MODULE-IV

FINANCIAL ESTIMATION

Project Cost:

Project Cost Management (PCM) is a method that uses technology to measure cost and

productivity through the full life cycle of enterprise level projects. Beginning with estimating, a
vital tool in PCM, actual historical data is used to accurately plan all aspects of the project.

Project Cost Management (PCM) is a method that uses technology to measure cost and
productivity through the full life cycle of enterprise level projects.[citation needed]
PCM encompasses several specific functions of project management including estimating, job
controls, field data collection, scheduling, accounting and design. PCM main goal is to complete
a project within an approved budget[1]
Beginning with estimating, a vital tool in PCM, actual historical data is used to accurately plan
all aspects of the project. As the project continues, job control uses data from the estimate with
the information reported from the field to measure the cost and production in the project. From
project initiation to completion, project cost management has an objective to simplify and
cheapen the project experience. [2]
This technological approach has been a big challenger to the mainstream estimating software and
project management industries.[3] [4]

Project Cost Management is one of the ten Knowledge Areas outlined in the A Guide to the
Project Management Body of Knowledge (aka the PMBOK Guide). It is used during the
Planning and Monitoring & Controlling Process Groups.
There are 4 processes in this knowledge area including

1. Planning Cost Management

2. Estimating Costs
3. Determining Budget
4. Controlling Cost

Earned value management is a project management technique for measuring project performance
and progress. It has the ability to combine measurements of the project management triangle:
scope, time, and costs.

Types of Cost

Let’s start with defining the cost types. Generally speaking, there are four major types of costs:
 ● Preplanning costs. These are the costs incurred before the actual launch of the project.
They can include hiring new employees and staffing the project team, conducting market
research and other preparatory work. Consultancy and insurance fees also fall under this
type.
● Material costs. They include the costs of any materials required to build a product or
complete a project. For example, if you were to make a chair, you would need to buy
pieces of wood, nails or screws, glue, and paint. In the IT industry, material costs can
include buying third-party software, servers, storage space, and so on.
● Human resources. The largest portion of these expenses are payroll costs for all
employees working on the project. Any salary should be taken into account here,
regardless of the employee’s role, level, or tenure. Very often, salary calculations are
based on employee’s monthly performance, for example the number of hours worked.
● Operating costs. Any costs incurred to ensure the daily operations of a business are
operating costs. For example, the office rent, legal fees or office supplies.

Sources of Finance: Sources of finance for business are equity, debt, debentures, retained
earnings, term loans, working capital loans, letter of credit, euro issue, venture funding etc.
These sources of funds are used in different situations.
Cost of production: The costs related to making or acquiring goods and services that directly
generates revenue for a firm. It comprises of direct costs and indirect costs. Direct costs are those
that are traceable to the creation of a product and include costs for materials and labor whereas
indirect costs refer to those costs that cannot be traced to the product such as overhead.
Types of Costs of Production

Fixed Costs

Fixed costs are costs that don’t change with the quantity of output produced. That is, they have to
be paid even if there is no production output at all. For example, if you want to open a burger
restaurant, you will need to pay rent for your location. Let’s say USD 1,000 per month. This is a
fixed cost, because it does not matter if and how many burgers you sell, you will still have to pay
rent. Similarly you’ll have to pay your waitress’ salary, regardless of the quantity of burgers she
serves. If she earns USD 1,000 per month, your total fixed costs add up to USD 2,000 per month.

Variable Costs

Variable costs are costs that change with the quantity of output produced. That is, they usually
increase as output increases and vice versa. Unlike fixed costs, variable costs are not incurred if
there is no production. Therefore, they are usually reported per unit. For example, in the case of
your imaginary burger restaurant, the costs of meat, burger buns, lettuce, and BBQ sauce would
be considered variable costs. Let’s assume all ingredients add up to USD 5 per burger. If you sell
20 burgers and your only variable costs are the costs of the ingredients, your total variable costs
result in USD 100. By contrast, if you sell 200 burgers, your total variable costs add up to USD
1,000. If you don’t sell any burgers at all, your total variable costs are zero. Simply put, you
don’t have to buy buns if you are not going to serve any burgers.

