5.

PROJECT MANAGEMENT
FINANCIAL APPRAISAL

PART I PROJECT COST AND ITS FINANCING

Prof. A. G. Mendhi

INTRODUCTION
Basic questions raised (by Financial Institutions / stake holders) during any project appraisal exercise are: 1. Can we sell the goods / services ? 2. Can you produce the goods / render the services ? 3. Can we earn a decent (satisfactory) return on the investment made in the project?

ANSWER TO THE LAST QUESTION LIES IN FINANCIAL APPRAISAL

Prof. A. G. Mendhi

IN THIS SESSION:
Elements of project cost Means of financing Profitability Projections (Financial Institution Guidelines) Project financing Institutions, other means of financing Projecting Cash Flows Projecting Balance Sheet Break-even analysis

Prof. A. G. Mendhi

ESTIMATING PROJECT COSTS

Two Methods of building project budget or project cost:
1. Top Down approach: Quick and economical method. Also called analogous method. Reliability depends on the degree of similarity between the projects, scalability of parameters and expertise of the estimating team in given field. 2. Bottom up approach: Time consuming and costly but more accurate technique.
Prof. A. G. Mendhi

ELEMENTS OF PROJECT COST

Land & site development Buildings & civil works Plant and machinery Technical know-how & engg. Fees, expenses on foreign technicians & training of project personnel abroad Miscellaneous fixed assets Preliminary & Pre-operative expenses Margin money for working capital Initial cash losses, if applicable
Prof. A. G. Mendhi

LAND & SITE DEVELOPMENT

Cost of acquisition of land (basic cost, cost of conveyance, stamp duty, etc.) (Extra land acquired but not meant for the project is not considered) Premium paid on leasehold land & conveyance charges paid. (Lease Rent?) Cost of site development: Leveling, Approach roads, Internal Roads, Fencing, Gates, etc. Cost of tube wells.
Prof. A. G. Mendhi

COST OF BUILDINGS & CIVIL WORKS

Factory building Administrative building Auxiliary buildings housing utilities equipment, warehousing / storage house, etc. Non-factory buildings: Residential buildings / staff quarters, canteen, guest house, watch & ward, time office, etc. Places of prayer, Silos, tanks, garages, etc. Drainage, sewerage system, etc. Any other civil work including special foundations, podiums, etc. Architects fees
Prof. A. G. Mendhi

PLANT AND MACHINERY

Cost of indigenous machinery (FOR value + sales tax, Octroi, other taxes and transportation cost to the site) Cost of imported machinery (FOB value, shipping charges, cost of insurance, clearing, loading & unloading, import duty and local transportation costs) Cost of stores & spares Foundation and installation charges For financial appraisal, FIs normally insist on three latest quotes and allow for a provision for inflation, foreign currency rate fluctuation, etc. if not separately provided in provision for contingencies.
Prof. A. G. Mendhi

TECHNICAL KNOW-HOW AND ENGINEERING FEES

Fees of consultants, collaborators, etc. for: Assistance on technical matters e.g. Project Report, selection of process / technology, plant and machinery, detailed project engineering, supervision during installation and commissioning, etc. Expenses on foreign technicians and on training of Indian technicians abroad (all expenses). Recurring payment of royalty does not form a part of the project cost; it is treated as operating expense.
Prof. A. G. Mendhi

MISCELLANEOUS FIXED ASSETS

Assets, which are not a direct part of the manufacturing process. - Furniture and fixtures, - Office equipment and machines, - Vehicles, - D.G. sets, Transformers, Switchgear, boilers, piping systems, workshop and quality control / laboratory equipment, - Investment in effluent treatment plants, - Payments for trade marks, licences, copyrights, deposits paid to Electricity Boards, etc.
Prof. A. G. Mendhi

PRELIMINARY EXPENSES
Expenses incurred on identification of the project, market survey, Techno-Economic Feasibility Report, drafting of Memorandum and Articles of Association for the company, Incorporating and registering of the company, Legal charges, etc.. Expenses incurred on capital issues by the company such as underwriting commission, brokerage, fees to registrars of issue, managers to the issue, printing, publishing, advertising, listing fees, stamp duty, etc.

