of capital.

Project indivisibility

Capital projects are considered indivisible means capital project has to be either

accepted or rejected so it cannot be accepted partially. Ex. Three indivisible projects X,

Y and Z require investment of Rs 5 million, 4 million and 3 million. NPV of the projects

are 2 million, 1.5 million and 1 million respectively. Total funds available to firm for

investments are 7 million. Based on the criteria of NPV Project X is superior. But in this

situation acceptance of X with NPV of 2 million will make rejection of Y and Z due to

capital rationing, which together provides NPV of 2.5 million. Hence because of

indivisibility of projects, there is need for comparing projects before the acceptance or

rejection decisions are made.

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Comparing projects under constraint:

Ranking Conflicts In a given set of Projects, preference ranking tends to differ from one

criterion to other criterion. For example NPV and IRR criteria may yield different

preference rankings similarly preference ranking conflict may arise between NPV and

BCR methods. When preference rankings differ, the set of projects selected as per one

approach tends to differ from set of projects selected on the basis of another approach.

Conflicts in project ranking may arise because of

Size disparity

Time disparity

Life disparity

Size disparity: Size of the capital projects may tremendously differ ( NPV refers to size

while IRR and B/C ratio does not refers to size of capital).

Time disparity: due to varying pattern of cash inflows ( IRR assumes that cash inflows

can be reinvested at the same rate or return while NPV and B/C ratio analysis assumes

that cash inflows can be reinvested at the firms cost of capital). It may be solved by

defining reinvestment rate.

Life disparity: When mutually exclusive alternatives have different project life. This

conflict can be taken care by defining reinvestment rate.

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Illustration:
Take a set of five projects A,B,C,D, and E for which investment outlay, expected annual

cash flow and project life are as below.

Project Investment Outlay Expected Annual Project Life

(Rs.) Cash Flows (Rs.) (Years)
A 10,000 4000 12
B 25,000 10,000 4
C 30,000 6000 20
D 38,000 12,000 16
E 35,000 12,000 9

NPV, IRR and BCR for all five projects and rankings are shown below.
Project NPV(Rs.) NPV IRR (%) IRR BCR BCR
Ranking Ranking Ranking
A 14,776 4 39 1 2.48 1
B 5370 5 22 4 1.21 5
C 14,814 3 19 5 1.49 4
D 45,688 1 30 3 2.20 2
E 28,936 2 31 2 1.83 3

It is evident from the above conclusion that the three criteria rank the projects

differently. In the absence of capital rationing all the projects would be selected under

three approaches. But in case of funds constraints ranking may differ so acceptance will

depend on the evaluation criteria being adopted.

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Problem:

Five projects, A, B, C, D, and E are available to a company.

M N O P Q

Initial investmentRs 20,000 50,000 85,000 90,000 150,000

Annual cash inflowRs 5,000 10,000 20,000 20,000 25,000

Life( in years) 8 9 6 6 10

Salvage value Rs 6,000 – – 20,000 40,000

Projects N and Q are mutually exclusive. Otherwise the projects are independent.

If the cost of capital for the firm is 12 percent, which projects should be chosen at

the following budget levels: Rs 300,000 and Rs 350,000. Assume that the decision

criterion is the net present value. Use the feasible combinations approach.

Solution:

The NPVs of the projects are as follows:

NPV (M) = 5,000 x PVIFA(12%,8) + 6,000 x PVIF(12%,8) – 20,000 = Rs.7,264
NPV (N) = 10,000 x PVIFA(12%,9) – 50,000 = Rs.3,280
NPV (O) = 20,000 x PVIFA(12%,6) – 85,000 = - Rs.2,780
NPV(P) = 20,000 x PVIFA(12%,6) + 20,000 x PVIF(12%,6) – 90,000 = Rs.2,360
NPV (Q) =25,000 x PVIFA (12%,10) + 40,000 x PVIF(12%,10)
– 150,000 = Rs.4,130

As the NPV of O is negative it is rejected. N and Q are mutually exclusive. The

feasible combinations, their outlays, and their NPVs are given below.

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 Combination Outlay NPV
(Rs.) (Rs.)
M 20,000 7,264
N 50,000 3,280
P 90,000 2,360
Q 150,000 4,130
M&N 70,000 10,544
M&P 110,000 9,624
M&Q 170,000 11,394
N&P 140,000 5,640
P&Q 240,000 6,490
M&N&P 160,000 12,904
The preferred combination is M & N & P

Integer Linear Programming Model

By constraining the decision variables to 0 or 1, the integer linear programming model

can handle almost any kind of project interdependency.

