Projects – Analysis and Implementations

Introduction

Project management is the discipline of planning, organizing and managing resources to

bring about the successful completion of specific project goals and objectives.

A project is a finite endeavor (having specific start and completion dates) undertaken to
create a unique product or service which brings about beneficial change or added value. This
finite characteristic of projects stands in sharp contrast to processes, or operations, which are
permanent or semi-permanent functional work to repetitively produce the same product or
service.

Project is an organised programme of activity carried out to reach a defined goal, often of a
non-recurring nature. It is a package of time-bound, scheduled and assembled activities
dedicated to the attainment of a specific activities of successful completion of a work on time
and within the allotted budget.

The primary challenge of project management is to achieve all of the project goals and
objectives while honoring the project constraints. Typical constraints are scope, time and
budget.

As a discipline, Project Management developed from different fields of application including

construction, engineering and defense. In the United States, the two forefathers of project
management are Henry Gantt, called the father of planning and control techniques, who is
famously known for his use of the Gantt chart as a project management tool, and Henry Fayol
for his creation of the 6 management functions, which form the basis for the body of
knowledge associated with project and program management.

Characteristics of a project

• A project has a mission or a set of objectives.

• A project has to terminate at some time or other.
• All project has a life cycle represented by growth maturity and decline.
• A project is a unique and no two projects are similar
• A project is a customer specific.
• A project is exposed to risk and uncertainty and the extent of these two depend upon
how the project moves through the various stages in its life span.
• A substantial portion of work in a project is done by sub-contracting.
Project classifications

1 Quantifiable and Non Quantifiable projects.

• Quantifiable: Industrial development, power generation, mining etc.

• Non Quantifiable: Health education and defence etc.

2 Sectoral projects.

• Agriculture and allied sector

• Irrigation and power sector
• Industry and mining sector
• Transport and communication sector
• Social services sector
• Miscellaneous.

Financial Institutions classifications.

(Based on National and state financial Institutions)

• New projects
• Expansion Projects
• Modernization Projects
• Diversification Projects.

Project Life Cycle/ Project development stages

Traditionally, project development includes a number of elements: four to five stages, and a
control system. Regardless of the methodology used, the project development process will
have the same major stages:

• Initiation,
• Planning or development,
• Production or execution,
• Monitoring and controlling, and
• Closing.
Initiation

The initiation stage determines the nature and scope of the development. If this stage is not
performed well, it is unlikely that the project will be successful in meeting the business’s
needs. The key project controls needed here are an understanding of the business
environment and making sure that all necessary controls are incorporated into the project.
Any deficiencies should be reported and a recommendation should be made to fix them.

The initiation stage should include a cohesive plan that encompasses the following
areas:

• Study analyzing the business needs in measurable goals.

• Review of the current operations.
• Conceptual design of the operation of the final product.
• Equipment and contracting requirements.
• Financial analysis of the costs and benefits including a budget.
• Stakeholder analysis, including users, and support personnel for the project.
• Project charter including costs, tasks, deliverables, and schedule.

Planning and design

After the initiation stage, the system is designed. Occasionally, a small prototype of the final
product is built and tested. Testing is generally performed by a combination of testers and end
users, and can occur after the prototype is built or concurrently. Controls should be in place
that ensure that the final product will meet the specifications of the project charter.

• The results of the design stage should include a product design that:
• Satisfies the project sponsor, end user, and business requirements.
• Functions as it was intended.
• Can be produced within quality standards.
• Can be produced within time and budget constraints.

Executing
Executing consists of the processes used to complete the work defined in the project
management plan to accomplish the project's requirements. Execution process involves
coordinating people and resources, as well as integrating and performing the activities of the
project in accordance with the project management plan. The deliverables are produced as
outputs from the processes performed as defined in the project management plan.

Monitoring and Controlling

Monitoring and Controlling consists of those processes performed to observe project

execution so that potential problems can be identified in a timely manner and corrective action
can be taken, when necessary, to control the execution of the project. The key benefit is that
project performance is observed and measured regularly to identify variances from the project
management plan.

Monitoring and Controlling includes:

• Measuring the ongoing project activities (where we are);

• Monitoring the project variables (cost, effort, ...) against the project management plan
and the project performance baseline (where we should be);
• Identify corrective actions to properly address issues and risks (How can we get on
track again);
• Influencing the factors that could circumvent integrated change control so only
approved changes are implemented

Closing/ Project clean up

Closing includes the formal acceptance of the project and the ending thereof. Administrative
activities include the archiving of the files and documenting lessons learned.

Closing phase consist of two parts:

• Close project: to finalize all activities across all of the process groups to formally close
the project or a project phase
• Contract closure: necessary for completing and settling each contract, including the
resolution of any open items, and closing each contract applicable to the project or a project
phase.

Phases of a Project /Capital Budgeting

• Planning
• Analysis
• Selecting
• Financing
• Implementation
• Review
1.Planning
It is a Preliminary screening of the project proposal. It is done to Assess whether the project is
worthwhile

2.Analysis

• Market Analysis – Demand, Market share

• Technical Analysis – technical viability production process, m/c, plant size
• Financial Analysis – Risk and Return, meet the debt and return expectations?
• Economic – Social cost benefit analysis, impact on income, savings and investment in
the society
• Ecological – Damage and corrective actions

3. Selection
It Involves risk analysis with the tools and techniques for risk analysis. Appraisal tools used
includes.
• Non Discounting – Pay Back Period and ARR
• Discounting – NPV, IRR and BCR

4. Financing
• Capital structure decision – Debt and Equity
• Flexibility, risk, income, control and taxes influence the capital structure decision

5. Implementation
• Designing, Construction, Training and Plant Commissioning
• PERT and CPM are used for effective implementation

6.Review

• Feedback
• Provides information for future decision making
• Suggest corrective actions
• Judgmental biases can be discovered

Generation & screening of Project ideas

Search for promising project ideas is the first step towards establishing a successful venture.
Barring few new ideas based on technological breakthroughs, most of the project ideas
involve combining existing fields of technology or offering variants of present products or
services.

Generations of Ideas

To stimulate the flow of ideas, the followings are helpful.

• SWOT analysis – identifying opportunities that can be profitably exploited.
• Clear articulation of objectives- Helps the employees to think more imaginatively.
• Fostering a conducive climate- helps to tap the creativity of the employees.
• Monitoring the environment

A promising investment idea enables a firm to exploit the opportunities in the

environment by drawing on its competitive strengths. Hence the firm must systematically
monitor the environment and assess its competitive abilities.

Business environment may be divided into 6 categories.

• Economic sector
• Governmental sector
• Technological sector
• Socio-demographic sector
• Competition sector
• Supplier sector.

Scouting for project ideas.

Wide variety of sources to be tapped to identify project ideas.

• Analyse the performance of existing industries.

• Examining the input and out put of various industries.
• Review of imports and exports.
• Study plan outlays and governmental guidelines.
• Suggestions from financial institutions and developmental agencies.
• Investigating local material and resources.
• Analysis of economical and social trends.
• Study of new technological developments.
• Clues from consumption abroad.
• Possibility of revive of sick units.
• Trade fairs.
• Stimulating creativity for generating new product ideas.

Preliminary screening
From the list of ideas generated, some kind of preliminary screening is required to eliminate
which prima facie not promising. Preliminary screening is based on the following.
• Compatibility with the promoter.
• Consistency with government priorities.
• Availability of inputs.
• Adequacy of markets.
• Reasonableness of cost.
• Acceptability of risk level.

Facets of Project Analysis

 Market/ Demand analysis.

 Technical Analysis.
 Financial analysis.
 Economic analysis.
 Ecological analysis.

1.Market and Demand analysis

Market analysis is concerned with

 Find out the aggregate demand

 Aggregate market share

Kinds of information required

 Past and present consumption level

 Past and present supply condition
 Production possibilities and constraints
 Imports and exports
 Structure of competition
 Cost structure
 Elasticity of demand

 Consumer behavior, intentions, preferences

 Distribution and marketing policies in use
 Administrative, technical and legal constraints.

1. Situational Analysis

Informal talk with customers, competitors, middlemen and others in the industry.
Situational Analysis is done when
- there is cost and time constraints
- the analysis generates enough data to measure the market

2.Collection of Secondary information

 Sources – Census of India, National Sample survey reports, annual survey of

industries etc..
 Evaluate the secondary information
 Examine the reliability, accuracy and relevance

3 Conduct Market Survey

Information sought in a market survey

 Total Demand and rate of growth

 Income and price elasticities of demand
 Motives for buying
 Satisfaction with existing products
 Unsatisfied needs
 Socio-economic characteristics of buyers
 Attitude towards various products

Types of surveys includes

(1) Census Survey

For goods which are used by a small no. of firms. Costly and infeasible in other cases
(2) Steps in Sample survey

 Define the target population

 Select the sampling scheme and size
 Develop questionnaire
 Recruit and train the field investigators
 Obtain information as per the questionnaire
 Scrutinise the information
 Analyse and interpret the information

4. Charaterisation of Market

Based on information gathered from secondary sources and through the market survey, the
market for the product/service may be described in terms of the following

 Effective demand in the past and present

 Breakdown of Demand
 Price
 Methods of Distribution and sales promotion
 Consumers
 Supply and competition
 Govt. policy

5. Demand Forecasting

(a) Qualitative methods

(1) Jury of executive method
(2) Delphi method
(b) Quantitative methods
(1) Trend projection method
(2) Exponential smoothing method
(3) Moving Average method
(4) Chain ratio method
(5) Consumption level method
(6) End use method
(7) Leading indicator method

Techniques of Demand Forecasting

(a) Qualitative methods
(1) Jury of executive method-
opinions of a group of managers
(2) Delphi method – Taking the opinions of a group of experts with the help of a mail
survey.

6.Market Planning

Market analysis includes analyzing current Market situation which includes competitive,
distribution and macro environment. Market analysis calls for SWOT analysis of the
organization.

Objectives
 Marketing strategy – target segment, product positioning, product line, distribution,
sales force, sales promotion and advertising
 Action Programme

Technical Analysis

Analysis of technical and engineering aspects of a project need to be done continually when a
project is formulated. TA seeks to determine whether the prerequisite for the successful
commissioning of the project have been considered and reasonably good choice have been
made with respect to location, size, process, etc.

Objective of Technical Analysis is to make sure that the project is technically feasible, Project
is optimal in terms of technology, size, location etc..

Essentials of Technical Analysis

• Manufacturing Process / Technology

-choice of suitable technology among the alternatives
- Technology appropriate to local economic, social and cultural conditions.

Flexibility with respect to product mix.

• Plant capacity- considering technological reqmt, input constraints, investment cost,

market conditions

• Location and site - proximity to RM, infrastructure, labour, govt. policy etc.
• Machineries and Equipment – depending on the production technolgy, plant capacity,
investment capacity, workers able to operate etc..
• Structures and Civil works – site preparation and development, building and structures,
outdoor works etc..

• Environmental Aspects – types of emissions, action for effluent treatment.

• Project charts and layouts – to define scope of the project and provide basis for project
engineering and estimation of the investment and production cost.
• Schedule of project implementation
- PERT & CPM Analysis
- Prepare work schedule

Financial Analysis

Financial analysis seeks to ascertain whether the proposed project will be financially viable in
the sense of being able to meet the burden of servicing the debt and whether the proposed
project will satisfy the return expectations of those who provide the capital.

