PROJECT FINANCE

DARSHANA RAJENDRA SHARMA

HPGD/OC17/1554
FINANCE

WELINGKAR INSTITUTE OF MANAGEMENT

DEVELOPMENT AND RESEARCH
YEAR OF SUBMISSION : AUGUST, 2019

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INTRODUCTION : The Indian Government is considering interlinking the various rivers
;Mahindra Motors is taking over an international motor company; Reliance Retail is planning to expand their
stores throughout the country; A steel plant wants to set-up new arc furnace; Meghna, a dentist is planning to
start her own clinic; Raj is planning to buy a motorbike; All these situations involve are Projects and involve a
Capital Expenditure Decision. Often, Capital Expenditure Decisions represent the most important decisions
taken by a firm. The consequences are Long-term, Irreversible and involve substantial outlays. Not only are
they extremely important but also pose difficulties due to measurement, uncertainty and have a temporal
spread. As a financial manager, the investment decisions that you will make today
will be critical to the future of your firm. A wise investment decision will
create wealth and make the owners or shareholders of the company richer
by exploiting an opportunity to increase the value of the firm. Alternatively,
a poor investment decision will decrease the value of your company and
destroy shareholder wealth. Throughout this subject, we shall assume that maximizing shareholder wealth is
the goal of the owners of the firm, the shareholders. We also
assume that managers, acting in the interest of the owners of the firm, use
shareholder wealth maximization as their ultimate decision criterion.However, in reality, there are many
conflicts of interest between the shareholders and the managers. Revenue expenditure if made on day-to-day
operations of the organization is for a relatively short period and has short-term impact.

Capital Expenditure :

Expenditure is incurred and benefits are available on recurring basis. Expenditure generally creates a Capital
Asset. Expenditure is charged to the P&L A/c in form of depreciation charges spread over the useful life period
of the assets. Expenditure is subject to completion report of the scheme or asset. Expenditure precedes
benefit/utility. Expenditure requires administrative approval from competent authority.

Revenue Expenditure :

Expenditure is made from one-time benefit/ utility. To avail benefit second time, the expenditure will have to
be incurred again. Expenditure is to use and maintain the assets so created. Expenditure is charged to the P&L
A/c in the same year in which it is incurred. Expenditure is subject to budgetary control only. Expenditure
follows benefit/utility. Expenditure requires only annual budgetary approval.

STEPS ON FORMULATING A PROJECT :

(a) Generation and Screening of Ideas :

Project idea can be conceived either from input or output side. The former are material based while the latter
demand oriented. Input based projects are identified on the basis of information
about agricultural raw materials,forest products, animal husbandry, fishing products, mineral resources, human
skills and new technical process evolved in the country or elsewhere. Output based projects are identified on
the basis of needs of population as revealed by family budget studies or industrial units as found by market
studies and statistics relating to imports and exports. Desk research surveying existing information in
economical and wherever necessary market surveys assessing demand for the output of project could help not
only in identification but in assessing viability of the project. Good ideas are the key to success for any project.
They can be generatedusing various methods such as:

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1. SWOT Analysis
2. Cost reduction
3. Productivity improvement
4. Increase in capacity utilization
5. Improvement in contribution margin
6. Expansion into promising fields

You can generate good ideas by following methodologies:

• Analyze the performance of existing industries

• Examine the inputs and outputs of various industries
• Review import and exports
• Study Plan Outlays and Governmental Guidelines
• Look at suggestions of Financial Institutions and Developmental
Agencies
• Investigate local materials and resources
• Analyze economic and social trends
• Study new technological developments
• Draw clues from consumption need
• Explore the possibility of reviving sick units
• Identify unfulfilled psychological needs
• Attend trade fairs
• Simulate creativity for generating new product ideas
• Hope that the chance factor will favor you
Preliminary Screening can be taken up looking at following aspects:
• Compatibility with the promoter
• Consistency with governmental priorities
• Availability of inputs
• Adequacy of market
• Reasonableness of cost
• Acceptability of risk level

The identification of project ideas is followed by a preliminary selection stage on the basis of their technical,
economic and financial soundness. The objective at this stage is to decide whether a project idea should be
studied in detail and to determine the scope of further studies. The findings at this stage are embodied in a
prefeasibility study or opportunity study.For purpose of screening and priority fixation, project ideas are
developed into prefeasibility studies. Prefeasibility studies give output of plant of economic size, raw material
requirement, sales realization, total cost of production, capital input/output ratio, labor requirement, power and
other infrastructure facilities. The project selection exercise should also ensure that it conforms to overall
economic policy of the government.

(b) Data Collection

Data collection is an important step towards formulation of the project. It forms the backbone on making a
good robust project. It has to be credible.Data is both primary and secondary.

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Primary Information

Primary Information represents the information that is collected for the first time to meet the specific purpose
on hand. Following are some of the various methods to obtain Secondary Information:

• Observation
• In-depth Techniques
• Experiments
• Market Survey

Data can be of various kinds – cost of raw materials, technical specifications of raw materials, buyers’ market
for finished products, price points to effectively enter the market, geographical areas, excise duties on raw
materials and finished products, transportation costs, competition
analysis, etc. Good amount of data is available through a number of sources – market
dealers, CMIE, the internet, Credit Agencies, Analysts, Trade Journals, etc. For specialized or exclusive
projects, Market Survey companies and
Technical Consultants can be contacted. Nothing can be worse than a skewed Project Report based on
inaccurate, unreal data. It can cause great repercussion on the fate of the Project.

Secondary Information

Secondary Information is the information that has to be gathered in some other context and is already
available. Following are some of the various methods to obtain Secondary Information:
• Census of India
• National Sample Survey Reports
• Plan Reports
• Statistical Abstract of India
• India Year Book
• Statistical Year Book
• Economic Survey
• Guidelines to Industries
• Annual Survey of Industries
• Stock Exchange Directory
• Trade Publications

(c) Documentation

All the data collected and assimilated has to be documented and presented in formats understandable to the
Project Team, and Top Decision Makers. It can be presented in various formats – Tables, Graphically – Pie
Charts,Bar Graphs, Line Graphs, etc.

(d) Project Appraisal

After ascertaining that a project idea is suitable for implementation, adetailed Project Appraisal is carried out
under the following heads:

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 1. Technical:

To assess whether that project is technically sound with respect to various parameters such as technology, plant
capacity, raw material availability, location, manpower availability, etc.

2. Economic:

To look into the economic benefits to the society and to the nation.

3. Market:

To understand the potential market for the products and at the marketing strategy. To review competence of the
marketing team.

4. Financial:

To assess the financial feasibility of project – cost of project, cost of capital, revenues, cash flows and return on
capital employed. Project Appraisal is the final document in the formulation of a project proposal. Project
Appraisal is prepared either by the financial institution or consultants or experts. The cost of project Appraisal
can be debited to project cost and can be counted as part of promoter’s contribution. The Project Appraisal
should contain all technical and economic data that are essential for the evaluation of the project. Before
dealing with any specific aspect, Project Appraisal should examine public policy w.r.t. the industry.After that,
it should specify output and alternative techniques of production in terms of process choice and ecology
friendliness, choice of raw material and choice of plant size. The Project Appraisal after listing and describing
alternative locations should specify a site after necessary investigation. The study should include a layout plan
along with a list of buildings, structures and yard facilities by size, type and cost. An essential
part of the feasibility study is the schedule of implementation and estimates of expenditure during construction.
Major and auxiliary equipment by type, size and cost along with specification of sources of supply for
equipment and process know-how has to be listed. The study has to identify supply sources and present
estimates, costs for transportation, services, water supply and power. The quality and dependence of raw
materials and their source of supply have to be investigated and presented in the feasibility study. Before
presentation of the financial data, market analysis has to be covered to help in establishing
and determining economic levels of output and plant size. Financial data should cover preliminary estimates of
sale revenue, capital costs and operating costs for different alternatives along with their profitability. Project
Appraisal should present estimates of working capital requirement to operate the unit at a viable level.
Additional information on financing, breakdown of cost of capital and cash flow is prepared.

(e) Conclusion

Once all the data is put on the paper, the Project Team and the Top management decision makers are to decide
the priority of the project visà- vis alternate proposals. They are prepared as to the profitability or revenue
decides whether the project has to be implemented or it is to be
shelved. The decision makers will decide based on various criteria on how the particular project will benefit
the organization. A particular project may be very sound financially may get shelved as it is less beneficial vis-
à-vis alternative project. Similarly, a project may not be financially viable but may be considered as it has
many indirect benefits such as improvement of
the quality or product or improved services to its customers.

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STEPS ON FINANCING THE PROJECT

a. Investment in the Project

Once a project is desired to be taken up for implementation, the project team along with the finance team will
work on the finance required for the above project. Heads such as Plant, Machinery, Equipment, Manpower,
Contingencies, Power Costs, Raw Materials, Working Capital requirements, etc.

b. Sources of Funds

Debt and Equity. A company can raise equity and debt capital from both public and private sources. Capital
raised from public sources is in the form of securities offered to public. These securities can be traded on
public secondary markets like Bombay Stock Exchange or National Stock Exchange, which are recognized
stock exchanges that facilitate trading of public securities. Promoters usually go for Projects that creates value
for the owners or shareholders of the firm. Maximum value for shareholders is created if project generates
maximum ROI and Cost of Source of Funds is kept as low as possible. If the Cost of Source of Funds is not
higher than ROI by at least 2% or the Net Present Value (NPV) of the project is negative, it is not worthwhile
doing the project. Private capital comes either in the form of loan given by banks, financial institutions,
NBFCs, Private Lenders in form of Term Loans, Working Capital, etc. Public capital comes either in the form
of issuing shares, preference, warrants, debentures, bonds to public, institutions, investors, PE companies, etc.

c. Cost of Each Source

The different sources of funds have varying costs. Debt and preference stock entail more or less fixed
payments, estimating cost of debt and preference is relatively easy. Preference capital carries a fixed rate of
dividend and is redeemable in nature. Cost of Equity is difficult to estimate. The difficulty stems from the fact
that equity shareholders have a residual claim on the earnings of the company. This means that they will
receive a return when all other claimants (lenders, preference shareholders) have been paid. Generally, equity
is costlier than debt as these investors expect higher rate of return compared to debt.

d. Weighted Average Cost of Capital Invested in the Project

A company’s cost of capital is the weighted average cost of various sources of finance used by it, viz., equity,
preference and debt.

Company cost of capital is the rate of return expected by existing capital providers. It reflects the business risk
of existing assets and the capital structure currently employed.

Project cost of capital is the rate of return expected by existing capital

providers for a new project or investment the company proposed to undertake. It depends on the business risk
and the debt capacity of the new project.

STEPS ON IMPLEMENTATION OF THE PROJECT

a. Engagement of Consultants

For all projects, Consultants are very much required. Consultants may be either in-house consultant or outside
consultant or foreign consultant. Sometimes, the projects are executed on turnkey contract basis or on EPC
contract basis. When the contractor is given full responsibility including the design, engineering, consultancy

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as well as monitoring and supervision of the project, in that case, there may not be requirement of a consultant.
But still, consultant may be required for the basic engineering and design supervision and approval.

b. Financial Closure

Before the contracts are finalized or even before approval of the Government is obtained for the projects
involving foreign direct investment (FDI), finalization of the financing of the projects has to be completed.
Financing of projects may be from external commercial borrowings, foreign
direct investment, financial institutions, and enquiry participation through joint venture or issue of shares to the
public. Completion of all these arrangements for financing modes of the project is called ‘Financial Closure’.

c. Contracts Finalization

Contracts may be Turnkey, Non-turnkey, Engineering Procurement Construction (EPC), Build Operate
Transfer (BOT), Build Own Operate Transfer (BOOT), Build Own Operate Lease (BOOL), Build Own
Operate Sale (BOOS), etc. Under this stage, mode of execution of project on the basis of any one of the above
mode of contract is decided.

d. Execution of Contracts/Project

After the contract/contracts have been finalized, the next stage for execution of the contract and the project
starts. This includes meetings with contractors, follow-up of the progress by the contractors, site activities, etc.

e. Monitoring and Control

Monitoring and control involves monitoring and control of physical progress, financial progress, quality
control, performance guarantee parameters, etc. so as to ensure the successful execution and completion of the
project.

f. Completion of Construction

This includes physical completion of project in all respects, so that the project may be finally commissioned
for commercial production.

g. Commissioning

After the project has been physically completed, i.e., the work on all activities such as civil engineering work,
structural fabrication, supply and installation of equipment have been completed, the next stage comes for the
commissioning of the project, so as to make the commercial utilization of the project. Commercial utilization
may be commercial production as
envisaged in the approved project.

h. Performance Guarantee Test

After the project has been commissioned and commercial production started, the next stage would be to do the
performance guarantee test as per the parameters envisaged in the contract.Handing over to Operation After the
performance guarantee tests have been conducted and plant and equipments have stabilized, the commissioned
plant is handed over to Operation Department. In some organizations, the handing over of the plant and

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equipment is done by executing the handing over and taking over act. Authorities from both the departments,
i.e., Project and Organization sign this Act. This is a statement signed jointly by the authorities of project and
operation department.

j. Closure of Contract

After the project has been completed, commissioned, performance guarantee test completed and handed over
to Operations, all the contracts are finalized and closed.

POST IMPLEMENTATION WORK

a. Completion Cost and Capitalization

The last but one activity in the project’s life cycle is to work out the completion cost and capitalize the cost of
completed project in the books of accounts.

b. Post Project Evaluation and Report

The last stage in the project life cycle is the post project evaluation and post completion audit report. In this
stage, after the completion of the project, the actual results, completion cost, profitability, etc. are compared
with the provisions made in the approved project. The variations are scrutinized for the adverse results for
correction in the future projects.

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 PROJECT APPRAISALS

Introduction to Project Appraisals

Project appraisal is the structured process of assessing the viability of a project or proposal. It involves
calculating the feasibility of a project before resources are committed. It is an essential tool for effective action
in starting a project. Project Appraisal is also a tool used to review the
projects completed by the organization.

When a project is at the conceptualization stage, the owners and managers have a rough idea of what they are
going to produce, what price they might sell it, and how many units will be sold. Many a times, project
conceptualization takes place on the basis of an idea or market gap
perceived by the Top Management or Project Manager.

Project Appraisal may be carried out by the various stakeholders or

interested parties such as:

• Owner of the project

• Banks, that do the financing
• Financial institutions, that do the financing
• Government appraising agencies.

The Project Appraisal gives a clear and unbiased view from an outsider’s point of view. It is a means which
can give a better picture of partnerships can choose the best projects to help them achieve what they want for
the organization. It is defined as taking a second look critically and carefully at a project by a person who is in
no way involved or connected with its preparation. He is able to take independent, dispassionate and objective
view of the project in totality, along with its various components

Any project’s success or failure depends on the pre-planning work carried out by the project’s team and the
promoters. A project’s success or failure depends 80% on thorough planning and appraisals and 20% on
execution and other parameters. The earlier the project appraisal starts the better it is for the organization. The
company is in a better position to decide how much capital to deploy for the project to decide to scrap an
unviable project.

Various types of examinations forming part of the Project Appraisal are:

1. Technical Appraisal
2. Economic Appraisal
3. Market Appraisal
4. Financial Appraisal

Project appraisal is a requirement before funding of project is done. But tackling problems is about more than
getting the systems right on paper. Experience in projects emphasizes the importance of developing an
‘appraisal culture’ which involves developing the right system for local circumstances and ensuring that
everyone involved recognizes the value of project appraisal and has the knowledge and skills necessary to play
their part in it.

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Project appraisal helps project managers to:

• Be consistent and objective in choosing projects

• Make sure their program benefits the organization
• Provide documentation to meet financial and audit requirements and to

explain decisions to all the stakeholders and auditors.

The terms evaluation, appraisal and assessment are used interchangeably .They are used in analyzing the
soundness of an investment project. The analysis is based on projections in terms of cash flows. The analysis is
carried out by the entrepreneurs or promoters of the project, the merchant banker who, is going to be involved
in the management and underwriting of public issue and public financial institutions who may lend money.
Project evaluation is indispensable because resources are limited and alternative opportunities in terms of
projects exist for commitment of resources. A Project should only be selected if it is superior to others in terms
of profitability (net financial benefits accruing to owners of project) or on national profitability (net overall
importance of the project) to the nation as a whole. The purpose of the project appraisal is to ensure that the
project is technically sound, provides reasonable financial return and
conforms to the overall economic policy of the country. In view of the importance of the competitive status of
unit, performance measures have to be applied to assess the ability of a unit to meet competition in the modern
business environment.

Importance for Appraisals

Appraisals are very important before dedicating resources towards a project. Some of the important reasons for
appraising a project are:

1. Appraisal justifies spending money on a project

Appraisal asks fundamental questions about whether funding is required and whether a project will create
value for the organization. It can give confidence that the money is being put to good use, and help identify
other funding to support a project. Getting it right may help an organization garner further resources to meet
the project objectives.

2. Appraisal is an important decision making tool

Appraisal involves the comprehensive analysis of a wide range of data, judgments and assumptions, all of
which need adequate evidence. This helps ensure that projects selected for funding:

• Will help the organisation achieve its objectives

• Are deliverable
• Are sustainable
• Have sensible ways of managing risk.

3. Appraisal lays the foundations for delivery

Appraisal helps ensure that projects will be properly managed, by ensuring appropriate financial and
monitoring systems are in place, that there are contingency plans to deal with risks and setting milestones
against which progress can be judged.

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4. Getting the system right

The process of project development, appraisal and delivery is complex and should be suitable to the
organization. Good appraisal systems should ensure that:

• Project application, appraisal and approval functions are separate

• All the necessary information is gathered for appraisal, often as part of

project development in which projects will need support.