Total Cost

Total cost describes the sum of total fixed costs and total variable costs. It includes all costs that
are incurred during the production process. Again, let’s say you managed to sell 200 burgers in
your first month. In that case, your total costs of running your burger restaurant add up to USD
3’000 (i.e. USD 2,000 fixed costs + USD 1,000 variable costs).

Average Cost

Average cost is defined as total cost divided by the quantity of output (i.e. the number of units
produced). This is an important factor when it comes to making production decisions, because it
tells us how much a typical unit of output costs. In addition to average total cost we can also
calculate average fixed cost (i.e. total fixed costs / number of units produced) and average
variable cost (i.e. total variable cost / number of units produced). In our example above, the
average total cost of producing a typical burger is USD 15 (USD 3,000 / 200 burgers).
Meanwhile, the average fixed cost is USD 10 per burger and average variable cost adds up to
USD 5 per burger.

Marginal Cost

Marginal cost is defined as the cost of producing one more unit of output. That is, it tells us by
how much total cost increases if an additional unit is produced. Marginal cost is an important
factor for decision making in the context of production processes, because it can be used to
calculate the optimal level of output (see also Profit Maximization). For example, let’s assume
that instead of 200 burgers, you sell 201 burgers. Now, total cost is USD 3,005, which equals an
increase of USD 5. Thus, the marginal cost of producing the 201st burger is USD 5 (USD 5 / 1
burger).

Financial analysis: The primary purpose of doing a financial analysis of a project is to evaluate
theproject's profitability or cost-effectiveness relative to some alternative project or investment.
Frequently, the results of the financial analysis are used to compare alternative projects to select
which ones should be implemented.
Characteristics of financial statement:
The following points highlight the nine characteristics of financial statements, i.e, 1. Depict True
Financial Position 2. Effective Presentation 3. Relevance 4. Attractive 5. Easiness 6.
Comparability 7. Analytical Representation 8. Brief 9. Promptness.

Ideal Financial Statement Characteristic # 1. Depict True Financial Position:

The information contained in the financial statements should be such that a true and correct idea
is taken about the financial position of the concern. No material information should be withheld
while preparing these statements.

Ideal Financial Statement Characteristic # 2. Effective Presentation:

The financial statements should be presented in a simple and lucid way so as to make them easily
understandable. A person who is not well versed with accounting terminology should also be
able to understand the statements without much difficulty. This characteristic will enhance the
utility of these statements.

Ideal Financial Statement Characteristic # 3. Relevance:

Financial statements should be relevant to the objectives of the enterprise. This will possible
when the person preparing these statements is able to properly utilize the accounting information.
The information which is not relevant to the statements should be avoided, otherwise it will be
difficult to make a distinction between relevant and irrelevant data.

Ideal Financial Statement Characteristic # 4. Attractive:

The financial statements should be prepared in such a way that important information is
underlined so that it attracts the eye of the reader.

Ideal Financial Statement Characteristic # 5. Easiness:

Financial statements should be easily prepared. The balances of different ledger accounts should
be easily taken to these statements. The calculation work should be minimum possible while
preparing these statements. The size of the statements should not be very large. The columns to
be used for giving the information should also be less. This will enable the saving of time in
preparing the statements.

Ideal Financial Statement Characteristic # 6. Comparability:

The results of financial analysis should be in a way that can be compared to the previous years
statements. The statement can also be compered with the figures of other concerns of the same
nature. Sometimes budgeted figures are given along with the present figures.

The comparable figures will make the statements more useful. The Indian Companies Act, 1956
has made it obligatory to give previous years figures in the balance sheet. The comparison of
figures will enable a proper assessment for the working of the concern.

Ideal Financial Statement # 7. Analytical Representation:

The information should be analyzed in such a way that similar data is presented at the same
place. A relationship can be established in similar type of information. This will be helpful in
analysis and interpretation of data.
Ideal Financial Statement # 8. Brief:
If possible, the financial statements should be presented in brief. The reader will be able to form
an idea about the figures. On the other hand, if figures are given in details then it will become
difficult to judge the working of the business.