Factors looked into while conducting the financial analysis are

• Investment outlay and cost of project

• Means of financing
• Cost of capital
• Projected profitability
• Break even point
• Cash flows of the project
• Projected financial position
• Level of risk.

Financial Analysis

Make financial estimates and projections by analyzing

• Cost of the project – supported by long term funds
• Plan the means of financing –considering cost, risk, control & flexibility
• Estimate of sales & production ( qty & value)
• Calculate the cost of productions –matl, utilities, labour, factory o/h etc.
• Financial Analysis
• Working Capital requirement and the means of financing
• Make profitability projections
• Prepare a projected cash flow statement
• Prepare a projected Balance Sheet
Economic analysis

EA also referred to as social cost benefit analysis, is concerned with judging a project from
the larger social point of view. In this evaluation focus is on the social cost and benefit of a
project which may often be different from its monetary costs and benefit.

The questions sought to be naswered in this analysis are.

 What would be the impact of project on the distribution of the income in the society.
 What would be the contribution of the project on employment, social order, savings and
investments etc.

Ecological analysis

 Environmental concerns have assumed greater significance.

 Mainly for those projects which have significant ecological implications.
 Analysis of likely damage caused by the project to the environment.
Mod 2

PROJECT ESTIMATION AND SELECTION

NATURE OF INVESTMENT DECISIONS

From the above discussion, you must be clear about the distinctive features of capital
investment:

• They have long-term consequences

• They often involve substantial outlays

• They may be difficult or expensive to reverse

Now that you know the nature of investment decisions, lets discuss the various forms of
investment decisions:

1. Replacement projects: Firms routinely invest in equipments meant to replace obsolete

and inefficient equipments, even though they may in serviceable condition. The
objective of such investments is to reduce costs (of labour, raw material, and power),
increase yield, and improve quality. Replacement projects can be evaluated in a fairly
straightforward manner; though at times the analysis may be quite detailed.

2. Expansion projects: These investments are meant to increase capacity and/ or widen
the distribution network. Such investments call for an explicit forecast of growth. Since,
this can be risky and complex, expansion projects normally warrant more careful
analysis than replacement projects. Decisions relating to such projects are taken by
the top management.

3. Diversification projects: These investments are aimed at producing new products or

services or entering into entirely new geographical areas. Often diversification projects
entail substantial risks, involve large outlays, and require considerable managerial
efforts and attention. Given their strategic importance, such projects call for a very
thorough evaluation, both quantitative and qualitative. Further, they require a
significant involvement of the board of directors.

4. Research and development projects: Traditionally, R%D projects absorbed a very

small proportion of capital budget in most Indian companies. Things however are
changing. Companies are now allocating more funds to R&D projects, more so in
knowledge intensive industries. R&D projects are characterised by numerous
uncertainties and typically involve sequential decision-making. Hence the standard
DCF analysis is not applicable to them. Such projects are decided on the basis of
 managerial judgment. Firms, which rely more on quantitative methods, use decision
tree analysis and option analysis to evaluate R&D projects.

5. Mandatory investments: These are expenditure required to comply with statutory

requirements. e.g., pollution control equipment, medical dispensary, fire fitting
equipment etc. These are often non-revenue producing investments. In analysing such
investments the focus is mainly on finding the most cost-effective way of fulfilling a
given statutory need.

ACCEPT-REJECT VERSUS RANKING APPROACHES

Two basic approaches to capital budgeting decisions are available. The accept- reject
approach involves evaluating capital expenditure proposals to determine whether they meet
the firm’s minimum acceptance criterion. This approach can be used then the firm has
unlimited funds, as a preliminary step when evaluating mutually exclusive projects, or in a
situation in which capital must be rationed. In these cases only the acceptable projects should
be considered.

The second method, the ranking approach, involves ranking projects on the basis of some
predetermined measure, such as the rate of return. The project with the highest return is
ranked first, and the project with the lowest return is ranked last. Only acceptable projects
should be ranked. Ranking is useful in selecting the best of a group of mutually exclusive
projects and in evaluating projects with a view to capital rationing.

EXPANSION VERSUS REPLACEMENT CASH FLOWS

Developing relevant cash flow estimates is most straightforward in the case of expansion
decisions. In this case, the initial investment, operating cash inflows, and terminal cash flow
are merely the after-tax cash outflow and inflows associated with the proposed outlay.
Identifying relevant cash flows for replacement decisions is more complicated; the firm must
find the incremental cash outflow and inflows that would result from the proposed
replacement. The initial investment in this case is the difference between the initial investment
needed to acquire the new asset and any after-tax cash inflows expected from liquidation
today of the asset being replaced. The operating cash inflows are the difference between the
operating cash inflows from the new asset and those from the replaced asset. The terminal
cash flow is the difference between the after-tax cash flows expected upon termination of the
new and the old assets.

INDEPENDENT PROJECTS
Independent projects are those where cash flows are unrelated or independent from one
another. The acceptance of one project does not necessarily eliminate other projects.
MUTUALLY EXCLUSIVE PROJECTS
Mutually exclusive projects are projects that are competing with one another. The acceptance
of mutually exclusive projects automatically eliminates other mutually exclusive projects that
are competing with one another.

CAPITAL BUDGETING:

EVALUATION TECHNIQUES
In essence, capital funds are invested for one basic reason: To obtain sufficient future
economic returns to warrant the original outlay i.e., sufficient cash receipts over the life of the
project to justify the investment made. Analytical methods of evaluation of capital projects
should take into account in one way or another, this basic trade-off of current cash outflows
against the future cash inflows.
To judge the attractiveness of any investment proposal, the financial manager must consider
the following elements

(i) The amount expended i.e., The net investment,

(ii) The potential benefits i.e., the operating cash inflows, and

(iii) The time period over which these benefits will accrue i.e., economic life of the project.

TRADITIONAL OR NON-DISCOUNTING –TECHNIQUES

As the name itself suggests, these techniques do not discount the cash flows to find out their
present worth.
There are two such techniques available i.e.,

(i) The Payback period method, and

(ii) The Accounting rate of return.

1 . PAYBACK PERIOD

The payback period as name suggest is defined as the number of years required for the
proposal's cumulative cash inflows to be equal to it cash outflows. In other words, the
payback period is the length of time required to recover the initial cost of the project. The
payback period therefore, can be looked upon, as the-length of time required for a proposal to
'break even' on its net investment.

The Decision Rule:

The payback period does not give any clear indication of the decision rule. The payback
period calculated for a proposal is to be compared with some predetermined target period. If
the payback period is more than the target period, then the proposal should be rejected,
otherwise-it-may be accepted if the payback-period is less than the target period. There is no
systematic or accepted way of determination of target period and choosing a target period is
subject to some arbitrariness on the part of the decision maker. Further, if the different
proposals are to be ranked in order of priority, then the proposal with the shortest payback
period will be first in the priority list.

Critical Evaluation:
Out of all the available Capital budgeting technique (some of which are discussed later), the
payback period is the easiest to understand and apply. The payback period measures the
direct relationship between annual cash inflows from a proposal and the net investment
required. . This technique has been a popular method of evaluation of capital budgeting
proposals merely because of its simplicity. Yet, it is having its own problems and
disadvantages. The payback period as a technique of evaluation of capital budgeting
proposals can be critically examined in terms of its advantages and disadvantages as follows:

Advantages of payback method:

1. The payback period is simple and easy, in concept as well as in its applications. In
particular, a small firm having limited manpower, which does not have any special skill to
apply other sophisticated techniques, can adopt it.
2. It gives an indication of liquidity. In case a firm is having liquidity problems, then the
payback period is a good method to adopt as it emphasizes the earlier case inflows.
3. In a broader sense, the payback period deals with the risk also. The project with a shorter
payback period will be less risky as compared to project with a longer payback period, as the
cash inflows which arise further in the future will be less certain and hence more risky. So, the
payback period helps in weeding out the risky proposals by assigning lower priority.
Disadvantages of payback method:
1. The payback period entirely ignores many of the cash inflows, which occur after the
payback period. This could be misleading and could lead to discrimination against the
proposal, which generates substantial cash inflows in later years. By restricting itself to
answering the question ‘when will this project make it initial investment?’ it ignores what
happens after the initial investment is recouped.

2 ACCOUNTING RATE OF RETURN OR AVERAGE RATE OF

RETURN (ARR)
The ARR is based on the accounting-concept of return on investment or rate of return. The
ARR may be defined as the annualized net income earned on the average funds invested in a
project. In other words, the annual returns of a project are expressed as a percentage of the
net investment in the project.
This clearly shows that the ARR is a measure based on the accounting profit rather than the
cash flows and is very similar to the measure of rate of return on capital employed, which is
generally used to measure the over all profitability of the firm.

The decision rule:

The ARR calculated as above is compared with the pre-specified rate of return. Obviously, if
the ARR is more than the pre-specified rate of return, then the project is likely to be accepted,
otherwise not. For example, in the above case the ARR of the proposal has been found to be
20%. In case, the firm requires a rate of return of at least 18%, then this proposal is
acceptable. However, if the minimum rate of return of the firm is 22% then this proposal is
likely to be rejected. The ARR can also be used to rank various mutually exclusive proposals.
The project with the highest ARR will have the top priority while the project with the lowest
ARR will be assigned lowest priority.

The Critical Evaluation:

No doubt, the ARR is relatively simple to calculate and easy to apply. The relevant data and
information required for its calculation is readily available in the accounting records. The ARR
state the economic desirability of an investment in terms of a percentage return on the original
outlay. Unlike the payback period, the ARR considers all the benefits arising out of the
proposal through out its economic life.
However, the ARR has certain limitations and drawbacks when used as a technique of
project evaluation as follows.

1. It ignores the time value of money and considers the profit earned in the 1st year as
equal to the profits earned in later years. It does not discount the future profits.

2. The ARR is based on the accounting profits rather than the cash flows. It has already
been noted in the previous chapter that accounting profits are affected by different
accounting policies. It has also been noted earlier that a sound evaluation technique
should be based on the cash flows rather than the accounting profits.

3. The ARR also ignores the life of the proposal. A proposal with a longer life may have
the same ARR as another proposal with a shorter life has. On the basis of ARR, both
the proposals may be placed at par, but the proposal with a longer life should be
preferred over the proposal with a shorter life (as the former proposal will generate the
returns for a longer period). However, the ARR method fails to distinguish between the
two.

4. The ARR technique also ignores the salvage value of the proposal. In real sense,
the salvage value is also a return from the proposal and should be considered.
 5. The ARR also fails to recognize the size of the investment required for the project.
Particularly, in case of mutually exclusive proposals, the two projects having
significantly different initial costs may have same ARR.

3 NET PRESENT VALUE (NPV) METHOD

The NPV is the first and the foremost of the discounted cash flow techniques. NPV is used
simply to weigh the elements of trade-off between investment outlays and the future benefits
in equivalent terms, and to determine whether the net balance of the present values is
favorable or not. The NPV of an investment proposal may be defined as the sum of the
present values of all the cash inflows less the sum of present values of all the cash outflows
associated with a proposal. In other words, the NPV of any proposal, that involves cash
inflows and outflow over a period of time, is equal to the net present value of all the cash
flows. Thus, the NPV is the sum of the discounted values of the cash flows of a proposal. In
case, the cash outflows i.e. the investment in the proposal occur only in the beginning at time
0, then NPV may be defined as the sum, of the present values of cash inflows less the initial
investment.
A rate of discount must be specified and applied to both inflows and outflows in order to find
out their present values. When the present values of all inflows and. outflows are added, the
resultant figure is denoted as net present value. The figure can be positive or negative,
depending on whether there is a net inflow or outflow from the project. A word should be said
about the rate of discount. From an economic point of view, this rate of discount should be the
rate of return, the investor normally enjoys from investments of similar nature and risk. In
effect, it is opportunity rate of return. In case of a firm, the choice of a discount rate is
complicated by the variety of investments available and by the type of financing provided by
both the shareholders and the debt investors. The rate so employed is the overall cost of
capital, which takes into account shareholders expectations, business risk and the leverage.