Aspects of Project Appraisals

Brief write-up on various types of appraisals namely:

1. Technical Appraisal

Technical Appraisal is the technical review to ascertain that the project is technically sound in all respects with
respect to various parameters such as technology, plant capacity, raw material availability, location, manpower
availability, etc. The technical review is done by qualified and experienced personnel available in institutions
and/or outside experts (particularly
where large and technologically sophisticated projects are involved).

2. Economic Appraisal

Economic appraisal is the economic review carried out by financial institutions that looks into the economic
benefits to the society and to the nation. They also look at various parameters such as resource cost and
effective rate of protection.
Admittedly, the economic appraisal done by financial institutions is not very
rigorous and sophisticated. Also, the emphasis placed on this appraisal is
rather limited.

3. Market Appraisal

Market Appraisal is carried out to understand the potential market for the products and at the marketing
strategy. A review of the market survey and competence of the marketing team. Also, whether the unit can sell
its products at the desired/estimated price points.

Financial appraisal is concerned with assessing the financial feasibility of a `new capital investment proposal
or expansion of existing productive facilities. This involves an assessment of funds required to implement the
project and the sources of the same. The other aspect of financial appraisal relates to estimation of operating
costs and revenues, prospective liquidity
and financial returns in the operating phase.

A 3D visual of the proposed project provide a vision to the project team.

Supporting Documents required by Financial Institution

to Appraise a Project

1. Completed Input Form in their format

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2. Company Profile, Promoters Profile
3. Past audited accounts for three years of the company and associated entities
4. Copies of J.V./Technical Collaboration, if any
5. Organization Chart
6. Profile of Key Staff Members
7. List of machineries procured/to be procured
8. Contracts/Arrangement to procure various raw materials
9. Market Survey Report from reputed Consultants/Surveyors
10.Marketing material prepared, catalogues
11.Financial Projections, Cash flows, Fund flows, Break-even Point Analysis
12.Licenses, Clearances for the project
13.Title deeds of land, Approvals to start construction
14.In-principle arrangement for Working Capital Facility from Banks, etc.

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 Technical Appraisal

Technical Appraisal is the technical review carried out by financial institutions to ascertain that the project is
technically sound with respect to various parameters such as technology, plant capacity, raw material
availability, location, manpower availability, etc. Is the project in a position to deliver marketable products
from the resources deployed? Is the Return on Investment sufficient to service the cost of loan/equity and leave
a reasonable amount for the enterprise to carry out sustainable operations?

Technical appraisal is important as:

1. It ensures that the project is technically feasible – all the inputs required to set up the project are available.

2. It facilitates the optimal project formulations in terms of capacity, technology, location, technology, size,
etc. Usually, technical appraisal is carried out by independent agencies carrying
out technical studies or by the institution by their in-house technical experts. The financial analyst participating
in the project appraisal exercise should be able to raise basic issues relating to technical analysis using common
sense and economic logic.

Evaluation of industrial projects is undertaken to compare and evaluate alternative variants of technology of
raw materials to be used, of production capacity, of location and of local production versus import.

A Petrochemical Plant is a highly technical and complex project

A Marina bay though looks simple is very technically challenging project

Aspects of Technical Appraisal

The technical review done by the financial institutions focuses mainly on

the following aspects:

• Manufacturing Process/Technology
• Technical Arrangements
• Material Inputs and Utilities
• Product Mix
• Plant Capacity
• Location and Site
• Machineries and Equipments
• Structures and Civil Works
• Environmental Aspects

Manufacturing Process/Technology

For a manufacturing product/service, often two or more alternative technologies are available. For example,

• Cement can be made either by dry process or the wet process.

• Vinyl chloride can be manufactured by using one of the following reactions: acetylene on hydrochloric acid
or ethylene on chlorine.
• Steel can be made either from Bessemer process or open hearth process.

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• Soda can be made by the electrolysis method or the chemical method.
• Paper, using bagasse as the raw material can be manufactured by the Kraft process or the soda process or the
Simon Cusi process.
• Soap can be manufactured by semi-bottled process or fully boiled process.

1. Production of Molten Steel

2. Production of iron and rough steel products
3. Production of Cement by the Dry Process
4. Production of Vinyl Chloride

Choice of Technology

The choice of technology is influenced by a variety of considerations such as:

• Availability of raw materials/inputs: Raw materials should be easily available for unhampered production
cycle. Sometimes, quality of some raw materials affects the process/technology used. For example, the quality
of limestone determines dry or wet process should be used for a
cement plant.

• Availability of manpower and transport: The plant should not be located where skilled labor for that industry
is not available. For example, a footwear company that required skilled stitching labor would not be advisable
to be set up where the laborers would be hesitant to travel/
stay.

• Plant Capacity: To meet a certain plant capacity requirement, only a certain production technology may be
viable.

• Investment outlay and production cost: The cost of technology/process should not be so high that the unit
itself is uncompetitive and cannot sustain over a period of time.

• Use by other Units: The technology adopted should be proven

successful by other units, preferably in India.

• Product mix: Usually, a number of products/variants/models are manufactured using the same process.
Therefore, the technology/process used must be able to produce all the products in the product mix.
• Latest developments: Technology adopted should be based on latest developments so that technological
obsolescence in near future is avoided.

• Ease of absorption: An advanced technology may be available but may have to be shelved due to inadequate
trained manpower to handle that
technology.

Technical Arrangements

It is important for a unit to have a good technical collaborator or a good consultant to guide it in relation to the
manufacturing process. Major technical inputs include:

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a. Selection of the process or technology. Design, purchase, procurement and installation of the plant and
training of the manpower.

b. Process and performance guarantees in terms of plant capacity, product quality and consumption of raw
materials and utilities.

c. Periodic Royalty fees or one-time licensing fees.

d. Period of collaboration agreement.

Material Inputs and Utilities

An important aspect of technical analysis is concerned with defining the materials and utilities required.
Material Inputs and Utilities may be classified into four broad categories:

a. raw materials
b. processed industrial material and components
c. auxiliary materials and factory supplies
d. utilities.

Product Mix

A company offering a wider choice to its consumers can cater to a wider segment of customers or offer better
consumer satisfaction. While planning production facilities for a firm, flexibility with respect to product mix
enables company to alter its product mix to survive in changing market conditions. For example, a garment
manufacturer can offer wide range in terms of size and quality to different consumers. Biscuit and Fast food
snack manufacturers can have smaller pouches at low cost for one-time users and larger economical sizes for
monthly family consumption.

Plant Capacity

Plant Capacity refers to the number of units or volume that can be produced during a given period. In
traditional manufacturing system, capacity is defined as the maximum output available. However, operating
conditions like power or raw material or labor shortages can influence capacity. Sometimes, seasonal
availability of raw materials (such as sugarcane for sugar plants) can hamper plant capacity.

It is indeed difficult to assess capacity.

For instance, paper plant capacity varies with grammage. In a textile mill, capacity varies with the composition
of yarn of different counts. The daily production in a sugar mill depends on sugar content of the cane; and
annual production on the length of the crushing season. The extent and degree of integration and facilities for
by-product recovery also affect size of project investment and profitability. An integrated textile mill with
cotton as a starting material would require larger investment and is more profitable than an unintegrated mill of
the same capacity producing fabric grey cloth.

Sometimes additional investment would improve the profitability enormously. In a caustic soda plant, recovery
of chlorine and hydrogen no doubt require additional investment but improve profitability as compared
to a plant producing just caustic soda.

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Location and Site

Location refers to a fairly broader area such as city or town or industrial zone where the plant is likely to be set
up. Site refers to the actual piece of plot where the plant is going to be set up. Usually, location is selected such
that it is close to supply of raw materials and/or to the markets where the final products shall be consumed.
Further, availability of infrastructure such as roads, power and water availability are critical. By power, we
broadly mean power supply that is cost-effective, uninterrupted and stable. Transportation of raw materials to
the plant and finished goods to the markets is also possible in cost-effective and available easily.
Polluting units should be set up away from residential areas, in approved industrial zones and where
permission from Pollution Control Board is easily available. Usually, polluting units are set up where the
Effluent Treatment Plants (ETPs) are already available to neutralize the output waste.

Machineries and Equipments

The machinery and equipments for a particular project are dependent on the production technology and plant
capacity. In selecting the machineries and equipments, the various stages should be matched well. If technical
expertise is insufficient, external consultants must be employed to ensure
smooth flow of production over long periods of time.

Structures and Civil Works

Structures and civil works comprise of:

a. site preparation and development

b. buildings and structures
c. outdoor works.

Structures and civil works are the domain of the technical team, equipment suppliers, architects, structural
consultants and the administration team. Various technical design parameters are taken into consideration such
as load requirements for machinery foundation, height of machinery/ceiling, ventilation, heat generated in the
production areas, cleanrooms, administrative staff requirements, loading/unloading areas, secure zones,
handling of effluents and wastages, etc.

Environmental Aspects

A project may cause environmental pollution in the form of emissions, effluent discharge, noise, heat and
vibrations. Environmental aspects of the project have to be properly examined. Polluting units should be set up
away from residential areas, in approved industrial zones and where permission from Pollution Control Board
is easily available. Usually, polluting units are set up where the Effluent Treatment Plants (ETPs) are already
available to neutralize the output waste.
In technical appraisal, inputs are scrutinized for availability and quality dependability. If there are seasonal
variations, especially, in the case of agricultural inputs, variations in price have to be checked. Similarly, power
quality has to be checked in terms of variation in supply voltage and in-line current frequency and duration of
blackouts. Finally, the quality and availability of water which shows seasonal trends especially in case of a
project requiring water as an input should be checked.

Flexibility of Plant and Flexible Manufacturing Systems

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The consumer demands are at an all-time high – choice of colors, taste, packaging, sizes and at the desired
prices. At the same time, the production being sustainable for the organization. Today is the age of mass
customization. Flexibility is desired at the production level so that more customization is
possible to suit the wide variety of users. Flexible manufacturing system is the emerging system to
manufacture what the customer wants. These systems help in production of a large variety of products in small
batch
sizes. The days of assembly line manufacturing emphasizing economies of scale are over. Even otherwise
flexibility imparts strength to the project to withstand market fluctuations and variations in the quality of
inputs.

Interdependence of the Parameters of Project

Undependable supply of basic inputs could result in closure of the project or bankruptcy of the organization. If
coal, the main ingredient for a power plant is not available in sufficient quantity, it can throw all project
calculations in disarray. It will affect not just the organization but also millions of consumers, production
facilities and the national economy. If iron ore is not available for a steel unit, it can disturb steel production
while will have a cascading effect on important infrastructure projects. It is better to have as much
interdependence of parameters so that shortfall in one can have disorder in the entire project. For example, a
small integrated paper plant using bagasse, paddy husk or straw without need to recover process chemicals is
considered more viable than large integrated paper mill requiring forest based raw material, water and
effluent disposal system.

Project Charts and Layouts

Project charts and layouts are the tools to define the scope of the project and provide the basis for detailed
project engineering. These are general functional layout, material flow diagram, production line diagram,
utility layout and plan layout. The various different kinds of technical drawings are:

1. General functional layout should facilitate smooth and economical movements of raw materials, work-in-
progress and finished goods.

2. Material flow diagram presents flow of materials, utilities, intermediate products, final products scrap and
emissions.

3. Production line diagram establishes the progress of production from one machine to another with
description, location, space required, need for power and utilities and distance from the next section.

4. Utility layouts show the principal consumption points of power, water

and compressed air which helps in the installation of utility supply.

5. Plant layout identifies the exact location of each piece of equipment determined by proper utilization of
space leaving scope for expansion, smooth flow of goods to minimize production cost and safety of workers.

Cost of Production

Estimates of production costs and projection of profitability is the concluding part of the technical appraisal.
Cost of production is worked out taking into account the build-up of capacity utilization, consumption norms
for various inputs and yields and recovery of by-products. In estimating production, a general build-up starting
with 40% and reaching a normal level of 80% in three to four years time is provided. In practice, capacity

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utilization may fall short of estimated levels on account of defective plant and machinery, inadequate operating
skills, inadequacy of raw materials, shortage of power and lack of demand. The cost of production and
profitability estimates take into account the level of production in different years and product-mix (which are
dependent on market potential, prices, marketing strategy, technical constraints relating to process and plant
facilities, and operators’ efficiency), norms of raw material consumption (including provision for wastage),
power and fuel requirement, their costs, salaries and wages, repairs and maintenance, administrative overheads,

selling expenses (including product promotion) and interest on borrowings. Adequate provision is made for
higher expenses in the initial years for, technical troubles, higher wastages and lower yields, lower operating
efficiency and higher selling costs. Here, too, comparison with similar projects is useful. The profitability
estimates should be on a, realistic selling price. In a competitive market, penetration price for a new producer
will have to be lower than the current price of an established manufacturer.

Assessing Competitive Status of a Project/Unit

Just delve over the technological developments over the past few years; Do we use the VCR nowadays, Audio
Players, CD Players, Fax machines,

Telex, Wire Connected Landline phones? Globalization of world economies and availability of new
technologies expose any product or project to the severe global competition. It is necessary to ensure that the
project/unit is strong and can face competition. The competitive status of a manufacturing unit is evaluated by
eight performance measures some of which form part of technical appraisal.

• Manufacturing Lead Time (MLT)

• Work-in-process (WIP)
• Throughput
• Capacity
• Flexibility
• Performability
• Quality

1. MLT:

The manufacturing lead time (MLT) is the total time required to process the product through the manufacturing
plant. MLT should ideally be equal to actual machining and assembly time. The ratio of MLT to the sum of
processing time is a good indicator of the time a part is unnecessarily lying on the factory floor. Real value is
added to a product during a product’s passage through the production system. Other times such as move time,
queue time and setup time should be reduced.

2. WIP:

Work-in-process (WIP) is the quantity of semi-finished product currently lying on the factory floor. WIP
constitutes an investment and many companies incur large WIP costs. Recent trend is to consider
inventory as avoidable since required items only are produced. WIP can be measured by multiplying the rate at
which parts flow through the factory with the length of time parts spend in the factory which is MLT. The
number of parts currently being processed should be equal to the number of busy machines which in turn
equals the total number of machines multiplied by the utilization factor. Ideally, there should be as many parts
waiting as are being processed. WIP should be low.

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3. Machine utilization: Machine utilization should not be decided with a view to amortize the cost of
machinery faster by higher utilization. Such a view turns a machine asset into an inventory asset. Idle inventory
may be perishable or may not be in demand resulting in tying up cash in raw materials. If the choice is between
idle machinery and building up inventory, let the machine be idle. Machine should be run to
manufacture exactly the right quality of exactly right things at exactly the right time.

3. Throughput:

Throughput is the hourly or daily production rate which is the reciprocal of production time per unit of the
product.

4. Capacity:

Capacity is defined in terms of possible output the plant is able to produce over some specified duration. In the
case of continuous plant, the duration is 24 hours a day, 7 days a week whereas in others it
is defined over a shift period. Capacity is measured as tons in the case of a steel mill, seat miles in the case of
airlines, rooms in the case of hotels and total available beds in the case of hospital. Available machine
hours are used to measure capacity when output is non-homogenous or the plant produces a variety of
products.

5. Flexibility:

Flexibility is the ability of the system to respond effectively to change. High degree of flexibility requires
higher levels of automation and large investment. Flexibility is fundamental to achieve
competitiveness. Further it provides a strategic advantage to handle risk associated with uncertain markets.
Transfer lines which produce identical parts do not have flexibility and cannot tolerate design
modifications or part mix changes or machine failure. On the other hand, job shops are highly flexible and are
used for manufacture of one of- a-kind products. Their trait is large MLT and high WIP.

6. Performability:

Performability is influenced by the unscheduled downtime of the equipment. In a manufacturing system, the
two constituents are the workpiece and the manufacturing in equipment.
Workpiece can cause faults resulting in line stops; and equipment can fail because of wearing down.
Production is then a function of repair time due to failures and fault. Reliability and availability measure the
percentage of down time and repair time. Reliability of a manufacturing system is defined as the probability
that it will perform well enough to produce quality products. Availability is the instantaneous availability of
a system at an operational time.

7. Quality:

Maintenance of high quality depends on the integrity of the materials and integrity of manufacturing process.
Together, they help the supply of products that are made right the first time. Quality is an
important constituent in attaining competitiveness. Total Quality Control (TQC) involves control of quality at
source. Errors should be corrected at the source where work is performed. This is defect prevention where
workers and supervisors have the primary responsibility for quality and any problems with process are
corrected immediately. Quality control at source provides fast feedback on defects. This is unlike the sampling
method employed after the lot has already been produced. The benefits of total quality control are fewer
rework labor hours and less material. Good quality increases productivity. The basic requirements of

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total quality control are process control, easy to see quality, insistence on compliance and 100% inspection.

Methods to Improve Quality and Productivity

India ranks at a dismal low vis-à-vis Global benchmarks in terms of launch of innovative products,
productivity and safety records. There is an urgent need to improve the quality and productivity to strengthen
the competitiveness of Indian industry. Among the methods used to Myron productivity and strengthen
competitiveness are expert systems and enterprise resource planning (ERP) which spread the use of lean
techniques and lean thinking. The adoption of these methods has to be insisted upon while making appraisal
to help improve the competitiveness of the unit.

1. Expert Systems (ES):

Expert Systems (ES) are being used in manufacturing environments to improve productivity and flexibility.
They are used along with capacity planning to ensure that parts are manufactured to meet due dates and
optimize use of production equipment. When used in conjunction with conventional methods, ES can handle
unforeseen circumstances allowing for easy extension and modifications to revised schedules. They are also
used for simulation of the scheduling system and to assist with machine learning of scheduling procedures.