Prof. A. G. Mendhi

PRE-OPERATIVE EXPENSES
Expenses incurred on the following till the start of the commercial production: Interest on borrowed funds during the implementation period, commitment charges, etc. Establishment expenses e.g. rent paid, traveling expenses, insurance charges, mortgage expenses, etc. Trial production or start up expenses. Miscellaneous expenses Pre-operative expenses can be apportioned to fixed assets on some acceptable basis. The firm may also treat them as deferrred revenue expenditure and write them off over a period of time.
Prof. A. G. Mendhi

PROVISION FOR CONTINGENCIES

This is a provision for unforeseen expenses: Inflation, Exchange Rate risks, Delay in execution and hence escalation of costs Any other miscellaneous costs / liabilities that may arise. Normal provision is 5% of firm costs and 10% for non-firm costs.
Prof. A. G. Mendhi

MARGIN MONEY FOR WORKING CAPITAL

Banks normally provide finance / credit facilities for meeting requirements of working capital. A part of this is to be brought in by the promoters basically from long term sources of finance. This is a critical element of project cost particularly if there are over-runs in the cost. FIs normally block an amount equivalent of the margin money from the term loans till the project is complete.

Prof. A. G. Mendhi

INITIAL LOSSES Most of the promoters do not show these as a part of the project cost. Prudence however calls for making such a provision if there are any initial losses since they could affect the liquidity position of the company.
Prof. A. G. Mendhi

PROJECT FINANCING
Types of Projects
Manufacturing Projects Infrastructure Projects Scientific Research Projects Innovative, experimental, developmental System development Projects Systems / software development & implementation Management Projects Managing change within organization

All Projects could be:

Greenfield Projects Expansion / Relocation Projects

Prof. A. G. Mendhi

PROJECT FINANCING
Project financing is a special case of financing in which lenders have to rely on repayment from the net cash flow generated by the project. Project finance is usually provided against assets of and the rights in a particular project rather than against the borrowers balance sheet, though Net worth of the promoters is also important. Financers are therefore concerned with the analysis of the risks associated with the project before they accept the investment opportunity which it represents. The cost and terms of financing therefore reflect the financiers view about the risks involved in implementing the project.
Prof. A. G. Mendhi

NEED FOR PROJECT FINANCING

Project financing is required in a number of situations:
For companies in general, to enhance their investment limits. To spread the risk among several parties to lessen adverse financial impact if any, and to increase their capacity to undertake more projects. For multinational corporations to protect their corporate balance sheets from the impact of large projects For governments to share the costs and risks of exploiting natural resources For governments to increase foreign capital investment in the country at no cost to the country.
Prof. A. G. Mendhi

FINANCING STRATEGY
The project will fail, no matter what is its technical merit, unless enough finance is made available to complete it. The design, implementation and management of project financing demands the same level of commitment from the promoters as the rest of the project management activities. Financial planning should begin at the same time, or in some cases even earlier than the technical project planning. While financing package is likely to reflect the complexity of the project, finance has some inherent characteristics, which themselves add to the complexity of undertaking.

Prof. A. G. Mendhi

SOURCES OF FINANCE
Identifying sources of finance Identifying suitable sources of finance is the first step in planning finance for a project. Finance for projects falls into two major categories:
Debt: Borrower has the obligation to repay. Debt also usually carries obligation to pay interest and to adhere to a prearranged repayment schedule. The lender has priority claim if borrower goes into liquidation. Equity: Funds subscribed by the shareholders from their own resources. There is no guarantee that the dividend will be paid and investors tend to loose their money if the project fails to perform. Equity shareholders have the last claim if the project goes into liquidation.
Prof. A. G. Mendhi

PROJECT FINANCING
Share Capital (Equity & Preference)- (dividend, claim, control, tax) Term Loans (Secured Borrowings) major source of finance Rupee or Foreign Currency Term Loan Incentives (Capital subsidy or seed capital, tax deferment or exemption) Debenture Capital (Debt instruments: convertible or nonconvertible, more flexible than term loans) Deferred Credit (usually offered by suppliers of plant and machinery interest and phased payment conditions vary bank guarantees are required) Other sources (unsecured loans by promoters, lease or hirepurchase programs, Public deposits, etc.)
Prof. A. G. Mendhi

SOURCES OF FINANCE
The main sources of debt finance are: Commercial banks Multilateral lending institutions Suppliers of equipment & services for the project Suppliers of raw materials to the project Buyers of output from the project The main sources of equity finance are: Internal: Corporate cash flow generated by existing business operations Public: Corporate or individual investors, or funds raised through stock markets Joint venture partners Government subscriptions & aids Multilateral investment institutions *Venture capitalists
Prof. A. G. Mendhi

RAISING CAPITAL IN INTERNATIONAL MARKETS:

Eurocurrency Loan: External Commercial Borrowings, raising capital in a global market: 1. These are syndicated loans. Syndication fee payable to lead bank. 2. Rate of interest is a floating rate usually linked to LIBOR or SIBOR 3. Tenor of up to 10 years is possible 4. Multi currency option is possible 5. Repayable in installments.
Prof. A. G. Mendhi