The merits of the NPV technique can be enumerated as follows.

1. It recognizes the time value of money. It helps evaluation of proposals involving cash
flows over a period of several years. The cash flows occurring at different point of time
are not directly comparable, but they can be made comparable by the application of
the discounting procedure.

2. The NPV technique considers the entire cash flow stream and all the cash inflows and
outflows, irrespective of the timing of their occurrence, are incorporated in the
calculation of the NPV.
3. The NPV technique is based on the cash flows rather than the accounting profit and
thus helps in analysing the effect of the proposal on the wealth of the shareholders in a
better way.
 4. The discount rate, k, applied for discounting the future cash flows is in fact, the
minimum required rate of return, which incorporates both the pure return as well as the
premium required to set off the risk.

5. The NPV technique represents the net contribution of a proposal towards the wealth of
the firm and is therefore, in full conformity with the objective of maximization of the
wealth of the shareholders. The NPV concept has a built in earnings requirements in
addition to the recovery of the investment. Thus, the cushion implicit in the positive
NPV is truly an economic gain that goes beyond satisfying the required rate of return.

The NPV technique has the following shortcomings:

i. It involves difficult calculations. Moreover, it may not be able to overcome the uncertainty
involve with cash flows occurring after a sizeable time gap. It fails to answer questions
such as: How to quantify the potential error inherent in the cash flow estimates, and
how does the measure help making investment choices if such errors are significant?
ii. The NPV technique requires the predetermination of the required rate of return, k, which
itself is a difficult job. If the value of the 'k' is not correctly taken, then the whole
exercise of the NPV may give wrong results.

iii. The NPV technique does not provide a measure of project's own rate of return; rather it
evaluates a proposal against an external variable i.e. the minimum required rate of
return.

iv. The decision under the NPV technique is based on a value, which is an absolute
measure. It ignores the difference in initial outflows, size of different proposals etc.
while evaluating mutually exclusive proposals.

4 PROFITABILITY INDEX (PI)

Quite often one may be faced with a choice involving several alternative investment of
different size. In such a case, he cannot be indifferent to the fact that even though the NPV of
different alternatives may be close or even equal, these involve commitments of widely
ranging amounts. In other words, it does make a difference whether an investment proposal
promises a NPV of Rs. 1,000 for an outlay of Rs. 10,000; or whether an outlay of Rs. 25,000
is required to get the same NPV of Rs. 1,000, even if the lives of the, projects are assumed to
be same. In the first case, the NPV is much larger fraction (Rs. 1,000/10,000) then what it is
in the second case i.e., (Rs. 1,000/ 25,000), which makes the first proposal clearly more
attractive. The PI technique is a formal way of expressing this cost/benefit relationship.
This technique which is a variant of the NPV technique, is also known as Benefit- cost
ratio, or preset Value index. The PI is also based upon the basic concept of
discounting the future cash flows and is ascertained by comparing the present value of
 the future cash inflows with the present value of the future cash outflows. The PI is
calculated by dividing the former by the latter.

Calculation:
The PI is calculated as follows:
PI = Total present value of cash inflows
Total Present Value of cash outflows

5 TERMINAL VALUE (TV)

The other variant of the NPV technique is known as the TV technique. In this case, a new
dimension is added to the NPV technique. As already discussed in the NPV technique, the
future cash flows are discounted to make them comparable. In the TV technique, the future
cash flows are first compounded at the expected rate of interest for the period from their
occurrence till the end of the economic life of the project. The compounded values are then
discounted at an appropriate discount rate to find out the present value. This present value is
compared with the initial outflow to find, out the suitability of the proposal.

6 DISCOUNTED PAYBACK PERIOD

This method is a combination of the original payback method and the discounted cash flow
technique. In this method, the cash flows of the project are discounted to find their present
values. The present value of the cash inflows is then compared with the present value of the
outflow, in order to identify the period taken to recover the initial cost or the present value of
outflow. This method thus, takes care of the main drawback of the pay back period method
and allows the consideration of the time value of money of cash flows. However, it still does
not take into account those cash inflows, which occur subsequent to the payback period, and
sometimes these cash inflows may be substantial. Since, it is a variant of the original payback
period method, the discounted payback period method is also calculated in the same way as
the payback period, except that the future cash inflows are first discounted and then the
payback is calculated. However the discounted payback method is superior as, in addition to
the recovery of original investment, the time value of money is also considered.

6 INTERNAL RATE OF RETURN (IRR)

The other important discounted cash flow technique of evaluation of capital budgeting
proposals is known as IRR technique. The IRR of a proposal is defined as the discount rate,
which produces a zero NPV i. e., the IRR is the discount rate which will quite the present
value of cash inflows with the present value of cash outflow. The IRR is also known as
Marginal Rate of Return or Time Adjusted Rate of Return. Like the NPV, the IRR is also
based on the discounting technique. In the IRR technique, the future cash inflows are
discounted in such a way that their total present value is just equal to the present value of
total cash outflows. The time-schedule of occurrence of the future cash flows is known but the
rate of discount is not. Rather this discount rate is ascertained, by the trial and error
procedure. This rate of discount so calculated, which equates the
present value of future cash inflows with the present value of outflows, is known as the

The Decision Rule:

In order to make a decision on the basis of IRR technique; the firm has to determine, in the
first instance, its own required rate of return. This rate, k, is also known as the cut-off rate or
the hurdle rate. A particular proposal may be accepted if its IRR, r, is more than the minimum
rate i. e., k, otherwise rejected. However, if the IRR is just equal to the minimum rate, k, then
the firm may be indifferent. In case of ranking of mutually exclusive proposals, the proposal
with the highest IRR is given the top priority while the project with the lowest IRR is given the
lowest priority. Proposals whose IRR is less than the minimum required rate, k, may
altogether be rejected. This decision rule is based on the fact that the NPV of the project is
zero if its cash flows are discounted at the minimum' required rate i. e., k. If the proposal can
give a return higher than this minimum required rate, then it is expected to contribute to the
wealth of the shareholders. It may be noted however, that the IRR, r, of the proposal is
internal to the project while the minimum required rate, k, is external to the project.

The Critical Evaluation:

Besides the NPV technique, the IRR technique is the other important discounted cash flow
technique of evaluation of capital budgeting proposals. The IRR technique has been
compared with the NPV technique at a later stage.

However, the merits of the IRR technique can be summarized as follows:

i. The IRR technique takes into account the time value of money and the cash flows occurring
at different point of time are adjusted for time value of money to make them comparable.
ii. It is a profit-oriented concept and helps selecting those proposals which are expected to
earn more than the minimum required rate of return. So, the IRR technique helps achieving
the objective of maximization of shareholders wealth.
iii. The IRR of a proposal is expressed as a percentage and is compared with the cutoff rate,
which is also expressed as a percentage. Thus, the IRR has an appeal for those who want to
analyze proposal in terms of its percentage return.
iv. Like NPV technique, the IRR technique is also based on the consideration of all the cash
flows occurring at any time. The salvage value, the working capital used and released etc. are
also considered.
v. The IRR technique is based on the cash flows rather than the accounting profit.

Thus, it can be stated that the IRR technique possesses all the ingredients of a sound
evaluation technique. Still it has, on the other hand, some draw backs, as follows:
a) As far as the calculation of IRR is concerned, it involves a tedious and
complicated trial and error procedure.
b) An important drawback of the IRR technique is that it makes an implied assumption that
the future cash inflows of a proposal are reinvested at a rate equal to the IRR. Say, in case of
mutually exclusive proposals, say A and B having IRR of 18% and 16%, the IRR technique
makes an implied assumption that the future cash inflows of project A will be reinvested at
18% while the cash inflows of project B will be reinvested at 16%. It is imaginary to think that
the same firm will have different reinvestment opportunities depending upon the proposal
accepted.
c) Since, the IRR is a scaled measure, it tends to be biased towards the smaller projects
which are much more likely to yield high percentage returns over the larger projects.

CAPITAL BUDGETING UNDER CAPITAL RATIONING

It is a situation where the firm has limited funds available but cannot be undertaken in view of
the limited funds. This situation may occur when a firm is either unable or unwilling to obtain
additional funds in order to undertake financially viable capital budgeting proposals. Thus a
firm by choice or under compulsions sets absolute ceiling on its capital spending in a period at
a level that will cause it to reject or avoid some of the profitable projects. For example, if a firm
has different proposals with positive NPV but the initial funds required for the implementation
of all these proposals are not available or cannot be procured from the capital market for one
reason or the other, the firm is said to be operating under condition of capital rationing. In
other words, a firm faces capital rationing when it finds itself unable to take on projects that
earn returns more than the cut-off rate because it does not have (i) the funds on hand, or (ii)
the capacity to raise the funds needed to finance these projects. In the context of the NPV
rule, this implies that the firm does not have and cannot raise the funds to take all the posi-
tive NPV proposals. The fact that a firm has many projects and limited resources does not
neces-sarily imply that it faces capital rationing, as the firm might still have the capacity to
raise funds from the capital market. The capital rationing may be described as:

1.Internal Capital Rationing:

It is a situation where the firm has imposed limit on the funds allocated for fresh investment
though (i) the funds might otherwise be available within the firm, or (ii) additional funds can be
procured by the firm from the capital market. Some firms may follow a policy of using only
internally generated funds (by ploughing back of profits) for new investments. Some firms
avoid debt capital because of the associated financial risk and avoid external equity because
of a desire not to loose control. This type of capital rationing implies that the firm is not willing
to grow further. Obviously, the internal capital rationing is not in the best interest of the
shareholders in the long run, as it results in foregoing the profitable proposals.

2. External Capital Rationing:

It is a situation when the firm is willing to undertake the financially viable proposals but is
unable to do so because either it is not having sufficient funds available at its disposal or the
capital market conditions are not conductive enough to let firm raise the required funds from
the market.
A firm having no capital rationing will like to take all the capital budgeting proposals which
have positive, NPV and reject those which are having negative NPV. In case-of mutually
exclusive proposals, the firm will like to take that proposal which has the highest positive NPV
irrespective of the funds requirements. But the problem is that if the firm is facing capital
rationing, then how to distribute the available scarce and limited capital funds among
competitive proposals.

At this stage, it is also necessary to classify different projects into 2 classes i.e.,
divisible projects and indivisible projects.

a) Divisible Projects:

There are certain projects, which can either be taken in full or can be taken in parts. For
example, it building (having 5 floors) can be constructed at a cost of 5 crores. However, if the
funds are not sufficiently available then only a part of the building, say only 2 floors, can be
constructed for the time being. But all the proposals may not be divisible.

b) Indivisible Projects:

There are certain proposals, which are indivisible. These proposals have a feature that
either the proposal as a whole be taken in its totality or not taken at all. For example, a
proposal to buy a helicopter cannot be taken in parts. Similarly, a multi stage plant can
only be installed fully but not in parts. There can be many instances of indivisible
projects.