An ES is a computer program that performs a task normally done by an expert and which in doing so, uses
captured, heuristic knowledge. It can make the best expertise available to a decision maker at the very moment
the decision must be made. Its primary function has been in diagnostics, decision making, system debugging
and problem solving. Of late, its use in the field of manufacturing has grown considerably, and now many
systems are being used in the areas of production scheduling, process planning, quality control and inventory
management. Expert system has two components, knowledge base and an inference engine. Inference engines
are of two types, backward chaining which is goal driven and forward chaining which is data driven. They can
be used to search knowledge and find a suitable solution to the problem one has. For metal industry,
researchers in the US have developed an ES to produce rolling mill schedules (procedures) that yield specified
values for metallurgical properties such as grain size and internal stress. The results were used to help
consolidate and downsize the overall operations. Expert systems are a way to convert corporate knowledge into
corporate assets. An ES enables the distribution of knowledge of experts present in one place and to
accumulate in one place; the knowledge of several widely separated experts. Usually, ES is faster and more
accurate as it uses the same logic normally used by the expert. Resort to ES is attributable to the need to cut the
lead time required to carry a product from conception to a finished state. To remain competitive in the global
context, manufacturing has to do better and more, using fewer resources. Lean manufacturing uses less of each
input: less labor, less machinery, less space, and less time in designing products. In lean production, each act in
the factory, as it were done on demand.

2. Enterprise Resource Planning (ERP):

Lean techniques apply the idea of lean production thinking to the whole company. The supply chain connects
the factory to its suppliers upstream and its customers downstream. Various parts of the company need to share
the flow of the same information. The new software program let the companies integrate their financial data
with payrolls, manufacturing and inventory records and purchasing. Enterprise Resource Planning (ERP) is the
toolkit that spreads lean thinking throughout the company. A company using ERP can know, how efficiently
its various resources, people, money, machines are being used to satisfy its customers. The integration of all
aspects of company data into the same software helps to keep manufacturing operations in balance and to keep

20
work flowing smoothly through the factory. Bottlenecks and imbalances show up quickly and can be set right.
Enterprise Resource Planning

Review of the Project

Finally, the technical appraisal of the individual project may be supplemented by a supplementary review of
the project in terms of interdependence of the basic parameters of the project which are plant size, location and
technology. The implementation of the project has Cost and Time overrun implications .The scheduling of
construction, delivery and installation of machinery and other potential causes of delay form an important part
of the technical aspects of the project appraisal .The schedule of construction depends mainly on the speed of
civil construction works, delivery period of equipment, as well as the efficiency of the management to tie up
various ends in a coordinated and speedy manner. Since an overrun in the pre-commissioning time invariably
leads to overrun in cost and consequential problems, it is important that the timing of construction is
realistically planned. For all main physical elements of the projects, from project concept, obtaining
Government approvals, tying up financial arrangements, engineering design, land acquisition, building
construction, procurement of equipment, its erection and testing to final commissioning, there must be realistic
time schedules and a coherent arrangement, which leads to the completion of the project on most economical
basis. Use of scheduling techniques like Gantt Charts, PERT, CPM and GERT and proper adherence to them is
an essential aspect to be insisted upon in technical appraisal.

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 MARKET APPRAISAL

Introduction

Market Appraisal is the review carried out by financial institutions to ascertain that the products manufactured
by the project can be sold and its value realized. It ascertains whether the company has competent sales force
and distribution network to sell the products manufactured. It is also necessary to establish how the project is
going to capture its share of the feasible market. Whether the unit can sell its products at the desired price
points?

It ascertains the size of the potential market and whether the organization has a suitable marketing strategy.
Is the project in a position to deliver marketable products from the resources deployed? Is the Return on
Investment sufficient to service the cost of loan/equity and leave a reasonable amount for the enterprise to
carry out sustainable operations?

Importance of Market Appraisal

Market appraisal is important as:

1. It ensures that the project has the competent sales force and distribution network to sell the products
manufactured.
2. It can sell the products at the price points such that it can service the interest on loans taken. Even after
servicing the loan, there is sufficient surplus for the unit to carry out sustainable operations.
3. It ensures that there is a potential market which can be met by the production capacity of the unit.
4. There is a well thought-out sales and marketing strategy favorable for long-term operations.

Sales and Marketing – Birth of a Project

While launching a new product/model, a promoter or CEO or Project In charge will delve on the following
questions: How many units can be sold in first year, its expected selling price, its cost?

Also, sales in further few years down the line. Then he will estimate the costs and profits generated.

Next he will ask what are the indirect costs such as the Cost of Capital, interest costs, sales costs, salaries, etc.
associated with the project. The other costs will have to be lower than the profit generated per year. Else,
he will have to go to scratch and work out the numbers again. Usually, corporations go about on a new project
in a systematic and well defined manner. There is a detailed study on the market, demand for the
product, technical aspects of the project, financial estimates, ways to raise the funds, etc.

Aspects of Market Appraisal

The Market Appraisal done by the financial institutions focuses mainly on

the following aspects:

• Demand Analysis
• Market Analysis

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The first step in project analysis is to estimate the potential size of the market for the product proposed to be
manufactured (or service planned to be offered) and get an idea about the market share that is likely to be
captured. Two broad issues are covered by Market and Demand Analysis:

• What is likely aggregate demand for the product/service?

• What share of the market will the proposed project enjoy?

These are very important, yet difficult questions in project analysis. Intelligent and meaningful answers to them
call for an in-depth study and assessment of various factors like patterns of consumption growth, income and
price elasticity of demand, composition of market, nature of competition, availability of substitutes, reach of
distribution channels, so on and so forth. It is not only essential to estimate the demand for the product but also
define the target customer to position the business in order to garner the unit’s share of sales. Further, it is
necessary to establish how the unit is going to capture its share of the feasible market.
Suppose a company wants to launch a new brand of high quality kitchenware in the domestic market.
Important questions that should be asked to get a correct Market and Demand Analysis will be:

• Who are the buyers of the kitchenware?

• What is the total current demand for this new kitchenware?
• How is the demand distributed temporarily (pattern of sales over the year geographically)?
• What is the break-up of demand of kitchenware of different types
• What price will the customers be willing to pay for the improved range of kitchenware?
• How can potential customers be convinced about the superiority of the new kitchenware?
• What price and warranty will ensure its acceptance?
• What channels of distribution are most suited for the kitchenware? What trade margins will induce
distributors to carry it?
• What are the prospects of immediate sales?

Demand Analysis

Demand Analysis for the product proposed to be manufactured requires collection of data and preparation of
estimates. Market appraisal requires description of the product, applications, market scope, market competition
from similar products/substitutes, areas of competitive advantage, pricing, etc. In a highly competitive
environment, customized products with short lifespan are vital. Customer needs are foremost to be kept in the
manufacturer’s mind. Functionality, costs, delivery, service, physical appearance, etc. are some of the key
parameters to be attended to.

Physical distribution and manufacturing are a part of the supply chain. Reasonable estimates have to be made
regarding existing and future demand of the product.

After gathering the information, the existing position has to be assessed to ascertain whether unsatisfied
demand exists. Since cash flow projections are to be made, possible future changes in the volume and pattern
of supply and demand have to be estimated. This would help in assessing the long-term prospects of the unit.

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Methods of Demand Forecasting

A wide range of forecasting methods are available to the market analyst. It can be classified into three broad
categories as under: Trend, Regression and End-use Method.

Trend Method

The Trend Projection Method assumes that the demand in the number of units/sales increases by the same
proportion as earlier. The behavior follows a linear equation or an exponential trend as in the past few years.
In a linear trend, it would increase by a constant amount whereas in an exponential trend, it would increase by
a constant percentage. Graphing the data will help to decide which period to choose and what type of form
to be used for forecasting. Only after analysis of past data the trend line should be fitted.

Regression Method

The Regression Method follows a concept of various dependent and independent factors or variables. The
dependent variable is the one subject to forecasting. The independent variable is the ones that cause changes in
the dependent variable. If rate of inflation is to be forecast, the independent variables may be money supply,
per capita availability of food grains and rate of monetization of the economy. Specification of
identification of factors is crucial in forecasting by regression approach. In multiple regressions, we have more
than one independent variable.

End-use Method

The method is appropriate for predicting demand of intermediate industrial products such as steel and caustic
soda. The industries using these materials are identified. An intensive study of the past and thorough
assessment of the future prospects of the various end-user industries is made. An expected production level of
the various end-user industries is made and based on that the product use forecasts are made. Provisions
have to be made for competition from substitute products and changes due to technological changes. Hence,
the end-use method should be used judiciously. The end-use approach enable preparation of industry-wise
customer demand forecasts and it is easy to evaluate any discrepancy in the forecasts with the actual value.

Comparison of Trend, Regression and End-use Methods The Trend Method simply assumes that the demand
follows the pattern as it has done so in the past. It cannot predict the turning points. Regression method is more
accurate than the trend method because it takes into account causal factors. In actual practice, forecasts by both
methods may be attempted.

The End-use Method has limitations as it may be difficult to estimate the projected output levels of consuming
industries. More important, the consumption coefficients may vary from one period to another in the wake
of technological changes and improvements in the methods of manufacturing.

Market Analysis

Market analysis deals with the study of the segmented market, product positioning, product promotion and
distribution strategies and analysis of the competition. Market analysis defines the target customer, the
resultant
market in terms of size, structure, growth prospects, trends and sales potential. Various private companies also
carry out market surveys for a fee. Further, good information relating to the market is available from various
manufacturer/trade associations, trade journals and related Government Organizations.

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Market Segmentation

Market Segmentation narrows the total market which is segmented by factors such as geographic (where they
live), demographic (who they are – age, sex, income), psychographic (why they buy – lifestyle factors) and
synchrographic (when they buy). After the target market is defined, the feasible market has to be defined by
identifying the various produce gaps. The unit’s share in the total feasible market is tied to the structure of
industry, the impact of competition, strategies for market penetration and continued growth and advertisement
budget.

Market share depends on industry growth which will increase the total number of users of the product and
conversion of users from the total feasible market during a sales cycle. A sales cycle has four distinct stages –
early pioneer users, early majority users, late majority users and late users.

Market Segmentation

Distribution Channels

Product Positioning and Pricing

Product Positioning will help place the product as a differential identity in the eyes of the potential buyer. The
strategy used for product positioning is usually the result of an analysis of customers and competition.
Product Pricing decision is very important because it has a direct effect on marketing and financial success of
the business. The basic rules of pricing are that they must cover costs and should be reduced only through
lower
costs. Prices may be determined on a cost plus basis as practiced by manufacturers to recover all costs, both
fixed and variable and realize a desired profit percentage. Mark-up pricing is used by all retailers which are
calculated by adding desired profit to the cost of the product. Finally,

competitive pricing as in the case of markets where there is an established price and the product is more or less
homogeneous.

Product Positioning

Product Positioning for Chocolate Brands

Distribution and Promotional Strategies

Choice of distribution channel to move the product from the factory to the end-user depends on channels being
used by competitors and the strategic advantage it would confer. The company may choose direct sales, OEM
(original equipment manufacturer) sales, manufacturer’s representative, wholesale distributors, brokers, retail
distributors or direct mail. Apart from channels being used by competitors, choice of distribution strategy is
based on factors such as pricing method and internal resources. A promotion plan consisting of controlled
distribution to sell the product has to be formulated after the distribution strategy is formulated. It
encompasses every marketing tool utilized in communication efforts. These are advertising, packaging, public
relations, sales promotion and personal sales.

Once the market has been researched and analyzed in terms of defining it, positioning the product and pricing,
distribution and promotional strategies – financial projections can be made for three or five years.

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Competitive Analysis

The purpose of competitive analysis is to determine the strengths and weaknesses of competitors. Strategies
that will confer a distinct advantage, barriers that can be raised in order to prevent competition from entering
the market and any weaknesses that can be exploited within the product development cycle.
The criteria employed to judge what constitutes a key asset or skill within an industry or market segment may
be identified from any analysis of reasons behind successful as well as unsuccessful companies, prime
customer motivators, major component costs and barriers to mobility.

Through the competitor analysis, a marketing strategy that will generate a unique asset or skill to provide a
distinct and enduring competitive advantage has to be framed. The results of market research which have
helped in defining the distinct competitive advantage have to be communicated in a strategic form that will
attract market share as well as defend it.

Competitive strategies usually fall into product, distribution, pricing, promotion and advertising. The
competitive advantage has to be clearly established. So, the appraiser of the project understands not only how
the goals will be achieved but why the company’s strategy will work.

Managerial Appraisal

In order to judge the managerial capability of the promoters, the following questions are raised:

• How resourceful are the promoters?

• How sound is the understanding of the project by the promoters?
• How committed are the promoters?

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 ECONOMIC APPRAISAL

Introduction

Let us study the names of some of the financial institutions that fund projects:

a. IDBI – Industrial Development Bank of India

b. SICOM – Small Industries Corporation of Maharashtra
c. IFCI – Industrial Financial Corporation of India
d. TFCI – Tourism Finance Corporation of India

We see that these institutions are formed for some specialized purpose. One’s objective is to promote Industrial
Development, someone if for small industries, someone else for promoting tourism. The goal is not simply to
earn profit.

This indicates that these institutions are formed for a greater purpose rather than just earning profit. Earning
money is important for creating sustainable institutions, but while earning profit, they also do a good to the
society and the vast majority of population.

Aspects of Economic Appraisal

Economic Appraisal of a project deals with the impact of the project on economic aggregates. The study of the
potential impact of the project to the nation and the society. We may classify these under two broad
categories: They are:

1. Employment generation – effect of the project on net social benefits or welfare

2. Foreign Exchange savings – effect of the project on foreign exchange The economic appraisal looks at the
project from the larger point of view. Economic Appraisal analyzes if the benefits will justify the project cost/
investment done. A successful project gives following benefits:

• Increased output
• Enhanced services
• Increased employment
• Larger government revenue
• Higher earnings
• Higher standard of living
• Increased national income
• Improved income distribution

The economic appraisal done by financial institutions is not very meticulous and precise. Also, the emphasis
placed on this appraisal is rather limited.

Employment Generation

While assessing the impact of a project on employment, the impact on unskilled and skilled labor has to be
taken into account. Not only direct employment, but also indirect employment should be considered.
Direct employment refers to the new employment opportunities created within the project and first round of
indirect employment concerns job opportunities created in projects related on both input and output sides of

27
the project under appraisal. Since indirect employment is to be counted, additional investment needed
in projects with forward and backward linkage effects should be counted.

Foreign Exchange Savings

A project may produce goods that have to be imported from foreign countries currently. By producing them in
our country, the country might save a lot of foreign exchange. Or a project could be Export Oriented that
might get a lot of foreign exchange within our country. In such cases, an analysis of the effects of the project
on balance of payments and import substitution is necessary. Special formats are prepared by the institutions
to study this impact.

The analysis of net foreign exchange effect may be done for the entire life of the project or on the basis of a
normal year. If two or more projects are compared on the basis of their net foreign exchange effect, the annual
figure should be discounted to their present value.

SMEs provide a good source of employment for the Nation

Social Cost Benefit Analysis

Social Cost Benefit Analysis (SCBA) is a methodology for evaluating investment projects from the social
point of view. Social Cost Benefit Analysis is concerned with the examination of a project from the view point
of maximization of net social benefit. SCBA has received a lot of emphasis in the last few decades as it is
believed that not just government but also private projects carry some responsibility in imparting social
benefits to the nation.

In SCBA, the focus is on the social costs and benefits of the project. These often tend to differ from monetary
costs and benefits of the project. The principal sources of discrepancy are:

a. Market imperfections
b. Externalities
c. Taxes and subsidies
d. Concern for savings
e. Concern for redistribution
f. Merit wants

a. Market Imperfections

Perfect market competition conditions are very rare. Market imperfections create inaccurate prices of products
and services. When imperfections exist, market prices do not reflect social values. The common imperfections
found in developing countries are:

i) rationing,
ii) prescription of minimum wage rate, and
iii) foreign exchange regulation.

Consumers pay less for a commodity under rationing than they would in a competitive market. When
minimum wages are prescribed by law, laborers are paid more than what they would be paid in perfect market
conditions. Similarly, foreign exchange rates in a regulated developing economy are less than what would
prevail in absence of exchange regulations.

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b. Externalities

A project may have beneficial external effects. A road created for its new project may benefit neighboring
areas. These benefits are considered in SCBA although they do not receive any monetary compensation from
the external beneficiaries. Similarly, a project may have harmful external effect like environmental
pollution. In SCBA, the cost of environmental pollution is relevant although the project sponsors do not incur
monetary costs.

c. Taxes and Subsidies

Taxes are definitely monetary costs and subsidies are monetary gains. For SCBA, they are irrelevant as they
are just considered as transfer payments.

d. Concern for Savings

For SCBA, the division of benefits between consumption and savings is relevant especially in developing
countries. However, for project sponsors this may be irrelevant.

e. Concern for Redistribution:

A private company is not bothered as to how project benefits are distributed amongst different groups in
society. The society however, is concerned about the distribution of benefits across different groups.

f. Merit Wants:

There are differences of goals amongst the marketplace and the policymakers. For example, a blood donation
camp or balanced nutrition program for school going children is not sought by consumers in the
marketplace. However, from SCBA point of view, it is very relevant.!