RAISING CAPITAL IN INTERNATIONAL MARKETS:

Global Depository Receipts: Indirect equity investment - Shares issued by a firm are held by a Depository (International Bank), which receives dividends, reports, etc. and issues claims. 1. Each receipt is a claim on specific number of shares. 2. GDRs are denominated in a convertible currency 3. GDRs may be listed on major stock exchanges 4. Issuer firm pays dividends in home currency. 5. Issuer firm can thus avoid listing procedures, disclosures, etc.
Prof. A. G. Mendhi

UNCONVENTIONAL SOURCES OF PROJECT FINANCING:

Leasing & Hire Purchase: Use of project assets through off-balance sheet financing. Forfaiting: Sale of financial instruments due to mature in future. Counter-Trade: Seller accepts goods or services in lieu of cash payments. Switch Trading: Making use, via a third party, of un-cleared credit surpluses arising from bilateral trade agreements. Offset: Exporter of technically advanced project incorporates an agreed value of materials, equipment & services supplied by the buyer.
Prof. A. G. Mendhi

UNCONVENTIONAL SOURCES OF PROJECT FINANCING:

Franchise Financing: Engineering, Procurement & Construction (EPC) contractors become equity holding joint venture partners for the project they design & build. Debt/Equity Swapping: Multinational technology owner buys host country debt at a discount. The debt is redeemed in local currency at favorable rate of exchange for setting up a local company. The local company uses transferred technology to earn foreign exchange, replace imports & generate local employment. Build Own - Operate Transfer (BOOT): Government grants concession to a project company (SPV) to build a facility and operate it on commercial basis. Facility is transferred to the government at the end of the concession. This type of finance arrangement is usually used for infrastructure projects.
Prof. A. G. Mendhi

PLANNING PROJECT FINANCE

How does one determine the specific means of finance? Norms of regulatory bodies and Financial Institutions Key business considerations:
Cost of finance (Debt funds are cheaper than equity?) Risk (Business risks & Financial risks) Control of the firm on the project and Flexibility (capacity to raise additional finance, if necessary)
Prof. A. G. Mendhi

EQUITY V/S DEBT

Shareholders have a residual claim over the income and assets of the firm. Dividend paid to equity holders is not a tax deductible payment. Equity ordinarily has indefinite life. Equity investors have a prerogative to control the affairs of the company. Creditors have a fixed claim equivalent to principal and interest outstanding. Interest paid to creditors is a tax deductible payment. Debt has a fixed maturity. Creditors play a passive role in the affairs of the company though they may impose certain restrictions to protect their interest.

Prof. A. G. Mendhi

LEADING FINANCIAL INSTITUTIONS / BANKS IN INDIA

Industrial Finance Corporation (IFC), Industrial Bank of India (IDBI), Industrial Credit and Investment Corporation of India (ICICI), Infrastructure Development Finance Corporation Ltd, (IDFC) State Industrial & Investment Corporations (SICOM, PICUP, RIICO, IPICOL, etc.) State Finance Corporations (SFCs like MSFC, GSFC, etc.) Banks like SBI, BoB, others
Prof. A. G. Mendhi

LEADING FINANCIAL INSTITUTIONS / BANKS IN INDIA (Contd.)

Export Credit Guarantee Corporation of India (ECGC). Export-Import (EXIM) Bank of India General Insurance Corporation of India (GIC) Life Insurance Corporation of India (LIC) National Bank for Agriculture And Rural Development (NABARD) National Housing Bank (NHBC) Small Industries Development Bank of India (SIDBI) Unit Trust of India (UTI)
Prof. A. G. Mendhi

TERM LOANS
Primary sources for term loans are Financial Institutions. Term Loans are normally payable in less than ten years. Usually there is a moratorium of two years and repayment is made in five to seven years. Repayment of principal is in terms of equated semiannual or quarterly installments. Term loans are used to finance purchase of fixed assets and margin money only.
Prof. A. G. Mendhi

TERMS AND CONDITIONS OF TERM LOANS

Currency: Rupee as also Foreign currency loans are possible Processing fee charged: usually one percent of loan amount sanctioned Security: First equitable mortgage of immovable properties / fixed assets Hypothecation of all movable properties subject to prior charges in favor of commercial banks for working capital loans
Prof. A. G. Mendhi

TERMS AND CONDITIONS OF TERM LOANS

Interest Payment & Principal repayment: Payable irrespective of the financial position of the borrower. Penalty imposed by FIs in case of default on interest and 2% p.a. for liquidated charges in case of default on principal repayment.
Prof. A. G. Mendhi

TERMS AND CONDITIONS OF TERM LOANS

Restrictive clauses: Nomination on Board of Directors. Management set up to be finalized in consultation with the FIs. Insist on making arrangements for additional funds if required through unsecured loans / deposits from promoters. Refrain from taking additional projects / financial commitments not related to the project without prior approval from FIs. Obtain various licences / permissions / clearances etc. from relevant Govt. Authorities.
Prof. A. G. Mendhi

TERMS AND CONDITIONS OF TERM LOANS (contd.)