Modified Internal Rate Of Return - MIRR

While the internal rate of return (IRR) assumes the cash flows from a project are reinvested at
the IRR, the modified IRR assumes that all cash flows are reinvested at the firm's cost of
capital. Therefore, MIRR more accurately reflects the profitability of a project.

For example, say a two-year project with an initial outlay of $195 and a cost of capital of 12%,
will return $121 in the first year and $131 in the second year. To find the IRR of the project so
that the net present value (NPV) = 0: NPV = 0 = -195 + 121/(1+ IRR) + 131/(1 + IRR)2 NPV
= 0 when IRR = 18.66% Solving for NPV using MIRR, we will replace the IRR with our MIRR
= cost of capital of 12% : NPV = -195 + 121/(1+ .12) + 131/(1 + .12)2 NPV
= 17.47 when MIRR = 12% Thus, using the IRR could result in a positive NPV (good project),
but it could turn out to be a bad project (NPV is negative) if the MIRR were used. As a result,
using MIRR versus IRR better reflects the value of a project.
CONCEPT OF COST OF CAPITAL

The concept of cost of capital has been used in capital budgeting as the discount rate or the
minimum required rate of return. In the NPV and PI techniques, the cash flows have been
discounted at this cost of capital to find out the desirability of the proposal. In the IRR method,
although this cost of capital is not directly used, still it was required to make the accept-reject
decisions. If a project's IRR is more than the cost of capital of the firm then the proposal is
considered to be acceptable, otherwise it should be rejected. So, the concept of cost of
capital has been used quite often without providing a good deal of explanation about how it is
obtained. Theoretically speaking, the cost of capital is the minimum required rate of return; a
project must earn in order to cover the cost of raising funds being used by the firm in financing
of the proposal. This can be substantiated as follows; if a firm accepts an investment
proposal, it will also need funds for it’s financing. These funds can be procured from different
types of investor i.e., equity share holders, preference share holders, debt holders, depositors
etc.,

These investor while providing the funds to the firm will have, an expectation of receiving a
minimum return from the firm. The minimum return expected by the investors depends upon
the risk perception of the investor as well as on the risk-return characteristics of the firm.
Therefore, in order to procure funds, the firm must pay this return to the investors. Obviously,
this return payable to investors would be earned out of the revenues generated by the
proposal wherein the funds are being used. So, the proposal must earn at least that much,
which is sufficient to pay to the investors of the firm. This return payable to investor is
therefore; the minimum return the proposal must earn otherwise, the firm need not take up the
proposal. In nutshell, therefore, the cost of raising funds is the minimum required rate of
return of the firm i.e., the cost of capital is the minimum return which the firm must earn on the
proposals in order to break-even. Thus, the minimum rate of return that a firm must earn in
order to satisfy the expectations of its investor is called the cost of capital of the firm. In other
words, the cost of capital is the rate of return; a firm must earn in order to attract the supplier
of funds to make available the funds to the firm.

IMPORTANCE AND SIGNIFICANCE OF COST OF CAPITAL

The importance and significance of the concept of cost of capital can be stated in terms of the
contribution it makes towards the achievement of the objective of maximization of the wealth
of the shareholders. If a firm's actual rate of return exceeds its cost of capital and if this return
is earned without of course, increasing the risk characteristics of the firm, then the wealth
maximization goal will be achieved. The reason for this is obvious. If the firm's return is more
than its cost of capital, then the investor will no doubt be receiving their expected rate of
return from the firm. The excess portion of the return will however be available to the firm and
can be used in several ways E.g. (i) for distribution among the shareholders in the form of
higher than expected dividends, and (ii) For reinvestment within the firm for increasing further
the subsequent returns. In both the cases, the market price of the share of the firm will tend to
increase & consequently will result in increase in the shareholders wealth.
In capital budgeting decision it helps accepting those proposals whose rate of return is more
than the cost of capital of the firm and hence results in increasing the value of the firm.
Similarly, the firm's value is reduced when the rate of return on the proposal falls below the
cost of capital. Thus, the concept of cost of capital is consistent with the goal of maximization
of shareholders wealth and it works as a tool to achieve this goal. Further, the cost of capital
has a useful role to play in deciding the financial plan or capital structure of the firm. It may be
noted that in order to maximize the value of the firm, the cost of all the different sources of
funds must be minimized. The cost of capital of different sources usually varied and the firm
will like to have a combination of these sources in such a way so as to minimize the overall
cost of capital of the firm.
Module 3
RISK ANALYSIS IN CAPITAL BUDGETING

The cash flows from an investment are estimated when the proposal is evaluated, however,
the returns are not known until the cash flows actually occur. The uncertainty of returns from
the moment, the funds are invested until management and investor know how much the
projects has earned, is a primary determinant of a proposal's risk. The owner of a firm are
ordinarily concerned with the riskiness of their capital, and management must therefore, take
risk into account in evaluation of capital budgeting proposals.

In case, the cash flows associated with a proposal are known with certainty then the
techniques such as NPV, IRR or any other may be used to evaluate the desirability of the
proposal. However, when the cash flows are not known with certainty, a measure of risk of
the proposal should also be brought into the evaluation system. Such resultant capital
budgeting decision criterion will then evaluate the proposals by considering both the risk and
return associated with the proposal. As already discussed above a proposal is said to contain
risk when the set of possible cash flows is known but it is not possible at time 0 (when the
decision is being taken) to predict the specific cash flows that will actually occur in future.

TYPES AND SOURCES OF RISK IN CAPITAL BUDGETING:

The risk in a project can be classified into different groups such as the project itself,
competition, shifts in the industry, international considerations etc., as follows:
1. Project Specific Risk:
This type of risk is project specific i.e., an individual project may have higher or lower cash
flows than expected, either because of the wrong estimation or because of factors specific to
that project. When firms takes a large number of similar projects, it may be argued that much
of this project specific risk would be diversified away The project specific risk affects only the
project under consideration and may arise from factors specific to project or estimation error.
2. Competition Risk:
The second type of risk is competition risk where the cash flows of a project are affected by
the actions of the competitors. Although, a good project analysis might consider the reactions
of the competitors, the actual actions taken by the competitors may be different from those
expected. In most of the cases, this risk will affect more than one project and is therefore
difficult to be diversified away in the normal course of business.
3. Industry Specific Risk:
The third type of risk is the industry specific risk i.e., the risk that primarily affects the earnings
and cash flows of a specific industry only. This risk may arise because of three factors. The
first is technology risk, which reflects the effects of technologies that change or evolve in
ways different from those expected when the project was originally analyzed. The second is
legal risk, which reflects the effect of changing laws and regulation affecting a particular
industry only. The third may be the commodity risk, which reflects the effects of price
changes in goods and services that are used or produced.
4. International Risk:
A firm faces this type of risk when it takes on projects outside its domestic market. In such
cases, the earnings and cash flows might be different than expected owing to exchange rate
movements or political changes. Some of this risk may be diversified away by a firm in the
normal course of business by taking on projects in different countries whose currencies may
not all move in the same direction. Multinational firms who hold projects in number of
countries are able to diversify away this risk.
5. Market Risk:
The last type of risk arises by the factors that affect essentially all companies and all projects,
of course in varying degrees. For example, changes in interest rate structure will affect the
projects already taken as well as those yet to be taken, both directly through the discount rate
and indirectly through cash flows. Other factors that affect all the projects may be inflation,
economic conditions etc. Although the expected values of these entire variables may be
considered in the capital budgeting analysis, changes in these variables will affect their
values. Firms cannot diversify away this risk in the normal course of business, although may
be considered to some extent only.
.
Assumptions of capital Budgeting under risk:
The discussion on capital budgeting under risky situations is based upon the following
assumptions:

1. That the firm is not having any capital rationing, and no profitable project will be rejected
for want of funds.
2. That the proposal’s net investment is known with certainty.

3. Each set of cash flows is known with certainty, and is mutually exclusive and
exhaustive.

4. The required rate of return of the firm is given and is indicative of the risk-return
characteristics of the proposal.

5. The firm is basically risk-averse. This assumption is important as it implies that the finance
manager will not accept a risky proposal unless its expected profits are sufficient to
compensate for the risk. The risk aversion also means that the additional risk will be
accepted only if it results in disproportionately larger increase in expected returns.

This assumption of risk aversions can be expressed in terms of the

followingprepositions:

�If
 the two proposals have the same expected return, then theproposal with lesser
risk will be preferred, and

�If
 two proposals have same degree of risk then proposal with thehigher expected
return would be preferred.
Incorporating Risk in the Capital Budgeting Analysis:

In all the capital budgeting decisions, there is always an element of risk involved which must
be considered while evaluating different investment proposals. There are several techniques
available to handle the risk perception of capital budgeting proposals. These techniques differ
in their approach and methodology to incorporate risk in the evaluation process. Broadly
speaking, these techniques can be grouped into conventional techniques and statistical
techniques as follows:

Conventional Techniques Statistical Techniques

1. Payback period 1. Probability Distribution Approach

2. Risk adjusted Discount Rate 2. Simulation Analysis

3. Certainty equivalents 3. Decision Tree Approach

4. Sensitivity Analysis

5. Financial Break-even

CONVENTIONAL TECHNIQUES OF RISK ANALYSIS

These techniques are also known as traditional or non-mathematical techniques to evaluate

risk. These approaches are simple and based on theoretical assumptions. Some of the
conventional techniques are as follows:

1 PAYBACK PERIOD:
As already discussed, the Payback Period method considers the time period over which the
original investment in the project will be recovered by the firm out of the cash inflows of the
project. The payback period is then compared with the target payback period. If the proposal's
payback period is less than or equal to the target payback period, it may be accepted,
otherwise rejected. In order to incorporate risk of the proposal, the target payback period may
be shortened. As a result some project, which would have been on the verge of being
selected, otherwise, will now be rejected. The shortening of the target payback period is
based on the assumption that larger the recovery period, more risky the proposal would
be.
The Payback Period as an approach to handle risk is simple and straight forward. But it fails
to measure the risk, which may be of different degree in different alternative proposals.
Moreover, it reduces only that risk which arises due to time period and thus allows for other
risks to prevail. The payback period also ignores the time value of money as well as the cash
flows arising after the payback period.

2 RISK ADJUSTED DISCOUNT RATE (RADR):

Another way of adjusting for risk is to modify the rate of return to include a risk, premium
wherever needed. In a sense, the reasoning behind this is quite simple i.e., the greater the
risk, the higher should be the desired return from a proposals. The RADR approach to handle
risk in a capital budgeting decision process is a more direct method. The RADR is based on
the premise that riskiness of a proposal may be taken care of, by adjusting the discount rate.
The cash flows from a more risky proposal should be discounted at a relatively higher
discount rate as compared to other proposals whose cash flows are less risky.

An investor is basically risk averse and try to avoid risk. However, he may be ready to take
risk provided he is rewarded for undertaking risk by higher returns. So, more risky the
investment is, the greater would be the expected return. The expected return is expressed in
terms of discount rate, which is also termed as the minimum required rate of return generated
by a proposal if it is to be accepted. Therefore, there is a positive, correlation between risk of
a proposal and the discount rate.