A Power Plant Generate a Lot of Social Benefits, Despite itself Creating Substantial Pollution

SCBA by Financial Institutions

While financial institutions approach project proposals primarily from finance point of view, they also evaluate
projects from larger social point of view. Though there a minor variations amongst various institutions, they
essentially follow a similar approach which is a simplified version of the Little-Mirrlees approach.
Various financial institutions in India carry out Economic Appraisals considering the following three aspects:

a. Economic Rate of Return

b. Effective Rate of Production
c. Domestic Resource Cost

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 FINANCIAL APPRAISAL

Introduction

Financial Appraisal is the review carried out by financial institutions to ascertain whether the project to be
financed is financial viable. The project could be a new project or expansion of existing production facilities.
Any project appraisal exercise involves asking the three basic questions: Can we produce the goods or
services? Can we sell the goods or services? Can we earn a satisfactory return on the investment made in the
project? While first two questions are answered can be answered reasonably well through the technical and
market appraisal. The most important question of earning sufficient return is answered through the Financial
Appraisal.

On aspect of Financial Appraisal is the assessment of funds required to implement the project and sources of
the same. The other aspect relates to estimation of operating costs and revenues, prospective liquidity and
financial returns in the operating phase.

The project’s direct benefits are estimated at the prevailing market prices. Financial appraisal is concerned with
the measurement of profitability of resources without reference to their source.

Importance of Financial Appraisal

Financial Appraisal is important as:

1. It ensures that the project is able to get a reasonable return on the investment made to carry on sustainable
operations.
2. It estimates the cash flows and reasonable level of profit that the unit can make from the operations.
3. It estimates the Cost of the Project and the Sources of Finance, their respective costs and the Cost of Capital
of the unit to complete the project.
4. It deals with various liquidity and Capital Structure ratios.
5. It determines the Break-even Point to find the exact level of sales and production when the unit can break-
even.

Working Results of Existing Units

For existing units, the banker and other stakeholders need to understand of the past performance of the
company. Although the financial projections may project a very rosy picture about the future, they would like
to assess

what has been your performance in the past. The company’s last three audited balance sheets and profit and
loss statements as well as the latest unaudited provisional accounts certified by the management/CA have to be
analyzed.

The latest balance sheet and profit and loss account may be analyzed with a view to ascertain, whether the
concern is under/overcapitalized, whether the borrowings raised are not out of proportion to its paid-up capital
and reserves, how the current liabilities stand in relation to current assets, whether the gross block has been
properly depreciated and has not been shown at an inflated value, whether there is any interlocking of funds

30
with associate companies and whether the concern has been ploughing back profits into the business and
building up reserves.
They also assess the changes in balance sheets of the company over a period of time with respect to sales,
profitability, fixed assets, etc.

Cost of the Project

The capital cost of the project whether it refers to expansion or a new project should be shown under:

i. Land and site development,

ii. Buildings,
iii. Plant and machinery,
iv. Technical know-how fees,
v. Expenses on foreign technicians and training of Indian technicians abroad,
vi. Miscellaneous fixed assets,
vii. Preliminary and pre-operative expenses,
viii. Provision for contingencies, and
ix. Margin money for working capital.

It has to be ascertained that all these items are covered in the cost and the expenditure under each item is
reasonable. It will help to compare the cost of the project with the cost of a similar project or by the
information about cost that may be gathered in respect of other units in the same industry with comparable
installed capacity and other common technical features.

Sources of Finance

The usual sources of finance for a project are:

• Share capital
• Term loans
• Debenture capital
• Deferred payments
• Miscellaneous sources
• Unsecured loans from promoters
• Internal accruals in the case of an existing unit.

How should a promoter or project manager plan out the Project Capital Structure? He will rationalize the
capital structure with the current legal and banking norms.

a. Share Capital:

Share Capital is the long-term contribution to the project by the promoters. Any financial institution/banker
would expect the promoter to contribute around 20-30% of the total project. This
promoter contribution increases with the increase in the size of the project. For large projects, bankers expect
promoters to contribute almost 50% of the total project cost. The promoter contribution will be
in the form of unsecured loans which the financial institution will insist to convert to Paid-up Equity Capital.
Thus, the promoter contribution becomes locked in the project.

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Some portion of the Share Capital can also be in the form of Preference Capital by the preference shareholders
who get generally paid a fixed dividend but who are not allowed to withdraw the sum invested. Preliminary
expenses incurred by the promoter are included in promoter’s contribution. Modern finance in the form of
Private Equity is available for startups and other companies that provide such companies with much needed
equity
capital to develop but comes at a higher cost are available nowadays.

b. Term Loans:

70-80% of the Project Cost is usually funded by the institution. It goes down to 50% for very large projects.
Depending on the project repaying capacity, the balance amount shall be funded by the financial institution for
the usual tenure as per their norms. This is in form is a reducing balance Term Loan, where there is a principal
repayment and interest on the outstanding loan balance. As the promoter repays and the outstanding loan
balance is reduced, the interest repayment also reduces. There are some concessions by the government for
technical entrepreneurs and female entrepreneurs. Usually, technical entrepreneurs have flexibility of lower
promoter contribution and female entrepreneurs get some discount in the rate of lending.

Terms loans are available in variety of forms such as Rupee Term Loans, Foreign Currency Term Loans,
Working Capital Term Loans, etc.

c. Debenture Capital:

Debentures are debt instruments to raise capital from the public. Maturity period is of 5 to 9 years. There are
convertible debentures and non-convertible debentures. Non-convertible debentures are straight debt
instruments. Convertible debentures are convertible partially or wholly into equity shares – conversion period,
price are determined in advance.

d. Deferred Payments:

Suppliers of capital goods offer a deferred credit facility under which the payments can be made over a period
of time.

e. Miscellaneous Sources:

A small portion of the project finance can come from miscellaneous sources like public deposits, unsecured
loans, hire purchase and lease facilities, etc.

f. Unsecured loans from promoters:

Promoters also do provide unsecured loans to bridge the gap between the promoter’s contribution and the
equity capital required.

g. Internal accruals in the case of an existing unit:

Internal accruals from existing operations can fund marginally gap between the capital needs for the project. It
is important that no gap is left in financing patterns. Otherwise it will result in cost overruns and time overruns
in the implementation of the project. Financial institutions stipulate a condition that any kind of cost overrun or
time overrun shall be funded by the promoters.

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While the emphasis of financial institution is on the viability of the project, they generally stipulate by way of
security, a first legal charge on fixed assets of the company ranking pari passu with the charge if any, in favor
of other financing institutions.

Financial Projections

Projected Profit and Loss Statements, Balance Sheets and Cash Flow Statements over a long period – say 5 to
10 years will give us the realistic picture of the finances of the project. What is the profit generated over a
period of time? What are the interest costs? What is the Return on Capital Employed? etc. These projected
financial statements are interrelated and are prepared on the basis of various assumptions regarding capacity
utilization, availability of inputs, their price trends and their selling prices, various indirect costs, statutory
taxes, etc. These assumptions should be scrutinized carefully before making estimates. A proforma is annexed
hereto. New units should not go for any sharp build-up of capacity within a year or two especially if the
product is new. The quantum of raw materials and utilities estimated to be consumed to obtain a particular
quality/quantum of end product is the core of cost of manufacture estimates and should tally with the
performance guarantees furnished by the collaborators/ machinery suppliers. In case of multiproduct
companies, the product mix is decided on the basis of contribution of each product, utilization of plant capacity
as well as market. There should also be reasonable annual increases in indirect costs such as wages and
salaries, electricity, etc.

Financial Appraisal’s main goal is to ascertain the profitability of the project. The promoter might present a
very rosy picture to the financial institution due to his own conviction on the project but it is the task of
analyst to verify the estimates. It is to be ensured that the profits projected are realistic and achievable.
Depreciation of fixed assets should be provided as per Income Tax Rules. The selling price should be fixed
keeping in view the present domestic price of the product. Repairs and maintenance will have to be provided
keeping in view the type of industry and the number of shifts to be worked. The profitability projections are
closely linked to the schedule of implementation. On the basis of profitability projections, cash flow and
projected balance sheets are prepared for a period of five to ten years.

Evaluation of Cash Flows and Profitability

There are various methods and two discounted cash flow techniques for financial appraisal to evaluate the cash
flows and profitability of investment. The methods should have three properties to lead to consistently correct
decisions.

1. It should consider all cash flows over the entire life of a project;
2. It should take into account the time value of money;
3. It should help to choose a project from among mutually exclusive

projects which maximize the value of the companies’ stock. The two popular methods for Financial Appraisal
are the:

1. Simple Rate of Return; and

2. Payback Period.

They employ annual data at their nominal value. They do not take into account the life span of the project but
rely on one year. The two Discounted Cash Flow techniques for Financial Appraisal are the:

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1. Net Present value Method (NPV)
2. Internal Rate of Return (IRR).

They take into consideration the project’s entire life and the time factor by discounting the future inflows and
outflows to their present value.

Simple Rate of Return Method

Simple Rate of Return is the ratio of net profit in a normal year to the initial investment in terms of fixed and
working capital. If one is interested in equity alone, the profitability of equity can be calculated.

Normal year is a representative year in which capacity utilization is at technically maximum feasible level and
debt repayment is still under way. The simple rate of return helps in making a quick assessment of
profitability, particularly projects with short life. Its shortcoming is that it leaves out the magnitude and timing
of cash flows for the rest of the years of a project’s life. For evaluation, accurate data is required. In its absence
simple rate of return may be incorrect. Simple rate of return method is suitable for financial analysis of existing
units. It is not suitable for optimizing investment.

Payback Period Method

Payback period for a project measures the number of years required to recover a project’s total investment
from the cash flows it generates. It is the expected number of years required to recover the original investment.
The Payback period shows that the project’s initial investment is recovered in ten years. Even if cash flows are
not uniform, the payback period can be calculated easily by adding together cash flows until the investment is
recovered. The payback method is calculated simple and lays importance to recovering the original investment
as fast as possible. The shorter the payback period, the quicker is the recovery of initial investment. But it
leaves out the time pattern of the cash flows within the payback period and the cash flows after the payback
period. Actually, it is biased against projects which yield higher returns in later years. The payback period
method is not suitable for evaluation of alternatives and to make systematic comparison.

Discounted Cash Flow Techniques

When appraising capital projects , basic techniques such as ROCE and Payback could be used. Alternatively,
companies could use discounted cash flow techniques discussed on this page, such as Net

Present Value (NPV) and Internal Rate of Return (IRR).

Cash Flows and Relevant Costs Money received today is worth more than the same sum received in the
future, i.e., it has a time value.

This occurs for three reasons:

1. potential for earning interest/cost of finance

2. impact of inflation
3. effect of risk.

Compounding

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A sum invested today will earn interest. Compounding calculates the future or terminal value of a given sum
invested today for a number of years. To compound a sum, the figure is increased by the amount of interest it
would earn over the period.

Formula for compounding:

To speed up the compounding calculation, we can use a formula to calculate the future value of a sum invested
now. The formula is:

F = P(1 + r)n

where, F = Future value after n periods

P = Present or Initial value
R = Rate of interest per period
N = Number of periods.

Discounting

In a potential investment project, cash flows will arise at many different points in time. To make a useful
comparison of the different flows, they must all be converted to a common point in time, usually the present
day, i.e., the cash flows are discounted. The present value (PV) is the cash equivalent now of money
receivable/ payable at some future date.

The cost of capital

In discounted cash flow techniques, the rate of interest is required. There are a number of alternative terms
used to refer to the rate of interest:

• cost of capital
• discount rate
• required return.

Discounted cash flow (DCF) techniques take account of this time value of money when appraising project
investments. The Discounted Cash Flow (DCF) methods are more objective than earlier methods. They take
into account both the magnitude and timing of expected cash flows in each period of a project’s life. They take
into account time value of money – a rupee today is has more value than a rupee at a later date. The two
methods are the:

1. Net Present Value (NPV) method

2. Internal Rate of Return (IRR).

Net Present Value (NPV) Method

To appraise the overall impact of a project using DCF techniques involves discounting all the relevant cash
flows associated with the project back to their PV (present value).

If we treat outflows of the project as negative and inflows as positive, the NPV of the project is the sum of the
PVs of all flows that arise as a result of doing the project.

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Decision rule:

The NPV represents the surplus funds (after funding the investment) earned on the project, therefore:

• if the NPV is positive – the project is financially viable

• if the NPV is zero – the project breaks even
• if the NPV is negative – the project is not financially viable
• if the company has two or more mutually exclusive projects under

consideration, it should choose the one with the highest NPV. Assumptions in Calculating the Net Present
Value The following assumptions are made about cash flows when calculating the net present value:

• all cash flows occur at the start or end of a year

• initial investments occur (T0)
• other cash flows start one year after that (T1).

Also interest payments are never included within an NPV calculation as these are taken account of by the cost
of capital.

Advantages and Disadvantages of Using NPV

Advantages

Theoretically, the NPV method of investment appraisal is superior to all

others. This is because:

• It considers the time value of money

• It is an absolute measure of return
• It is based on cash flows not profits
• It considers the whole life of the project
• It should lead to maximization of shareholder wealth.

Disadvantages

• It is difficult to explain to managers.

• It requires knowledge of the cost of capital.
• It is relatively complex.

Internal Rate of Return (IRR)

The IRR is another project appraisal method using DCF techniques. The
IRR represents the discount rate at which the NPV of an investment is zero.

As such, it represents a break-even cost of capital.

Advantages and Disadvantages of IRR

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Advantages

The IRR has a number of benefits, e.g.:

• It considers the time value of money.
• It is a percentage and therefore easily understood.
• It uses cash flows not profits.
• It considers the whole life of the project.
• It means a firm selecting projects where the IRR exceeds the cost of capital should increase shareholders’
wealth.

Disadvantages

• It is not a measure of absolute profitability.

• Interpolation only provides an estimate and an accurate estimate requires the use of a spreadsheet
programme.
• It is fairly complicated to calculate.
• Non-conventional cash flows may give rise to multiple IRRs which means the interpolation method can’t be
used.

Difficulties with the IRR Approach

Interpolation only provides an estimate (and an accurate estimate requiresthe use of a spreadsheet program).
The cost of capital calculation itself is also only an estimate and if the margin between required return and the
IRR is small, this lack of accuracy could actually mean the wrong decision is taken. Another drawback of IRR
is that non-conventional cash flows may give rise

to no IRR or multiple IRRs. For example, a project with an outflow at T0 and T2 but income at T1 could,
depending on the size of the cash flows, have a number of different profiles on a graph (see below). Even
where the project does have one IRR, it can be seen from the graph that the decision rule would lead to the
wrong result as the project does not earn a positive NPV at any cost of capital.

NPV versus IRR

Both NPV and IRR are investment appraisal techniques which discount cash flows and are superior to the basic
techniques such as ROCE or payback.

NPV is, therefore, the better technique for choosing between projects. The advantage of NPV is that it tells us
the absolute increase in shareholder wealth as a result of accepting the project, at the current cost of capital.
The IRR simply tells us how far the cost of capital could increase before the project would not be worth
accepting.
The modified internal rate of return (MIRR) solves many of these problems with the conventional IRR.

Estimating Cost of Capital with Capital Asset Pricing Model (CAPM)

In the analysis so far, the company’s cost of capital was used to discount the forecasted cash flows of the new
project. Many companies estimate the rate of return required by investors in their securities. Towards this
purpose, the company’s cost of capital is used to discount cash flows in all new projects. This is not an
accurate method since the risk of existing assets of a company may differ from the risk of new project assets.
Since investors require a higher rate of return from a very risky company, such a company will have a higher

37
cost of capital and will set a higher discount rate for its new investment opportunities. The cost of capital or
required rate of return on the project would be the same as the one on company’s existing assets if the risk is
the sane. The company’s cost of capital is the correct discount rate for projects that have the same risk as the
company’s existing business. If the project risk differs from the risk on existing assets, the project has to be
evaluated at its own opportunity cost of capital. The true cost of capital depends on the use to which it is put.
The capital asset pricing model (CAPM) can be used for estimating the company’s cost of capital. Each project
should be evaluated at its own opportunity cost of capital. Capital asset pricing theory tells us to invest in
any project offering a return that more than compensates for the project’s beta which measures the amount that
investors expect the stock price to change for each one per cent additional change in the market risk. The
discount rate increases as project beta increases. However, companies require different rates of return from
different categories of investment. The higher the beta risk associated with an investment, the higher the
expected rate of return must be to compensate investors for assuming risk. The CAPM provides a framework
for analyzing the relationship between risk and return. The CAPM holds that there is a minimum required rate
of return even if there are no risks, plus a premium for all non-diversifiable risks associated with investment.
Projects should be evaluated as portfolios and there is a reduction of risk when they are so combined.
To calculate the company’s cost of capital, the beta of its assets has to be ascertained. The beta cannot be
plugged into the capital asset pricing model to find the company’s cost of capital because the stock’s beta
reflects both business and financial risk. The beta has to be adjusted to remove the Financial Appraisal effect of
financial risk since borrowing increases the beta (and expected return) of its stock. A more reliable
estimate is an average of estimated betas for a group of companies in the same industry. While estimating
project betas, fudge factors to discount rates to offset bad outcomes of a project should be avoided. In cases
where project beta cannot be calculated directly, identification of the characteristics of high and low beta assets
(for instance, cyclical investments are high beta investment) would help to figure out effect on
cash flows. Finally, operating leverage should be assessed since high fixed production charges are like fixed
financial charges resulting in an increase in beta. The expected rate of return calculated from the capital asset
pricing model:

r = rf + B (rm – rf)

where r is discount rate, rf is interest rate on risk-free asset like treasury bill and rm expected return can be
plugged into standard discounted cash flow formula: The Capital Asset Pricing Model values only the cash
flow for the first period (C1). Projects, however, yield cash flows for several years. If the
risk adjusted rate r is used to discount the cash flow, we assume that cumulative risk increases at a constant
rate. The assumption will hold when the project’s beta is constant or risk per period is constant.