Constraints:

(1) Mutual Exclusive: Project 1 and Project 2 are mutual exclusive

• Constraint = X1 + X2≤ 1

(2) Delay Project 1 by One Year ( Cash out flow may same BUT NPV may change)

Add new project X11 in Objective function to define delay project, e.g. by delay project

1 NPV reduced to 50 from 60 (i.e. If NO Delay)

Then in Objective Function Maximise: 60X1 +50X11

Also Constraint: X1 + X11 ≤ 1

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Also in First Year NO CASH FLOW would occur for Delay Project 1 due to delay BUT

the same would occur in Second year.

(3) Contingency: Project 2 is contingent on the acceptance of Project 1 i.e. Project 2 can

not be accepted without accepting Project 1

• Constraint : X2 ≤ X1

(4) Project 3 is contingent on the acceptance of BOTH Project 1 and Project 2 i.e.

Project 3 can not be accepted without accepting Project 1 and Project 2

Constraint: 2X3 ≤ X1 + X2

(5) Project 3 is contingent on the acceptance of EITHER Project 1 OR Project 2

Constraint: X3 ≤ X1 + X2

(6) Out of Projects 1, 2, 3, 4 ONLY 3 can be accepted

Constraint: X1 + X2 + X3 + X4 ≤ 3

(7) Out of Projects 1, 2, 3, 4 ATLEAST i.e. MINIMUM 2 should be accepted

Constraint: X1 + X2 + X3 + X4 ≥ 2

(8) For Project 5, Out of Projects 1, 2, 3, 4 ATLEAST i.e. MINIMUM 2 should be

accepted

Constraint: 2X5 ≤ X1 + X2 + X3 + X4

(9) Complementariness: If undertaking one project influences the cash flow of another

project favourably then both projects are complemantary.

e.g. If both Project 1 and Project 2 are accepted together then following benefits would

occur

(i) The cost(i.e. Cash Outflow) would reduce by 5%

(ii) The net cash flow(i.e. NPV) would increase by 10%

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New Project X12 would reflect the combination of Project 1 and Project 2

Assume NPVs of 1 and 2 are 50 and 100 while Cash outflows of 1 and 2 are 40 and 20

then

In Objective function, Maximise: 50X1 + 100X2 + 165X12

Constraint(cash flow ): 40X1 + 20X2 + 57X12 ≤ Max. limit

Also X1 + X2 + X12 ≤ 1

Problem:

A firm is evaluating six investment opportunities:

Net present Cash outflow Cash outflow

Project value in period 1 in period 2

(j) (NPVj) (CFj1) (CFj2)

Rs Rs Rs

1 8,000 9,000 8,000

2 10,000 10,000 12,000

3 15,000 11,000 20,000

4 20,000 25,000 30,000

5 40,000 50,000 40,000

6 80,000 70,000 60,000

The budget available is limited to Rs 130,000 in year 1 and Rs 150,000 in year 2.

Any amount not spent in year 1 can be transferred to year 2. The amount so

transferred will earn a post-tax return of 6 percent.

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 There are two additional constraints: power constraint and managerial constraint.
The requirements and constraints applicable in this respect are:

Power Managerial
Project requirement requirement
(j) (Wj) (Mj)
1 3,000 10
2 5,000 15
3 4,000 20
4 8,000 25
5 10,000 30
6 20,000 40
Σ Xj Wj ≤50,000 ΣXj Mj ≤100
Develop a linear programming formulation of the above capital budgeting problem.

Solution:

The linear programming formulation of the capital budgeting problem under various

constraints is as follows:

Maximise 8 X1 + 10 X2 + 15 X3 + 20 X4 + 40 X5 + 80 X6

Subject to
9 X1 + 10 X2 + 11X3 + 25 X4 + 50 X5
+ 70 X6 + SF1 = 130 Funds constraint for year 1

8 X1 + 12 X2 + 20 X3 + 30X4 + 40 X5
+ 60 X6 ≤ 150 + 1.06 SF1 Funds constraint for year 2

3 X1 + 5 X2 + 4 X3 + 8 X4 + 10 X5
+ 20 X6 ≤ 50 Power constraint

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 10 X1 + 15 X2 + 20 X3 + 25 X4 + 30 X5
+ 40 X6 ≤ 100 Managerial constraint

0 ≤ Xj ≤ 1 (j = 1,….8) and SF1 ≥ 0

Rupees are expressed in ’000s. Power units are also expressed in ’000s.
Detailed Project Report

A Detailed Project Report (DPR) is a business information document consisting of

information related to proposed project. It provides the information regarding regulatory

clearances and raising capital.