A firm at any point of time has a risk level emanating from the existing investment. The firm
also has a discount rate to reflect that level of risk. In case, there is no risk of the existing
investment, then the present discount rate may be known as the risk free discount rate. If the
risk level of the new proposal is higher than the risk level of the existing investment, then the
discount rate to be applied to find out, the present values of the cash flows of the proposal
should also be higher than the present discount rate. Similarly two different proposals having
varying degree of risk should be evaluated at different discount rates. The difference between
the discount rate applied to a risk less proposal and a risky proposal is known as the risk
premium. The RADR may be expressed in terms of Equation as follows:

Ka = k +α
Where Ka = Risk Adjusted Discount Rate
k = Risk free Discount Rate, and
α = Risk Adjustment Premium

It may be noted that the risk free discount rate is described as the rate of return on the
government securities. Since all the business proposals have higher degree of risk as
compared to zero degree of risk of government securities, the RADR is always greater than
the risk free rate. As the risk of a proposal increases, the risk adjustment premium i.e., a, also
increases. The relationship between the risk free rate, the risk premium the RADR and the
risk return line has been explained in the following figure.
3 CERTAINTY EQUIVALENTS (CE):

An alternative approach to incorporate the risk is to adjust the cash flows of a proposal to
reflect the riskiness. The CE approach attempts at adjusting the future cash flows instead of
adjusting the discount rates. The expected future cash flows, which are taken as risky and
uncertain, are converted into certainty cash flows. Intuitively, more risky cash flows will be
adjusted down lower than will the less risky cash flows. The extent of adjustment will vary and
it can be either subjective or based on a risk return model. These adjusted cash flows are
then discounted at risk free discount rate to find out the NPV of the proposal.
The procedure for the CE approach can be explained as follows:
Step1.
Estimation of the future cash flows from the proposal. These cash flows do have some degree
of risk involved.
Step 2.
The calculation of the CE factors for different years. These CE factors reflect the proportion of
the future cash flow a finance manager would be ready to accept now in exchange for the
future cash flow. The CE factors represent the level of present money at which the firm would
be indifferent between accepting the present money or the future cash flow. For example,
cash inflow of Rs. 10,000 is receivable after 2 years. However, if the inflow is available right
now, the firm may be ready to accept even 70% of Rs. 10,000 i.e., Rs. 7,000 only. This 70%
or .7 is the CE factor. For different years the CE factors, will be different to account for the
timing as well as the varying degree of risk involved. It may be noted that higher the riskiness
of a cash flow, the lower will be the CE factor.
Step 3.
The expected cash flows for different years as calculated in step 1 above are multiplied by the
respective CE factors and the resultant figures are described as certainty equivalent cash
flows.
Step 4.
Once all the cash flows are reduced to CE cash flows then these CE cash flows are dis-
counted at risk free rate to find out the NPV of the proposal.

Decision rule in CE approach

Accept a proposal with positive CE NPV. In case of mutually exclusive proposals the rule is
that the proposal having the highest positive CE NPV is accepted.

4 SENSITIVITY ANALYSIS:

As discussed that the NPV of a project is based upon the series of cash flows and the
discount factor. Both these determinants depend upon so many variables such as sales
revenue, input cost, competition etc. Given the level of all these variables, there will be a set
series of cash flows and hence there will be a NPV of the proposal. However, if any of these
variables changes then the value of the NPV will also change. It means that the value of NPV
is sensitive to all these variables. However, in most of the cases, the value of NPV will not
change in the same proportion for a given change in anyone of these variables. For some
variables the NPV may be less sensitive while for others the NPV may be more sensitive. The
Sensitivity Analysis (SA) deals with the consideration of sensitivity of the NPV in relation to
different variables contributing to the NPV. .
In general, the SA is a theoretical procedure whereby values of the variable parameters
(inputs) are changed to denote different situations/assumptions, and the effect of these
changes is measured on the expected value of the outcome (result). When applied to the
capital budgeting situations, the SA is a technique to evaluate the effect of changes in factors
contributing to cash flows on the value of the NPV of the proposal .

The ‘single point’ estimates of cash flows or the expected results are based on the judgment
of the analyst and the information available. In fact, these are the averages of the possible
outcome, implicitly weighed by their respective probabilities. By introducing a range of high,
low and expected levels of cash inflows and outflows, the analyst can use a form of sensitivity
analysis to indicate the consequences of expected fluctuations, and thus the degree of risk. At
times, the past experience can provide clues to the range of future outcomes, but essentially
the projection of future cash flows has to be judgmental and based on specific estimates.

The following steps are required to apply the SA to, capital budgeting proposals:

A) Based on the expectations for the future, the cash flows are estimated in respect of the
proposal.
B) To identify the variables which have a bearing on the cash flows of a proposal. For
example, some of these variables may be the selling price, cost of inputs, market share,
market growth rate etc.,
C) To establish the relationship, between these variables and the output value i.e., the effect
of these variables on the value of NPV of the proposal.
D) To find out the range of variations and the most likely value of each of these variables, and
E) To find out the effect of change in any of these variables on the value of NPV. This
exercise should be performed for all the factors individually. For example, in case of a project
involving .the product sale, the effect of change in different variables such as number of units
sold, selling price, discount rate etc., can be taken up on the NPV or IRR
of the project. This information can be used in conjunction with the basic capital budgeting
analysis to decide whether or not to take up the project.

5 BREAK-EVEN ANALYSIS:
Traditional break-even analysis attempts to estimate the revenues that will be needed in order
for a project to break even in accounting terms- that is, to make a net income zero. However,
a capital budgeting proposal may be analyzed as to how much revenue will be needed for a
project to break even in financial terms-that is, to make the net present value zero.
The financial break-even is computed by first estimating the annual cash flows needed to
make the net present value zero, then ascertaining the revenues needed to generate this
annual cash flow, and finally estimating the number of units that have to be sold to create this
revenue.

In fact, the financial Break-even is a higher hurdle because it requires the firm to make
sufficient returns to cover the discount rate on the funds invested in the project.
Consequently, the financial break-even will be higher (in units and amount) then the
accounting break-even.

STATISTICAL TECHNIQUES OF RISK ANALYSIS

The different techniques discussed in the previous lesson were conventional techniques to
study, analyze and incorporate the risk associated with a proposal, fail to measure and
quantify the risk in precise terms. On the other hand, there are certain statistical techniques
available to measure and incorporate risk in a capital budgeting decision process. These
techniques, as discussed below, can be used to evaluate the risk-return characteristics of a
capital budgeting proposal. The most important concept used in these statistical techniques is
that of probability. Therefore, before analyzing the statistical techniques of incorporating risk,
the concept of probability must also be understood.

The Concept of Probability:

The probability may be defined as the likelihood of happening or non-happening of an event.
It may be described as a measure of chance of happening or non-happening of an event. For
example, one may say that there are 20% chances that the sales will increase by 80% during
the year, or that there are 75% chances that the firm will be able to achieve 50% market
share over a period of next 5 years. These descriptions of 20% and 75% chances are the
description of probability of the respective events. So, the probability may be taken as a
measure of an opinion about the likelihood of happening of an event. If the event is certain to
happen, then the probability is defined as one and if the event has no chance of occurrence,
then the probability is described as 0. So, the probability always has a value between 0 and 1.
While estimating the cash inflows resulting from a proposal say, at the end of year 1, a
finance manager may find that he is not having one estimation of cash inflow rather he has a
series of estimation of cash inflows for the that year and for each estimation there is a
probability that the actual cash flows may be same as estimated. For example, the following is
the series of estimated cash inflows together with their probabilities at the end of year 1.

Cash flows Probabilities

Rs. l,00,000 .2
1,50,000 .4
1,75,000 .3
2,00,000 .1
Similarly, series of estimated cash inflows may be available for different other years also.
Two points are worth noting here.
First, that the total of probabilities for anyone year would always be equal to one, and
Second, that the actual cash inflow may be any figure, even other than the cash inflows
given in the series. It may be noted that the series of expected cash inflows together with
the associated probabilities for a particular year is also know as probability distribution.

1 Probability Distribution:
The probability distribution may be defined as a set of possible cash flows that may occur at a
point of time and their probabilities of occurrence, In the probability distribution given above
for year 1, there are 4 possible cash inflows.
The probabilities given for these cash inflows can be interpreted as follows: There is a 20%
chance that the cash inflows will be Rs. 1,00,000; there is 40% chance that the cash inflow
will be Rs. 1,50;000 and so on.
In some cases, the probabilities can be assigned on the basis of past experience or historical
data. But it may not always be possible in a capital budgeting decision. The reason for this is
obvious. The capital budgeting decisions are, generally, not of repetitive nature. Moreover,
data available from the experience of other firms may not be available or not at all relevant,
because each capital budgeting situation is a specific situation. Therefore, in most of the
capital budgeting situations, the decision maker on the basis of some relevant facts and
figures and his subjective considerations usually assigns the probabilities.
If the decision maker foresees a risk in the proposal then he has to prepare a separate
probability distribution to summarize the possible cash flow for each year through the
economic life of the proposal. Thereafter, the next step is to find out the expected value of
probability, distribution for each year.

Expected value of a Probability Distribution:

The initial step required in evaluating a risky proposal is to find out the expected value of
probability distribution for each year. For this, each cash flow of the probability distribution is
multiplied by the respective probability of the cash flow and then adding the resulting
products. This final figure is then considered as the expected value of the cash inflow for that
year for which the probability distribution has been considered. This procedure is to be
adopted for the probability distributions for all the years and then the expected value of cash
inflows are discounted at an appropriate discount rate to find out the NPV of the proposal.

Standard Deviation: An Absolute Measure of Risk and Variability.

The statistical tool of standard deviation provides a measure of spread of the distribution of
expected cash flows. The standard deviation as a technique of measuring dispersion can be
used to measure the deviations of each possible cash flow about the expected value of cash
flow. It is also named as root-mean-square deviation and is calculated by taking the square
root of the mean of squared deviations. These deviations refer to the difference between,
possible cash flow and the expected value of the cash flow. The following steps are needed to
ascertain the standard deviation of the probability distribution of cash flows:
Step1.
Find out the probability distribution of the cash flows over different years and find out
expected value of cash flow for each year.
Step 2.
Subtract each cash flow (CF) from the expected value of the cash flow i.e., EVCF and get the
square of the differences i.e., (CF-EVCF)2.
Step 3.
Multiply the squared deviations i.e., (CF-EVCF)2 by the probabilities of the occurrence of its
corresponding cash flow, i.e., find out PI (CF1-EVCF)2, or P2 (CF2-EVCF)f or P3 (CF3-EVCF)2
etc. where Pi is the probability of a particular cash flow.

Step 4.
Add these products i.e., find out the sum of Pi (CFi-EVCF) 2 and get the square root of this
figure i. e., find out the value of,
21)(EVCFCFPiini−=Σ=σ
This value is called the standard deviation, σ. It may be noted that the standard deviation is
calculated by taking all deviations positive or negative. This implies that the risk aversion
extends to, all the deviations from the expected value even if the deviations are positive i.e.,
when the possible cash flow are more than the expected value of the cash flow. The larger
dispersion will produce a larger standard deviation and therefore, larger standard deviation
indicates riskier capital budgeting proposals.

Coefficient of Variation: A Relative Measure of Risk.

Coefficient of Variation (CV) is a relative measure of dispersion and can be applied in capital
budgeting decision process to measure the risk of a project particularly in case when the
alternative projects are of different sizes. The CV is defined as the standard deviation of the
probability distribution divided by its expected value i.e.,

CV = σ/EVCF.