FINANCIAL ANALYSIS

An integral aspect of Financial Appraisal is Financial Analysis which takes into account the financial features
of a project, especially sources of finance. Financial Analysis helps to determine smooth operation of the
project over its entire life cycle. The two major aspects of financial analysis are liquidity analysis and capital
structure analysis. For this purpose, ratios are employed which reveal existing strengths and weaknesses of the
Project.

Liquidity Analysis

Liquidity ratios or solvency ratios measure a project’s ability to meet its short-term obligations. Two ratios are
calculated to measure liquidity, the current ratio and quick ratio.

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 a. Current ratio:

The current ratio is defined as current assets [cash, bank balances, investment in securities, accounts receivable
(sundry debtors) and inventories] divided by current liabilities [accounts payable
(sundry creditors), short-term loans, short-term creditors and advances from customers]. It is computed by, The
current ratio measures the assets closest to being cash over those liabilities closest to being payable. It is an
indicator of the extent to which short-term creditors are covered by assets that are expected to be converted to
cash in a period corresponding to the maturity of claims. A current ratio 1.5 to 1.0 is considered acceptable.

b. Acid test or Quick ratio:

Since inventories among current assets are not quite liquid, the quick ratio excludes it. The quick ratio includes
only assets which can be readily converted into cash and constitutes a better test of liquidity. A quick ratio of
1 : 1 is considered good from the viewpoint of liquidity.

Capital Structure Analysis

Long-term solvency ratios measure the project’s ability to meet long-term commitments to creditors. Creditors’
claims on a company’s income arise from contractual obligations which must be honored. The larger the
amount of these claims, the higher the chances of their not being met, legal action may be initiated to enforce
the fulfillment of the claims. The two long-term solvency ratios are: debt utilization ratio and coverage ratio.

a. Debt utilization ratio:

Debt utilization ratio measures a company’s degree of indebtedness which measures the proportion of the
company’s assets financed by debt relative to the proportion financed by equity. Debt includes current
liabilities and long-term debt. Creditors prefer low debt ratios because the lower the ratio, the greater the
cushion against creditor’s losses in the event of liquidation. The owners prefer higher levels either to magnify
earnings or to retain control total debt.

b. Debt-Equity Ratio:

Debt-Equity Ratio is the value of the total debt divided by the book value of equity. In calculation of debt,
short-term obligations of less than one year duration are excluded.

c. Fixed Assets Coverage Ratio:

Two other ratios relating to long-term stability used by development finance institutions (DFIs) in appraisal of
projects are fixed assets coverage ratio and debt coverage. The fixed
assets coverage ratio shows the number of times fixed assets cover loan.

d. Debt Coverage Ratio:

The debt coverage ratio measures the degree to which fixed payments are covered by operating profits. The
ratio emphasizes the ability of the project to generate adequate cash flow to
service its financial charges (non-operating expenses). Debt coverage ratio measures the number of times
earnings cover the payment of interest and repayment of principal. A debt coverage ratio of 2 is
considered good.

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e. Interest Coverage Ratio:

The interest coverage ratio measures the number of times interest expenses are earned or covered by profits.

f. Market Value Ratio:

Market value ratios relate to the company’s share price to its earnings and book value per share. These ratios
are a performance index of the company and indicate the investor’s perception of the company’s performance
and future prospects.

g. Price Earnings Ratio:

P/E Ratio relates the per share earnings to price of the share. P/E Ratios are computed for companies as well as
for the market. P/E ratios are higher for companies with high growth prospects and lower for riskier
companies.

h. Market/Book Value Ratio:

The ratio of market price of the share of the company to its book value per share gives an indication of how
investors regard the company. Generally, if the returns on assets are high, these shares sell at higher multiples
of book value than those with low return. Book value per share is the sum of net worth (paid-up
capital plus reserves) divided by number of shares outstanding.

I .Market/Book Value Ratio (M/B ratio):

If the market price per share is divided by book value, we get the market book (M/B) ratio

Break-Even Point (BEP)

An essential aspect of financial appraisal is the determination of BEP. Unless it is determined, other measures
make no sense. To calculate and project cash flows, it is important to assess the BEP. Break-even is that
level of production and sales at which total revenues are exactly equal to operating costs. BEP occurs at that
production level at which net operating income (sales – operating cost) is zero.

Break-even Point

It indicates the volume necessary for profitable operation of the project. With the help of break-even analysis,
the quantity required to be produced at a given sales price per unit to cover total fixed cost and variable cost
can
be found. If BEP is too high, the price assumed for the output may have to be reviewed. In summary, the
viability of a project can be assessed with the help of break-even analysis. For the purpose of break-even
analysis, the conventional income statement has to be classified into fixed and variable costs.

APPRAISAL OF ADVANCED MANUFACTURING SYSTEMS

Intangible and Tangible Benefits

For evaluation of advanced manufacturing systems, conventional appraisal techniques may be unsuitable since
there are a large number of hidden benefits in such systems. These benefits are of tangible and intangible

40
natures which have to be quantified. A few such benefits of advanced manufacturing systems are listed here.
Quantification of such benefits can be carried out by analytic hierarchy process and other processes.

Intangible Benefits

• Centralized database
• Better quality control
• Faster product introduction
• Better competitive standing
• Greater customer satisfaction
• Improved employee participation
• Consistently high product quality
• Improved on-time product delivery
• Redistribution of personnel skills
• Better data quality for management
• Consistent and tireless operation
• Shortened design and manufacturing lead time
• Ability to simulate the total factory operations
• Wider variety of designs within a product family
• Ability to attract and retain high-quality engineers
• Ability to handle increasingly complex product designs
• Flexibility in design, product mix, volumes and schedules
• Greater control, accuracy and repeatability of production process

Tangible Benefits

• Lower inventory.
• Reduced labor costs.
• Less scrap and rework.
• Higher throughput and yield.
• Fewer engineering prototypes through the use of CAD.
• Reduced changeover costs and time.
• Improved and safer working conditions.
• Increased design and drafting productivity.
• Reduced and more predictable maintenance cost.
• Eliminated data re-entry and duplicated data processing systems. Strategic Issues

The strategic issues to be considered before taking a decision on acceptance or rejection of a proposal to set up
an advanced manufacturing system as compared to other traditional manufacturing systems are:

1. The goal of the company in 7 to 10 years.

2. The advantage, the investment is going to provide over competitors.
3. Ability to capture a greater proportion of the market for the company’s products.
4. Ability to respond to market changes quickly.
5. Impact of improvements in quality and consistent output in obtaining competitive advantage.
6. Incremental sales resulting from the publicity gained from the company installing advanced manufacturing
technology.

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An advanced system should be viewed as a long-term, strategic move, not a tactical adjustment in a strategy.
The installation of such a system is comparable to other strategic moves like installing a new computing
system or hiring a new dynamic, result-oriented, but a very highly paid CEO. The benefits of such moves
cannot be immediately quantified. Their impact is felt in the long run. Shortcomings of Traditional Financial
Analysis for Advanced Manufacturing Systems like FMS

Traditional evaluation assumes:

1. Impact of investment is limited to immediate environment of equipment.

2. Capabilities and rates of new equipment are assumed to be well known and do not change, i.e., not increase
but will decrease as machine ages.
3. Savings and benefits can be estimated with accuracy and ease.
4. The pros and cons of the project can be envisaged by the manager or specialist concerned with the project.
5. Evaluation should be done case by case.

These assumptions are not applicable to FMS as it integrates the complete facilities of different stages of
manufacturing. CNCs would just reduce labor costs, but FMS in addition to reducing labor costs can also help
in controls and in-process inspection, work tracking, transportation, tool control, scheduling and production
control. FMS would require a smaller and dedicated team, which is generally more motivated, loyal and
sincere. It has generally been observed in FMS that the capabilities of the system tend to increase over passage
of time because of increasing understanding of operations of the system and the accumulated experience,
upgradability of the system, both software and hardware, to speed up operations and intrinsic flexibility of the
system. FMS has the flexibility to process several part types simultaneously. In contrast, a transfer line requires
full capital expenditure before production can start. On the other hand, changes in product type, or mix, or
volume cannot be easily effected in transfer line since such changes result in underutilization of lines. Actual
costs and benefits are difficult to evaluate in FMS. Many hidden costs like new skilled labor, training costs,
costs due to adjustments or refining cannot be accurately estimated. Hidden/non-financial savings like simple
and fast engineering change over, reduction of lead time are difficult to quantify to take into calculation in
profit and loss account. Further, FMS operations and benefits cut across various functions. A broader team is
required to evaluate FMS projects. Finally, capital costs cannot be appraised on a case by case basis. They have
to be evaluated by senior management of the company on a long-term plan basis of say 5 to 10 years. Financial

evaluation of FMS is feasible in the following cases:

1. Total FMS picture is taken into consideration by evaluating

a. costs: direct and indirect of traditional systems and

b. savings: direct and indirect/non-financial savings of FMS.

2. All intangible benefits are evaluated and a hypothetical value attached to every qualitative benefit.
3. Estimates of savings and costs cover 7 to 10 year period taking into consideration long-term impact of FMS.
4. Probability and sensitivity are taken into account.
5. Justification/appraisal results are seen in a broader/strategic perspective.

Before rejecting an FMS investment proposal, the following factors may be considered:

1. What are the other options?

2. What happens if investment is not made in FMS?
3. What are the methods employed by competitor?

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4. How can the benefits of FMS open up new markets and make the company more competitive?

Conclusions

1. FMS should be an integral part of a well-defined strategy to meet the corporate goals.
2. While evaluating FMS, judicious designing should be done. FMS project may be unviable but technically
feasible.
3. Traditional methods of analysis may lead us astray from real justification of the FMS project.
4. Conventional appraisal techniques should be used to compare different systems, as relevant facts of FMS
will not be highlighted.

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 CAPITAL STRUCTURE

Introduction

Project financing structure refers to the way a company finances its assets through some combination of equity,
debt, or hybrid securities. A company’s capital structure is then the composition or ‘structure’ of its liabilities.
For example, a company that sells Rs. 20 crores in equity and Rs. 80 crores in debt is said to be 20% equity-
financed and 80% debtfinanced. The company’s ratio of debt to total financing, 80% in this example is referred
to as the company’s leverage. In reality, capital structure may be highly complex and include dozens of
sources. Gearing Ratio is the proportion of the capital employed of the company which come from outside of
the business finance, e.g., by taking a short-term loan etc. This topic starts with a theory that shows capital
structure is irrelevant in a world with no taxes and no other market imperfections. It will also show that when
you increase the level of debt in a company, you increase the required rate of return on equity because
increasing leverage increases the risk of equity.

Capital Structure Decision – Theory and Practice

The financing choices manager affect the liabilities and stockholder’s equity side of the balance sheet. Capital
budgeting decisions, on the other hand, affect the asset side of the balance sheet. Managers have choices of
debt and equity. The key question is what mix of these securities will maximize the value of the shareholders.
Debt service requires interest payments that are tax deductible, but equity service requires dividends, which are
paid from after tax income. However, increases in the use of debt increase the risk of default on debt service
and can lead to bankruptcy. Managers must also make choices about whether to use fixed-rate or floating-rate
debt, and how to mix long term and short-term debt. These issues affect the cost of debt.

Capital Structure – an Overview

Companies raise capital for their investment projects with a mix of debt and equity instruments. The
combination of all of these instruments is known as the company’s capital structure. For the purposes of our
discussion, let us look at some key differences between debt and equity. Key differences are:

It is important that a company consider its appropriate mix of debt and equity. For a given level of sales, higher
use of debt in proportion to equity makes the company more risky, because the proportion of operating
income needed to cover debt service increases with increasing debt.

Therefore, the probability rises that if sales decline due to changes in market conditions, the company will not
be able to service the debt. Clearly, debt and equity present different opportunities to investors. You might ask
why companies use both debt and equity financing. By issuing debt, a company’s owners can keep a greater
amount of equity for themselves. Assuming a company’s investments are profitable, the owners can finance
their projects and also reap the benefit of these investments. Some companies, however, might not be able to
make the annual interest payments on debt – or they might desire the flexibility to use their cash flow for other
investments – and will tend to issue equity instead. Furthermore, there is a key difference between the way
debt and equity are paid. Companies pay interest to debt holders and dividends to equity holders. Interest
expenses are tax deductible, but dividend payments are not. As a result, companies receive a tax benefit from
issuing
debt. Most companies usually use a mix of debt and equity financing – despite the tax advantages of debt – to
suit their strategic and competitive interests.

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Modigliani and Miller Proposition I and II

A company’s capital structure is a mix of the various debt and equity instruments used to finance the company.
To assess the value of a company, your first need to determine the appropriate discount rate use. Should you
use the rate that is appropriate for a company financed with 100% equity? Or should you use a company’s cost
of debt as the rate at which to discount its cash flows? Or a mix of both?

Modigliani-Miller

The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for
modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it
disregards many important factors in the capital structure process factors like fluctuations and uncertain
situations that may occur in the course of financing a company. The theorem states that, in a perfect market,
how a company is financed is irrelevant to its value. This result provides the base with which to examine real-
world reasons why capital structure is relevant, that is, a company’s value is affected by the capital structure it
employs. Some other reasons include bankruptcy costs, agency costs, taxes, and information asymmetry. This
analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which
maximizes the value of the company. In 1958, Franco Modigliani and Merton Miller (referred to as MM)
published an article that discussed whether companies could vary their capital structures to obtain better returns
– that is, whether companies could manipulate the amounts of debt and equity financing in their capital
structures to yield a higher overall return. MM showed the conditions under which the value of a project is
invariant to how it is financed. MM also demonstrated that when a company finances a project using more debt
than equity, the residual equity becomes riskier, because it is supporting more debt claims. So even though the
debt will require a lower rate because financing with debt rather than equity is cheaper, the equity will in turn
require a higher discount rate as it takes on more risk. However, the overall rate, or the weighted average cost
of capital (WACC), will not be affected as the ratio of debt to equity in a company’s capital structure changes.
These claims are based on specific assumptions. It was MM’s intention to define this ‘constant value’
condition as a benchmark, much like the frictionless state or perfect vacuum in physics, or the concept of
perfect competition in economics. These conditions may not exist in the ‘realworld’, but they provide useful
anchors for thought, or benchmarks against which real conditions can be measured. MM’s propositions offer a
basis for understanding why a company’s decisions about capital structure may, in fact, matter. Capital
structure in a Perfect Market: Consider a perfect capital market (no transaction or bankruptcy costs; perfect
information); companies and individuals can borrow at the same interest rate; no taxes; and investment returns
are not affected by financial uncertainty. Modigliani and Miller made two findings under these conditions.
Their first ‘proposition’ was that the value of a company is independent of its capital structure. Their second
‘proposition’ stated that the cost of equity for a leveraged company is equal to the cost of equity for an
unleveraged company, plus an added premium for financial risk. That is, as leverage increases, while the
burden of individual risks is shifted between different investor classes, total risk is conserved and hence no
extra value created. Their analysis was extended to include the effect of taxes and risky debt. Under a classical
tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases
as the proportion of debt in the capital structure increases. The optimal structure then would be to have
virtually no equity at all, i.e., a capital structure consisting of 99.99% debt. Capital structure in the real world:
If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the
cause of its relevance. The theories below try to address some of these imperfections, by relaxing assumptions
made in the M&M model.

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MM Proposition I

According to MM Proposition I, the total value of the securities issued by a company does not depend on the
company’s choice of capital structure. In other words, the value of the company is determined by its real assets
and growth opportunities and not by the types of securities (debt or equity) it issues. Under particular
conditions, the company’s value turns out to be constant regardless of its capital structure.

MM Proposition I applies in a world under the following assumptions:

1. Capital structure does not affect investment policy.

2. Cash flows paid out to different securities are taxed at the same rate.
3. No costs of bankruptcy exist.
4. Managers’ goal is to maximise shareholder wealth.
5. Everyone has immediate and equal access to all relevant information about the company.
6. No transaction costs exist.

If these conditions hold, the company is said to operate in a perfect market (comparable to perfect vacuum in
physics).

MM Proposition I is based on the idea that investors can, on their own, replicate any capital structure designed
by a company. Companies cannot change value by altering the composition of their financing. If one capital
structure has a greater value than another, then investors could sell the capital structure of greater value and
buy the one of lesser value.

MM Proposition II

The following formula states that the company’s weighted average cost of capital is a weighted average of its
cost of debt (rd) and its cost of equity (re):

We also know that a company’s capital structure has no impact on the cash flows the company is expected to
generate. If the value and the future cash flows generated by a company are not affected by its capital structure,
then it must be true that the company’s weighted average cost of capital is unaffected by a
company’s capital structure. What about the cost of equity? How does the capital structure choice impact the
cost of equity?

MM Proposition I and II point to the conclusion that companies cannot change in value simply by repackaging
their securities from equity to debt, or vice versa. As equity is replaced by debt, a company’s overall value and
its cost of capital cannot be reduced, because the riskiness of the equity increases as the amount of debt
increases. This increase in risk of the equity offsets the reduction in risk that results from issuing debt. In other
words, while the fraction of low-cost debt increases, equity demands a return high enough to compensate for
the extra risk it is bearing. Thus, using the asset beta to calculate the cost of capital is appropriate in a world
based on MM’s assumptions where debt, but no tax, exists. Application in the Real World Every company has
a limit to the amount of debt it can support. If a company goes beyond this debt capacity level, it risks
bankruptcy. Debt does matter in the real world! Consider what happens when MM’s assumption that there is
no tax differential between debt and equity is relaxed. In the real world, corporations are taxed on operating
cash flow after interest payments have been made. Cash paid to shareholders as dividends is taxed first to the
corporation, but interest payments are not. Therefore, two companies that have equivalent earnings before
interest but

46
different capital structures – perhaps one with all stock and the other with
bond interest payments – will be worth different amounts. In a world with

taxes, companies with identical assets, cash flows, and risk will be worth different amounts as capital structures
differ. This concept will become clearer as you learn more about the benefits of the debt tax shield.