Restrictive clauses (contd.): Repayment of existing loans with concurrence of FIs Refrain from additional borrowings or seek FIs approval for the same. Restriction on transferring shareholdings of promoters /ownership of any fixed assets of the company Restrictions on making fundamental changes in Memorandum and Articles of Association
Prof. A. G. Mendhi

TERM LOAN PROCEDURES

Submission of loan application: Promoters background Particulars of the industrial concern (Annual reports and balance sheets) Particulars of the project (Project Report: Capacity, process, technical arrangements, manpower, utilities, implementation schedule, project cost, financing pattern, marketing arrangements, etc.) Profitability and cash flow statements, Economic considerations, social cost benefit analysis, EIA study if necessary Government consents / permissions.
Prof. A. G. Mendhi

TERM LOAN PROCEDURES (contd.)

Initial processing of loan application (Flash Report). Appraisal of the proposed project. Issue of the letter of sanction. Acceptance of terms and conditions by the applicant unit. Execution of loan agreement. Creation of security. Disbursement of loans. Monitoring.
Prof. A. G. Mendhi

FINANCIAL APPRAISAL BY FINANCIAL INSTITUTIONS:

Justification of estimate of cost of capital Justification for estimate of working capital Adequacy of Rate of Return: IRR: should be 3 to 5 % more than WACC and not less than 15% DSCR: 1.5 to 2.0 or more ROI: should be ideally 15% or more Justification of Debt:Equity Ratio Should be 1.5:1 Debt should be adequately covered by investment in immovable fixed assets Stock Exchange regulations are to be met in case of listing. Promoters should contribute a certain minimum percentage of the project cost Means and capacity of the promoters to contribute to a reasonable share of the project cost
Prof. A. G. Mendhi

FINANCIAL ESTIMATES AND PROJECTIONS

Estimates of production and sales Assume progressive increase in effective capacity utilization (50%, 60%, 75% and 90% in 1st, 2nd, 3rd and fourth year of operation constant thereafter). Assume production equal to sales or make a provision for stocks. Assume realistic x-factory selling price. Each product to be treated separately. Selling price is net of excise and if selling commission is included, it should also be shown as item of expense (part of selling expenses) Changes in selling price should be considered only with corresponding changes in costs of production.
Prof. A. G. Mendhi

ESTIMAATES OF COST OF PRODUCTION

Cost of raw materials Cost of consumables Cost of utilities Cost of labor Cost of Factory overhead
Prof. A. G. Mendhi

ESTIMATED REQUIREMENTS OF RAW MATERIALS & CONSUMABLES

S r. N o. 1. 2. 3. 4. 5. 6. Raw Material

Requirement per 1000 litres of Biodiesel

Unit

Approx. CIF Price Per unit (Rs.) 5.00 22.00 42.00 10.00 20.00

Annual Requirement Quantity Cost (Rs. Lakh) 359.33 69.30 3.35 1.26 2.52 435.76

Jatropha Seeds Methanol Caustic Potash Liquid Catalyst Solid Catalyst TOTAL

3.42 150 3.8 6.00 6.00

Tonne Litre Kg Litre Kg

7,187 3,15,000 7,980 12,600 12,600

(At 70% Capacity Utilisation, for Year I)

Prof. A. G. Mendhi

ESTIMATED REQUIREMENTS OF UTILITIES

Norms of consumption given by consultants or technical collaborators. Else, go by the standards established in existing units. Make a higher provision. Power: Connected load X loading factor X No. Of hours in a day X No. of working days in a year X prevailing tariff + provision for other requirements. Fuel: Annual consumption X Price Water: Annual consumption X Price
Prof. A. G. Mendhi

LABOR
All manpower employed in the factory to be considered Salaries and wages assumed on the basis of prevailing rates in the industry. Remuneration to include basic salaries, allowances (DA, HRA, LTA, Medical, etc.), statutory provisions like PF, gratuity, insurance, bonus, etc. Normally (basic + fixed percentage) provided. Annual rise of 5% is usually assumed for annual increments.
Prof. A. G. Mendhi