It may be noted that the CV is a pure number and is not affected by the measuring unit. The
advantage of CV over standard deviation is that the former can be used to compare the
riskiness of mutually exclusive proposals even if their expected values are not equal. The CV
is also useful in evaluation of those proposals whose initial outlays differ substantially.

PROBABILITY DISTRIBUTION APPROACH:

In the preceding section the concept of probability has been introduced to take care of the risk
and variability of cash flows. The expected values of cash flows were calculated for difference
year and then the NPV and the standard deviation were calculated, in order to reach at a
capital budgeting decision. Now this analysis can be extended and the probability theory can
be applied to know something more about the variability cash flows.

The concept of probability has been used to find out the NPV of the proposal. It results in
acceptance of those proposals, which have a positive NPV. However, in actual practice
the value of NPV may be less than 0 or just 0 or a positive value. The probability
distribution approach attempts to determine the probability that the actual NPV occurrence
is going to be less than 0 and that the project has therefore, been accepted wrongly. Thus,
the probability distribution approach helps in determining the error of judgment of the firm
in selecting a proposal, which at a later stage turns out to be a negative NPV project. In
order to develop the probability distribution approach, an important assumption regarding
the behavior of cash flows needs to be made. The re-quired assumption is whether the
cash flows associated with a project are independent cash flows or dependent cash flows.

A proposal is set to be having independent cash flows when the cash flow of any period is not
affected by the cash flow or flows of any of the preceding period. For example, the expected
cash flow of year 2 is not affected by the cash inflow of year 1 and similarly the cash flow of
year 5 is not affected by the cash inflow of year preceding period i.e., year 1 through year 4.
On the other hand, a proposal is said to have dependent cash flows when the favorable or
unfavorable cash flow in a particular period affects the cash flow of any period thereafter. In
practice, most of the proposals have dependent cash flows. The effect of the nature of cash
flow on the calculation of the value of NPV may be analyzed as follows:

2 SIMULATION ANALYSIS:

Simulation is yet another statistical technique to deal with uncertainty and is also based on
the concept of probabilities. Theoretically speaking, simulation refers to 'Creation of an
Appearance without the Reality'. Thus, in simulation, the appearance seems to be true but it
is not real. Simulation therefore, refers to representation of a system that reacts to a change
to any of input variable in a similar way as to that variable which is being simulated. There are
several techniques of simulation, however, the Monto Carlo Method is the most common. The
Monto Carlo Method is based on the concept of random numbers and is useful in the analysis
of uncertainty.
The simulation analysis can be applied to capital budgeting decision situations also. When
applied to capital budgeting, the simulation requires the generation of values of cash flows
using predetermined-probability distribution and the random numbers. The different
components of cash flows are placed in relation to one another in a mathematical model. The
process of generating the values of cash flows is repeated numerous times to result in a
probability distribution of cash flows. The process of generating the random number and using
the probability distribution of cash flows help generating values of different variables. These
values are then put in a mathematical model to develop a NPV. By repeating the same
process for number of times say a thousand or ten thousands times, a probability distribution
of NPV is created. The simulation allows considering the projects under alternative scenarios.
The decision maker can consider the effect of a limited number of plausible combinations of
variables affecting the outcome of a proposal. The application of simulation analysis has been
analyzed in the following example.

3 DECISION TREE APPROACH:

Quite often a firm may have to take a sequential decision i.e., the present decision is affected
by the decisions taken in the past or it affects the future decisions of the same firm. In capital
budgeting, the evaluation of a project frequently requires a sequential decision making
process where the accept-reject decision is made in several stages. Instead of taking a
decision once for all, it is broken up into several parts and stages. At each stage there may be
more than one option available and the firm may have to decide every time that which option
is to be taken for. This can be explained with the help of a simple situation.

A firm is considering to launch a new product and to install a plant with capacity of 10,000
units a month. It is hopeful of selling the entire production. However, if due to one or the
other factor, the demand is not generated to lift even the break-even level of production,
then the firm will face a heavy loss. In this case, it will be better for the firm to first install a
pilot project and go for test marketing. If the market accepts the product, full-fledged plant
may be installed in the next stage. This is a two-stage decision. The first occurs before the
test market. At that point, the cash flows related to both the test and to the production
must be considered. After the test, another decision must be made. At this point, the cash
flows related to the market test are sunk costs and are irrelevant to the decision to be
made. At this second point, the decision to be made cannot affect the cash flows already
made in connection with the market test. Hence according to the incremental cash flows
rule, they are not relevant. The only relevant flows are those related to the production
phase. However, in practice there may be multi stages decisions also.
An analytical technique used in sequential decisions is decision tree. The decision tree
approach can take care of these types of multi stages decisions. The decision tree approach
gets its name because of the resemblance with a tree having number of branches. A decision
tree is a branching diagram representing a decision problem as a series of decisions to be
taken under conditions of uncertainty. A present decision depends upon the past decision and
their outcomes. The decision trees are the diagrams that permit the various decisions
alternatives, their outcomes and probabilities of their occurrences to be mapped in a clear
fashion. In a typical decision tree, therefore, the project is broken down in to clearly defined
stages, and the possible outcomes at each stage are listed along with the probabilities and
cash flows effect of each outcome.
Steps in Decision Tree Approach:
While constructing a decision tree for a given problem the following steps may be required.

1. Break the Project into clearly defined stages. In some cases, this is fairly easy to do
so. For example, a computer software company may take up the project of new
package in different stages, i.e., research and development, market testing, limited
production and then full production. Similarly, other capital budgeting decisions may
also be broken up in different stages.

2. List all the possible outcomes at each stage. Specify the probability of each outcome
at each stage based on information available. This task will become progressively
more difficult as more and more stages introduced.

3. Specify the effect of each outcome on the expected cash flows form the project.

4. Evaluate the optimal action to be taken at each stage in the decision tree, based on
the outcome at the previous stage and its effect on cash flows.

5. Estimate the optimal action to be taken at the vary first stage, based on the
expected cash flows over the entire projects and all the likely outcomes of the cash
flows. Following example illustrates the decision tree approach.

CAPM ( CAPITAL ASSET PRICING MODEL )

CAPM was developed by financial economist william sharpe. Its based on idea that
investment includes systematic and un systematic risk. CAPM is evolved as a way to
measure systematic risk. General idea behind CAPM is that investors need to be
compensated in two ways.
1) time value of money, that’s given by risk free rate of interest
2) compensation for taking additional risk.

This compensation is calculated by taking a risk measure (beta) that compares the return of
the asset to the market over a period of time.

CAPM FORMULA

Rs = Rf + Bs (Rm – Rf )

Where,
Rs = return required on the investment
Rf = return on risk free investment
Bs = beta of the security (systematic risk)
Rm = average return on all the securities

CAPM reflects the mathematical relationship bet risk and return. Higher the risk (beta) the
higher is the required return.

ASSUMPTIONS UNDER CAPM

A) all investors have rational expectations

B) there are no arbitrage opportunities
C) returns are distributed normally
D) fixed quantity of assets
E) perfect capital market
F) risk free rates exists with time less borrowing capacity and universal access
G) no inflation and no change in interest rates exists
.

Limitations of CAPM

A) this model does not appear to adequately explain the variations in stock returns. ( many
empirical studies shows that low beta stocks may offer higher return than what expected in
the model)
B) this model assumes that all investors agree about the risk and expected return of all assets
( homogeneous expectations assumptions)
C) this model assumes no taxes and transactions cost
D) this model assumes investors demand higher return in exchange of a higher risk. This may
not hold good always.
Module 4

Project financing

Project finance is the financing of long-term infrastructure and industrial projects based upon
a complex financial structure where project debt and equity are used to finance the project,
rather than the balance sheets of project sponsors. Usually, a project financing structure
involves a number of equity investors, known as sponsors, as well as a syndicate of banks
that provide loans to the operation. The loans are most commonly non-recourse loans,
which are secured by the project assets and paid entirely from project cash flow, rather than
from the general assets or creditworthiness of the project sponsors, a decision in part
supported by financial modeling.[1] The financing is typically secured by all of the project
assets, including the revenue-producing contracts. Project lenders are given a lien on all of
these assets, and are able to assume control of a project if the project company has
difficulties complying with the loan terms.

Project Financing

It is a method of financing very large capital intensive projects, with long gestation period,
where the lenders rely on the assets created for the project as security and the cash flow
generated by the project as source of funds for repaying their dues.

Typical characteristics of Infrastructure Projects

Some of the typical characteristics are

* Large capital costs
* Long gestation periods
* Assets are not easily transferable
* Services provided are not tradable
* Revenues only in local currency; borrowing may be in foreign currency
* Tariffs are politically sensitive
* Social aspects involved
* Vulnerable to regulatory policies
* Limited recourse financing needed

Project financing through Loan Syndication

The process of involving several different lenders in providing various portions of a loan.
Mainly used in extremely large loan situations, syndication allows any one lender to provide a
large loan while maintaining a more prudent and manageable credit exposure because the
lender isn't the only creditor.
There has been a sharp rise in loan off-take recently, with the credit growth being 25% higher
than the previous year. As India Inc. goes on a capital expenditure and expansion spree, the
financial system is witnessing a subtle change in the way credit is mopped up. More and more
corporates are looking at loan syndications - a common phenomenon in the West.

"Syndication is an arrangement where a group of banks, which may not have any other
business relationship with the borrower, participate for a single loan."

"A syndicated facility is a lending facility, defined by a single loan arrangement, in which
several or many banks participate."

The standard theory for why banks join forces in a syndicate is risk diversification. The banks
in the syndicate share the risk of large, indivisible investment projects. Syndicates may also
arise because additional syndicate members provide informative opinions of investment
projects or additional expertise after the funding has been extended.

In other words - if a company wants a huge amount as a loan for expansion or any other
purpose, say when Reliance or ITC wants money, loans are got from the banks. But
generally, its got from a single bank and that single bank alone shares the risk. Take the case
of funding a rocket launch - if the launch is a failure, then the bank which funds for it may
become bankrupt. But in syndication, many banks come together and fund a single project,
hence sharing the risks. This also assists in getting competitive interest rates for the banks.
Generally, when a group of banks get together, they select a lead bank which handles all the
dealings with the company, such as negotiating the interest rates, and hence a deal is signed
between the company and the banks. Loan syndication is basically done to share the total
loss or liability.

Typically, syndicated loans are structured as term loans or operating revolvers. However, they
may also include tranche or segmented structures, letters of credit, acquisition facilities,
construction financing, asset-based structures, project financing and trade finance.

WHEN DOES A CORPORATE GO FOR SYNDICATION?

Corporates opt for syndication when: -

� The borrower wants to raise large amount of money quickly and conveniently

� The amount exceeds the exposure limits or appetite of any one lender .

� The borrower does not want to deal with a large number of lenders

Traditionally, loan syndication was practiced in Europe. Euro syndicated loan is usually a
floating rate loan with fixed maturity, a fixed draw down period and a specified repayment
schedule. One, two or even three banks may act as lead managers and distribute the loan
among themselves and other participating banks. One of the lead banks acts as the agent
bank and administers the loan after execution, disbursing funds to the borrower, collecting
and distributing interest payments and principal repayments among lead banks, etc. A typical
Euro credit would have maturity between 5 to 10 years, amortization in semi-annual
installments, and interest rate reset every three or six months with reference to LIBOR.