Trade-Off Theory

Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to financing with debt
(namely, the tax benefits of debt) and that there is a cost of financing with debt (the bankruptcy costs and the
financial distress costs of debt). The marginal benefit of further increases in debt declines as debt increases,
while the marginal cost increases, so that a company that is optimizing its overall value will focus on this
trade-off when choosing how much debt and equity to use for financing. Empirically, this theory may explain
differences in D/E ratios between industries, but it doesn’t explain differences within the same industry.
After a certain level of Debt, the Firm’s Value reduces instead of ncreasing

Pecking Order Theory

Pecking Order Theory tries to capture the costs of asymmetric information. It states that companies prioritize
their sources of financing (from internal financing to equity) according to the law of least effort, or of least
resistance, preferring to raise equity as a financing means “of last resort”. Hence, internal financing is used
first; when that is depleted, then debt is issued; and when it is no longer sensible to issue any more debt, equity
is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal
financing when available, and debt is preferred over equity if external financing is required (equity would
mean issuing shares which meant ‘bringing external ownership’ into the company). Thus, the form of debt a
company chooses can act as a signal of its need for external finance. The pecking order theory is popularized
by Myers (1984) when he argues that equity is a less preferred means to raise capital because when managers
(who are assumed to know better about true condition of the company than investors) issue new equity,
investors believe that managers think that the company is overvalued and managers are taking advantage of
this overvaluation. As a result, investors will place a lower value to the new equity issuance.

Agency Cost

There are three types of agency costs which can help explain the relevance of capital structure.

1. Asset substitution effect:

As D/E increases, management has an increased incentive to undertake risky (even negative NPV) projects.
This is because if the project is successful, shareholders get all the upside, whereas if it is unsuccessful, debt
holders get all the downside. If the projects are undertaken, there is a chance of company value decreasing and
a wealth transfer from debt holders to shareholders.

2. Underinvestment problem (or Debt overhang problem):

If debt is risky (e.g., in a growth company), the gain from the project will accrue to debt holders rather than
shareholders. Thus, management has an incentive to reject positive NPV projects, even though they have the
potential to increase company value.

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 3. Free cash flow:

Unless free cash flow is given back to investors, management has an incentive to destroy company value
through empire building and perks etc. Increasing leverage imposes financial discipline on management.

Structural Corporate Finance

An active area of research in finance is that which tries to translate the models above as well as others into a
structured theoretical setup that is time-consistent and that has a dynamic setup similar to one that can be
observed in the real world. Managerial contracts, debt contracts, equity contracts, investment returns, all have
long lived, multi-period implications. Therefore, it is hard to think through what the implications of the basic
models above are for the real world if they are not embedded in a dynamic structure that approximates reality.
A similar type of research is performed under the guise of credit risk research in which the modeling of the
likelihood of default and its pricing is undertaken under different assumptions about investors and about the
incentives of management, shareholders and debt holders. Examples of research in this area are Goldstein, Ju,
Leland (1998) and Hennessy and Whited (2004).Other The neutral mutation hypothesis—companies fall into
various habits of financing, which do not impact on value.

• Market timing hypothesis—capital structure is the outcome of the historical cumulative timing of the market
by managers.
• Accelerated investment effect—even in absence of agency costs, leveraged companies invest faster because
of the existence of default risk.
• Capital structure substitution theory—managements of public companies manipulate capital structure such
that earnings per share are maximized.
• In transition economies, there have been evidences reported unveiling significant impact of capital structure
on company performance, especially short-term debt such as the case of Vietnamese emerging market
economy.

Capital Gearing Ratio

• Capital bearing risk includes debentures (risk is to pay interest) and preference capital (risk to pay dividend at
fixed rate).
• Capital not bearing risk includes equity share capital. Therefore, we can also say,

Arbitrage

Similar questions are also the concern of a variety of speculator known as a capital structure arbitrageur, see
arbitrage. A capital structure arbitrageur seeks opportunities created by differential pricing of various
instruments issued by one corporation. Consider, for example, traditional bonds and convertible bonds. The
latter are bonds that are under contracted – for conditions, convertible into shares of equity. The stock option
component of a convertible bond has a calculable value in itself. The value of the whole instrument should be
the value of the traditional bonds plus the extra value of the option feature. If the spread (the difference
between the convertible and the non-convertible bonds) grows excessively, then the capital structure
arbitrageur will bet that it will converge.

The Debt Tax Shield

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One of the key assumptions made in the analysis above is that there are no taxes. In fact, governments claim
some of the cash flows in the form of taxes. Although tax laws differ from country to country, in most
countries, interest costs can be deducted as an expense. This discussion assumes that the tax code allows
deduction of interest costs as a business expense before computing taxes. Equity holders and debt holders are
not the only claimants to the cash flows of a company – the government is an additional claimant. The
government exercises its claim by taxing the company’s earnings. Payments to debt holders and equity holders
are taxed differently; interest payments to debt holders are tax-deductible, reducing a company’s taxable
income by the amount of the interest expense. Therefore, the amount of debt (and the corresponding interest
payments due) in a company’s capital structure reduces the government’s share of the company’s cash flows
and increases what is left for equity and debt holders.

Debt Capacity

In a market that is perfect, except for the existence of corporate taxes, the greatest value to a company would
result from a capital structure with 100% debt. In practice, however, companies do not hold 100% debt, or
anywhere near that percentage for the following reasons: Why Companies Do Not Hold 100% Debt?

Possible Bankruptcy

First, if a company goes bankrupt, it will no longer be able to utilize its tax shield from debt. As leverage
increases, the probability of financial distress increases, moderating the company’s incentives to add more
debt.

Additional Costs

There are additional costs of financial distress that also reduce a company’s incentive to increase leverage. For
example, when the company is in financial distress, it will incur various legal, accounting and administrative
expenses. Negative Action Various concerned parties will also react negatively.

• Creditors:

More importantly, creditors will raise their required interest rate to compensate for the higher risk of
bankruptcy.

• Stakeholders:

Other stakeholders in the company will also become increasingly worried as leverage increases, and take
actions that are likely to worsen the company’s situation.

• Employees:

For example, employees might start looking for other jobs because they do not want to work for a company
that might go bankrupt in the near future. Note that it is likely that the best employees are the ones to find new
jobs first.

• Customers:

Customers might also be worried about the survival of the company and its commitment to supply spare parts
in the future and the value of product warranties. These customers might decide to switch to another supplier.

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• Suppliers:

Finally, suppliers will be increasingly reluctant to trade on favorable credit terms as the probability of financial
distress increases.

Impact on Cash Flows

This discussion reflects another departure from the perfect market assumption of MM. Here, we see that in
reality, adding more debt to the capital structure of a company that is close to financial distress will
negatively impact the company’s future cash flows. Thus, in reality’ capital structure and future cash flows are
not independent (in contrast to the assumptions made by MM).

Flexibility

Another reason not to have a capital structure with 100% debt is the desire for flexibility that comes from
having cash on hand. Issuing new bonds or new shares is expensive. If a company is financially constrained, it
might be hard to obtain additional financing when a good investment opportunity arises, thereby limiting its
growth potential. This ‘opportunity cost’ must be considered as the company takes on additional amounts of
debt.

Covenants

Finally, a company might be limited in the amount of debt it can take on based on covenants (promises) in
existing debt contracts that prohibit companies from issuing debt beyond a certain level. The trade-off between
the tax advantage of debt financing and the disadvantage of financial distress costs results in a different optimal
debt level for each company. This Optimal debt level is often referred to as a company’s debt capacity. A
company’s debt capacity reflects the owner’s subjective willingness to bear risk; other owners may have the
desire or ability to take on more debt. In fact, according to some, this issue is the motivation behind some
mergers and acquisitions. If a company’s owners choose not to take on debt because they do not want to bear
the default risk, other potential owners or investors may see an arbitrage opportunity to buy the company and
increase its debt capacity.

Weighted Average Cost of Capital (WACC)

The WACC method allows analysts to value a company at any capital structure – that is, at any amount of debt
and equity – to determine a blended discount rate that reflects the relative shares of debt and equity in
the company. This blended discount rate is the WACC, and it is used to value the company’s expected future
cash flows. The WACC method can be used to value a company under either its current capital structure or
under a proposed or different structure. If you want to value a company at its current capital structure, the basic
WACC method is appropriate. However, you will often want to know if a greater valuation can be achieved by
increasing the debt ratio. In these cases, you must extend your analysis to consider WACC under changing debt
conditions. WACC declines as the per cent of debt in the capital structure increases because of the debt tax
shield. Also note that the return on assets is defined as the required rate of return on the company’s assets if the
company is 100% equity financed.

Focus on WACC

Let us consider the components of the equation in greater detail in the section below.

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Components of the WACC Formula

Return on Debt (Rd)

Return on debt (rd) is the expected return required by debt holders as compensation for the risk associated with
their debt claims. If you are evaluating a new investment project, the return on debt to use in the
WACC calculation is the cost of debt to the company if the company was to raise capital in the debt markets
today. You should not use the interest rate for debt that is already on the balance sheet. All other things equal,
the higher the percentage of debt on a company’s balance sheet, the greater the interest rate the company will
have to pay to debt holders. This is so because greater amounts of debt increase the default risk of the
company. In the figure, this is illustrated by a flat rd line for low and medium levels of debt, and an upward
sloping line for higher levels of debt. Return on Equity (Re) Return on equity (re) is the expected return
required by equity holders as compensation for the risk associated with their equity claims. The expected return
on equity can be determined by using the Capital Asset Pricing Model (CAPM) formula or any other asset
pricing relationship such as the Arbitrage Pricing Theory. Specifically, the CAPM measures risk of the equity
(through equity beta) and converts this risk measure into an expected return on equity, as shown in the
following formula.

Note that the equity beta will, other things held constant, be higher as the debt ratio increases because of the
increased risk of holding equity. This higher equity beta will yield an increased return on equity because of the
increased proportion of debt, a concept illustrated in the graph shown above. Also note that at high debt levels,
the slope of re as a function of the debt level is decreasing. The reason for this is that part of the increased risk
resulting from the increased debt level is borne by debt holders.

Equity (E)

Equity (E) is the market value of the equity. This amount can easily be determined by multiplying the number
of shares issued and outstanding by the current stock price.

Debt (D)

Debt (D) is the market value of the debt. In practice, we often assume that the market value of the debt is the
same as the book value. Sometimes, we can calculate the value of long-term debt by multiplying the number of
bonds outstanding by the market price. Short-term debt is determined by using the amount shown on the
balance sheet because it is due within one year. Companies often list the value of debt in the notes to their
financial statements. Remember, a company will generally issue debt up to its perceived debt capacity. Thus, it
is assumed in this course that the company is always operating at its current debt capacity.

Debt + Equity (D + E)

Debt + Equity (D + E) is equal to the market value of the company. Recall that D and E are the market values
of debt and equity, respectively. E is also referred to as the ‘equity value’ of the company.

Marginal Corporate Tax Rate

The marginal corporate tax rate (Tc) is used in determining WACC. In doing this, make sure that you count all
taxes that a company bears. For example, in the US, companies have a marginal federal tax rate of 35%; they

51
also have to bear state taxes. When considering state taxes, analysts often use a total marginal tax rate of 40%.
The marginal tax rate should be used instead of the average tax rate, because the tax deduction of interest
payments will take effect at the marginal rate (i.e., the rate at which the last dollar is taxed).

WACC under Changing Debt Conditions

As you have learned, the WACC method can be used to value a company atb its debt capacity. WACC is a
dynamic tool, however, and can also be used to value a company at any capital structure different from its
current one. Use of WACC under changing debt conditions differs from basic WACC in that it requires you to
estimate the cost of capital for a company or asset at an all-equity capital structure and then re-estimate your
calculations assuming a revised capital structure. In practice, using WACC under changing debt conditions
involves recalculating a company’s beta in a two step process. First, you must recalculate beta so that it reflects
an allequity capital structure. This is known as unleveraging beta. Second, you must recalculate beta at the new
capital structure, which is known as releveraging beta.

Financial Closure

Financial closure means that all the sources of funds required for the project have been tied up / have been
arranged. A key milestone in project implementation, financial closure may take a long time particularly
for infrastructure projects, because several things have to be sorted out to the project structure fundable. For
example, it took about three years to hammer out a in power purchase agreement to be signed by the
independent power producers with respective state electricity boards. In general, financial closure is achieved
soon when:

• Suitable credit enhancement is done to the satisfaction of lenders.

• Adequate underwriting arrangements are made for market-related offerings.
• The resourcefulness of the promoters is well established.
• The process is started early and concurrent appraisal is initiated if several lend agencies are involved.

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 PROJECT PLANNING, RISKS AND MANAGEMENT

Project Planning

The key to a successful project is in the planning. The first thing to do while undertaking any kind of project is
to create a Project Plan. Many times, project planning is ignored in favour of getting on with the work.
However, many people fail to realize the value of a project plan in saving time, money and many problems.

Step 1: Project Goals

A project is successful when the needs of the stakeholders have been met. A stakeholder is anybody directly, or
indirectly impacted by the project. As a first step, it is important to identify the stakeholders in your project. It
is not always easy to identify the stakeholders of a project, particularly those impacted indirectly. Examples of
stakeholders are:

• The project sponsor, financier

• The customer, end-user, dealers, intermediaries
• The project manager and project team.

Once you understand who the stakeholders are, the next step is to find out their needs. The best way to do this
is by conducting stakeholder interviews. Take time during the interviews to draw out the true needs that
create real benefits. Needs that aren’t relevant and don’t deliver benefits can be recorded and set as a low
priority.

The next step, once you have conducted all the interviews, and have a comprehensive list of needs is to
prioritize them. From the prioritized list, create a set of goals that can be easily measured. This way it will be
easy to know when a goal has been achieved. Once you have established a clear set of goals, they should be
recorded in the project plan. It can be useful to also include the needs and expectations of your stakeholders.
This is the most difficult part of the planning process completed. It’s time to move on and look at the project
deliverables.

Step 2: Project Deliverables

Using the goals you have defined, create a list of things the project needs to deliver in order to meet those
goals. Specify when and how each item must be delivered. Add the deliverables to the project plan with an
estimated delivery date. More accurate delivery dates will be established during the scheduling phase, which is
next.

Step 3: Project Schedule

Create a list of tasks that need to be carried out for each deliverable identified in Step 2. For each task, identify
the following:

• The amount of effort (hours or days) required to complete the task.

• The resource who will carryout the task.

Once you have established the amount of effort for each task, you can workout the effort required for each
deliverable, and an accurate delivery date. Update your deliverables section with the more accurate delivery

53
dates. At this point in the planning, you could choose to use a software package such as Primavera or Microsoft
Project (Gantt Charts) to create your project schedule. Alternatively, use one of the many free templates
available. Input all of the deliverables, tasks, durations and the resources who will complete each task. A
common problem discovered at this point, is when a project has an imposed delivery deadline from the sponsor
that is not realistic based on your estimates. If you discover this is the case, you must contact the
sponsor immediately. The options you have in this situation are:

• Renegotiate the deadline (project delay).

• Employ additional resources (increased cost).
• Reduce the scope of the project (less delivered).

Use the project schedule to justify pursuing one of these options.

Microsoft Projects and Primavera are two effective software programs designed to implement complex
projects.

Step 4: Supporting Plans

This section deals with plans you should create as part of the planning process. These can be included directly
in the plan.

Human Resource Plan

Identify by name, the individuals and organizations with a leading role in the project. For each, describe their
roles and responsibilities on the project.

Next, describe the number and type of people needed to carryout the project. For each resource detail start
dates, estimated duration and the method you will use for obtaining them.

Create a single sheet containing this information.

Communications Plan

Create a document showing who needs to be kept informed about the project and how they will receive the
information. The most common mechanism is a weekly or monthly progress report, describing how the
project is performing, milestones achieved and work planned for the next period.

Risk Management Plan

Risk management is an important part of project management. Although often overlooked, it is important to
identify as many risks to your project as possible, and be prepared if something bad happens.

Here are some examples of common project risks:

• Time and cost estimates too optimistic.

• Customer review and feedback cycle too slow.
• Lack of resource commitment.
• Unexpected budget cuts.
• Unclear roles and responsibilities.

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• Stakeholders input is not sought, or their needs are not properly understood.
• Stakeholders changing requirements after the project has started.
• Stakeholders adding new requirements after the project has started.
• Poor communication resulting in misunderstandings, quality problems and rework.

Risks can be tracked using a simple risk log. Add each risk you have identified to your risk log; write down
what you will do in the event it occurs, and what you will do to prevent it from occurring. Review your risk log
on a regular basis, adding new risks as they occur during the life of the project. Remember, when risks are
ignored they don’t go away.

Project Risk Management

Project Risk Management is an important aspect of project management. Project Risk Management is one
areas in which a project manager must be competent. Project risk is ‘an uncertain event or condition that, if it
occurs,
has a positive or negative effect on a project’s objectives’. Good Project Risk Management depends on
supporting organizational factors, clear roles and responsibilities, and technical analysis skills.
Project risk management in its entirety, includes the following six process groups:

1. Planning risk management

2. Risk identification
3. Performing qualitative risk analysis
4. Performing quantitative risk analysis
5. Planning risk responses
6. Monitoring and controlling risks.