FACTORY OVERHEADS
These would normally include

Cost of repairs and maintenance (Generally 2 to 3% on plant & machinery and 1.5% on Buildings/civil construction and MFA). Costs would increase with the age of machinery. Insurance (o.5% on all factory assets) Rents, taxes to be guided by prevailing rates. Provision for miscellaneous factory expenses
Prof. A. G. Mendhi

ESTIMATES OF WORKING CAPITAL & ITS FINANCING

Working capital is required mainly for maintaining adequate stocks of raw materials (both indigenous and imported), Work in progress, finished goods and provision for accounts receivables (i.e. credit given to customers) and cash on hand required for meeting day to day expenses. Usually Tandon Committee norms are followed by Banks. Accordingly at least 25% of the requirements of working capital are to be financed by the promoters and to be brought in as long term finance. Banks normally insist that Cash-on-hand be financed entirely by the promoters. Promoters can follow the format given in the application form prepared by all India Financial Institutes.

Prof. A. G. Mendhi

WORKING CAPITAL (CONTD.)

ITEM (A) Current Assets NO. OF MONTHS FINANCIAL YEAR OF OPERATION I II

Raw Material & Packaging Work in progress Finished goods Outstanding Debtors / Accounts receivable Sub-total (A)

1.50
0.1 1.50

1.00

Prof. A. G. Mendhi

WORKING CAPITAL (CONTD.)

(B) Minimum cash on hand Salaries and wages Utilities Others (Rent, Tax, packing and selling expenses, Repairs & maintenance, Insurance, etc.)

NO. OF YEAR I MONTHS 1.00 1.00

YEAR II

1.00

Sub-total (B) (to be funded 100% by promoters)

Prof. A. G. Mendhi

WORKING CAPITAL (CONTD.)

(C) Current Liabilities Trade credit on raw materials Trade credit on consumables Other credits Sub-total (C) NET W. Capital N=(A+B-C) M= Margin @ 25% of (A-C) + B Working capital loan availed= N-M
Prof. A. G. Mendhi

N0. of months 0.5 0.5 1.0

YEAR I

YEAR II

ESTIMATES OF WORKING RESULTS / PROFITABILITY STATEMENTS

A= Cost of production B=Total Administrative expenses (2 to 3% of sales) C= Total Selling expenses (5 to 10% of sales) D= Royalty payable (2 to 5% of sales) E=Total cost of production (A+B+C+D) F= Sales revenue G= Gross profit before interest= F-E

Prof. A. G. Mendhi

ESTIMATES OF WORKING RESULTS / PROFITABILITY STATEMENTS (contd.)

H= Total financial expenses (Interest payable on both long and short term loans) I=Depreciation J= Operating profit (G-H-I) K= Other income L= Preliminary expenses written off M= Profit or (Loss) before taxation (J+K-L)
Prof. A. G. Mendhi

ESTIMATES OF WORKING RESULTS / PROFITABILITY STATEMENTS (contd.)

N= Provision for tax O= Profit after Tax (PAT=M-N) P= retained profit = (O- Dividend declared on Equity & preference shares) Q= Net cash accrual = (P+I+L)
Prof. A. G. Mendhi

DEPRECIATION
Straight Line Depr.Rate (%)
Non Factory Building 1.63% Factory Building 3.34% *Plant and Machinery 10.34% Miscellaneous Fixed Assets 6.33%

WDV Method (Taxation purpose)

Non Factory Building 5.0% Factory Building 10.0% *Plant and Machinery 25.0% Miscellaneous Fixed Assets 10.0%

*Three shifts per day basis

Prof. A. G. Mendhi

DEPRECIATION CALCULATIONS
Provision for contingency and pre-operative expenses estimated in project cost are added proportionately to the cost of fixed assets to arrive at the depreciable value of fixed assets. Preliminary expenses in excess of 2.5 % of the project cost (excluding margin money) should also be added to the cost of the fixed assets to arrive at the depreciable value of fixed assets.

Prof. A. G. Mendhi

Table 7.7: BOOK DEPRECIATION STRAIGHT LINE METHOD (Figures in Rs. Lakh)

ITEM

St. Valu Line e Depr. at Rate Cost (%)

FINANCIAL YEAR OF OPERATION II III IV V VI VI VI IX I II X

Land

14

Building

1.63

78

1.2 1.2 1.2 1.2 1.2 1.2 1.2 1.2 1.2 1.2

Plant and Machinery

10.34 124

13 13 13 13 13 13 13 13 13 7

Miscellaneous Fixed Assets

6.33

14

0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8
Prof. A. G. Mendhi

TOTAL BOOK

ITEM

WDV Depr. Rate (%)