Ideal Financial Statement # 9. Promptness:

The financial statements should be prepared and presented at the earliest possible. Immediately
at the close of the financial year, statements should be ready.

Qualitative characteristics of financial statements

There are mainly five types of financial statements; statement of financial position, income
statement, statement of changes in equity, statement of cash flows and disclosure notes. The
former four mainly show the relevant financial data to a business but the last one mostly includes
the non-financial data that assists the users of the statements to understand the numbers depicted
in financial data.

The main purpose of the financial statements is to educate the shareholders about the financial
status and financial performance of their company. This is because the shareholders are the real
owners of the company but the company is governed and administered by directors. As directors
act as stewards of shareholders, it is their duty to prepare financial statements that are free from
material misstatements as well as also posses some qualitative characteristics which are
important to enhance their quality and relevance. Following are the main qualitative
characteristics of financial statements:

Understandability:

The financial statements are published to address the shareholders of the company. So it is
important that these statements must be prepared in such a way that is easy  to understand and
interpret for the shareholders. The information provided in these statements must be clear and
legible. For the sake of understandability, the management must consider not only the statutory
data and information but also the voluntary information disclosures which would make financial
statements easier to understand. The directors must elaborate the information provided in the
statements where necessary.

Relevance:

The information provided in the financial statements must be relevant to the needs of its users.
Although the main statutory recipients of these statements are ‘shareholders’, but there are many
other stakeholders that rely on these statements during their decision making process e.g. Fund
Providing Institutions (Banks, Insurance Companies, Assets Funding Firms etc.), potential
investors (for making investments in prospective companies), suppliers (for the assessment of
credit rating) etc. So the information provided in these financial statements must be relevant to
the ‘information needs’ of all these stakeholders, which could affect their economic decisions.
Reliability:

The information provided in the financial statements must be reliable and true. The information
extracted to prepare these financial statements must be from reliable and trustworthy sources.
The financial statements must depict the true and fair picture of the status of the company affairs.
This means that the information provided must not have any significant errors or material
misstatements. The transactions shown must be based on the concepts of prudence and must
represent the true nature of company’s transactions and operations. The areas that are judgmental
and subjective in nature must be presented with due care and keen competence.

Comparability:

The financial statements must be prepared in such a way that they are comparable with prior year
financial statements. This characteristic of financial statements is very important to maintain, as
it makes sure that the performance of the company could be monitored and compared. This
characteristic is maintained by adopting accounting policies and standards that are applied are
consistent from period to period and between different jurisdictions. This enables the users of the
financial statements to identify and plot trends and patterns in the data provided, which makes
their decision making easier.

Timeliness:

All the information in the financial statements must be provided within a relevant span of time.
The disclosures must not be excessively late or delayed so that while making their economic
decisions the users of these statements posses all the relevant and up-to-date knowledge.
Although this characteristic may take more resources but still it is a vital characteristic as
delayed information makes any corrective reactions irrelevant.

Working capital:

Working capital (abbreviated WC) is a financial metric which represents operating

liquidity available to a business, organisation or other entity, including governmental entities.
Along with fixed assets such as plant and equipment, working capital is considered a part of
operating capital. Gross working capital is equal to current assets. Working capital is calculated
as current assets minus current liabilities.[1] If current assets are less than current liabilities, an
entity has a working capital deficiency, also called a working capital deficit.

Working capital is the difference between the current assets and the current liabilities.
The basic calculation of the working capital is done on the basis of the gross current assets of the
firm.

Current assets, such as cash and equivalents, inventory, accounts receivable and marketable
securities, are resources a company owns that can be used up or converted into cash within a
year.
Current liabilities are the amount of money a company owes such as accounts payable, short-
term loans and accrued expenses, which are due for payment within a year.

Project income statement:

Definition: An income projection statement is a formal document prepared by finance or

accounting officers within a company. Income projection statements look at the monies the
business will gain over a specific period, normally one year, minus anticipated expenses for that
period.