Syndicated loans can be structured to incorporate various options, e.g., a drop lock feature
converts the floating rate loan into a fixed rate loan if the benchmark index hits a specified
floor. A multi-currency option allows the borrower to switch the currency of denomination on a
roll-over date. Security in the form of government guarantee or mortgage on assets is
required for borrowers in developing countries like India.

Some of the important roles in Syndicated Loans include: -

� Arranger / Lead Manager: The lead manager is a bank that is awarded the mandate by
the prospective borrower and is responsible for placing the syndicated loan with the other
banks and ensures that the syndication is fully subscribed. They are entitled to the
arrangement fee and undergo a reputation risk during this process.

� Underwriting Bank: It is the bank that commits to supplying the funds to the borrower - if
necessary from its own resources if the loan is not fully subscribed. The lead manager or
another bank may play this role. Not all syndications are underwritten. The risk is that the loan
may not be fully subscribed.

� Participating Bank: This bank participates in the syndication by lending a portion of the
total amount required. It is entitled to receive the interest and the participation fee. But it,
however, faces risks such as: -

* Borrower credit risk

* Passive approval and complacency

� Facility Manager / Agent: This bank takes care of all the administrative arrangements
over the term of loan, e.g., disbursements, repayments, compliance. This bank acts on behalf
of all the banks participating. This may be either the lead manger or the underwriting bank.

STAGES INVOLVED IN THE PROCESS

� Premandate Phase: The prospective borrower may liaise with a single bank or it may
invite competitive bids from a number of banks. The lead bank identifies the needs of the
borrower, designs an appropriate loan structure, develops a persuasive credit proposal, and
obtains internal approval. The mandate is created. The documentation is created with the
help of specialist lawyers.

� Placing the Loan: The lead bank can start to sell the loan in the market place. The lead
bank needs to prepare an information memorandum, term sheet, and legal documentation
and approach selected banks and invite participation. The lead manager carries out the
negotiations and controversies are ironed out. The syndication deal is closed, including
signing of the mandate.

Bilateral Loans Syndicated Loans Bond Markets

Similar to
Loan Size Lowest Larger
syndicated loans
Public
Lowest Medium Highest
Disclosure
Driving Factor Relationship Relationship or transaction Transaction
Extensive and frequently Extensive but less
Covenants Rarely negotiated
negotiated frequently negotiated
Borrowing
Floating rate Floating rate Fixed rate
Rate
Revolving credit or fully Revolving credit or fully
Funding Fully
funded term loan funded term loan

� Post Closure Phase: The agent now handles the day-to-day running of the loan facility.

BENEFITS OF LOAN SYNDICATIORS FOR BORROWERS

Syndicated loans provide borrowers with a more complete menu of financing options. In
effect, the syndication market completes a continuum between traditional private bilateral
bank loans and publicly traded bond markets. This has resulted in a more competitive
corporate finance market, which has permitted issuers to achieve more market-oriented and
cost-effective financing.

The main objective of the loan was broad-basing the medium-to-long-term funding sources for
HDFC and also to reduce the overall cost of funding. The proceeds of the loan will be utilized
for lending to individuals across the country for residential housing. HDFC is in the process of
finalising suitable risk management arrangements to hedge against foreign exchange
fluctuations.

DISADVANTAGES

Managing multiple bank relationships is no small feat. Each bank needs to come to an
understanding of the business and how its financial activities are conducted. A comfort level
must be established on both sides of the transaction, which requires time and effort.
Negotiating a document with one bank can take days. To negotiate documents with four to
five banks separately is a time-consuming, inefficient task. Staggered maturities must be
monitored and orchestrated. Moreover, multiple lines require an inter-creditor agreement
among the banks, which takes additional time to negotiate.

CONCLUSION
One advantage of syndication loans is that this market allows the borrower to access from a
diverse group of financial institutions. In general, borrowers can raise funds more cheaply in
the syndicated loan market than by borrowing the same amount of money through a series of
bilateral loans. This cost saving increases as the amount required rises.

Project financing Issue of equity shares:

Firm can raise finance by issuing equity shares in different forms like:
a) By going for IPO
b) By going for subsequent issue
c) By right issue
d) By private placement
e) By preferential allotment
a) Initial public offer of equity shares (IPO):-
If the firm is issuing the shares for the first time, it is referred to as initial public offer.
Initial public offer will be followed by listing of the equity shares in the stock exchange.
Benefits of going public:

 Access to capital
 Respectability
 Investors recognition
 Liquidity to promoters
 Signals from markets

Cost of going public (limitations):-

 Dilution of control
 Loss of flexibility
 Disclosure
 Accountability
 Public pressure
 Costs associated with issue

Steps involved in IPO

 Approval of board of directors
 Appointment of lead managers (merchant banker)
 Appointment of other intermediaries like co-managers, underwriters, registrar,
bankers, brokers etc.
 Filing of prospectus with SEBI
 Filing of prospectus with Registrar of companies.
  Printing and dispatch of prospectus
 Statutory announcement of the issue
 Promotion of the issue
 Collection of application by lead manager
 Processing of application by lead manager
 Allotment of shares
 Listing of the shares in stock exchange.
b) Subsequent issue/ public issue by listed companies:
A company whose shares are already listed in stock exchanges may think of
generating some more finance by issuing equity shares. this is referred to as subsequent
issue.
The company need to fulfill certain conditions before going for subsequent issue of equity
shares like:
a) Company should be listed in stock exchange for atleast 3 years.
b) Company need to have a track record of payment of dividend for atleast 3 years
immediately proceeding the year of issue.
Procedure for issue of equity shares of a limited company is similar to that of an IPO.
The company is having a freehand in fixing the prices of subsequent issue. The general
practice in India is that 6 months average closing price is taken as issue price.
c) Right issue:
Right issue involves selling equity/securities in the primary market to existing
shareholders. This can be done after meeting some requirements specified by SEBI.
When company issues additional capital, it has to be first offered to existing
shareholders. The shareholders however may forfeit this right partially or fully to enable the
company to issue additional capital to public.

Characteristics of right issue:-

1) Number of rights that a shareholders gets is equal to the number of shares held by
him.
2) The number of rights required to subscribe an additional shares is determined by
issued company.
3) Price per share is determined by the company.
4) Existing shareholders can exercise right and can apply for the share.
5) Shareholders who renounce their rights are not entitled for additional shares.
6) Rights can be sold
7) Rights can be exercised only during a fixed period (usually 1 month)
Merits of right issue:
1) Less expensive as compared to direct public issue
2) Management of applications and allotment is less cumbersome.
Limitations:
i) Can be used by only existing company
ii) Cannot be used for large issues
iii) Wider ownership bare cannot be achieved.
d) Private placements
It involves allotment of shares (or other securities) by a company to few selected
sophisticated investors like mutual funds, insurance companies, banks etc.
Private placement of equity:- Usually unlisted companies who are not ready for IPOs can
go for this. Price can be freely determined by company as it is not regulated by SEBI.
Private placement of debt:- Companies can directly place their debentures, bonds etc.
In Indian context private placement of debt of listed companies and equity of unlisted
companies are popular.
Advantages of private performance:
1) Helpful in rising small size of funds
2) Less expensive as compared to other methods
3) Takes less time as compared to other type of issues.
e) Preferential allotment:
It is an issue of equity by a listed company to selected investors at a price which may or
may not be related to prevailing market price. It is not a public issue of shares. This kind of
preferential allotment is made mainly to promoter or their friends and relative.
The company should pass special resolution to do preferential allotment. In case if the
government is having a state in the company., the central government permission is
necessary.
Pricing:- price of preferential allotment must not be lower than 6 months average closing
price.
Pricing regulations of preferential allotment to FII’s are more stringent.
Lock in period:- The shares allotted under preferential allotment process will attract a lock in
period. If it is allotted a promoter, the lock in period will be 3 years and to others, it is 1 year.

PROJECT FINANCING THROUGH DEBENTURES:

 Debentures / bond is a debt instrument indicating that a company has borrowed
certain sum of money and promises to repay if future under clearly defined terms.

Debenture holders are the long term creditors of the organization and are
eligible to get stipulated amount of interest and re-payment on the maturity.

Features:
a) Interest:- Debentures carries a fixed rate of interest, which is a contractual payment by
the company. Interest is allowed as deduction for tax purpose.
b) Maturity:- debentures have fixed maturity usually 7 – 10 years. They are redeemable
after the maturity period.
c) Redemption:- After the maturity debentures are redeemed. They may be redeemed at
par or at premium.
d) Sinking fund:- A sinking fund si created by the company for the purpose of
redemption of the bond. Every year a fixed sum is transferred to the fund and that
money will be used to redeem the debentures.
e) Buy back/ call provision:- Company may exercise call option, there by can redeem
the debentures before the maturity wherever buy back is done the company has to
redeem at a premium.
f) Trust:- When the debentures is issued by the company a trust is created. It includes
trustees drawn from company’s directors, investors, bankers etc. it is the duty of the
trust to protect the interest of the investors.
g) Security: Debentures are either secured or unsecured. If it is secured the debenture
holders can exercise lien on company’s assets.
h) Yield:- Debentures are listed in the stock exchange there will be a market value of
debentures. Yield on the debenture is related with its market value.
i) Claims on asset and income:- Before payment of dividend to shareholders interest
on debentures are paid same way. Before payment of capital to shareholders, capital
be paid to debenture holders, therefore debentures holders are having preferential
claim over shareholders.
j) Compulsory credit rating:- The company issuing debentures need to take
compulsory credit rating from approved agencies.
Types of debentures:
i) Non convertible debentures: There are the debentures, which will not converted in to
equity shares by the company.
ii) Fully convertible debentures:- These are the debentures which will be fully
converted into equity shares as per the terms of issue. The conversion will be made at
the end of stipulated period.
iii) Partly convertible debentures: Here only a part of debenture will be converted into
equity shares at the end of the period and remaining part will be redeemed by the
company.
iv) Innovative debt instruments
1) Zero interest debentures/bonds (ZIB):-
Zero interest bonds, do not carry any explicit interest. They are sold at discount,
the difference between face value and acquisition price is the return/ gain on the bond.
For eg:- Rs. 100 face value bond may be issued at Rs. 50 for period of 6 years. The
investor pays Rs. 50 on the bond at the time of issue and gets RS. 100 on maturity.

2) Deep discount bonds:

It is similar to ZIB. In case of deep discount bond, it carries a marginal rate of
interest and issued at discount and redeemed as par.
Example :- Rs. 100 face value bond issued at Rs. 70, 6 years and redeemed at Rs.
100 over 6 years period it carries a interest of 3 years.
Organization like IDBI, SIDBI have issued this type of debentures.
3) Secured premium notes:
It is a secured debenture which is redeemable at premium in different
installments. It carries no interest in lock-in period. TISCO has issued in 1992.
Example:- Rs. 100 face value instrument is issued at par, for 3 years there will be no
interest from 4th year onwards till the 8th year it will be redeemed at RS. 35 per annual.
4) Floating rate bonds:
Interest rate on these bonds are not fixed. Interest is linked to market rate of
interest. Interest is payable on the benchmark rates like bank rate, maximum interest
on term deposits etc.
Advantages of debentures:
a) Less costly : as compared to equity shares
b) Tax deduction :- Interest payable on debentures is allowed as deduction for tax
purpose.
c) No ownership dilution:- As the debenture holders does not carry any interest payment.
d) Fixed interest:- Interest rate does not increases with increase in profits of organizatin.
e) Reduced real obligation:- Although interest payable is fixed, with the change in inflation
rate, the real obligation the part of the company reduces.
Limitations of debentures:
i) Obligatory payment:- If the company fails to pay the interest on debentures the
investors can ask for the declaring company as bankrupt. Interest payment on
debenture is obligatory.
ii) Financial risk associated with debenture is higher than shares.
iii) Cash out flow on maturity is very high.
iv) The investors may put various restrictions/ covenants while investing in the
debentures.