FINANCIAL YEAR OF OPERATION Value at Cost I II III IV V

Land

14

Building

10.00

78.26

7.83

7.04

6.34

5.70

5.13

Plant and Machinery

25.00

124.21

31.05

23.29

17.47

13.10

9.83

Miscellaneous Fixed Assets

15.00

13.94

2.09

1.78

1.51

1.28

1.09

TOTAL TAX DEPRECIATION

Prof. A. G. Mendhi

40.97

32.11

25.32

20.09

16.05

INTEREST CALCULATIONS
Interest on Long Term loans is taken as the present rate of interest charged by the Financial Institutions. The interest burden will decrease with the repayment of the loan by the borrower. For simplicity, Interest is calculated on the average of the balances at the beginning and at the end of the year. For short term loans / credit facilities, the rate of interest would be equal to the rate of interest charged by commercial banks. No repayment is assumed.
Prof. A. G. Mendhi

TYPE OF LOAN

FINANCIAL YEAR OF OPERATION

I II III IV V VI VII VIII

Short-term loan13% Interest

Table 7.6: LOAN REPAYMENT AND INTEREST SCHEDULE (Figures in Rs. Lakh)

Loan at the end of the year

Interest Long-term loan@ 13% Loan at the beginning Repayment Loan at the end of the year Interest

65.91
8.57

79.12
10.29

93.53 109.19 114.60

12.16 14.19 14.90

120.28 126.24 132.49 1

15.64 16.41 17.22

142.90 142.90 18.58

142.90 142.90 122.49 108.20 20.41 14.29 14.29 93.91 13.14

93.91 14.29 79.62 11.28

79.62 14.29 65.33 9.42

65.33 14.29 51.04 7.56

142.90 122.49 108.20

Prof. A. G. Mendhi

18.58

17.25

14.99

PART II MARCH 5, 2006

ESTIMATES OF WORKING RESULTS / PROFITABILITY STATEMENTS (contd.)

Prof. A. G. Mendhi

ESTIMATING CASH FLOWS

It is important to estimate the cash flows for a project to make a proper investment evaluation. All care and precautions need to be taken to ensure that the implementation of the project does not get hampered as a result of lack of adequate cash or finance in time. Correct estimate of cash flows is thus a key element in the process of successful financial planning.
Prof. A. G. Mendhi

ELEMENTS OF CASH FLOWS

1. 2. 3. There are three phases in the life of any project: Setting up or investment phase. Operational phase Terminal phase / Winding up phase Accordingly the cash flows would also be categorized in three classes. 1. Initial investment, 2. Operational cash flows and 3. Terminal cash inflow
Prof. A. G. Mendhi

LIFE OF A PROJECT
How is the life of a project determined and what should be the normal period / horizon for estimating cash flows? Life of a project is usually minimum of the following: 1. Physical life of the plant (wear and tear, depreciation, ask the supplier). 2. Technological life of the plant (chips manufacturing Manual to automatic operations) 3. Product life of the plant (computers / chips) 4. Investment Planning Horizon of the Firm
Prof. A. G. Mendhi

BASIC PRINCIPLES OF CASH FLOW ESTIMATION

1. Separation principle 2. Incremental principle 3. Post tax principle and 4. Consistency principle
Prof. A. G. Mendhi

SEPARATION PRINCIPLE
Two sides viz. investment side and financing side should be treated separately. Cost of capital is used as a hurdle rate against which rate of return on investment side is compared.
CASH FLOW TIME CASH FLOW 0 -100 1 +120 RATE OF RETURN 20%

TIME

0 +100 1 - 115 COST OF CAPITAL 15%

PROJECT

FINANCING SIDE
Prof. A. G. Mendhi

INVESTMENT SIDE

SEPARATION PRINCIPLE
Operationally this means that in cash flows on investment side, interest on debt is ignored while computing profits & Taxes. Hence, Profit before interest and tax (1-tax rate) = (profit before tax +interest) * (1-tax rate) = (profit before tax) (1-tax rate) +interest (1-tax rate) = Profit after tax + interest (1-tax rate)
Prof. A. G. Mendhi

INCREMENTAL PRINCIPLE
Cash flows of a firm should be measured in incremental terms.
Cash flows for firm Without project for t Project cash flows = For the year t Cash flows for firm with the project for t

1. 2. 3. 4. 5.