How to Calculate a Projected Income Statement

To create a projected income statement (also called a statement of projected earnings), use
historical information, customer research and market data to estimate future changes in sales
volume. Then, adjust each line item on the income statement to reflect the change and put the
data in an income statement format.

Determine Change in Sales Volume

Estimate how much you expect your sales volume to increase. To do this, you need to have a
solid understanding of your market, your sales channels and your customers. Consider
information such as:

● Historic trends in sales volume growth for your company.

● Your relationship with each major customer and how much you expect them to purchase
in the future.
● Your ability to convert new customers through marketing.
● The popularity of your products and services.
● Product seasonality that affects purchasing behavior.
Convert Change in Sales Volume to a Percentage Format
Calculate the percentage of increase or decrease you expect in sales volume. To do this, subtract
the last year's sales volume by projected sales volume, and divide by last year's sales volume. For
example, if you sold 2,000 units last year and expect to sell 2,500 units this year, you're
expecting a 25 percent increase in sales volume -- 500 divided by 2,000.
Project Sales Revenue
Multiply the amount of units you expect to sell by the price you expect to sell each unit for. For
example, if you plan to charge $50 per unit in the upcoming year, projected revenue is 2,500
multiplied by $50, or $125,000.
Project Expenses
To project expenses, you need to understand how costs behave. Separate your costs into variable,
mixed and fixed costs and analyze each separately.
Variable Expenses
Variable expenses are directly correlated with sales volume. That means, if your sales volume is
growing, these costs will grow at a proportional rate. Potential variable expenses include:

● Cost of goods sold, which is comprised of direct labor, direct materials and
manufacturing overhead.
● Sales commissions.
● Credit card processing fees.
● Freight and shipping.

To calculate projected variable expenses, multiply last year's expense for each line item by the
projected increase in sales volume. For example, if variable expenses were $3,000 last year,
projected variable costs would be 3,000 multiplied by 1.25, or $3,750
Mixed Expenses
Mixed expenses can vary and increase along with production but they don't necessarily increase
proportionally. At certain levels, they don't increase at all. Potential mixed costs include:

● Sales, customer service and operations salaries.

● Health insurance, workers' compensation and payroll taxes associated with increased
salaries
● Professional fees, such as those for legal and accounting services.
● Utilities like phone, internet, energy and trash.
● Transportation and parking expenses.

Use your knowledge of business operations to project each mixed expense. For example,
consider whether or not the increase in sales volume means you need to hire additional staff in
sales, customer service and operations. Think about whether or not the increased activity will
force you to upgrade your internet or phone plan, or if your accountant will bill you more now
that you have increased transactions.
Fixed Expenses
Fixed costs tend to stay the same even when production changes. Potential fixed costs include:

● Property taxes
● Rent
● Business fees and licenses
● Business insurance
● Salaries for non-operational staff, like the president, human resources, administration and
accounting.
● Office supplies
● Depreciation
● Interest expense

Expect these costs to stay the same from year to year, unless you have an inclination otherwise.
For example, if you know that your rent is going to increase or that you'll have to buy a new
office space, budget for these expenses. If you know you're going to buy new equipment,
increase depreciation expense accordingly.
Create the Projected Income Statement
Using last year's income statement as a template, input your projections for each revenue and
expense line item. Subtract total expenses from total revenues to arrive at projected net income
and have a helpful profit forecast for your company. Date the document for the upcoming year
and clearly label it Projected Income Statement so that no one who reads it confuses it with an
actual income statement.
projected profitability: Definition. An income projection statement is a formal document
prepared by finance or accounting officers within a company. Income projection statementslook
at the monies the business will gain over a specific period, normally one year, minus anticipated
expenses for that period.

Investment Evaluation Techniques: There is a large number of investment

evaluation techniques. They can be distuingished into two groups - statistical methods and
dynamic methods. Techniques and methods for evaluating investments are used for assessing
whether and how fast the invested funds.