PROJECT FINANCING THROUGH VENTURE CAPITAL

Venture capital plays a strategic role as a source of finance especially in case of small
scale, high technologies drivers and risky ventures. It is a very populars concept in advanced
countries and it is gaining its importance in developing countries also.
Venture capital is considered as synonym of high risk capital.
A business organization involving in new, innovative, and risky business/ project may
not be able to get its financial requirements fulfilled from any traditional sources. Therefore
they approach a specialized agency specially meant for financing such project. Such
agencies are called as venture capitalist or venture capital firm.
Venture capital is early stage financing of new and young enterprises seeking to grow
rapidly.
Features:

 Venture capitalist or venture capital firm is inclined to assume a high degree of risk for
earning high return.
 Venture Capital Firm (VCF) not only provides fund but also takes active part in
management.
 Financial burden of assisted firm is negligible in first few years.
 VCF normally plans to liquidate its investment in the assisted firm after 3 – 7 years.
 VCF normally invests in equity capital of assisted firm and tends to invest for long term.

Stages in venture capital financing

1) Early stage financing
a) Seed financing for supporting a concept/ idea.
b) R & D financing for product development
c) Start up capital for initial production and marketing
d) First stage financing for full scale production and financing.
2) Expansion financing
a) Second stage financing for working capital and initial expansion.
 b) Development finance for facilitating public issue.
3) Acquisition / buyout finance
a) Acquisition finance to acquire new firm for further growth.
b) Turnaround financing for turning around a sick unit.

Venture capital investment process

 Deal origination
 Screening of the project
 Detailed evaluation of projects:- It includes technical, marketing and financial
evaluation.
 Post investment activity :- It includes providing technical and management assistance
and controlling the project.
 Liquidating the investment or exit from the project.
Venture capital in India:
In Indian context venture capital gained importance in post liberalization era. Various
financial institutions like IDBI, IFCE, ICICI, SFC’s, SIDBI and most of the commercial banks
have set up their own fully owned subsidiary company to carry on venture capital business.

Limitations of venture capital in India:

 Inadequacy of equity capital financing by venture capitalists.

 Focus on low risk ventures by venture capital firms.
 Conservative approach followed by venture capital firms.
 Delay in project evaluation by venture capital firms.
Module 6
Project Review and Administration Aspect

CONTROL OF IN-PROGRESS PROJECTS

Though a lot of effort is expended in selecting capital projects, things often go wrong in the
implementation phase. This is evident from the frequent cost and time over-runs witnessed in
practice. Hence it is necessary to exercise strict control on in-progress capital projects. There
are two aspects of controlling in-progress capital projects.
Establishment of internal control procedures For every in-progress capital project, proper
control accounts are set-up. These are charged with all relevant expenditures, which are
further classified into capital and revenue items. These accounts reflect out-of-pocket
payments as well as allocated expenses. The project by project segregation of costs ensures
that proper attention can be directed to projects as they approach various milestones.
Use of regular progress reports periodic progress reports compare actual expenditures
against estimates. They offer several benefits: (a) they provide timely information so that
corrective action can be initiated to tackle potential problems. (b) they generate inputs for
cash budgeting and fund raising. (c) they serve as the basis for calculating variances and
explaining variances.

POST COMPLETION AUDITS

An audit of a project after it has been commissioned is referred to as a post-audit or a post-
completion audit. Most firms do a post-audit for projects above some threshold level.
Regular post-completion audits of capital projects: (1) provide a documented log of
experience that may be valuable in improving future decision making, (2) enable the firm in
identifying individuals with superior abilities in planning and forecasting, (3) help in
discovering systematic biases in judgement, (4) induce healthy caution among project
sponsors, and (5) serve as a usefull training ground for promising executives who need
broader business experience and exposure.
It is a common practice to use book ROI defined as
Net income
Book value of assets
For evaluating existing businesses and projects on a continuing basis. Though widely used,
the book ROI has two serious flaws:
• Even though a project may earn a constant economic rate of return, its book ROI
displays wide variation across time.

• There is an upward bias in the book ROI of a business which has substantial
investment in intangible assets.

ABANDONMENT ANALYSIS
Capital expenditure management is a dynamic process. A capital investment cannot be
regarded as a commitment till the end of the project life. As time rolls on, changes occur
which can alter the attractiveness of projects or even entire divisions. Hence capital
investments must be reappraised periodically to determine whether they should be continued
or terminated or divested.
The techniques used to analyze a new project can also be used to analyse whether an
existing project should be continued or terminated. However, there are some differences
between an existing project and a new project.
• Most of the investment in a new project is still to be made and hence is a relevant cash
outflow. By contrast, much of the investment in an existing project represents a sunk
cost, which is not relevant for project analysis.

• In the case of new project, the estimates of cash flows are likely to be more uncertain.
On the other hand, thanks to the experience that the firm has with an existing project,
the estimates of its future cash flows are likely to be more precise

• The discount rate to be used for reappraising an existing project is likely to be different
from that used to analyze the same project when it was initiated.

ADMINISTRATIVE ASPECTS OF CAPITAL BUDGETING

The discussion on administrative aspects of capital budgeting has been organiosed as
follows:
1. Identification of promising investment oppurtunities.

2. Classification of investments.

3. Submission of proposals.

4. Decision making

5. Preparation of capital budget and appropriation.

6. Implementation

7. Performance review

1 IDENTIFICATION OF PROMISING INVESTMENT OPPURTUNITIES

Often firms have an abundance of investment proposals but a dearth of really worthwhile
proposals. For identifying promising investment oppurtunities the following points should be
borne in mind:
1. Monitor changes in market demand, sources of supply, profitability, competition,
governmental policies, economic conditions, and technological developments.

2. Formulate long-range plans and perspectives based on analysis of oppurtunities and

threats in the environment and assessment of internal strengths, weaknesses,
capabilities, and limitations.
 3. Communicate long-range plans and corporate perspectives to all persons who are
likely to be involved in capital budgeting.

4. Encourage employees to make suggestions and reward them suitably for valuable
suggestions

In short, the relationship between the firm and its environment should be regularly analyzed,
corporate plans and perspectives must be widely shared, and the creativity and imagination of
the employees must be tapped.

2 Classification
The classification of capital expenditure proposals refers to the grouping of similar
proposals into separate categories. Classification helps in decision making, budgeting and
control.
Investment proposals may be classified in many ways. We suggest below a
scheme of classification which can, with minor modification, be adopted for most
manufacturing enterprises:
1. Replacement investment: These represents capital expenditures for the replacement of
existing fixed assets- this may become necessary because of the expiry of normal life
or because of a change in technology.
2. Modernization and rationalization investments: These comprise capital expenditures
for improving productivity, increasing efficiency, reducing costs, and ensuring greater
reliability.
3. Expansion investments: These represent capital expenditures for increasing capacity.
4. New product investments: These represent capital expenditures to manufacture new
products.
5. Research and development investments: These represent capital expenditures on
basic research and development.
6. Obligatory and welfare investments: These represent expenditures on facilities which
are obligatory and /or conducive to employee welfare

3 Submission of proposals;
To ensure that all relevant information for proposals is gathered systematically, a
standardised proposal from may be used by all the sponsors of investment projects. A
suggested proposal form is shown in exhibit 23.8
To help the sponsor of the project in filling and submitting the form:
1. A procedures manual setting forth in detail the firms capital budgeting policy and
techniques may be prepared and widely disseminated.
2. short duration training programmes may be organized.
3. the help of a staff person may be made available to the sponsor of the project.
The proposal form, before it reaches the capital budgeting committee, should normally be
routed through persons who can comment on the estimates furnished by the sponsor. The
routing channel, however, cannot be standardised. It will vary from one organization to
another and, perhaps, from one proposal to another.
4 Decision making
It may be argued that the optimal capital budgeting for the firm as a whole can drawn
up only when capital investment decisions are completely. This, however, is not desirable in
most cases because some decentralization is required to facilitate quick decisions, develop
executives, and conserve top management time for important matters.

5 Preparation of capital budget and appropriation

Smaller projects which can be approved at lower levels may be covered by a blanket
appropriation so that they can be undertaken expeditiously. Since these projects require small
outlays, no elaborate funds’ planning is required for them. Projects of larger magnitude (which
generally require the approval of the capital budget committee or managing director or the
board of directors) may be included after approval in the tentative capital budget. The final
capital budget, which serves as the basis of budgetary appropriations, should be drawn up
after the availability of funds is ensure. Often careful planning of funds is required before
budgetary appropriations are made.

6 Implementation;

Delay in implementation and the consequent increase in the project cost are very
common. Cases are not infrequent where the actual time for execution has exceeded planned
time by 50 percent. Cost over runs are also very common. In many cases over runs have
been between 30 percent and 100 percent. These facts emphasise the need for expeditious
implementation at a reasonable cost.

6 PERFORMANCE REVIEW

Performance review is meant for evaluating actual performance vis-à-vis projected

performance. It is concerned with the verification of assumptions regarding both revenues and
costs. In scope, it is broader than the popularly used accounting review which is concerned
only with costs.

AGENCY PROBLEM:
In theory, managers as agents of shareholders are supposed to take actions that
maximize the welfare of the shareholders (the principals). In practice, managers enjoy
substantial autonomy and have a natural inclination to purse their own goals. This is the
agency problem. To prevent from being dislodged from their position, managers may try to
achieve some acceptable level of performance as far as share holder welfare is concenered.
However, beyond that their personal goals may enquire priority. Inter alia, they seek to;
• Preside over a big empire that gives them power, stature, and higher compensation.
 • Pursue pet projects that draw on their special skills and competencies so that their
position in the organization is entrenched.
• Enjoy generous compensation and lavish perquisites.
• Shirk efforts because identifying and implementing high-NPV projects is a very
demanding proposition.
• Avoid risks because acceptance of eye firm- specific risks, although quite acceptable
to diversified share holders, can threaten the security of their job and the growth
prospects with the firm.
Agency costs can be mitigated by monitoring the actions and behavior of the managers and
by offering them right incentives that motivate them to maximize value.

EVALUATING THE CAPITAL BUDGETING SYSTEM OF AN ORGANISATION

The soundness of the capital budgeting system of an organization may be evaluated in terms
of the following criteria;

Result - Are the results of the capital budgeting system consistent with the goals of the
organization?
Techniques - Are efficient techniques being employed for purposes of capital expenditure
planning, decision making and control?
Communications - Are the premises underline capital budgeting communicated to those who
participate in this process?
Decentralization: Is there meaningful delegation and decentralization which permits
decision making at appropriate levels?
Intelligibility - Are the policies, methods of analysis, and procedures understood by
different segments of the organization which are involved in capital budgeting?
Flexibility - Does the system have sufficient flexibility to respond to the dynamic changes in
the environment and to permit variations in approaches for projects with differing
characteristics?
Control - Are adequate controls being exercised in the implementation phase to ensure
that slippages are mitigated?
Review - Is there a systematic review of capital investments which permit meaningful
feedback for improving the system and its effectiveness?