To ascertain the cash flows following principles should be followed: Consider all incidental effects (positive and negative effects such as product cannibalization). Ignore sunk costs, Include opportunity costs (Is there any alternative use of existing resource with the firm if the project is not undertaken?), Check allocation of overhead costs and Estimate Working capital systematically.
Prof. A. G. Mendhi

POST TAX PRINCIPLE

Cash flows are measured on a after tax basis. 1. What tax rate should be used for project cash flows? Average tax rate or the marginal tax rate that would be applicable to projects income? 2. Treatment of losses 3. Effect of non-cash charges (depreciation)

Prof. A. G. Mendhi

CONSISTENCY PRINCIPLE
Cash flows and discount rates applied to them must be consistent with respect to investor group and inflation. Investor group: cash flow to be estimated from the point of view of all investors (equity holders as also the lending agencies)

Prof. A. G. Mendhi

CASH FLOW FOR ALL INVESTORS

PBIT (1-tax rate) +Depreciation - Capital Expenditure - Change in working capital

Prof. A. G. Mendhi

CASH FLOW FOR EQUITY SHAREHOLDERS

Profit after tax (PAT) +Depreciation - preference dividend - Capital Expenditure - Change in working capital - repayment of debt + proceeds from debt issues - Redemption of preference capital + proceeds from preference issue You can discount the cash flows at WACC for all investors while for the equity holders, you can discount using cost of equity

Prof. A. G. Mendhi

PROJECTED CASH FLOW STATEMENTS

(A) Sources of Funds: 1. Share issue. 2. Profit before tax + interest added back 3. Depreciation for the year 4. Increase in secured long term loans. 5. Other medium / long term loans added during the year. 6. Increase in unsecured loans or deposits. 7. Increase in short term loans for working capital 8. Sale of fixed assets or investments 9. Other income
Prof. A. G. Mendhi

PROJECTED CASH FLOW STATEMENTS

(B) Uses / disposition of Funds:
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. Capital Expenditure for the project. Other normal capital expenditure. Increase in working capital Decrease in secured long term loans. Decrease in other medium / long term loans. Decrease in unsecured loans or deposits. Decrease in short term loans for working capital Increase in investments in other companies. Interest on both long and short term loans. Taxes paid Dividends paid during the year. Other expenditure
Prof. A. G. Mendhi

PROJECTED CASH FLOW STATEMENTS

C. Opening Balance of cash in hand and at bank. D. Net Surplus / Deficit (A-B) E. Closing Balance of cash in hand and at bank (C + A B)
Prof. A. G. Mendhi

PROJECTED BALANCE SHEET

LIABILITIES 1. Share Capital Equity Preference 2. Reserves & Surplus 3. Secured Loans 4. Unsecured Loans 5. Current Liabilities & Provisions 1. 2. 3. ASSETS Fixed Assets Investments Current Assets, Loans & Advances given 4. Miscellaneous Expenditures & Losses

Prof. A. G. Mendhi

BREAK-EVEN ANALYSIS
Also called Cost, Volume, Profit (CVP) Analysis. Studies relationship between costs, revenues and profits. Break-even indicates the level of sales at which the costs and revenues are in equilibrium i.e. there is noloss and no-profit situation. This equilibrium point is called break-even point. In other words, break even point is that level / point of sales at which the total revenue is equal to total costs.
Prof. A. G. Mendhi

BREAK-EVEN ANALYSIS
Pre-requisite of break-even point calculation or using CVP analysis is that total costs can be divided into fixed costs and variable costs. Variable costs are those that change in direct proportion to change in volume of production. Fixed costs remain fixed / constant irrespective of the volume of operation.

Prof. A. G. Mendhi

FIXED COSTS
Salaries Fixed Selling Expenses Depreciation Administrative overheads Repairs and maintenance Insurance Interest on long term loans Amortization of expenses
Prof. A. G. Mendhi

VARIABLE COSTS
Raw Materials Consumables Utilities Wages Variable Selling Expenses / commissions / royalty linked to sales Interest on short term loans
Prof. A. G. Mendhi

DETERMINING BREAK-EVEN POINT

1. 2. Two methods are usually adopted: Mathematical Formula Graphic approach Mathematically, Break Even Point (BEP) can be calculated in terms of units, sales or percentage capacity utilization. Each unit sold will cover its part of the variable cost and leave remainder (called contribution) to cover a part of the fixed costs. Break even will occur when sufficient units are sold so that total contribution is just equal to total fixed costs. Contribution per unit is the difference between selling price per unit and variable cost per unit.
Prof. A. G. Mendhi

DETERMINING BREAK-EVEN POINT

1. Mathematical Formula: s v = c (selling price - variable cost = contribution) per unit c . Q = C (Q = Total sales in units, C= Total contribution) S = s.Q (S= Total Sales in value terms) C F = Profit (Total contribution less total fixed costs) For break even, C-F=0 F c.Qb = F Hence, Qb = ---------(s v). Qb = F (s v)
Prof. A. G. Mendhi