Project Risk Management is the identification, assessment, and prioritization of risks followed by coordinated
and economical application of resources to minimize, monitor, and control the probability and/or impact
of unfortunate events or to maximize the realization of opportunities. It will reap great rewards for an
organization. If uncertainties in a project are taken care of or removed, it will result in timely completion of
projects in the estimated budgets. Also, all threats and firefighting will be removed.

Project Management using Work Breakdown Structure (WBS)

The Work Breakdown Structure, usually shortened to WBS, is a tool project managers use to break projects
down into manageable pieces. It is the start of the planning process and is often called the ‘foundation’ of
project planning. Most project professionals recognize the importance and benefits of a WBS in outperforming
projects without one.

What is a WBS?

A WBS is a hierarchical decomposition of the deliverables needed to complete a project. It breaks the
deliverables down into manageable work packages that can be scheduled, costed and have resources assigned
to
them. As a rule, the lowest level should be two-week work packages. Another rule commonly used when
creating a WBS is the 8/80 rule. This says no single activity should be less than 8 hours, or greater than 80
hours.

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A WBS is deliverables based; meaning the product or service the customer will get when the project is
finished. There is another tool called a Product Breakdown Structure (PBS), which comes before the WBS and
breaks a
project down into outputs (products) needed to complete the project.

Why Create a WBS?

These are some of the benefits of a WBS:

• Provides a solid foundation for planning and scheduling.

• Breaks down projects into manageable work packages.
• Provides a way to estimate project costs accurately.
• Makes sure no important deliverables are forgotten.
• Helps project managers with resource allocation.
• Provides a proven and repeatable approach to planning projects.
• Provides an ideal tool for team brainstorming and for promoting team cohesion.

WBS Inputs

There are three inputs to the WBS process:

1. Project Scope Statement: Detailed description of the project’s deliverables and work needed to create them.
2. Statement of Requirements: Document detailing the business need for the project and what will be delivered
in detail.
3. Organizational Process Assets: The organization’s policies, procedures, guidelines, templates, plans, lessons
learned, etc.
These items give you and your team all the information needed to create the WBS. You’ll also need a WBS
template.

WBS Outputs

There are four outputs from the WBS process:

1. Work Breakdown Structure (WBS): Del iverables based decomposition of the total project scope.
2. WBS Dictionary: Accompanying document describing each WBS element.
3. Scope Baseline: The Project Scope Statement, WBS and WBS Dictionary.
4. Project Documentation Updates: Changes and additions to project documentation.

How to Create a WBS?

A WBS is easy to create. Once the aims and objectives of the project are understood, a meeting can be
arranged where the project team breaks down the deliverables needed to complete the project. Creation is best
done as a team exercise. This helps engage your team and gives them an
emotional stake in the project. It’s a good idea to involve your stakeholders
at this point.
There are two formats in which the WBS can be expressed, tabular form and graphical form. The tabular form
can be created in a spreadsheet; numbering each level and sub-level. The graphical form can be created
using drawing software, creating a tree style diagram. Either form starts with the project name as its first level.
Then all the top-level deliverables are added. Remember, at the second level, you are looking to

56
identify everything needed to complete the project. Break down each second level deliverable until you reach
work packages of no less than two weeks. As a general rule, two-week work packages are
manageable. You might also consider the 8/80 rule at this point. It is up to the team how each item is broken
down; there are no rules that definethis, and it will reflect the style of the team creating the WBS. It’s
important to note that activities and tasks are not included in a WBS, these are planned out from the work
packages later. Check no major areas or deliverables have been missed, and you’ve only included the work
needed to complete your project successfully. Your WBS should contain the complete project scope, including
the project management work packages. Conducting the WBS creation as a team
exercise helps make sure nothing is forgotten. This level of decomposition makes it easy to cost each work
package and arrive at an accurate cost for the project. Similarly, people can be assigned
to the work packages; however, you may prefer to add the skills needed for the work packages and leave the
people allocation until you create your schedule, when you can see the timeline. The next step is to transfer
your WBS output into a project schedule, typically a Gantt chart. Expand the work packages with the activities
and tasks needed to complete them. The Gantt chart is used to track progress across time of the work packages
identified in your WBS.

Why Projects Fail?

In a perfect world, every project would be “on time and within budget.” But reality (especially the proven
statistics) tells a very different story. It is not uncommon for projects to fail. Even if the budget and schedule
are met,one must ask “did the project deliver the results and quality we expected?” True project success must
be evaluated on all three components.

Otherwise, a project could be considered a “failure.”

Have you ever seen a situation where projects begin to show signs of disorganization, appear out of control,
and have a sense of doom and failure? Have you witnessed settings where everyone works in a silo and no one
seems to know what the other team member is doing? What about team members who live by the creed “I’ll do
my part (as I see fit) and after that, it’s their problem.” Even worse is when team members resort to finger
pointing. Situations similar to these scenarios point to a sign that reads “danger.” And if you read the fine print
under the word “danger” it reads, “your project needs to be brought under control or else it could fail.” When
projects begin to show signs of stress and failure, everyone looks to the project manager for answers. It may
seem unfair that the burden of doom falls upon a single individual. But this is the reason why you chose to
manage projects for a living! You’ve been trained to recognize and deal with these types of situations.
There are many reasons why projects (both simple and complex) fail; the number of reasons can be infinite.
However, if we apply the 80/20 rule, the most common reasons for failure can be found in the following list:

1. Undefined objectives and goals

2. Poorly managed
3. Lack of management commitment
4. Lack of a solid project plan
5. Lack of user input
6. Lack of organizational support
7. Centralized proactive management initiatives to combat project risk
8. Enterprise management of budget resources
9. Provides universal templates and documentation
10.Poorly defined roles and responsibilities
11.Inadequate or vague requirements

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12.Stakeholder conflict
13.Team weaknesses
14.Unrealistic timeframes and tasks
15.Competing priorities
16.Poor communication
17.Insufficient resources (funding and personnel)
18.Business politics
19.Overruns of schedule and cost
20.Estimates for cost and schedule are erroneous
21.Lack of prioritization and project portfolio management
22.Scope creep
23.No change control process
24.Meeting end-user expectations
25.Ignoring project warning signs
26.Inadequate testing processes
27.Bad decisions

Even with the best of intentions or solid plans, project can go awry if they are not managed properly. All too
often, mishaps can occur. This is when the project manager must recognize a warning sign and take action. If
you understand the difference between symptoms and problems and can spot warning signs of project failure, it
will help you take steps to right the ship before it keels over. Yes, it’s the project manager’s responsibility to
correct the listing no one else. In addition to applying the processes and principles taught in project
management class, you can also use your personal work skills of communication, management, leadership,
conflict resolution, and diplomacy to take corrective action .During the course of managing a project, the
project manager must monitor activities (and distractions) from many sources and directions. Complacency can
easily set in. When this happens, the process of “monitoring” breaks down. This is why the project manager
must remain in control of a project and be aware of any activity which presents a risk of project failure.

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 PROJECT QUALITY ASSURANCE AND AUDIT

Project Quality Management

The Quality Management Plan defines the acceptable level of quality, which is typically defined by the
customer, and describes how the project will ensure this level of quality in its deliverables and work processes.

Quality management activities ensure that:

• Products are built to meet agreed-upon standards and requirements.

• Work processes are performed efficiently and as documented.
• Non-conformances found are identified and appropriate corrective action is taken.

Quality Management plans apply to project deliverables and project work processes. Quality control activities
monitor and verify that project deliverables meet defined quality standards. Quality assurance activities
monitor and verify that the processes used to manage and create the deliverables are followed and are effective.

Quality Plan Components

The Quality Management Plan describes the following quality management components:
1. Quality objectives
2. Key project deliverables and processes to be reviewed for satisfactory quality level
3. Quality standards
4. Quality control and assurance activities
5. Quality roles and responsibilities
6. Quality tools
7. Plan for reporting quality control and assurance problems

Rationale/Purpose

The purpose of developing a quality plan is to elicit the customer’s expectations in terms of quality and prepare
a proactive quality management plan to meet those expectations. The Quality Management Plan helps the
project manager determine if deliverables are being produced to an acceptable quality level and if the
project processes used to manage and create the deliverables are effective and properly applied.

Who is Involved?

1. Project Manager
2. Project Team
3. Customer
4. Project Sponsor

Project Audit

A Project Audit involves comparing actual results with predicted results and explaining the differences, if any.
The post-audit serves three purposes:

1. Improvement of forecasts
2. Improvement in operations

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3. Identification of termination opportunities.

It provides an opportunity to uncover issues, concerns and challenges encountered during the project life cycle.
Conducted midway through the project, an audit affords the project manager, project sponsor and project
team an interim view of what has gone well, as well as what needs to be improved to successfully complete the
project. If done at the close of a project, the audit can be used to develop success criteria for future projects by
providing a forensic review. This review identifies which elements of the project were successfully managed
and which ones presented challenges. As a result, the review will help the organization identify what it needs
to do to avoid repeating the same mistakes on future projects. Regardless of whether the project audit is
conducted mid-term on a project or at its conclusion, the process is similar. It is generally recommended
that an outside facilitator conduct the project audit. This ensures confidentiality, but also allows the team
members and other stakeholders to be candid. They know that their input will be valued and the final report
will not identify individual names, only facts. Often, individuals involved in a poorly managed project will find
that speaking with an outside facilitator during a project audit allows them to openly express their emotions
and feelings about their involvement in the project and/or the impact the project has had on them. This
“venting” is an important part of the overall audit.

A successful project audit consists of three phases:

1. Success Criteria, Questionnaire, and Audit Interview Development.

2. In-depth Research.
3. Report Development.

Phase 1: Success Criteria, Questionnaire and Audit Interview Development

1. Success Criteria Development

Interview the core project sponsor and project manager to determine their “success criteria” for the project
audit and find out what they expect to gain from the audit. This ensures that their individual and collective
needs are met.

2. Questionnaire Development

Develop a questionnaire to be sent to each member of the core project team and to selected stakeholders.
Often, individuals will complete the questionnaire in advance of an interview because it helps them to gather
and focus their thoughts. The actual interview will give the facilitator the opportunity to gain deeper insights
into the team member’s comments. The questionnaire simply serves as a catalyst for helping team members
and stakeholders reflect on the project’s successes, failures, challenges and missed opportunities.

3. Audit Interview Questions

There are many questions that can be asked in an audit interview. It is most effective, however, to develop
open-ended questions, i.e., questions that cannot be answered with a simple “yes” or “no.” Develop interview
questions that will help identify the major project successes; the major project issues, concerns and challenges;
how the team worked together; how vendors were managed; how reporting and meetings were handled;
how risk and change were managed, etc. Questionnaires can be used for team members and/or other
stakeholders who are unable to attend an interview.

Phase 2: In-depth Research

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1. Conduct individual research interviews with the project sponsor, project manager and project team members
to identify past, current and future issues, concerns, challenges and opportunities.

2. Conduct individual research interviews with stakeholders, including vendors, suppliers, contractors, other
internal and external project resources and selected customers.

3. Assess the issues, challenges and concerns in more depth to discover

the root causes of any problems.

4. Review all historical and current documentation related to the project, including team structure, scope
statement, business requirements, project plan, milestone reports, meeting minutes, action items, risk logs,
issue logs and change logs.

5. Review the project plan to determine how the vendor plan has been incorporated into the overall project
plan.

6. Interview selected stakeholders to identify and determine their initial expectations for the project and
determine to what extent their expectations have been met.

7. Review the project quality management and the product quality management to identify issues, concerns and
challenges in the overall management of the project. Identify any opportunities that can be realized through
improvements to the attention of project and product quality.

8. Identify any lessons learned that could improve the performance of future projects within the organization.

Phase 3: Report Development

1. Compile the information collected from all of the interviews.

2. Compile the information collected from individuals who only completed the questionnaire.
3. Consolidate the findings from the project documentation review.
4. Identify the issues, concerns and challenges presented through the review of the project quality management
and product quality management plans and isolate the opportunities you believe may be realized.
5. Identify all of the project’s issues, concerns and challenges.
6. Identify all of the project’s opportunities that can be realized through the report’s recommendations.
7. Identify the lessons learned that can improve the performance of future projects within the organization.
8. Finalize the creation of the report and recommendations based on the findings and present the detailed report
and recommendations, including a road map to get future projects to the “next level” of performance.

Conclusion

The purpose of a project audit is to identify lessons learned that can help improve the performance of a project
or improve the performance of future projects by undertaking a forensic review to uncover problems to be
avoided. In this way, project audits are highly beneficial to the organization and provide the following
outcomes:

• Development of lessons learned on the project that can be applied to both the organization and its vendors.
• Development of strategies which, if implemented within the organization, will increase the likelihood of
future projects being managed successfully.

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• Development of strategies which, if implemented within the organization, will increase the likelihood of
change initiatives being managed successfully.
• Development of project success criteria which might include on-time, onbudget, meeting customer and other
stakeholder requirements, transition to next phase successfully executed, etc.
• Recognition of risk management so that risk assessment and the development of associated contingency plans
becomes commonplace within the organization.
• Development of change management success criteria which might include how staff are involved, how
customers are impacted, how the organization is impacted, transition to next level of change to be
initiated, etc.
• Development of criteria that will continue the improvement of relationships between the organization and its
vendors, suppliers and contractors regarding the management of projects.
• Application of the lessons learned on the project to future projects within the organization.

II. Executive Summary

Include everything that you would cover in a five-minute interview. Explain the fundamentals of the proposed
business: What will your product be? Who will your customers be? Who are the owners? What do you think
the future holds for your business and your industry? Make it enthusiastic, professional, complete, and concise.
If applying for a loan, state clearly how much you want, precisely how you are going to use it, and how the
money will make your business more profitable, thereby ensuring repayment.
……………………………………………………………………………………………………………………
……
III. General Company Description

Mission Statement:

Many companies have a brief mission statement, usually in 30 words or fewer, explaining their reason for
being and their guiding principles. If you want to draft a mission statement, this is a good
place to put it in the plan, followed by: Company Goals and Objectives: Goals are destinations—where you
want your business to be. Objectives are progress markers along the way to goal achievement. For example, a
goal might be to have a healthy, successful company that is a leader in customer service and that has a
loyal customer following. Objectives might be annual sales targets and some specific measures of customer
satisfaction.

Business Philosophy:

What is important to you in business?

To whom will you market your products? (State it briefly here—you will do a more thorough explanation in
the Marketing Plan section).

Describe your industry.

Is it a growth industry? What changes do you foresee in the industry, short term and long term? How will your
company be poised to take advantage of them? Describe your most important company strengths and core
competencies. What factors will make the company succeed? What do you think your major competitive
strengths will be? What background experience, skills, and strengths do you personally bring to this new
venture?

Legal Form of Ownership:

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Sole proprietor, Partnership, Corporation, Limited Liability Corporation (LLC)? Why have you selected this
form?
……………………………………………………………………………………………………………………
……
IV. Products and Services

Describe in depth your products or services (technical specifications, drawings, photos, sales brochures, and
other bulky items belong in Appendices).
What factors will give you competitive advantages or disadvantages? Examples include level of quality or
unique or proprietary features. What are the pricing, fee, or leasing structures of your products or
services?
……………………………………………………………………………………………………………………

V. Marketing Plan

Market Research – Why?

No matter how good your product and your service, the venture cannotsucceed without effective marketing.
And this begins with careful, systematic research. It is very dangerous to assume that you already know
about your intended market. You need to do market research to make sure you’re on track. Use the business
planning process as your opportunity to uncover data and to question your marketing efforts. Your time will be
well spent.

Market Research – How?

There are two kinds of market research: primary and secondary. Secondary research means using published
information such as industry profiles, trade journals, newspapers, magazines, census data, and
demographic profiles. This type of information is available in public libraries, industry associations, chambers
of commerce, from vendors who sell to your industry, and from government agencies. Start with your local
library. Most librarians are pleased to guide you through their business data collection. You will be amazed at
what is there. There are more online sources than you could possibly use. Your chamber of commerce has
good information on the local area. Trade associations and trade publications often have excellent industry-
specific data. Primary research means gathering your own data. For example, you could do your own traffic
count at a proposed location, use the yellow pages to identify competitors, and do surveys or focus group
interviews to learn about consumer preferences. Professional market research can be very costly, but there are
many books that show small business owners how to do effective research themselves. In your marketing plan,
be as specific as possible; give statistics, numbers, and sources. The marketing plan will be the basis, later on,
of the all-important sales projection.

Economics

Facts about your industry:

• What is the total size of your market?

• What per cent share of the market will you have? (This is important only if you think you will be a major
factor in the market.)
• Current demand in target market.
• Trends in target market—growth trends, trends in consumer preferences, and trends in product development.
• Growth potential and opportunity for a business of your size.

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• What barriers to entry do you face in entering this market with your new company? Some typical barriers are:

○ High capital costs

○ High production costs
○ High marketing costs
○ Consumer acceptance and brand recognition
○ Training and skills
○ Unique technology and patents
○ Unions
○ Shipping costs
○ Tariff barriers and quotas

• And of course, how will you overcome the barriers?

• How could the following affect your company?

○ Change in technology
○ Change in government regulations
○ Change in the economy
○ Change in your industry

Product

In the Products and Services section, you described your products and services as you see them. Now describe
them from your customers’ point of view.

Features and Benefits

List all of your major products or services. For each product or service:
• Describe the most important features. What is special about it?
• Describe the benefits. That is, what will the product do for the customer?