Techniques and methods for evaluating investments are used for assessing whether and how fast
the invested funds return. Investing is always in some way about investing funds (directly or
indirectly) and the aim is either a financial income, interest or some ither positive effect, which
leads to the increased competitiveness, market position or to the future returns (investment into
educated people leads to the future success).
Evaluation is simpler for direct financial investment which leads into clearly measured outcome -
the profit. In practice however we have kind of investment where a direct financial result may
not be clear at first sight or in the short term. For example investments into educating people,
into quality or security improvement is difficult to assess.
For the financial evaluation there is a large number of investment evaluation techniques. They
can be distinguished into two groups - statistical methods and dynamic methods.
Static evaluation methods
They focus especially on monitoring of cash benefits or measuring of the initial expenditures.
They don’t include a risk factorand take the time into account only in a limited extent:

● Average Annual Return

● Average Payback Period
● Average Percentage Return
● Payback Period

Dynamic evaluation methods

They take into account the time and risk factor, the basis is discounting of input parameters.

● Net Present Value

● Internal Rate of Return
● Profitability Index
● Payback Period
● Accounting-Based Profitability Measures
Investment decision rule: Investment Decision Rules. Stand-Alone project: we decide whether to “accept” or “reject”
the investment opportunity. The value of accepting the project is given by its NPV and the value of rejecting the project is zero. When a
project is selected, the change in firm value is given by the project's NPV.

Investment Decision Rules:

Companies and investors will use these 3 common decision rules to decide if an investment is worth pursuing or not:

● Net Present Value (NPV)

● Internal Rate of Return (IRR)
● Payback Period

Today you will learn what each of the 3 is and how you can apply them to your investment decisions you make. I’ll be
demonstrating these rules in the context of real estate so that fellow investors can see how to use the 3 decision rules in
determining whether a property is a good investment. Companies in all industries use these 3 decision rules though as it
helps them to decide how much net income to retain and invest for growth vs pay out to shareholders in the form of a
dividend. Enjoy!

The NPV Decision Rule:

Present Value (PV) is the value of a cost or benefit that has been computed in terms of cash today. Similarly, Net Present
Value (NPV) considers the present value of benefits vs costs in order to determine if the investment is a gain, break even, or
loss.

● NPV = PV of Benefits – PV of Costs

If the NPV is positive, the benefits outweigh the costs and you should take on the investment

If the NPV is negative, the costs are more than the benefits and you should not do the investment

The positive NPV left over after subtracting out costs from benefits is the gain the company receives, which can be in the
form of cash, value, etc.

Costs are the cost of capital, meaning what your money could be earning in another investment if you were to decline the
current investment opportunity being presented to you.

Let’s consider the following example:

 Suppose you are offered the following investment opportunity: In exchange for $5,000 today, you will receive $5,500 in one
year. If the interest rate you could receive from another investment elsewhere, such as the bank, is 8% per year, then:

● PV of Benefit = ($5,500 in one year) / ($1.08 in one year / every $1 today)

● PV = $5,092.60

In other words you would need to invest $5,092.60 in the bank at 8% to receive $5,500 in one year, and since this
investment only costs you $5,000 to receive $5,500 in one year then it is the better deal and you should accept.

● The NPV = $5,092.60 – $5,000 = $92.60 = positive NPV

● The firm will increase its value an additional $92.60 over the next year from undertaking this investment instead of
taking the 8% return investment.

When making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to
receiving its NPV in cash today.

Payback period: Payback period (PP) is the number of years it takes for a company to recover
its original investment in a project, when net cash flow equals zero. In the calculationof
the payback period, the cash flows of the project must first be estimated. The payback
period is then a simple calculation.

Formula
The formula to calculate payback period of a project depends on whether the cash flow per
period from the project is even or uneven. In case they are even, the formula to calculate payback
period is:

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period
and then use the following formula for payback period:
B
Payback Period = A +
C
In the above formula,
A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A
Both of the above situations are applied in the following examples.
Decision Rule
Accept the project only if its payback period is LESS than the target payback period.
Examples
Example 1: Even Cash Flows
Company C is planning to undertake a project requiring initial investment of $105 million. The
project is expected to generate $25 million per year for 7 years. Calculate the payback period of
the project.
Solution
Payback Period = Initial Investment ÷ Annual Cash Flow = $105M ÷ $25M = 4.2 years