Preparation of DPR is a costly and time-taking job (which may even extend to one year)

when reports of specialists from different streams like market research, engineering

(civil, mechanical, metallurgical, electrical, electronics), finance etc. as relevant to the

project itself—are considered in the DPR.

Objectives of Detailed Project Report (DPR):

(a) the report should be with sufficient details to indicate the possible fate of the project
when implemented.

(b) the report should meet the questions raised during the project appraisals, i.e. the
various types of analyses—be it financial, economic, technical, social etc.—should also

be taken care of in the DPR.

While most of lenders don`t prescribe a specific format for preparing, a DPR, they do
specify the kind of information a DPR should provide.

In general, A DPR consists of following:

• Business and management section

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• Technical and marketing section

• Financial section

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 • Project Execution Strategy

• Implementation details

• Risk Impact Analysis

Business and Management section

• Project company`s business history along with details of major projects

undertaken in the past.

• Financial history details like lenders, credit facilities, shareholding pattern,

financial performance etc.

• Details of project sponsors in terms of personal information, past experience,

business and financial risk track record, net worth, existing bank relationships,

promoter group details.

• Business and operating environment like competition, pricing structure etc.

• Management team profile like that of directors, business heads, compensation

structure of top management, key appointments and resignations in the past

three years.

• Organization structure in terms of business divisions, departments, personnel

etc.

Technical and Marketing Section

• Details of location, land acquisition, installed capacity , products, manpower

requirements and availability, projects logistics, key projects constraints, current

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 status of project, project implementation schedule, list of key approvals required

and status etc.

• Details of present and proposed technology in terms of source of technology and

details of collaborator and terms and conditions of collaboration, technology

transfer etc

• Details of inputs required for the project arrangement like water, power, raw

material availability, transportation of raw materials and finished goods

• Marketing aspects and marketing arrangement in terms of potential users and

market segments, distribution methodology, competitor analysis

Financial Section

(1) Cost of Project and Means of Financing

• 1) Capital Outlay, Proposed Means of Financing and Capital Phasing

• 2) Assumptions for Financial Modelling (with summary justification and basis)

• 3) Details of equity already injected in project SPV

(2) Financial Structuring

• a) Debt Equity Ratio (including details of various sources of equity, sources of

debt and other funds and sequencing of the same)

• b) Treatment of incentives approved

• c) Drawdown requirements including split by source

• d) Loan schedule and DSCR analysis

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 (3) Loan Ageing

• (4) Financial Indicators (NPV, EIRR, PIRR, DSCR, PAT, PBT, Breakeven period

by Cash and EBITDA)

• Profitability indicator like gross profit margin, net profit margin, eps, cash

earnings per share, ROCE, and return on net worth

(5) Financial Structuring including the Incentives as approved by GoI

• (6) Major Investments and Fund Raisings Planned (With supporting documents

for funds required to be shown for demonstration of commitment

• (7) Projected financial statements like projected income statement, projected

cash flow statement, projected balance sheet

• (8) Taxation schedule (in line with applicable laws and standards)

Project Execution Strategy

1) Institutional Framework (including details of vendors/contractors/partners identified

for major activities) for project design, development and construction

2) Infrastructure details and strategy for securing/ implementing the same: a) Land b)

Power c) Water d) Sewage disposal e) Effluent Treatment Plant

3) Packaging, procurement and contracting strategy and framework

4) Project management framework and philosophy

5) Cost & Time overrun contingency measures and strategy

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Implementation details

1) Project Phasing (Quarterly activity plan supported by detailed Gantt Charts)

including major milestones

2) Project O&M Planning (including growth capex plans and assumptions)

3) Key Activities by quarter

4) Organization Structure proposed (with details of management team and role of

partners) upto three levels (starting with CEO). Also append the profiles of the

personnel proposed as well as the roles and responsibilities of each.

5) Procurement Details (including phasing, timing and sequencing, apart from

overall procurement strategy)

6) Services and Service Levels proposed with implementation partners and

contractors/ vendors

7) Outsourcing and Contractor details and scope of work envisaged 8) Details of

permissions, clearances and fulfilment of other statutory requirements for the

projects, accompanied by a detailed note on plans for fulfilment of each

Risk Impact Analysis

1) Project Financial Viability and Going Concern viability analysis and details

2) Business Sustainability Plan

3) Risk Analysis (financial and business), along with financial impact estimation for top

10 risk factors (upside and downside)

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4) Risk Mitigation Plan including costs associated with the individual plans

5) Detailed estimation of risk due to cost or time overruns and mitigation plans for the

same

6) Mitigation plan for Forex exposure risk

7) Technology obsolescence risk assessment and mitigation plan