Note the difference between features and benefits, and think about them. For example, a house that gives
shelter and lasts a long time is made with certain materials and to a certain design; those are its features. Its
benefits include pride of ownership, financial security, providing for the family, and inclusion in a
neighborhood. You build features into your product so that you can sell the benefits. What after-sale services
will you give? Some examples are delivery, warranty, service contracts, support, follow-up, and refund policy.
Customers Identify your targeted customers, their characteristics, and their geographic locations, otherwise
known as their demographics. The description will be completely different depending on whether you plan
to sell to other businesses or directly to consumers. If you sell a consumer product, but sell it through a channel
of distributors, wholesalers, and retailers, you must carefully analyze both the end consumer and the
middleman businesses to which you sell. You may have more than one customer group. Identify the most
important groups. Then, for each customer group, construct what is called a demographic profile:

• Age
• Gender
• Location
• Income level
• Social class and occupation
• Education

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• Other (specific to your industry)

For business customers, the demographic factors might be:

• Industry (or portion of an industry)

• Location
• Size of company
• Quality, technology, and price preferences
• Other (specific to your industry)

NCIER

Competition

What products and companies will compete with you? List your major competitors: (Names and addresses)
Will they compete with you across the board, or just for certain products, certain customers, or in certain
locations?

Will you have important indirect competitors? (For example, video rental stores compete with theaters,
although they are different types of businesses.)

How will your products or services compare with the competition?

Use the Competitive Analysis table below to compare your company with your two most important
competitors. In the first column are key competitive factors. Since these vary from one industry to another, you
may want to customize the list of factors. In the column labeled Me, state how you honestly think you will
stack up in customers’ minds. Then check whether you think this factor will be a strength or a weakness for
you. Sometimes, it is hard to analyze our own weaknesses. Try to be very honest here. Better yet, get some
disinterested strangers to assess you. This can be a real eye-opener. And remember that you cannot be all
things to all people. In fact, trying to be causes many business failures because efforts become scattered and
diluted. You want an honest assessment of your company’s strong and weak points. Now, analyze each major
competitor. In a few words, state how you think they compare. In the final column, estimate the importance of
each competitive factor to the customer. 1 = critical; 5 = not very important.

Niche

Now that you have systematically analyzed your industry, your product, your customers, and the competition,
you should have a clear picture of where your company fits into the world. In one short paragraph, define your
niche, your unique corner of the market.

Strategy

Now outline a marketing strategy that is consistent with your niche.

Promotion

How will you get the word out to customers?

Advertising

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What media, why, and how often? Why this mix and not some other?
Have you identified low-cost methods to get the most out of your

promotional budget?

Will you use methods other than paid advertising, such as trade shows, catalogs, dealer incentives, word-of-
mouth (how will you stimulate it?),and network of friends or professionals? What image do you want to
project? How do you want customers to see you? In addition to advertising, what plans do you have for graphic
image support? This includes things like logo design, cards and letterhead, brochures, signage, and interior
design (if customers come to your place of business). Should you have a system to identify repeat customers
and then systematically contact them?

Promotional Budget

How much will you spend on the items listed above? Before start-up? (These numbers will go into your startup
budget.) Ongoing? (These numbers will go into your operating plan budget.)

Pricing

Explain your method or methods of setting prices. For most small businesses, having the lowest price is not a
good policy. It robs you of needed profit margin; customers may not care as much about price as you think;
and large competitors can underprice you anyway. Usually, you will do better to have average prices and
compete on quality and service.

Does your pricing strategy fit with what was revealed in your competitive
analysis?

Compare your prices with those of the competition. Are they higher, lower,
the same? Why?

How important is price as a competitive factor? Do your intended

customers really make their purchase decisions mostly on price?

What will be your customer service and credit policies?

Proposed Location

Probably, you do not have a precise location picked out yet. This is the time
to think about what you want and need in a location. Many start-ups run
successfully from home for a while.
You will describe your physical needs later, in the Operational Plan section.
Here, analyze your location criteria as they will affect your customers.
Is your location important to your customers? If yes, how?
If customers come to your place of business:
Is it convenient? Parking? Interior spaces? Not out of the way?
Is it consistent with your image?
Is it what customers want and expect?
Where is the competition located? Is it better for you to be near them (like

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car dealers or fast-food restaurants) or distant (like convenience food stores)?

Distribution Channels

How do you sell your products or services?

Retail

Direct (mail order, Web, catalog)

Wholesale

Your own sales force

Agents

Independent representatives

Bid on contracts

Sales Forecast

Now that you have described your products, services, customers, markets, and marketing plans in detail, it’s
time to attach some numbers to your plan. Use a sales forecast spreadsheet to prepare a month-by-month
projection. The forecast should be based on your historical sales, the marketing strategies that you have just
described, your market research, and industry data, if available. You may want to do two forecasts: (1) a “best
guess”, which is what you really expect, and (2) a “worst case” low estimate that you are confident you can
reach no matter what happens. Remember to keep notes on your research and your assumptions as you
build this sales forecast and all subsequent spreadsheets in the plan. This is critical if you are going to present it
to funding sources.
……………………………………………………………………………………………………………………
……
Operational Plan

Explain the daily operation of the business, its location, equipment, people, processes, and surrounding
environment.

Production

How and where are your products or services produced?

Explain your methods of:

• Production techniques and costs

• Quality control
• Customer service
• Inventory control
• Product development

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Location

What qualities do you need in a location? Describe the type of location you’ll have.

Physical requirements:

• Amount of space
• Type of building
• Zoning
• Power and other utilities

Access:

Is it important that your location be convenient to transportation or to suppliers?

Do you need easy walk-in access?

What are your requirements for parking and proximity to freeway, airports, railroads, and shipping centers?
Include a drawing or layout of your proposed facility if it is important, as it might be for a manufacturer.
Construction: Most new companies should not sink capital into construction, but if you are planning to build,
costs and specifications will be a big part of your plan.

Cost:

Estimate your occupation expenses, including rent, but also including maintenance, utilities, insurance, and
initial remodeling costs to make the space suit your needs. These numbers will become part of your financial
plan. What will be your business hours?

Legal Environment

Describe the following:

• Licensing and bonding requirements

• Permits
• Health, workplace, or environmental regulations
• Special regulations covering your industry or profession
• Zoning or building code requirements
• Insurance coverage
• Trademarks, copyrights, or patents (pending, existing, or purchased) Personnel
• Number of employees
• Type of labor (skilled, unskilled, and professional)
• Where and how will you find the right employees?
• Quality of existing staff
• Pay structure
• Training methods and requirements
• Who does which tasks?
• Do you have schedules and written procedures prepared?
• Have you drafted job descriptions for employees? If not, take time to write some. They really help internal
communications with employees.

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• For certain functions, will you use contract workers in addition to employees? Inventory
• What kind of inventory will you keep: raw materials, supplies, finished goods?
• Average value in stock (i.e., what is your inventory investment)?
• Rate of turnover and how this compares to the industry averages?
• Seasonal buildups?
• Lead time for ordering?

Suppliers

Identify key suppliers:

• Names and addresses

• Type and amount of inventory furnished
• Credit and delivery policies
• History and reliability Should you have more than one supplier for critical items (as a backup)?
Do you expect shortages or short-term delivery problems? Are supply costs steady or fluctuating? If
fluctuating, how would you deal with changing costs?

Credit Policies

• Do you plan to sell on credit?

• Do you really need to sell on credit? Is it customary in your industry and expected by your clientele?
• If yes, what policies will you have about who gets credit and how much?
• How will you check the creditworthiness of new applicants?
• What terms will you offer your customers; that is, how much credit and when is payment due?
• Will you offer prompt payment discounts? (Hint: Do this only if it is usual and customary in your industry.)
• Do you know what it will cost you to extend credit? Have you built the costs into your prices?

Managing Your Accounts Receivable

If you do extend credit, you should do an aging at least monthly to track how much of your money is tied up in
credit given to customers and to alert you to slow payment problems.

You will need a policy for dealing with slow paying customers:

• When do you make a phone call?

• When do you send a letter?
• When do you get your attorney to threaten?

Managing Your Accounts Payable

You should also age your accounts payable, what you owe to your suppliers. This helps you plan whom to pay
and when. Paying too early depletes your cash, but paying late can cost you valuable discounts and can damage
your credit. (Hint: If you know you will be late making a payment, call the creditor before the due date.)
Do your proposed vendors offer prompt payment discounts? A payables aging looks like the following table.

Management and Organization

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Who will manage the business on a day-to-day basis? What experience does that person bring to the business?
What special or distinctive competencies? Is there a plan for continuation of the business if this
person is lost or incapacitated? If you’ll have more than 10 employees, create an organizational chart
showing the management hierarchy and who is responsible for key functions. Include position descriptions for
key employees. If you are seeking loans or investors, include resumes of owners and key employees.

Professional and Advisory Support

List the following:

• Board of directors
• Management advisory board
• Attorney
• Accountant
• Insurance agent
• Banker
• Consultant/s
• Mentor and Key Advisors

VIII. Personal Financial Statement

Include personal financial statements for each owner and major stockholder, showing assets and liabilities held
outside the business and personal net worth. Owners will often have to draw on personal assets to finance the
business, and these statements will show what is available. Bankers and investors usually want this information
as well.

IX. Start-up Expenses and Capitalization

You will have many expenses before you even begin operating your business. It’s important to estimate these
expenses accurately and then to plan where you will get sufficient capital. This is a research project, and
themore thorough your research efforts, the less chance that you will leave out important expenses or
underestimate them .Even with the best of research, however, opening a new business has away of costing
more than you anticipate. There are two ways to make allowances for surprise expenses. The first is to add a
little “padding” to each item in the budget. The problem with that approach, however, is that
it destroys the accuracy of your carefully wrought plan. The second approach is to add a separate line item,
called contingencies, to account for the unforeseeable. This is the approach we recommend. Talk to others who
have started similar businesses to get a good idea of how much to allow for contingencies. If you cannot get
good information, we recommend a rule of thumb that contingencies should equal at least 20% of the total of
all other start-up expenses. Explain your research and how you arrived at your forecasts of expenses.
Give sources, amounts, and terms of proposed loans. Also explain in detail how much will be contributed by
each investor and what per cent ownership each will have.

X. Financial Plan

The financial plan consists of a 12-month profit and loss projection, a fouryear profit and loss projection
(optional), a cash flow projection, a projected balance sheet, and a break-even calculation. Together they
constitute a reasonable estimate of your company’s financial future. More important, the process of thinking
through the financial plan will improve your insight into the inner financial workings of your company.

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12-Month Profit and Loss Projection

Many business owners think of the 12-month profit and loss projection as the centerpiece of their plan. This is
where you put it all together in numbers and get an idea of what it will take to make a profit and be
successful. Your sales projections will come from a sales forecast in which you forecast sales, cost of goods
sold, expenses, and profit month-by-month for one
year.

Profit

projections should be accompanied by a narrative explaining the major assumptions used to estimate company
income and expenses.

Research Notes:

Keep careful notes on your research and assumptions, so that you can explain them later if necessary, and also
so that you can go back to your sources when it’s time to revise your plan.

Four-year Profit Projection (Optional)

The 12-month projection is the heart of your financial plan. This section is for those who want to carry their
forecasts beyond the first year. Of course, keep notes of your key assumptions, especially about things that you
expect will change dramatically after the first year.

Projected Cash Flow

If the profit projection is the heart of your business plan, cash flow is the blood. Businesses fail because they
cannot pay their bills. Every part of your business plan is important, but none of it means a thing if you run out
of cash.

The point of this worksheet is to plan how much you need before start-up, for preliminary expenses, operating
expenses, and reserves. You should keep updating it and using it afterward. It will enable you to foresee
shortages in time to do something about them—perhaps cut expenses, or perhaps negotiate a loan. But
foremost, you shouldn’t be taken by surprise. There is no great trick to preparing it: The cash flow projection is
just a forward look at your checking account. For each item, determine when you actually expect to receive
cash (for sales) or when you will actually have to write a check (for expense items). You should track essential
operating data, which is not necessarily part of cash flow but allows you to track items that have a heavy
impact on cash flow, such as sales and inventory purchases. You should also track cash outlays prior to
opening in a pre-start-up column. You should have already researched those for your start-up expenses plan.
Your cash flow will show you whether your working capital is adequate. Clearly, if your projected cash
balance ever goes negative, you will need more start-up capital. This plan will also predict just when and how
much you will need to borrow. Explain your major assumptions, especially those that make the cash flow
differ from the Profit and Loss Projection. For example, if you make a sale in month one, when do you actually
collect the cash? When you buy inventory or materials, do you pay in advance, upon delivery, or much later?
How will this affect cash flow? Are some expenses payable in advance? When? Are there irregular expenses,
such as quarterly tax payments, maintenance and repairs, or seasonal inventory buildup, that should be
budgeted? Loan payments, equipment purchases, and owner's draws usually do not
show on profit and loss statements but definitely do take cash out. Be sure
to include them.

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And of course, depreciation does not appear in the cash flow at all because you never write a check for it.

Opening Day Balance Sheet

A balance sheet is one of the fundamental financial reports that any business needs for reporting and financial
management. A balance sheet shows what items of value are held by the company (assets), and what its debts
are (liabilities). When liabilities are subtracted from assets, the remainder is owners’ equity. Use a start-up
expenses and capitalization spreadsheet as a guide to preparing a balance sheet as of opening day. Then detail
how you calculated the account balances on your opening day balance sheet.

Optional: Some people want to add a projected balance sheet showing the estimated financial position of the
company at the end of the first year. This is especially useful when selling your proposal to investors.

Break-Even Analysis

A break-even analysis predicts the sales volume, at a given price, required to recover total costs. In other
words, it’s the sales level that is the dividing line between operating at a loss and operating at a profit.
Expressed as a formula, break-even is: (where, fixed costs are expressed in dollars, but variable costs are
expressed as a per cent of total sales.) Include all assumptions upon which your break-even calculation is based

Appendices

Include details and studies used in your business plan; for example:

• Brochures and advertising materials

• Industry studies
• Blueprints and plans
• Maps and photos of location
• Magazine or other articles
• Detailed lists of equipment owned or to be purchased
• Copies of leases and contracts
• Letters of support from future customers
• Any other materials needed to support the assumptions in this plan
• Market research studies
• List of assets available as collateral for a loan

Refining the Plan

The generic business plan presented above should be modified to suit your specific type of business and the
audience for which the plan is written.

For Raising Capital

For Bankers

• Bankers want assurance of orderly repayment. If you intend using this plan to present to lenders, include:
๏ Amount of loan
๏ How the funds will be used
๏ What this will accomplish—how will it make the business stronger?
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๏ Requested repayment terms (number of years to repay). You will probably not have much negotiating room
on interest rate but may be able to negotiate a longer repayment term, which will help cash flow.
๏ Collateral offered, and a list of all existing liens against collateral.

For Investors

• Investors have a different perspective. They are looking for dramatic growth, and they expect to share in the
rewards:
๏ Funds needed short-term
๏ Funds needed in two to five years
๏ How the company will use the funds, and what this will accomplish form growth
๏ Estimated return on investment
๏ Exit strategy for investors (buyback, sale, or IPO)
๏ Percent of ownership that you will give up to investors
๏ Milestones or conditions that you will accept
๏ Financial reporting to be provided
๏ Involvement of investors on the board or in management

For Type of Business

Manufacturing

• Planned production levels

• Anticipated levels of direct production costs and indirect (overhead) costs
—how do these compare to industry averages (if available)?
• Prices per product line
• Gross profit margin, overall and for each product line
• Production/capacity limits of planned physical plant
• Production/capacity limits of equipment
• Purchasing and inventory management procedures
• New products under development or anticipated to come online after start-up

Service Businesses

• Service businesses sell intangible products. They are usually more flexible than other types of businesses, but
they also have higher labor costs and generally very little in fixed assets
• What are the key competitive factors in this industry?
• Your prices
• Methods used to set prices
• System of production management
• Quality control procedures. Standard or accepted industry quality standards
• How will you measure labor productivity?
• Per cent of work subcontracted to other companies. Will you make a profit on subcontracting?
• Credit, payment, and collections policies and procedures
• Strategy for keeping client base

High Technology Companies

• Economic outlook for the industry

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• Will the company have information systems in place to manage rapidly changing prices, costs, and markets?
• Will you be on the cutting edge with your products and services?
• What is the status of research and development? And what is required to:

○ Bring product/service to market?

○ Keep the company competitive?

• How does the company:

○ Protect intellectual property?

○ Avoid technological obsolescence?
○ Supply necessary capital?
○ Retain key personnel?

High-tech companies sometimes have to operate for a long time without profits and sometimes even without
sales. If this fits your situation, a banker probably will not want to lend to you. Venture capitalists may
invest, but your story must be very good. You must do longer-term financial forecasts to show when profit
take-off is expected to occur. And your assumptions must be well documented and well argued.

Retail Business

• Company image
• Pricing:○ Explain mark-up policies.
○ Prices should be profitable, competitive, and in accordance with company image.
• Inventory:
○ Selection and price should be consistent with company image.
• Inventory level: Find industry average numbers for annual inventory turnover rate (available in RMA book).
Multiply your initial inventory investment by the average turnover rate. The result should be at least
equal to your projected first year’s cost of goods sold. If it is not, you may not have enough budgeted for
startup inventory.
• Customer service policies: These should be competitive and in accord with company image.
• Location: Does it give the exposure that you need? Is it convenient for customers? Is it consistent with
company image?
• Promotion: Methods used, cost. Does it project a consistent company image?
• Credit: Do you extend credit to customers? If yes, do you really need to, and do you factor the cost into
prices?

______________________________________Thank You_______________________________________

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