DETERMINING BREAK-EVEN POINT

Mathematical Formula: F Qb = ---------(s v) Total fixed costs = --------------------------------------------selling price variable cost per unit
Prof. A. G. Mendhi

2. Mathematical Formula in Rupee terms: F.s F Qb.s = ---------- = -----------(s v) 1 v/s Total fixed costs Rb = --------------------------------1- variable cost ratio Rb = Total fixed costs --------------------------------Contribution ratio

Contribution Ratio is also called P/V ratio

Prof. A. G. Mendhi

BREAK EVEN CHART

Value

Prof. A. G. Mendhi

Output

ADVANTAGES OF BEP ANALYSIS

It is a simple device to understand your accounting data. It tells you the bottom line of achievements i.e. minimum sales and hence production that your company must achieve. It can form the basis for further profit improvement studies. It is a useful method to assess risk implications of alternative actions.
Prof. A. G. Mendhi

LIMITATIONS OF BEP
This is only a supply side (i.e.: costs only) analysis. It tells you nothing about what sales are actually likely to be for the product at various prices. It assumes that total costs can be separated into two components viz. fixed and variable costs It assumes that fixed costs (F) are constant It assumes average variable costs are constant per unit of output, at least in the range of sales (both prices and likely quantities) of interest. The selling price per unit remains the same i.e. it does not change with volume or other factors. The firm manufactures only one product or in case of multiple products, the product mix remains the same. Production and sales are synchronized i.e. inventories remain the same!!
Prof. A. G. Mendhi

DEBT SERVICE COVERAGE RATIO (DSCR)

It shows to FIs the capacity of the company to pay back the principal as well as the interest on the term loans given by them.
PAT + DEPR. + Intr. On LT Debt + Amortized Exp. DSCR = ------------------------------------------------------------------Repayment of LT Debt + Interest on LT Debt Total cash accrual over ten year period = ---------------------------------------------------------Total Debt service burden over ten years
Prof. A. G. Mendhi

SENSITIVITY ANALYSIS
FIs normally carry out sensitivity analysis on projected working results to assess the impact of adverse changes in following parameters of the project: 1. Increase in raw material prices, 2. Decrease in selling prices, 3. Increase in operating costs Impact on IRR, BEP & DSCR of 5% to 10% variation in above parameters is usually assessed to know how well the project can sustain these changes.
Prof. A. G. Mendhi

CONCEPT OF AVERAGE COST OF CAPITAL

A firms cost of capital is the weighted average cost of various sources of finance used by it viz. Equity, Preference shares, Long Term Debt and short term debt. Many firms do not take into account the short term debt while calculating WACC. WACC is used as the hurdle rate in capital budgeting / project financing (why?) WACC = Pi X ri Where, Pi is the proportion of the ith source of finance and ri is the cost of this source of finance.
Prof. A. G. Mendhi

QUESTIONS
1. What is Long Term Funds principle for evaluation of project cash flows? Why is it necessary to exclude Financing costs when the long-term funds principle is accepted? (2002) 2. What are the relative merits of building a project budget from bottom-up and from the top-down methods? How does the assignment of costs to individual project activities help in effective cost & schedule control? (2003)
Prof. A. G. Mendhi

QUESTIONS
3. Following information is available about a proposed expansion project: Initial project outlay is Rs.50.0 crores consisting of Rs.40.0 crores fixed assets & Rs.10.0 crores current assets. The financing pattern: Equity Rs.15.0 crores, Term loans Rs.30.0 crores, Working Capital advances Rs.4.0 crores & Trade Credits Rs.1.0 crores. Term loan repayable in ten equal six monthly instalments, the first instalment due 18 months after starting of production. Interest on term loan will be @ 12.0% p.a. applicable on opening balance at the beginning of the year. The levels of working capital and trade credit remain unchanged till end. The interest on working capital advance will be @ 15.0% p.a. Sales revenues are Rs.65.0 crores p.a. while operating costs excluding depreciation & interest are Rs.45.0 crores. Depreciation on fixed assets is charged @ 25.0% p.a. on Written down value (W.D.V.) basis. Project life being 7 years, the salvage value will be Rs.5.34 crores for fixed assets. Current assets recovery will be at cost. Average corporate Income Tax rate is 40.0% Work out the project cash flows during its life from long term funds point of view. (2002)
Prof. A. G. Mendhi

QUESTIONS
4. What are the various ways of financing a project along with the relative merits or demerits of each of them? Your answer should include all traditional as well as non-traditional means of financing. The sources should cover both domestic as well as foreign sources of financing. What is the criterion used for determining Life of the project for determining time span of cash flow projections? (2003)

5.

Prof. A. G. Mendhi